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Saturday, August 3, 2013

UK Supreme Court Resolves that Contributions to Underfunded Pensions of an Affiliate Are Not "Expenses of Administration" Even Though Assessed Post-Insolvency-Proceeding

Traveling in the UK and elsewhere towards the end of July, I read in one of the UK papers a story about a decision of the Supreme Court of the UK in the insolvency proceedings of Nortel and Lehman.  The court held that pension liabilities are pari passu with general unsecured claims in insolvency proceedings. Returning home, I read the opinion online (here: scroll down to 24 July judgments).  I found it interesting how much the court's reasoning parallels US bankruptcy law (without actually mentioning so).  Here is a short summary:

1.  The Pensions Act of 1995 establishes (section 75) minimum funding requirements for pension plans ("schemes" in the UK parlance; but I will generally use American parlance throughout this post as I assume most readers of this blog are US-centric) and specifies that deficiencies in funding are "provable debts" (equivalent to the US's "general unsecured claims") in insolvencies.  Much like section 502(b) of the US Bankruptcy Code, it states that  "a section 75 debt is to be taken, for the purposes of an employer’s insolvency, to arise immediately before the occurrence of the insolvency event."  The Lehman UK and Nortel UK plans were underfunded.

2.  By the Pensions Act 2004 (30 years after ERISA!), the UK appointed a pensions regulator and set up a pension protection fund to backstop pensions, funded by taxes on pension plans themselves.  To protect the fund against corporate asset-shuffling, the law empowers the regulator, inter alia, and regardless of whether the plan sponsor is in insolvency proceedings or not, to issue "Financial Support Directions" ("FSD"), which may require a variety of actions from the target companies to support their affiliate's pension plan.  A specific form of FSD is a "Contribution Notice" ("CN") which requires the targets to pay a specific amount of money. toward the pension plan sponsor's funding deficiency. Such potential liability is similar to the liability ERISA imposes on "commonly controlled entities", although it seems to be ad hoc and discretionary, as opposed to strict and automatic under ERISA.  The CN, because it requires payment of a specific amount of money, would clearly be a "claim" in a US proceeding, whereas theoretically some forms of FSD might, under a KovacsMidlantic National Bank line of reasoning, escape "claim" characterization and be seen as a non-dischargable regulatory obligation.

3. Post the entry of Lehman and Nortel's UK companies into administration, the pensions regulator conducted an investigation into the respective pension plans' funding status and determined to issue some kind of FSD's to certain of their affiliates, which the court presumed, would "in due course" eventually take the form of CN's to contribute to the underfunding.  The actual issuance of those FSD's was "informally stayed" pending litigation of the ranking the resulting liability would have in the insolvencies.

4. The issue was a familiar one: whether the post-insolvency-proceeding FSD was an "expense of administration" in the proceedings of the companies targeted, simply because it was promulgated post-commencement of insolvency proceedings, or whether the issuance of an FSD merely crystallized a contingent liability that loomed over the targeted companies prior to the insolvency by virtue of being in a corporate group with an underfunded pension plan, such that it was merely a pre-petition claim, to use American parlance.  Similar to the US bankruptcy laws, an expense of administration is the highest priority unsecured claim in a UK insolvency proceeding (and even has priority over floating charges, but not fixed charges).  (Also, by way of clarification, there are two types of insolvency proceedings in the UK: administration and winding-up/liquidation; but the opinion explains that the issue operates identically regardless whether the company enters one or the other, or whether it begins in administration and then transitions to a winding up). Thus, the characterization determined whether the pension funding claims would be fully satisfied as admin expenses, or only partially satisfied, pari passu with other general unsecured debts.

5.  Reversing both lower courts, the high court held the FSD liability should be classified a pre-petition claim.  Its reasoning resembles very much the reasoning that US courts go through in analyzing an admin expense / general unsecured claim issue.

