February 12
Should pensions take all the credit for insolvency?

In response to a question about private sector pension schemes and their ranking in the creditor chain asked in the House of Commons on 22 January, the Secretary of State for Work and Pensions, Esther McVey, said that it is an important issue that “needs to be brought forward under the governance rules for pensions.” So what are the current rules and how might they change?

UK insolvency law dictates that in insolvency and liquidation, the creditors are broadly dealt with in the following order:
1.     Fixed charge creditors
2.     Expenses of the insolvency proceedings
3.     Preferential creditors
4.     Floating charge creditors
5.     Unsecured debt
6.     Shareholders
Currently, in the absence of any security, the majority of the pension liabilities rank equally with other unsecured creditors of the sponsoring employer. Only unpaid contributions are treated as preferential creditors (usually a small amount).
The question of whether this is a fair order is not a recent one. At the time of the Lehman Brothers group litigation, the question of giving the Financial Support Direction (FSD) and Contribution Notices (CN) a “super-priority” (therefore placing it at 2. on the above list) among other creditors was considered by various courts and panels, but the Supreme Court hearings overruled their judgements. It said that the FSD and CN liabilities should be treated as unsecured provable debts. (We summarised some implications of the rulings at the time they were published here) This has solidified the position of the pension obligations as those of the unsecured creditors of the company. Only contingent assets granted to the pension schemes, such as security over certain assets of the employer, would rank higher in insolvency.
At the time the discussion was sparked by the collapse of some of the biggest financial institutions in the world. This time the question was asked exactly a week after the announcement of Carillion’s liquidation (see our blog here), which immediately prompted the Work and Pensions and BEIS Committees to launch an enquiry into its collapse and handling of the pension scheme. The enquiry was to focus primarily on “how a company that was signed off by KPMG as a going concern in Spring 2017 could crash into liquidation with a reported £5bn of liabilities and just £29 million left in cash less than a year later”.
While the level of cash is usually a good indicator of the company’s liquidity and financial health, it is important to remember that in liquidation (note this is different to administration), the money comes from a recovery on all of the company’s assets, and not just the cash it is holding. Looking at just cash can indeed be misleading in this situation as companies in distress are likely be very low on cash. In liquidation, the company sells all of its assets (unless any of them have been pledged as security), and distributes the recovered cash among its creditors in the order of priority. The process can take years, and the exact payout is not known until the process is concluded.
The Secretary of State for Work and Pensions’ comments should not be taken as a direct promise of an imminent review or change. But even if the Government did follow up on this statement, implementation of any changes in this area could prove very complicated. Putting substantial pension scheme deficits ahead of other creditors could affect available levels of borrowings or the cost of capital if the banks demand higher interest or additional security to protect their position. This could make it very hard for any company with a material DB scheme to borrow. Other creditors would also likely voice their disagreement.
Cases like Carillion or BHS have also raised a question about the fairness of the magnitude of the dividend payouts relative to profitability and pensions contributions. It seems that a lot of the discussion is currently evolving around this central theme of whether the pension schemes are treated ‘fairly’. This is not surprising given that the regulatory guidance itself (published in August 2015) tells us that the trustees should seek to understand whether “the scheme is being treated fairly with the other stakeholders of the employers”. The problem is that there might be as many definitions of “fair” outcomes, as there are stakeholders in a company, meaning it is rather unlikely that these discussions will come to a firm conclusion anytime soon.
We await the white paper on defined benefit security and sustainability with interest…

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