UK: Ten Covenant Questions For DB Scheme Trustees

Assessment of the employer covenant (the legal obligation and financial ability of scheme employers to support their defined benefit ("DB") scheme now and in the future) underpins any discussion of DB scheme funding between the trustees of the DB scheme and the employer group. However, monitoring the employer covenant is an important trustee responsibility at all times, not just when a triennial valuation and funding discussion is underway.

This article discusses ten key questions that the trustees of a DB scheme should always be asking themselves when considering their employer covenant and any proposed corporate activity within the employer's group.

Answering these questions often becomes increasingly pressurised if the employer covenant weakens. But even a currently healthy employer covenant can weaken rapidly as a result of a wide range of factors. Notwithstanding the significant improvement in funding levels for many DB schemes as a by-product of the Truss/Kwarteng gilts crisis, recent times have shown how rapidly economic conditions can harden. So trustees need to ask these questions even when their employer covenant feels healthy.

The draft funding code of practice for DB schemes (the "Code") has been published and is subject to consultation. When finalised, the Code will introduce significant changes to the way that future funding discussions between DB scheme trustees and their employers will run. But the ten questions discussed in this article will remain relevant no matter what changes the Code introduces.

Are we in danger of being "covenant complacent"?

The surge in gilt rates from September has, in many cases, significantly reduced DB scheme funding deficits. This improvement in funding levels has effectively projected those DB schemes years ahead in their funding journey, and means that "endgame" options such as buy-in and buy-out with an insurer, or the achievement of a steady-state self-sufficiency funding level, are starting to look credible and potentially achievable. Improved funding levels have also seen a strong uptick in employer companies expressing concern about overfunding and the risk of unnecessary pension surpluses.

But it is also important for trustees whose funding levels have improved to ensure that they do not make the mistake of becoming complacent about ongoing covenant risk.

The same economic crisis that improved funding has also brought economic headwinds: spiralling inflation, repeated energy cost crises, and increasingly shaky consumer sentiment. So finding the money to close the remaining funding gap may be increasingly difficult for employer companies who are facing tougher market conditions. Tougher market conditions bring increased risk of insolvency; and if the employer companies go into an insolvency process, that will undo all of the careful planning towards an "endgame" solution because a mandatory PPF assessment period will start.

Notwithstanding the increase in gilt yields, for some schemes funding levels have actually worsened as a result of toughening trading conditions or other market events affecting their employers. For these schemes, reliance on their employer covenant has become even more critical.

In any event, there are a number of accounting bases which can be relevant when discussing scheme funding levels in covenant discussions. Trustees should ensure that they understand that basis upon which scheme liabilities have been valued and which basis is most appropriate for their purposes to ensure that they are making a correct assessment of the position. Actuarial advice will be key.

Although this is a very basic point, it is surprising how often trustees and employers risk holding discussions about particular covenant issues without prior consensus over which funding basis is in play. A pension scheme can have a surplus on an accounting basis, but at the same time can still have a deficit on a scheme funding basis. That can lead to very different negotiating perspectives for the trustee and the employer companies, with each focusing on a different basis.

Are we getting the covenant information that we need?

A pervasive issue in covenant discussions is the importance for the trustees of confirming that they have appropriate information on the financial position of the employer and its group and the potential impact of any proposed transaction on the employer covenant. Proper information flows are vital to enable the trustees and their advisers to make informed decisions in line with the trustee directors' fiduciary duties to members.

Trustees will often be best-placed to act when they have early access to information. Ideally, employers will keep trustees promptly informed as to their financial position and any plans that will change or impact upon the pension scheme. The Pensions Regulator expects trustees and employers to work together openly and collaboratively, with good information sharing. Trustees should encourage open dialogue on this basis.

There are baseline legal obligations on employers to provide information to trustees under the Occupational Pension Schemes (Scheme Administration) Regulations 1996. These obligations are expected to be bolstered by new notifiable events regulations later this year.

