Q&A: Managing pension liabilities in bankruptcy situations
January 2013 | SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY
Financier Worldwide Magazine
FW speaks with Richard Farr at BDO LLP, Linc Rogers at Blake, Cassels & Graydon LLP, James H.M. Sprayregen at Kirkland & Ellis LLP, and Richard Jones at Punter Southall, about managing pension liabilities in bankruptcy situations.
FW: Broadly speaking, could you outline the continued challenges that pension obligations and liabilities present in corporate bankruptcies?
Jones: For the most part, pension scheme claims are unsecured creditors of companies in bankruptcy but often they are very significant unsecured creditors and thus can dilute other unsecured creditors very significantly. This is particularly the case in jurisdictions such as the UK, where the claim made in a bankruptcy situation is significantly greater than the claim on an ongoing basis due to the need to secure the benefits with an insurance company. Further, any bankruptcy that involves the pension scheme not receiving its claim in full can lead to actions by the various pensions regulatory bodies to attempt to secure a better deal for the pension scheme, the prime example being the ability of the UK Pensions Regulator in certain situations to impose additional obligations.
Farr: A number of challenges in dealing with pension obligations and liabilities come to mind. The first is quantum and volatility. Pension obligations not only get bigger the closer a corporate gets to bankruptcy, but even when the full Section 75 buyout liability becomes the claim – that is, the amount for which an insurance company would take the liability off your hands. That amount will fluctuate significantly on a day to day basis until finally settled. Second, who is the stakeholder? The owner of the liability is the trustee of the scheme but the Pension Protection Fund (PPF) will inevitably be involved, either because there is a likely ‘PPF deficit’ – which is less than S75 but still unfunded – or as an adviser to the pensions regulator. If the proceeds are potentially sufficient from the insolvency or Chapter 11 to settle the PPF deficit and more, the trustees have a more active role in determining the eventual settlement. Third, communications. Obligations to communicate to members may upset the delicate balance between informing members and inadvertent leaking of price sensitive information. Finally, unanticipated liability. The pensions regulator’s moral hazard powers potentially give the scheme claim super priority status or allow the pensions regulator to pursue a connected party purchasers, adversely impacting on a potential purchaser’s willingness to buy without having first obtained clearance from the pensions regulator.
Rogers: In a recent decision known as Re Indalex, the Court of Appeal for Ontario departed from earlier case law and held that the deemed trust provision – a form of statutory security interest – of the Pension Benefits Act (Ontario) secures the obligation of a pension plan sponsor to fund the wind-up deficiency on the wind-up of a defined benefit pension plan. The Court of Appeal also held that on the facts of Re Indalex the court-ordered charge securing DIP financing did not have priority over the statutory deemed trust. In addition, the Court of Appeal concluded that in acting as both pension plan administrator and plan sponsor (which is typical) Indalex was in a conflict of interest between its duties to pension beneficiaries and its duties to other stakeholders. This led to the imposition of a constructive trust over Indalex’s proceeds of sale, also ranking in priority to the DIP lender’s charge. At the present time, Re Indalex remains on reserve before the Supreme Court of Canada. Until the Supreme Court renders its decision and provides further guidance, there will remain an added degree of complexity and uncertainty in connection with financing insolvent companies with large pension deficits.
Sprayregen: Pension obligations and retiree medical liabilities are among the thorniest issues to resolve in a bankruptcy case because they involve not only very difficult economic issues, but implicate broad sociopolitical issues and have a massive impact on the quality of life of thousands of people. In addition, calculating these obligations involves many complicated assumptions and use of discount rates for multiple decades in the future which further complicates the analysis.
FW: To what extent have pension issues become more apparent since the onset of the financial downturn?
Farr: Warren Buffet once said that you never knew who wasn’t wearing a swimming costume until the tide went out. Recessionary factors always increase the pension deficit, as falling equity values and credit defaults on bonds are not good for asset performance charts. Pension claims are an increasing and significant factor of the demise of ‘old economy’ companies. Further, innovation can be stifled by legacy pension liabilities restricting business expansion.
Sprayregen: Pension issues have become more apparent since the financial downturn because the loss on pension assets has been dramatic, both in terms of reduced stock market value and reduced return on investment. That has exacerbated the problem.
Rogers: Pension plans in Canada have continued to face growing funding deficiencies since 2009, mainly due to poor investment returns and historically low interest rates. The Office of the Superintendent of Financial Institutions – the federal pensions regulator in Canada – reported that 93 percent of all federally-regulated defined benefit pension plans in Canada were underfunded as at 31 December 2011, as compared to 76 percent as at 31 December 2010. The growth in the number of underfunded pension plans has translated into a growing number of issues relating to pension deficits in corporate insolvencies. Pension deficits have been a major factor, if not the most significant factor, in a number of high profile corporate insolvencies in Canada over the past few years, including Whitebirch, AbitibiBowater and Catalyst Paper.
