Legal responsibilities

Since the UK Pensions Act came into force in April 2005, its impact on behaviour in the boardroom has been significant. Under the Act, the Pensions Regulator has a mission to protect members, minimise the risk of claims on the national Pension Protection Fund and improve the administration of schemes.

Though these goals are laudable, they are also onerous. Their effect has been that companies considering any corporate development decision involving acquisition, merger, divestment, or indeed any form of restructuring or refinancing, need to consult extensively with trustees and seek clearance from the Pensions Regulator. Failure to do so may prejudice the success of such corporate action and invalidate directors' and officers' (D&O) protection for senior executives.

In the light of these extended requirements it is perhaps little wonder that 83% of companies that AIG (Europe) UK surveyed at our annual corporate governance seminar in 2006 were anticipating increased litigation against company directors, and 97% were concerned about new pension trustee exposures.

<B>Trustees' responsibilities</B>

At the core of the Act, the aim is to ensure that members of schemes can rely on qualified individuals to oversee their pension. Trustees are required to be conversant with scheme documentation and have appropriate knowledge and understanding of pensions and trust law and the principles underpinning investment and funding. They owe duties of honesty, loyalty and good faith to trust beneficiaries, must exercise due care and diligence in discharging their duties and must not have conflicts of interest.

Trustees are explicitly warned that they need to know and understand enough to be able to ask challenging questions of their advisers, and are required to be assertive in negotiations with employers that sponsor the schemes under their stewardship.

If trustees suspect wrongdoing, whistleblowing is not just encouraged, it is mandatory. Specifically, trustees are required to make written reports to the Regulator as soon as reasonably practical if they find any non-compliance or specific failures. Some events, for example a change in the employer's credit rating, changes of executive positions or changes in key scheme posts need to be notified to the Regulator the next day. In addition, they must keep up to date, undergo regular training, and be able to demonstrate to the Regulator that that they have met the required legal standards.

The net result of these requirements is that trustees now find themselves with extended responsibilities and may be obliged to disclose sensitive information within extremely short timescales, leaving little opportunity to consult with their advisers, or indeed their insurers.

What is more, the liabilities for trustees and their schemes do not diminish when the scheme is closed, wound up, or put into run off. Effectively this means that pension fund trustees are on the hook, even when the scheme is no longer active, and even after they have given up their responsibilities and moved on to other roles or retired.

<B>Risks and penalties</B>

In part, companies have brought these troubles on themselves by using corporate restructurings as an opportunity to dump pension debts.

- Contribution notices Now, under the 'moral hazard' provisions of the Pensions Act, the Regulator can circumvent these plans by issuing a contribution notice which transfers liability from employers to those 'associated' or 'connected' with them.

These terms are very loosely defined, but can include individual directors or trustees, as well as group companies, and can require the employer, associate or other 'connected person' to pay all or part of the pension debt out of their own pocket. Clearly, this poses a direct risk. With the total deficit for final salary pension plans of FTSE 100 companies running at £110bn in 2006, according to actuaries at Deloitte, this is a real concern for directors and companies alike.

Even if trustees were not voting on a proposed restructuring, but had merely agreed to pay outstanding debts to an unsecured creditor that left the fund with less security, they could potentially be issued with a notice to make good the shortfall.

n Clearance statements To avoid censure, companies are increasingly consulting with the Regulator. Though such a step is not mandatory, it is self evidently in companies' and directors' interests to gain confirmation that any proposed restructuring is not considered prejudicial to the funding of any schemes and will therefore not lead to the imposition of a contribution notice.

Provided the Regulator is presented with all the facts, its decision is binding - thus protecting companies and officers against the threat of future litigation. However, it should be noted that if there is a material change in circumstances, or if the circumstances described in the application are found to be inaccurate, then the clearance can be rescinded.

- Financial support directions If such clearance is not obtained, the consequences are significant, prejudicing not just the success of the immediate transaction in question, but also putting the company at risk of a 'financial support direction' which, once imposed, will last for the lifetime of the scheme.

The powers available to the Regulator under the Act include the ability to make all group companies jointly and severally liable, to make the holding company liable and to require that additional financial resources be made available.

In order to grant the clearance required to prevent such liabilities arising as part of commercial transactions, the Regulator will look for evidence that trustees have been involved in negotiations and have taken steps to ensure that the business is compensated for any deficit arising as a result of a reduction in the number of staff paying into a scheme.

- Restoration order Other routes open to the Pensions Regulator include the imposition of a restoration order, which requires that money or property that has been transferred out of the scheme in the two years preceding an insolvency event or application for support from the PPF (Pension Protection Fund) be returned to the trustees or paid to the PPF as appropriate, in order that the scheme can be restored to the position it would have been in had the transaction not occurred.

The Regulator will also assess whether steps have been taken to pay off any debt arising under the accounting standard FRS 17, preferably on day one, or at a maximum within three years - a much more stringent requirement than companies were used to.

Whereas the old regulator (OPRA) would tend to wait to be notified of a problem with a pension scheme, the Pensions Regulator is taking an active approach and over the next year or so will obtain detailed feedback from every single scheme in the UK (of a particular size). If the Regulator chooses to, it can visit any of these schemes to investigate potential problems and, if appropriate, issue penalties and fines.

