Editor's Note: European legislators and courts continue to wrestle with two different issues, both of which are very much in the public eye: the fallout from large-scale financial collapses and the funding of pension schemes. In Italy, the Parmalat failure inspired rapid statutory reform, important features of which are now in the early stages of constitutional challenge. In the United Kingdom, there has been a complete overhaul of pensions legislation, including the creation of a new regulatory regime that effectively gives the new Pensions Regulator a seat at the table in any restructuring scenario. 2006 will continue the pace of European reform in these areas.

The special administrator of Parmalat commenced clawback actions against various banks with a face value of 7.5 billion euros. A recent decision by the Court of Parma in the clawback action against one major bank (which is a test case to establish a precedent for all of the claims against the banks) has resulted in these proceedings being suspended. The Parma court has referred the question of the constitutionality of Article 6 of the Marzano law (under which the clawback actions are made) to the Constitutional Court. The date for the Constitutional Court hearing has not yet been set, but it is expected that it will take place in mid-2006.

Clawbacks under Italian law

Depending on the type of insolvency or restructuring proceeding, clawback claims can potentially be made against any party that has entered into a transaction with, has been granted security by or has received a payment from the insolvent company during the relevant timeframe. A claim will only succeed if the creditor was aware of the insolvency at the time of the transaction. In practice, constructive knowledge may be sufficient. The relevant timeframe depends upon the type of transaction. At the time of the Parmalat insolvency, the relevant timeframe was within either the 12-month or the 24-month period preceding the insolvency. This timeframe has now been reduced by statute to six months or 12 months.

A new form of restructuring proceeding was introduced by the Marzano law to deal with complicated insolvencies such as Parmalat. This new type of restructuring proceeding was substantially the same as an existing type of proceeding: “extraordinary administration.” Both types of proceeding have the same purpose, and the insolvent company is able to continue in business during the restructuring.

However, the law on clawbacks in extraordinary administration is different from that introduced for restructuring proceedings under the Marzano law. When a company is in extraordinary administration, the administrator can only bring a clawback claim once the continuation of business phase has ended and the company is being liquidated. Under the Marzano law, Article 6 provides that clawback actions can be commenced at any time. Accordingly, the special administrator of Parmalat commenced the clawback actions against the banks that are referred to above while Parmalat continued in business.

The Grounds on Which the Parmalat Clawback Actions Have Been Challenged

The banks have challenged the clawback actions brought by the special administrator on two grounds:

1. The provision of the Marzano law that permits clawback actions to be brought at any time is constitutionally invalid; and
2. The clawback provisions are in breach of EU law on state aid.

The case that has just been heard by the Parma court deals with the first of these grounds. The banks argued that the clawback provisions of the Marzano law were in breach of Article 3 of the Italian constitution, which requires equality of treatment. Extraordinary administration and special administration under the Marzano law have the same purpose, yet clawback actions—it was argued—are treated in a very different way.

The banks also argued that the clawback provisions were in breach of Article 41 of the Italian constitution, which requires freedom of competition. At the time the clawback actions were filed, Parmalat was a large company continuing to trade. If such a company were allowed to bring a clawback action, this would give it a competitive advantage as it would have an increased cash flow as a result of money received from clawback actions brought against former creditors.

The Parma court held that both grounds gave rise to a serious challenge to the constitutionality of Article 6 of the Marzano law and so should be referred to the Constitutional Court.

U.K.: New Legislation Dealing with Underfunded Pension Schemes

There have recently been important changes in U.K. pensions legislation. These changes relate to the powers of the new Pensions Regulator and the legal obligations of sponsoring employers and some third parties in relation to pension liabilities. The changes are likely to have a significant impact on companies with a defined benefits pension scheme, particularly where those companies are facing financial difficulties.