Jones: The downturn has made pension issues far more apparent in two ways. Firstly, schemes are less well funded – that is, they have bigger deficits. This is due to poor performance of their assets and very low bond yields which has pushed up the value placed on pension liabilities. Secondly, more sponsoring employers have become insolvent or have been forced to restructure due to severe financial difficulties. This has led to more schemes entering the lifeboat funds, the Pension Protection Fund (PPF) in the UK and the Pension Benefit Guarantee Corporation (PBGC) in the US. As the compensation provided by these lifeboat funds is less than the full pension promise to which members were entitled, such events often make the headlines, particularly when they involve large or well known companies.
FW: How can the involvement of a regulator in the bankruptcy process affect negotiations surrounding pensions? In what ways are regulators bringing their power and influence to bear?
Sprayregen: The involvement of a regulator has a tremendous impact. Regulators have both economic needs and legal, and, at times, political needs. As a result of that, the negotiation dynamics in this situation are not the same as where only private creditors are involved. That has the impact of complicating the negotiations.
Rogers: Pensions regulators are more frequently taking active roles in insolvency proceedings involving sponsors of underfunded pension plans. Such involvement has typically taken the form of ordering the wind-up of an insolvent employer’s pension plan or the appointment of a replacement plan administrator or advancing statutory lien and deemed trust claims in favour of the pension fund or plan administrator. However, as a result of statutory amendments that came into effect in 2011, the federal pensions regulator in Canada now has authority to also approve agreements between insolvent employers and their creditors and other relevant parties to alter the terms under which required pension contributions are made. This added flexibility in addressing pension funding issues is a tool that we expect to be utilised more frequently in future insolvencies. Similar statutory amendments are expected to be implemented in Ontario and other Canadian jurisdictions.
Jones: The involvement of a regulator in the bankruptcy process can add significant complications and slow the whole process down. For example, the UK Pensions Regulator can look back to past corporate activities which may have nothing to do with the bankruptcy itself in determining whether and to what extent the pension scheme has a claim against the insolvent entities. If the UK Pensions Regulator considers there to be a past event – within certain statutory time limits – which left the pension scheme worse off in terms of the level of financial support available, it will seek to exercise its powers to ensure the support which should have been available will be recognised in the bankruptcy proceedings.
Farr: The pensions regulator will always look to maximise its claim in an insolvency. Its powers are wide-reaching and the pensions regulator has a six year look back test for inappropriate value shifting away from the pension scheme, known as Type A events. The very fact of an ‘under-resourced’ or ‘service company’ employer within a group of companies gives the pensions regulator the potential to spray paint other companies within the group with S75 guarantees – Financial Support Directions, or FSDs. FSDs issued post insolvency are an expense of the Administrator and rank ahead of floating charges – and, bizarrely, the Administrator’s expenses. It will drive a very hard bargain to minimise the claims on the PPF. A regulator is likely to be risk averse – innovative economically justifiable solutions may be unacceptable. Pension risk will adversely impact value. In terms of powers and influence, a pensions regulator has a two year period in which to decide whether to issue an FSD. It has a six year look back for wrongdoings – a hindsight test in a backdrop of an insolvent group. Other stakeholders can obtain clarity on the pensions regulators’ positions by asking for clearance, although this will come at a high price.
FW: In a cross-border case, what additional challenges tend to arise when dealing with pensions regulators in multiple jurisdictions?
Rogers: Cross-border insolvencies with underfunded pension plans in multiple jurisdictions involve the additional challenge of dealing with competing pension claims governed by different statutory regimes and regulators with varying degrees of authority. For example, in the Nortel Networks insolvency, there were underfunded pension plans in several jurisdictions including Canada, the UK and the US. Each jurisdiction has its own statutory regime for determining the extent and priority of claims in respect of pension deficits and the applicable pensions regulators take different approaches as to the extent of their involvement in the process. Such differences can complicate the process of negotiating an acceptable solution for addressing pension claims. For example, in the Nortel case restructuring litigation arose as a result of a UK pension claim being asserted against the Canadian parent company, in the face of a stay of proceedings in Canada.
