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Pensions: the new counterparty

Creditors play a critical role in most business sales, says SJ Berwin. Some creditors have extensive rights: senior banks, for instance, may have a right to be repaid in full on a change of control; others, including trade creditors, play a critical part in the financial stability and working capital needs of the business going forward, even if they do not have any direct voice at the time of the transaction.

The position of the pension scheme as a creditor of a business is often overlooked, but where there is an (underfunded) final salary pension scheme in place – that is, one where the benefits are defined by reference to the final salary of the beneficiary, rather than by reference to the contributions made – that scheme can be one of the largest creditors the business has. The employer may be making regular contributions to the scheme, but if these turn out to be insufficient, the employer has (ultimately) to make up the scheme’s shortfall.

As is well known, recent falls in stock markets have left many final salary pension schemes in the UK with serious deficits, and so the likelihood of a shortfall arising is often very significant. Other creditors usually have some way to protect themselves against an insolvent debtor. Banks have financial covenants, and powers to call for immediate repayment if those covenants are breached. They often also have security.

Landlords have rent deposits and rights to forfeit the lease. Trade creditors may have retention of title clauses and can always stop doing business with a debtor when they feel uncomfortable with the degree of their exposure, or if they wish to exert pressure on the business to pay. All creditors have the right to petition for liquidation in cases where their debts are not being paid.

Powers of the trustees Pension scheme trustees, on the other hand, are charged with looking after the interests of their beneficiaries, but do not usually have “normal” creditor rights. They must rely on whatever trust powers they possess under the scheme’s governing provisions, and under the general law.

In many cases, those powers may be rudimentary or limited in scope, but often include a “nuclear option”: a right (if the trustees believe it is in their beneficiaries’ interests) to wind up the scheme and (if the scheme is underfunded) to claim an immediate debt from the employer equal to the scheme’s funding shortfall. Trustees are obliged by law to act in the best interests of their beneficiaries, and this obligation will undoubtedly extend to (legitimately) using (or threatening to use) such of their trust powers as may assist them to achieve this.

However, this does not extend to using (or threatening to use) their trust powers improperly (for example, for a purpose for which the trust powers were not intended). Moreover, in their dealings with the employer, and just like any other creditor, trustees ought to behave commercially and rationally. As trustees emerge as a critical party in any acquisition or takeover, it is vital that they adopt similar thinking processes to other creditors.

Of course, the main issue that trustees are likely to have to consider in respect of a private equity backed acquisition is whether the company will become more heavily geared (which was an issue in the WH Smith/Permira transaction). Borrowings made to finance the acquisition will be secured against the company’s assets, and since pension funds have no security for their obligations (and rank behind secured creditors) it is possible that a change of ownership may weaken the trustees’ security.

This may have two consequences: first, it may encourage the trustees to use whatever powers they have (if any) to block the sale unless they can be satisfied about the financial security of their pension scheme; secondly, it may make them more conservative in their future investment policy, which will increase the apparent “deficit” of the scheme. In either case, the trustees’ views can pose significant issues for any potential deal.

When should trustees exercise their power?

However, if they are thinking like any ordinary creditor, the trustees need to pause before invoking any power they may have to wind up the scheme, or otherwise to block a deal, and to consider the wider implications of the transaction. In many cases, the change of ownership structure may well enhance the prospects of the business. New management, or at least newly incentivised management, and possibly an injection of capital, could be good news for a stagnating and unwanted non-core business.

The additional borrowings may make the business riskier, but the sale might actually secure the income stream for the pension scheme in the future. Even if the trustees are not convinced that the sale will improve the employer’s long term financial position – or at least will not make it any worse – they should still be reluctant to use any power they have, and especially any power to wind up the scheme. Many of the scheme’s beneficiaries may still be working at the employer and all will have an interest in the employer’s wellbeing. It is unlikely to be in their interests for the employer to be forced to make a huge single payment to the scheme without any good reason (which could threaten jobs and may cause the employer to abandon any defined benefits scheme for the future), except in the most extreme of situations.

Furthermore, any exercise of the trustees’ powers which causes financial losses to the employer (and/or the scheme’s beneficiaries) could ultimately be challenged through the courts, with unfortunate consequences for the trustees if they are found to have improperly exercised their trust powers. Persuading trustees to come to the table and talk – not always easy in itself – is likely to be critical to many sale processes. But understanding their position – their powers, which vary from scheme to scheme, and their interests as a large unsecured creditor of the business – is critical to satisfying their concerns and achieving a satisfactory deal.

For more information on the material in this features please email the authors, Steven Davis (steven.davis@sjberwin.com) or Wyn Derbyshire (wyn.derbyshire@sjberwin.com).

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on its services to the private equity industry please contact Jonathan Blake or Simon Witney in its London office +44 (0)20 7533 2222 or visit our website at www.sjberwin.com