Financial Support Directions and Contribution Notices issued by The Pensions Regulator after a target company has gone into administration give rise to liabilities that rank as administration expenses under Rule 2.67(1)(f) Insolvency Rules 1986.

So found the Court of Appeal as it dismissed the appeals in the Nortel and Lehman cases.

In a serious blow to the rescue culture, the court found that it could not under the relevant statutes classify such liabilities as provable debts and, since classifying them as debts payable only once other creditors had been paid in full (the "black hole" result) cannot have been the intention of Parliament, classifying them as administration expenses was the only option.

It seems likely that the decision will be appealed to the Supreme Court, but the Court of Appeal gave some indications that the underlying statute fails to achieve what perhaps it might:

30. Given the precedent set in relation to section 75 by the 1995 [Pensions] Act, and given the relationship between the obligation under a financial support direction and the liability under a contribution notice, on the one hand, and the section 75 debt on the other, it might not have been surprising to find that the 2004 [Pensions] Act provided that the liability under a contribution notice was a provable debt in the insolvency of the relevant target company. One looks in vain for any such express provision in the 2004 Act.  

111. This conclusion does lead to some curious consequences. Given the close relationship between the section 75 debt and the liability under a contribution notice, it is odd to find that while the section 75 debt is provable in the insolvency of the employer, the contribution notice liability is payable with much higher priority as an expense in the insolvency of the target. It is the more odd that, as is not disputed, the employer can itself be a target, so that, by service of a contribution notice, it appears that the Pensions Regulator can produce a situation under which the priority of the relevant part of the debt is enhanced (to the extent of the amount payable under the contribution notice) from being merely provable (and expressly not preferential) to being payable as an expense. (The point of allowing for service of a financial support direction on the employer is said to be that, in particular circumstances, there may not be a section 75 debt, for example if there is no question of insolvency, but this argument from anomaly can be made, even if less strikingly, by reference to how the liability would rank if there were such a debt.)

      

112. On the other hand it might be said to be at least as odd, and a good deal more so, if the liability under a contribution notice had a lower priority than that of the section 75 debt, being relegated to the black hole, and if a potential target company could avoid the effect of the financial support direction regime by putting itself, or being put, into administration before any decisive step could be taken by the Pensions Regulator to impose any liability under this regime. Even if the issue of the Warning Notice is the critical stage, the possible target company (or at least the group) would be likely to have plenty of notice before that stage that the Pensions Regulator was interested in it, not least because it will have been the subject of requests for information under section 72 of the Act.

      

113. There is force in the argument that the potentially very large liability under an eventual contribution notice, and the open-ended nature of the obligation under a financial support direction, could be a serious impediment to the rescue culture which underlies the administration regime.

The troubling part of this judgment, to my mind, is its consideration of the justification for Parliament not having specified that the liabilities arising from financial support directions and contribution notices would be provable debts:

In a situation in which the regime applies, because the employer was either a service company or insufficiently resourced, then even if the targets are themselves insolvent, they may still have more assets available than the employer does, despite the insolvency. We were told that this is the case in the Nortel insolvency, where, apart from the effect of an eventual financial support direction and contribution notice, creditors of the targets would be expected to receive a significantly higher level of dividend than those of the employer. The legislation has a valuable and realistic purpose if it enables some redistribution of assets in such a situation, where otherwise the creditors of the targets would be able to share in a greater volume of assets, partly as a result of having had the benefit of services (including employees) provided by the employer, but without having to pay in full for the provision of those services, in particular without having to contribute appropriately to the pension liabilities in respect of its employees.

The reality is that Parliament gave relatively little thought to the liabilities being administration expenses. Why should unconnected creditors suffer more than the pension scheme (or the PPF)? It is no less a disincentive to the moral hazard of group companies passing risk to the Pension Protection Fund in the event of an employer's insolvency if the group companies attract massive unsecured claims.

This is a case where the statute needs to be changed.

Chris Laughton is a Restructuring & Insolvency partner at Mercer & Hole. The views given in this blog are personal to the author. If you would like to discuss the contents of this post with Chris you can call him on 020 7353 1597. 

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The administrators of 20 Lehman and Nortel companies face meeting Financial Support Directions (FSDs) and Contribution Notices (CNs) from The Pensions Regulator as an expense of the administrations because of the judgment handed down by Mr Justice Briggs.

The implications for the rescue culture are severe - unless the hope expressed by Briggs J

"that a higher court may find a way through or around the existing authorities"

is rewarded as the case is appealed.

The scope of the decision should not be underestimated. Any administration of a company that has been, at any time within the previous two years, an associate or connected to an employer with a defined benefit pension scheme shortfall, has a contingent expense, payable in priority to all other creditors (and the administrators' fees) that could amount to the whole shortfall.

Briggs J clearly reached his decision with considerable misgivings, recognising its unfairness and injustice. He observed, in relation to what he described as "a legislative mess" that

"the Insolvency Service or Parliament might wish to consider a suitable amendment, either to the Rules or to the 2004 Act, if persuaded as I have been that the conferring of super-priority as expenses upon the financial liabilities arising from the FSD regime is both potentially unfair to the target's creditors and inconsistent with a decision taken in 2004 not generally to elevate employees' pension claims above the claims of those creditors."

