Caveat emptor (and the emptor’s lenders) – beware the widened ‘moral hazard’ regime
Lenders beware! ‘Moral hazard’ risk in M&A work might be well-understood, with all parties well-versed in navigating and addressing the interests of the pension trustees. But the widened regime now catches others involved with both transactions and refinancings, such as banks providing leveraged finance, who are now squarely within the Pensions Regulator’s powers. As lenders become more aware of the risks, they may seek to impose additional requirements on their corporate clients, but also need to beware of increasing their risk of existing powers being used against them.
‘Moral hazard’ has been with us for a long time now – too long, some might say. It’s an accepted part of life at the M&A coalface that corporate activity cannot legitimately be structured in a way that causes ‘material detriment’ to any DB pension scheme which either seller or target may have. This includes anything that might materially impact the pension scheme, not only on an ongoing basis but also in the event of employer insolvency. Given that most UK corporates have some kind of secured debt within their business, and the proliferation of leveraged financing structures (particularly amongst PE deals), it is little wonder that the spectre of the Pensions Regulator looms large over the vast majority of corporate transactions where a DB pension scheme is involved.
The moral hazard regime was widened in October 2021 in significant ways. We’ve covered these in a previous newsletter, but now they are in force the extensions are firmly on the radar of lenders and their advisers – and are leading to additional requirements being imposed by them on borrowers.
- New employer-related tests. Two new Contribution Notice tests were introduced looking not at the impact of corporate activity on a pension scheme but instead at how the resources of its employers, or the scheme’s recovery on a hypothetical insolvency, might be affected relative to the scheme’s ‘section 75’ / buyout deficit. The threshold for these tests is much easier to fail than the previous more subjective tests, meaning there will be more reliance on the requirement that the Regulator acts “reasonably” – whatever that means – when policing compliance with the widened regulatory regime, or deciding when to consider issuing a Contribution Notice. Mitigating the detriment shown by these new tests is already featuring prominently where transactions involve DB schemes. These powers apply to employers, or anyone connected or associated with an employer – so lenders have historically been relaxed about the fact they are not themselves within scope of the Regulator’s Contribution Notice power.
- Providing up to date information. The Regulator can now impose fines of up to £1m for non-compliance with its moral hazard regime (the previous limit was £50,000), which also now includes the civil offence of knowingly or recklessly providing false or misleading information to either the Regulator or the pension trustees. This is already markedly affecting the way in which parties’ negotiations with pension trustees are carried out. TPR has also been bestowed with wider information-gathering powers, including the ability to search premises and/or to compel people to attend an ‘under caution’ interview as part of any moral hazard investigation it carries out.
- Criminal offences. Two new offences introduced – both punishable with an unlimited fine or up to 7 years in jail. “Avoidance of employer debt” catches someone who acts without reasonable excuse and affects the amount of debt due or the level of recovery by the pension scheme, where it was intended to have this effect. “Conduct risking scheme benefits” catches someone who acts without reasonable excuse and affects the chances of benefits being paid, where it was known (or ought to have been known) that it would have this effect. During the passage of the new legislation through Parliament it was estimated that up to 5 people would be prosecuted each year, with up to 2 of them receiving a custodial sentence.
- Everyone in scope, whether or not a scheme employer or ‘connected or associated’. This is the big one. It’s not just scheme employers who are caught by the new criminal offences – they apply to anyone involved with a DB pension scheme, whether or not they meet the Insolvency Act tests for being connected or associated. Solicitors. Other advisers. Banks. Insurers. Investment counterparties. And lenders. Financial institutions who are the lifeblood of the PE community are now firmly within the Regulator’s sights, should they engage in activity which either (i) constitutes one of the new criminal offences or (ii) aids, abets or assists an actual offender. Which is leading to lenders taking new interest in how their corporate clients have dealt with their DB pension scheme as part of any transaction or refinancing.
But it’s not all bad news. The Regulator has said that its new criminal powers are not intended to affect normal business activity. Any prosecution will have to prove the offence by reference to the (much higher) criminal burden of proof. A lack of reasonable excuse will also have to be demonstrated by the prosecution, again to the same threshold. Prosecutions are unlikely to be enforceable overseas. And there are only anticipated to be a few of them each year – so far we have not seen any reach the courts but that doesn’t mean the Regulator isn’t planning in the background.
From a lender perspective, there is a fine line between getting the comfort you want that the scheme employer has done the right things in relation to the pension scheme so that the lender risk of criminal prosecution is minimised and becoming too involved so that you increase the likelihood of being a target for the Regulator’s other powers. Too little diligence leaves you at risk of criminal prosecution; too much diligence increases your risk of a contribution notice…
Concluding thoughts? The widened moral hazard regime represents a sea-change to the way in which pensions-related activity is monitored and enforced in the UK. Refinancings in particular, as well as just ‘pure’ M&A, will require specialist pensions-related input. The new criminal offences in particular, and their potential application to normal business professionals, are perhaps the most eye-opening. Only time will tell how often they are used. But no financing professional should be resting on their laurels – the Regulator clearly means business, and lenders and their advisers need to be putting their potential exposure at the forefront of their minds whenever the word ‘pension’ features in a deal with which they are involved – being particularly careful not to create more risk by attempting to deal with another.