Pension scheme priority for insolvent companies ruling due on Friday

Last year the High Court ruled that a claim by the Pensions Regulator, on behalf of former employees of Nortel Networks and Lehman Brothers' European division who had been members of defined benefit pension schemes, took priority over other creditors.

In his ruling Mr Justice Briggs said that where the Pensions Regulator had begun to raise a Financial Support Direction (FSD) against a company related to the one that sponsored the pension scheme, that FSD would rank above claims of other creditors, including banks.

"This case is of major significance to pensions and restructuring practitioners and all creditors of companies associated with a defined benefit pension scheme in deficit. It is of particular importance to pension creditors and banks reliant on floating charge security," said Alastair Lomax, a restructuring specialist with Pinsent Masons, the law firm behind Out-Law.com.

A defined benefit pension scheme is a scheme that promises a set level of pension once an employee reaches retirement age no matter what happens to the value of the pension investment. This means that the employer running the scheme bears the risk that the investment will lose value.

Members of defined benefit pension schemes whose employers can no longer afford to pay the pensions they have promised can claim compensation from the Pension Protection Fund (PPF), which is funded by contributions from eligible schemes.

Since 2004 the Pensions Regulator has had wide powers to seek financial contributions or support to meet a pension scheme deficit from companies connected to or associated with the pension scheme employer through FSDs and contribution notices. These powers prevent the "moral hazard" that companies in the same group might "throw the burden of pension scheme deficiencies upon the PPF", according to the High Court ruling.

When Lehmans and Nortel went into administration the Regulator began the process to issue an FSD against companies within the two groups that did not participate in the pension scheme. Nortel's scheme was approximately £2.1 billion in deficit, while Lehmans' was approximately £148 million in deficit.

When a company is placed into administration or liquidation, not all of its debts can be paid. The law therefore dictates the order in which different debts can be settled. Secured creditors, who hold fixed charges indicating that a specified asset can be used to satisfy a particular debt, are normally paid first. Any surplus is then made available alongside the proceeds of the sale of other assets to settle the expenses of the administration, employee claims and other debts. This means that in the majority of insolvencies, unsecured creditors will remain unpaid or only receive a small percentage of the debt.

The High Court decided that the Regulator's claims for contributions enjoyed "super-priority" status as first-ranking administration expenses, because the claims were made after the administrators were appointed in each case. Had the claims been made before the administrators' appointment the claims would have ranked lower in the hierarchy, as an unsecured provable debt.

Delivering the ruling, Mr Justice Briggs described the regime as unfair to the other creditors and "a legislative mess".

"Parliament has, either through deliberate intent or (I suspect in reality) inadvertence, legislated in such a way as to leave the priority problems associated with the implementation of the FSD regime on insolvent companies to be dealt with by a technical formula which was neither designed nor, in my view, fit for that special purpose," he said.

Restructuring law specialist Alastair Lomax said the original ruling was "a paradigm case of the law of unintended consequences".

"Its impact on the fair, equal and proportionate division of assets on insolvency is serious," he said.

A report on the Court of Appeal's verdict will follow on Out-Law.com in due course.

Editor's note 14/10/11: For more see our coverage of the verdict.