Such a judgment hardly clarifies the effect of an FSD on an insolvent "target". In reality, the interests of pension scheme members and the Pension Protection Fund have collided with the rescue culture like a wrecking ball.

The judgment merits reading for its detailed consideration of the interaction of insolvency and pensions law, for its analysis of administration expenses and the Toshoku principle, and for the finding that parliament legislated (probably inadvertently) for the pensions/insolvency interaction to be addressed by a mechanism that is not fit for purpose.

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As the UK economy begins, in late 2009, to recover from the harshest recession in 75 years, insolvency is becoming somewhat more prevalent than has been the long term experience of most of us. The few high profile administrations such as Lehman and Woolworths are likely to be followed by many ordinary smaller businesses encountering formal insolvency procedures. Formal insolvencies tend to lag on economic recovery because of reluctance to invoke them and the time it can sometimes take to do so.

Now is therefore an ideal time to remind you about corporate insolvency and this is the first of a series of posts to do so.

Definitions

The word insolvency can be used either in a general sense to identify a company’s illiquidity or over-indebtedness (technical insolvency), or more specifically to identify a company subject to a formal insolvency procedure (formal insolvency).

Technical insolvency is most simply identified using the terms of s123 Insolvency Act 1986 ("IA86"):

• ‘the company is unable to pay its debts as they fall due’ (illiquid – the cashflow test); or
• ‘the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’ (over-indebted – the balance sheet test).

Classic evidence of the cashflow test being failed includes creditors having issued writs or statutory demands and late payment of PAYE and VAT.

Realisation that the balance sheet test includes contingent and prospective liabilities often puzzles directors because so many companies do fail that test, but it is the case that prospective and contingent liabilities are taken into account when assessing a company’s technical insolvency.

Of course, failure of one of the two tests does not immediately lead to adverse practical consequences or penalties. This is in contrast to some jurisdictions, such as Germany, where it is a criminal offence for directors not to instigate formal insolvency proceedings within three weeks of failing similar illiquidity and over- indebtedness tests. In the UK it is more helpful to consider the concept of the ‘zone of insolvency’.

A distressed company may move into insolvency but with a ‘reasonable prospect of avoiding insolvent liquidation’.

This paraphrase of part of s214 IA86 (the section that deals with wrongful trading) allows for the taking of a somewhat longer view than under the German system. It is not, however, a view without risk. Even if there had been a long period during which there was a reasonable prospect of avoiding insolvent liquidation, followed by a calamity that caused liquidation, the company will have been technically insolvent from the moment it failed either the cashflow test or the balance sheet test.

One consequence of technical insolvency is that it determines whether transactions entered into by the company are at risk of being overturned under insolvency legislation relating to antecedent transactions such as transactions at an undervalue (s238 IA86) and preferences (s239). In order for an administrator or a liquidator to be able realistically to take court action to overturn a transaction at an undervalue or a preference, the company must have been in the zone of insolvency at the time of the transaction.

However, the section that more clearly focuses directors’ minds on the zone of insolvency is s214. Wrongful trading – incurring losses when a director ‘knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation’ can lead to the court declaring that the director is personally liable for the amount the court orders to be paid. That amount is likely to reflect the losses suffered by creditors during the period of wrongful trading.

The practicalities of technical insolvency are that:

•  it can lead to formal insolvency;
• it introduces additional risks, notably for the directors personally, at a time when the company is already stressed; and
• the onset of technical insolvency is an ideal time – perhaps even the best time – for a company to take specialist insolvency advice.

Case Study

In July 2007 I was consulted by an AIM listed company whose directors where concerned about its financial position. Since then I have advised the board many times about the risks they face and whether they have a reasonable prospect of avoiding insolvent liquidation. At times there has been a gap of several months between consultations and at times we have spoken every few days. The company remains in the zone of insolvency but it currently has a reasonable prospect of avoiding insolvent liquidation and it is less illiquid and less over-indebted than when I was first consulted. It has achieved this through enhancing its profitability and attracting investment. As a start-up company in a relatively new sector it has already become a market leader although it has yet to break even. If it were to stumble and fall into formal insolvency, it seems to me unlikely that the directors would be at significant risk of a wrongful trading action. Also, for the last two years they have been aware that any transactions at an undervalue or preferences could be overturned in the event of formal insolvency – but I am not aware of there having been any such transactions!

Look out for Part 2, which will explain how best to avoid formal insolvency despite failing the technical insolvency tests.

Chris Laughton is a partner at Mercer & Hole. The views given in this blog are personal to the author.

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A new special insolvency procedure for investment firms that hold client assets or client money is to be introduced in response to issues arising in the administration of the UK subsidiary of Lehman Brothers.

A review of the insolvency arrangements for these investment firms will by the summer of 2009 consider:

• the precise definition of the firms to which the new procedure should apply;
• the treatment of unencumbered client money and client assets;
• the treatment of client money and client assets which have been posted as collateral;
• arrangements to enable a temporary continuation of brokerage activities (including the matching of unsettled trades); and
• how the insolvency procedure would work and what the objectives for the new procedure should be.

Following the review, there will be full formal consultation on the draft secondary legislation, in line with normal legislative procedure.

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