Farr: Many overseas advisers and principals express surprise and dismay over the apparent powers of the UK pensions regulator – a concept and power that does not exist elsewhere. The closest is the PBGC in the US. Pension funding plans are agreed by negotiation between the employer and the scheme within a regulatory framework – this negotiation ability can add complexity in an M&A or restructuring transaction when determining the appropriate price adjustment to make for the scheme. Overseas players also find it hard to understand the negotiation stance of the PPF or pensions regulator. In addition, once overseas players become aware of the risks, they may take the easier path and abandon future UK investment.
Overseas players also find it hard to understand the negotiation stance of the PPF or pensions regulator. In addition, once overseas players become aware of the risks, they may take the easier path and abandon future UK investment.
Jones: To my knowledge, it is only the UK Pensions Regulator which has the power to pursue claims against overseas entities. The Nortel and Lehman Brothers cases are very good examples of where the UK Pensions Regulator has intervened in overseas bankruptcy proceedings to try to enhance the position of the UK pension scheme. Nortel’s UK scheme had a deficit of £2.1bn, whist the shortfall in Lehman Brothers’ UK scheme stood at £148m. In each case, the UK Pensions Regulator has issued Financial Support Directions (FSDs) against various overseas entities requiring that those entities provide financial support to the UK pension scheme. Those FSDs have been challenged and it remains to be seen whether and to what extent the parties concerned will ultimately provide the directed financial support.
FW: What lessons can we draw from the treatment of pensions in some recent high-profile bankruptcy cases?
Jones: Few lessons can be learnt at this stage as we still don’t know conclusively whether and to what extent the UK Pensions Regulator’s powers will be upheld in overseas bankruptcy proceedings. Following the progress of the Nortel and Lehman Brothers cases should tell us much in due course. What is clear is that cross-border issues can significantly complicate matters, making the process a much lengthier one. In the UK, striking a deal with the Pensions Regulator and the Pension Protection Fund which staves off insolvency is not impossible, but the constraints are very restrictive. We have seen cases where all the usual rules would appear to have been met, yet still a deal that would prevent insolvency could not be reached, with the Readers Digest case being a good example.
Farr: Given the Nortel experience, it will be unlikely if many European advisers will accept a centre of main interests (COMI) plea from London. Other countries also have pensioners and post-retirement medical promises, all of which can put in jeopardy by country specific action. As a result, there is a possibility of counter-claiming financial support from the UK to support employee claims of overseas businesses. Insolvency may be the only answer in an attempt to cleanse companies from pension liabilities, because the PPF or pensions regulator will not accept economic obvious solutions which conflict with wider policy issues.
Rogers: Since the Indalex decision, a number of cases have addressed the priority of pension claims in an insolvency. For example, in Re Timminco, the Ontario Court was satisfied that it could grant court-ordered charges ranking in priority to the deemed trust provided for in pension legislation after pensions regulators and the unions representing pension beneficiaries were provided notice of the debtor’s request for the priority charges. The Ontario Court concluded that if the priority charges (including a priority charge securing DIP financing) were not granted the purposes of the federal insolvency legislation would be frustrated and, on that basis, invoked the doctrine of federal paramountcy. This doctrine provides that when validly enacted federal legislation, such as federal insolvency legislation, comes into conflict with validly enacted provincial legislation, such as provincial pension legislation, the federal legislation trumps. Outside of Ontario, in Re Whitebirch the Quebec Court held that the principles in Indalex did not have application in that province. In Re Catalyst, the British Columbia court granted charges in priority to pension claims, after pension beneficiaries received notice of the requested relief.
FW: Could you explain some of the solutions you have seen adopted to restructure pensions liabilities in the current market?
Farr: The scheme should be treated like a partner or owner. We are seeing an increasing use of equity based share solutions to enable the company to effect a turnaround with the scheme obtaining a significant contribution for its cooperation. Mitigation in the form of intangible assets should be adopted because there is nothing left to secure. Lenders are cooperating more with schemes because they both realise that there is only one parachute that they both need to share – pari passu security, carve outs, cessation of payments over the longer period.
Sprayregen: There is room for great creativity in resolving pension liabilities in the current market, all the way from offloading the liabilities to an insurance company that is willing to take on the liability for a price, to termination of plans, freezing of plans, modifying plans and a variety of other creative solutions. Where stakeholders and regulators work closely together to address these very difficult issues, creativity can help resolve the issues.
Rogers: One of the solutions for restructuring pension liabilities in Canada has been the adoption of specific regulations under applicable pension legislation which provide relief from the general statutory funding requirements. Air Canada, General Motors and AbitibiBowater are examples of plan sponsors that were able to convince the government to adopt special pension funding regulations which provided them with various forms of relief from the general funding requirements, typically in the form of a longer amortisation period to fund the deficits under the plans. Another solution is the ability, in some circumstances as part of a court supervised restructuring, to obtain a stay from having to make special payments to fund a pension deficit during the period in which the employer is under protection from its creditors. While temporary in nature, such cash flow relief can sometimes make the difference between a company being able to continue operations or being forced into liquidation.