However many trustees want to go beyond this to agree a detailed contractual framework for information provision, tailored to the specific circumstances of their covenant. They therefore negotiate information sharing agreements with their employers. To facilitate agreement, trustees will typically be prepared to enter into confidentiality obligations to reassure employers that information provided will remain confidential.

Are we differentiating group vs. entity analysis?

Where a group of companies (or other entities) is interlinked, particularly in terms of strategy and day-to-day operations, there can be a tendency for the financial condition of those companies to be considered on a group basis. However, caution must be exercised when trustees are considering financial information prepared on a group basis.

When times are good, trustees may expect that group companies will support each other. So, if one group company has obligations to the DB scheme, the trustee would anticipate that other group companies would be prepared to provide financial support to that company so that it could meet its obligations to the DB scheme. But this is a big assumption to make and may not reflect either the legal obligations of the different companies, nor the commercial reality of what would happen. This is particularly the case if there is a downturn in the group's financial health. As economic conditions tighten, group companies may be unwilling, and indeed legally unable, to provide financial support to other members of the group.

Instead trustees must understand which specific group companies the DB scheme has an enforceable legal claim against and must base their analysis of covenant strength on the financial and legal position of those entities. Unless a group company has a legal obligation to provide funding to the DB scheme (whether directly as a scheme employer or otherwise through arrangements such as guarantees or the grant of security), trustees must challenge themselves very carefully as to what, if any, strength that company adds to the employer covenant, particularly in an employer insolvency scenario.

Do we have up-to-date analysis of the impact of structural subordination?

In funding and covenant discussions, trustees might be presented with options to improve the position of the DB scheme (e.g. to mitigate the impact of any proposed transaction and/or to improve covenant strength).

One element of the support on offer might include the offer of a guarantee from a group company who may not already have obligations to the DB scheme. This can be a helpful covenant-enhancing tool, because it improves the DB scheme's position by giving it direct contractual recourse to another party for payment of the relevant debt.

However, care should be taken when determining the identity of the group company providing the guarantee. Often a "parent company" guarantee might be offered from an entity high up the group structure. At first sight this might seem desirable, because that parent company "owns" the entirety of the group via direct and indirect shareholdings; but there is a danger that the value of those direct and indirect shareholdings may prove to be low (or indeed nothing) in an insolvency scenario. If the guarantor company does not have any assets of its own other than valueless shareholdings, then the value of the guarantee that it has given to the trustee is questionable.

To illustrate, it is common for trading or asset holding companies to sit lower in a group structure, often with a number of intermediate group companies between those companies and the ultimate parent company. In a group insolvency situation, each trading or asset holding group company would realise its valuable assets and then would use the proceeds to repay all of its own creditors before paying any returns to its immediate shareholder. That immediate shareholder would then need to repay all of its own creditors with the proceeds received before it could return any funds to its immediate shareholder. This chain continues up the group structure, with the ultimate parent company only receiving any surplus return after the creditors of companies lower down in the chain have been paid off in full. Often the surplus return to the ultimate parent company is minimal. The ultimate parent does not have direct legal recourse to the valuable assets lower in the group structure and so is is left having to wait for value to flow up to it through its direct and indirect shareholdings. This is referred to as "structural subordination".

Trustees must ensure that they have a clear and up-to-date understanding of how structural subordination issues like this affect their employer covenant. Group reorganisations and corporate activity can alter the structural subordination analysis dramatically. One frequently-arising point is the impact of intra-group debt balances, which can be difficult to predict in an insolvency situation.

Do we fully understand the DB scheme's insolvency ranking?

In addition to understanding which group companies have legal obligations to the DB scheme, it is also important to understand where the DB scheme's claim would rank in an insolvency of those companies.

Under English law, the ranking of liabilities of a company on insolvency – i.e. the order that they are paid – is determined by statute. Very broadly, creditors with the benefit of security or who are given preference by law (including some types of tax claim) will have priority over unsecured claims. The expenses of the insolvency process will also take priority.

The starting position for a DB scheme is that its debt claim on insolvency will be an unsecured claim, ranking alongside the company's other unsecured creditors and behind secured and preferential creditors.