6.  The court's reasoning (isn't this just like one of those case summaries law students write up?) begins at paragraph 58: "on the face of it, the sensible and fair answer would appear to be that the potential liability of a target, under a FSD issued after an insolvency event, and in particular the liability under a CN issued thereafter, should be treated as a provable debt. There seems no particular sense in the rights of the pension scheme trustees to receive a sum which the legislature considers they should be entitled to receive having any greater or any lesser priority than the rights of any other unsecured creditor."

7.  Continuing: "if a CN had been issued in respect of a company before an insolvency event, it would give rise to a provable debt, and the courts below considered that, if a CN were issued after an insolvency event, it would give rise to a provable debt if it was based on a FSD issued before the insolvency event. It appears somewhat arbitrary that the characterisation and treatment of the liability under the FSD regime should turn on when the FSD or CN happens to have been issued, if it is based on a state of affairs which existed before the insolvency event."  The court noted the practical consequences of an "expense of administration" ruling: "Where the Regulator is proposing to issue a FSD in respect of a company not yet in administration or liquidation, it would be well advised to wait for the insolvency event, if the decisions below are right, because the amount recoverable under a subsequent CN would inevitably be greater than under a CN issued following a FSD issued before the insolvency event."

8. The court also noted the illogic and unsound policy of treating the debtors in a corporate group differently: "It would be strange if the employer company’s statutory obligation to make good a shortfall in its employees’ pension scheme ranked lower in its insolvency than the more indirect statutory obligation of a target to make that deficiency good ranked in the target’s insolvency."

9. The court also discusses at length whether the affiliates' liability is a "provable debt" at all, what we in the US used to call the "Frenville" issue until that case was overruled by the Third Circuit.  The reasoning is again very similar to the US analysis of whether something is a "claim" that can be discharged in a chapter 11:
"Where a liability arises after the insolvency event as a result of a contract entered into by a company, there is no real problem. The contract, in so far as it imposes any actual or contingent liabilities on the company, can fairly be said to impose the incurred obligation. Accordingly, in such a case the question whether the liability falls within para (b) will depend on whether the contract was entered into before or after the insolvency event."

10.  But, "Where the liability arises other than under a contract, the position is not necessarily so straightforward....the mere fact that a company could become under a liability pursuant to a provision in a statute which was in force before the insolvency event, cannot mean that, where the liability arises after the insolvency event, it" should be viewed as a pre-petition debt.  As a general principle, the court said, to have incurred a pre-petition "debt", the company "must have taken, or been subjected to, some step or combination of steps which (a) had some legal effect (such as putting it under some legal duty or into some legal relationship), and which (b) resulted in it being vulnerable to the specific liability in question, such that there would be a real prospect of that liability being incurred."

11.   The court then proceeds to determine that the contingent FSD liability satisfies the two conditions: "if one asks whether those potential liabilities of the Target companies in these two appeals satisfy the requirements ... the answer is yes."

"As to the first requirement, on the date they went into administration, each of the Target companies had become a member of a group of companies, and had been such a member for the whole of the preceding two years – the crucial look-back period under the 2004 [Pensions] Act. Membership of a group of companies is undoubtedly a significant relationship in terms of law: it carries with it many legal rights and obligations in revenue, company and common law.

"As to the second requirement, by the date they went into administration, the group concerned included either a service company with a pension scheme, or an insufficiently resourced company with a pension scheme, and that had been the position for more than two years. Accordingly, the Target companies were precisely the type of entities who were intended to be rendered liable under the FSD regime. Given that the group in each case was in very serious financial difficulties at the time the Target companies went into administration, this point is particularly telling. In other words, the Target companies were not in the sunlight, free of the FSD regime, but were well inside the penumbra of the regime, even though they were not in the full shadow of the receipt of a FSD, let alone in the darkness of the receipt of a CN."

In other words, the court seems to say, the day before the insolvency, there was a pretty decent prospect the regulator would issue an FSD to the affiliates, and that determines their contingent liability should be treated as a pre-petition debt.

This is, I think, a very similar result and analysis to what you would see in the US.  It is probably a good idea for management of multinational insolvencies that the US and UK take a similar approach to this kind of issue.