Jones: In the UK, strict legislation to protect pension rights people have already earned makes it very difficult to restructure pension liabilities. Various liability reduction exercises are possible, but they tend to have a relatively limited impact on the size of the pension problem. However, businesses in severe financial difficulty can, in certain circumstances, strike a deal with the PPF and the UK Pensions Regulator to shed their pension obligations. The criteria for doing so are very strict – insolvency must be highly likely within 12 months in the absence of a deal, the pension scheme must receive a settlement which is worth more than the likely recovery it would make on insolvency and the PPF must receive an equity stake in the business. These requirements make the applicability very limited, but it does at least offer some businesses the opportunity to recovery and thrive once free of the burden of their pension scheme.
FW: What is your advice to stakeholders in a bankruptcy when it comes to setting their expectations for a desirable outcome?
Rogers: In an insolvency proceeding there is typically insufficient collateral value in the assets of the debtor to satisfy all claims against it. Accordingly, from the outset of a case it is often predetermined that at least some stakeholders will suffer economic loss. The challenge facing the courts and the professionals administering the case is to identify the solution that best minimises that loss, recognising that eliminating loss for all stakeholders is not an achievable outcome. With respect to pension issues, a going concern purchaser of assets, for example, may not be willing to assume pension liabilities of the debtor, potentially resulting in a decrease in benefits for the plan beneficiaries. If the only alternative, however, is a liquidation of the debtor, pension beneficiaries will be no better off, but, other stakeholders including customers, suppliers, secured creditors and the broader economic community would be prejudiced. Setting expectations for stakeholders often involves explaining that insolvent companies have a limited universe of alternatives and the insolvency process is designed to secure the best achievable outcome, not a perfect one.
Jones: For holders of unsecured debt and other unsecured creditors, the outcome will depend heavily on the position of the pension scheme and whether and to what extent the UK Pensions Regulator might have grounds to intervene. For those parties, establishing the size of the pension scheme’s claim, the assets against which its claim can be made and the risk of regulatory action to enhance the pension scheme’s position are key. The particular circumstances can vary enormously. In general, pension schemes rank alongside other unsecured creditors, but in some cases schemes have been provided with security over assets or parent company guarantees which strengthen their claims. Regulatory action is very rare and is only taken when the UK Pensions Regulator considers the pension scheme to have been treated unfairly in the past.
Farr: Make sure you price the pension risk correctly before you start restructuring or investing. Pricing is a combination of actuarial, economic, investment and legal risks. Also ensure you identify in advance the potential exposure in terms of potential historic Type A events or from past economic benefit that has flowed from the employer (FSD risk) and, where appropriate, engage with the pensions regulator to obtain clearance.
Richard Farr is head of Pensions Advisory at BDO LLP. Formerly Head of Pensions at Swiss Re from 2007 to 2009, Mr Farr was responsible for developing pension risk transfer opportunities. He previously was a partner at PwC from 2005 to 2007. In 2005 he advised the Pensions Regulator on its original Clearance Guidance rules. Mr Farr is a Member of the Institute for Turnaround, FSA CF30 approved, and an FCA.
Linc Rogers has a varied and dynamic practice focusing on all aspects of commercial reorganisations, distressed acquisitions, debtor-in-possession (DIP) financing and security enforcement. He has also been engaged in a variety of out of court work outs and financing deal structuring matters. Mr Rogers has been involved in a number of high-profile engagements in a wide variety of industry sectors, including automotive, retail, manufacturing, high tech, financial services, and oil and gas.
James H.M. Sprayregen is recognised as one of the country’s outstanding restructuring lawyers, and has led some of the most complex Chapter 11 filings in recent history. He has extensive experience representing major US and international companies in and out of court as well as buyers and sellers of assets in distressed situations. He has experience advising boards of directors, and generally representing domestic and international debtors and creditors in workout, insolvency, restructuring, and bankruptcy matters.
Richard Jones is head of Punter Southall Transaction Services (PSTS). He has a degree in Business Economics and became a Fellow of the Institute of Actuaries in 2002. Mr Jones has been involved in numerous international mergers and acquisitions, particularly involving UK and US interests. He is the lead consultant for an investment company which has global pension arrangements with liabilities totalling in excess of $3bn.
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Blake, Cassels & Graydon LLP
James H.M. Sprayregen
Kirkland & Ellis LLP