Moral Hazard Provisions

To reduce the risk of pension schemes falling into the Pension Protection Fund (which is modelled on the U.S. Pension Benefit Guaranty Corp. (PBGC)), the Pensions Act 2004 includes “moral hazard” provisions. As of April 6, 2005, the Pensions Regulator has significant powers to look to third parties (i.e., not just participating employers) to contribute to pension schemes in certain circumstances. These powers are:

• Contribution Notices: The Regulator can, by issuing a notice, require contributions to schemes (other than money-purchase schemes, unap-proved schemes, schemes for over-seas employees and most public-sector schemes) not only from participating employers, but also, in appropriate circumstances, from other connected and associated persons.
• Financial Support Directions: The Regulator can also require financial support to be put in place where a participating employer is a “service company” or is “insufficiently resourced.”

In addition, there is a new funding requirement on ceasing to participate: As of Sept. 2, 2005, the debt arising under s75 Pensions Act 1995 when an employer ceases to participate in a multi-employer scheme has increased from the Minimum Funding Requirement (MFR) level to the buyout level. The buyout level is the cost of securing all benefits by purchasing matching policies with an insurance company. This is usually a far greater amount than the MFR level, and represents a very significant change with a major impact on corporate transactions and internal restructurings.

These provisions can affect intra-group reorganisations as well as sales to third parties if the effect is that employer ceases to be a participating employer.

Contribution Notices

The power. The Regulator can issue a contribution notice (CN) to a person stating that the person is under a liability to pay the full s75 debt. The notice may be issued to an employer or a person who is “connected with” or “an associate of” an employer where:

• there has been an act or deliberate omission (on or after April 27, 2004, and within the last six years) that reduces the recovery of a s75 debt or, otherwise than in good faith, reduces the amount of the debt;
• that person was a party to (or “knowingly assisted” in) that act or omission;
• the Regulator considers that reducing the s75 recovery/debt was the main purpose (or one of the main purposes) of the act or omission; and
• the Regulator thinks it is reasonable to impose the debt on that person.

The definitions of connected parties and associates are very wide and includes other group companies, directors and 33 1/3 percent shareholders.

Financial Support Directions

The power. The Regulator can issue an FSD where, at any time within the last 12 months, the employer is or was:

• a service company (i.e., its turnover principally derived from providing services to other group companies); or
• insufficiently resourced (i.e., it did not have sufficient assets to meet 50 percent of the s75 debt in relation to the scheme and at that time there was a connected or associated person who did have sufficient resources).

An FSD requires the person to whom it is issued (again, it must be reasonable for the Regulator to do this) to ensure that financial support for the scheme (broadly, funding or guarantees) is put in place within a specified period and maintained throughout the life of the scheme. (Companies must notify the Regulator of anything that later has an impact on the financial support.) The FSD can be directed at the employer or person “connected” with the employer, but unlike CNs, it cannot generally be issued against an individual.

Practical effect. This provision could be triggered even where the sale or restructuring has occurred for legitimate reasons. Recipients of an FSD will have to consider carefully the most appropriate type of financial support to provide. Agreeing that all group companies will be jointly and severally liable could cause problems with later transactions.

Funding on Ceasing to Participate (s75)

Section 75 debt. The s75 debt is a statutory debt on an employer that is triggered when it stops participating in a multi-employer scheme (but other employers continue to participate). The debt is a share of any total funding deficiency in the scheme. The share is normally based on the share of the liabilities attributable to employment with that outgoing employer (including its share of “orphan” members whose service did not relate to a current employer).

Before Sept. 2, 2005, the funding deficiency was calculated on the minimum funding requirement (MFR) basis. Because this is a relatively low test, often no debt arose. Since Sept. 2, this debt has increased to the much higher buyout level, potentially giving rise to a funding deficiency in most occupational pension schemes.

Approved withdrawal arrangements. The Regulator, trustees and the leaving employer can agree that the debt payable by the leaving employer is less than the buyout debt. The minimum is the MFR level (presumably in the future the “scheme-specific level”) plus any cessation expenses; the balance must be guaranteed, with payment triggered if the scheme starts to be wound up, a relevant insolvency event occurs in relation to all the current active employers or the Regulator reasonably so decides.

The detail is complex, and there are numerous conditions—e.g., the Regulator must be satisfied that the s75 debt “is more likely to be met” if the agreement is approved. It is not yet clear how the Regulator will interpret this condition.