Trustees must take advice on the DB scheme's position as against other creditors and the likely returns to the DB scheme in an insolvency scenario. This is the ultimate benchmark of the strength of the employer covenant.

Do we understand the legal duties position of the employer company directors?

The duties of the directors of employers or other group companies supporting the DB scheme's liabilities are a matter for those directors themselves. But it is important for trustees to understand the parameters within which the directors will need to operate as a result of these duties. This is particularly acute when negotiating in a distressed situation.

In the ordinary course of business, the primary duty of the directors will be to promote the company's success for the benefit of its shareholders. However, when a company is in distress, this duty can alter so that the directors are also required to consider, and in some cases prioritise, the interests of the company's creditors. For further detail on this point, see our article on the Supreme Court judgment in Sequana. This is a critically important perspective shift given that DB schemes are typically one of the largest creditors of companies.

It is also important for trustees to understand that the legal duties of the directors of group companies in a distress situation may make it more difficult – and sometimes prohibited – for the directors to agree to covenant enhancement arrangements with the trustees. It can be a breach of duty for directors to enter into transactions that benefit particular creditors, and those transactions can be set aside under the insolvency legislation (see further point 7 below). This introduces an important timing element because negotiations over arrangements to enhance the employer covenant may be overtaken by events (and in particular the worsening financial position of the relevant company) so that the directors may no longer be able to agree to the same terms because their legal duties have tightened.

Are we confident that transactions we enter into are not vulnerable to challenge?

Certain types of transactions can be challenged if a company entering into them subsequently enters into administration or liquidation within prescribed time periods.

Whilst this is particularly an issue when a company is in distress, it is not always clear when distress might occur. It is therefore always worth trustees thinking about the risk of challenge when entering into any form of agreement with a company. Agreements which enhance the covenant position for the DB scheme (such as enhanced contribution payments, the grant of security or giving a guarantee) could fall within the relevant provisions. The time periods in which the administrator or liquidator can look back at transactions can often be up to 2 years.

The trustees should take legal advice to ensure that transactions entered into are as legally robust as possible. This will involve ensuring that the rationale for entering into the transaction is reasonable and properly documented. There are various defences which apply to the different provisions. Trustees should take advice on the risk of challenge before relying on a transaction as being covenant-enhancing.

Have we considered the covenant impact of proposed transactions?

Trustees will often be approached by employers before they enter into a transaction which has the potential to have an impact on the covenant. For instance, the employer might plan to dispose of a business division and then grant a dividend to shareholders from the proceeds. The employer should engage with the trustees to provide an explanation of the anticipated effect of the transaction on the employer covenant. The employer may propose mitigation for any detriment.

However, trustees should independently verify the potential impact of that transaction on the employer's covenant strength. Trustees must take stock of the employer covenant strength and consider what mitigation (or additional mitigation) should be offered to the DB scheme. Trustees also need a clear understanding of their own powers and how they apply to these circumstances. This may necessitate a review of their scheme documentation. In addition, trustees will want to consider whether they want to involve The Pensions Regulator, taking account of The Pensions Regulator's anti-avoidance powers.

Are we managing trustee conflicts?

Conflicts situations can arise in a number of occasions as a trustee or trustee director is undertaking their role. For instance, the trustee might also be a director or employee of the employer, or the trustee might act as a trustee for a number of DB schemes within the same group.

It is important that trustees identify, monitor and manage any conflicts of interests or the potential for any conflicts of interests to arise and keep their conflicts policy under review. Professional advice may need to be taken to work out the best approach at managing conflicts and trustees will need to be alive to the potential for conflicts to arise to know when to take this advice. The conflict position often becomes more sensitive when the covenant is deteriorating.

Do we have the advice that we need?

To answer all of the previous questions requires the trustees to have worked through complex actuarial, accounting, and legal considerations. Trustees must take appropriate advice from professional advisers with the requisite expertise in these areas, so that the trustees can be confident that they are properly carrying out their duties.

Discussions may need to be had with employers to manage the costs of professional advice, however, it is important that trustees are properly advised to ensure that they are complying with their duties and obligations.

Originally published 20 June 2023

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.