<B>Exoneration clauses broaden exposure</B>

While it is the trustees that bear the brunt of greater regulatory scrutiny, the reality is that there are other entities exposed to the mistakes of the trustees as well, such as the company and the plan itself. This is because though trustees may be personally liable for the running of their scheme, many companies lay off much of the risk by providing trustees with indemnities and exoneration clauses within the trust deed.

In essence, exoneration clauses exempt trustees and former trustees from liability for any actions carried out as part of their duties, other than dishonesty. The jury is still out on whether subjective or objective tests should be applied to determine whether dishonesty has taken place, but acts that are likely to fall under the definition of dishonesty include:

- actual fraud which requires proof of dishonesty

- wilful default for example a deliberate breach of trust

- gross negligence a reckless disregard to duty of care

- judicious breach of trust a trustee who commits a deliberate breach in the belief it will further the interests of the funds' beneficiaries (generally this would not be construed as fraudulent and may be covered within an exoneration clause)

Although trustees should be able to rely on the exoneration clause if brought before the Pensions Ombudsman, they should be aware that the Ombudsman is likely to interpret these clauses very strictly, so great care needs to be taken over the precise wordings that are adopted.

<B>Indemnity clauses</B>

It may be that indemnity clauses are redundant if there is an appropriately drafted exoneration clause within the scheme. However, because exoneration clauses vary and the test for dishonesty is not entirely clear, an indemnity clause may provide protection for trustees where an exoneration clause falls short. Indemnities can be valuable in relation to two particular types of liability - the recovery of legal costs incurred in defending a claim against a trustee and the liability that trustees owe to third parties, for example professional advisers' fees.

<B>How can trustees protect themselves?</B>

Trustees of schemes should be very conscious of their potential financial liability and insist on the comfort of indemnity insurance. Issues for trustees to consider include:

- the scope of insurance

- defining the matters covered

- the continuation of cover on a claims made basis, particularly after a trustee has left office

- the provision of cover for legal expenses where a trustee is faced with the cost of defending a claim

- exoneration of trustees

Care is needed in selecting insurances because of the statutory restrictions on the scope of exoneration and indemnity clauses - for example where investment decisions are concerned, or where a trustee is also a director of the employer company, one of its associates, or of a corporate trustee.

Of course, relying solely on the protection of insurance and indemnities is not a complete solution. Active companies and their trustees should also be maintaining a watching brief on corporate governance, with appropriate bottom-up tests and controls in place throughout the organisation.

<B>Focus on corporate governance</B>

A focus on corporate governance is critical. For example, the Regulator issued a Code of Practice on Internal Controls in November last year, which, among other areas, suggested that trustees or managers of an occupational pension scheme must establish and operate adequate internal controls that ensure the scheme stays within its own rules and is run in accordance with legal requirements. These controls should enable trustees or managers to react to significant funding, operational, financial, regulatory and compliance risk and should play a key role in reducing the likelihood of fraud.

This Code of Practice was the latest of 10 Codes that have been issued by the Regulator to clarify the duties of trustees since April 05. While the focus of the codes varies, all point to the need for trustees to take steps to ensure that their confidence in the operation of their schemes and their stewardship of them is fully justified.

<B>What the future holds</B>

Looking back, five to 10 years ago pension trustees would have had little or no role in discussions about their exposures, and neither would the Regulator - so these provisions have undoubtedly changed the way business is transacted.

On a positive note, these provisions will mean greater data sharing with trustees, better communication and closer cooperation. However, they also increase the threat of litigation at both a personal and corporate level and this threat is now a very real concern for trustees, sponsoring employers and their directors.

Managing this risk effectively means that companies need to have a two-pronged approach. Firstly they need to embed effective processes, so that they can identify areas of risk and embed appropriate mitigation strategies. Secondly, trustees need to ensure that insurance protection is appropriate - whether for ongoing cover, run-off, overlooked beneficiary cover for schemes due to wind up, or new cover for schemes which are being started up, perhaps on the back of a deficit.

<B>Faced with corporate change, what should trustees consider?</B>

Trustees must always be mindful of the potential impact on members' security of any proposed corporate transactions or changes. Specifically they need to:

- Actively raise any concerns with the sponsoring employer and check that the employer can correct any underfunding

- Avoid conflicts of interest so that they are always acting in members' and beneficiaries' interests. This means that if an employee is also a trustee and gains knowledge of a corporate activity that will affect members' interests, he cannot simply disregard the information and should seek legal advice. The trustee will need to declare his interest and consider his position, which could involve opting out of decision-making on the issue where he has conflicts.

- Consider all the options open to the trustees, which may include seeking additional contributions or obtaining legal guarantees from the employer or others to provide additional money, should the scheme wind up while still in deficit.

- Monitor corporate activity. Trustees need to understand the sponsoring employer's financial position and the strength of its commitment to funding the scheme. Since trustees may not know about a transaction until after it has taken place, they need to decide how they will monitor activities and establish their likely impact on the pension scheme, for example by obtaining the employer's agreement that they will be given information at an early stage, subject to the usual restrictions.

- Take appropriate advice. Trustees may need to commission an investigating accountant or insolvency specialist with appropriate industry knowledge to assess the financial circumstances of the employer or group of companies. They may also wish to consult their legal adviser in these circumstances but will have to weigh up the costs of obtaining advice against the possible benefits to the scheme.

- Pass concerns to the Pensions Regulator promptly.