Notification to the Regulator

Employers and trustees are obliged to notify the Regulator of certain events under s69 of the Pensions Act 2004, including any decision causing a pension debt not to be paid in full, any change in an employer’s credit rating and a controlling company decision to sell an employer.

The Impact of These Provisions on Restructuring and Insolvency

When the financial condition of an employer is precarious, the fact that the potentially greater buyout debt is triggered by the commencement of formal insolvency proceedings may have a bearing on the decision to continue to trade. The directors might conclude that, properly having regard to the interests of the company’s general body of creditors, it is in the best interests of the creditors as a whole for the company to avoid formal insolvency proceedings so that those claims are not diluted by a claim made by the pension scheme that is valued on the buyout basis.

The combined effect of the new regulations and changes to the accounting standards (which require companies to show any scheme deficits on their balance sheet) will be to increase the prominence of defined benefit schemes that are in deficit or are underfunded. This will further differentiate the financial stability of employers that contribute to defined benefit pension schemes from those that do not.

As we see it, this may have two consequential effects on the insolvency and restructuring market. First, companies that have a primary liability (that is, as employer) to defined benefit schemes that are in deficit on a buyout basis may be forced to restructure or, in the worst-case scenario, commence insolvency proceedings. At the very least, such companies may find it harder and more costly to raise debt. As a consequence, the Regulator may consider issuing FSDs and CNs to other companies within the group. This may lead to a second raft of corporate restructurings and failures, caused by the overburdening of companies’ cash flow and balance sheets as a result of their financial obligations under FSDs and CNs.

Mitigating the Risk

Restructurings need to be planned carefully if they are to avoid triggering a buyout debt under s75 or the risk of participants being issued with CNs or FSDs. In particular, care must be taken where it is proposed as part of a restructuring that employees be transferred, companies wound up or value extracted from the group (for example, by way of payment of a dividend or the grant of security). This will be an issue even where the company’s pension scheme has no deficit on an ongoing basis because the Regulator is concerned with ensuring there is potential funding for the (much) higher buyout basis required under statute in certain situations. There are, however, some steps that can be taken to minimise the moral hazard risk.

Purpose. Purpose is a key part of the CN test. Care must therefore be taken in minuting the purpose of decisions that might weaken the strength of the participating employer’s ability to fund the pension scheme. “Purpose” will be assessed with the benefit of hindsight, and experience with insolvency and tax legislation is that it is notoriously difficult to assess.

Clearances. Where a restructuring involves, or might affect the financial position of, a participating employer of a defined benefit pension scheme, the parties to the restructuring should seriously consider the need to seek from the Regulator a clearance statement prior to completion.² Assuming full and accurate disclosure to TPR in a clearance application, the transaction will not be at risk of later being the subject of CNs or FSDs. Even where formal restructuring tools available in the United Kingdom are to be used, obtaining clearance could be prudent. This is because the decision by scheme trustees to seek to compromise a pension scheme debt gives rise to a duty on the employer and the scheme trustee to notify the Regulator of the proposed compromise. This might lead to a review of the proposed transaction by the Regulator. Unless a clearance notice is obtained in respect of the compromise, it is possible that the Regulator might issue a CN or FSD with respect to any deficit. As a result of the compromise of scheme debt, the scheme might also be excluded from the scope of the Pension Protection Fund. This would clearly be a result to be avoided if possible.

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Footnotes

1 Contributing authors are Enrico Castellani, Milan; Catherine Derrick, London; and David Pollard, London.
2 Transactions where companies should consider seeking clearance are called “Type A Events.” These include issuing security over material assets (other than security for new borrowings); returns of capital, including special dividends, share buy-backs and capital reductions; and changes in (direct or indirect) control of employers—e.g., a disposal or group reorganisation.

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Topic Tags:  Fraud International Insolvency Practice and Procedure Journal Date:  Wednesday, February 1, 2006 © American Bankruptcy Institute. All rights reserved. ABI is a (501)(c)(3) non-profit business (52-1295453)