The Company Covenant: Asking for More
31 Aug 2004
This article appeared in the Financial Times on 9 August 2004
The Company Covenant
Asking for More
[Article for FT – 9 August 2004]
The evening arrived: the boys took their places; the master in his cook’s uniform stationed himself at the copper … the gruel was served out … The gruel disappeared, and the boys whispered each other and winked at Oliver, while his next neighbours nudged him…He rose from the table, and advancing, basin and spoon in hand, to the master, said, somewhat alarmed at his own temerity - 'Please, sir, I want some more.'
The master … turned very pale. He gazed in stupified astonishment on the small rebel for some seconds, and then clung for support to the copper. The assistants were paralysed with wonder, and the boys with fear.
'What!' said the master at length, in a faint voice. 'Please, sir,' replied Oliver, 'I want some more.'
Trustees are increasingly in the position of Oliver Twist, asking for more. Mostly they are asking for more money, and ideally enough money to plug the deficit. But it is not always immediately available.
The employer’s covenant, or promise, to its pension scheme is attracting more attention, and rightly so. This is partly because the employer’s promise stretches far into the future. This brings uncertainty about whether the employer will be able to meet the obligations. In some cases there will be very little doubt, but considerable uncertainty in others. And there is a broad spectrum in between. The fundamental point is that a company’s prospects, and ultimately its survival, are not certain. Recent experience shows that companies can rapidly move from unquestioned financial standing to financial ruin.
How should trustees approach this risk? There are no simple answers, but we can start in the right way.
First, the risk must be recognised.
Secondly, it must be considered carefully without rushing to conclusions.
Thirdly, it should be discussed with the employer in a measured manner.
One potentially fruitful way to continue is to look at the pension scheme as an unsecured creditor of the employer. In most cases it is a substantial unsecured creditor. In some cases it will be the largest. The obligations are payable long into the future – perhaps for 70 years or so. As such, the pension scheme trustees should consider how other unsecured long term creditors seek to control their risk.
Such a creditor would, in nearly all cases, prefer to become a secured creditor. So the first area to explore is whether any form of security might be available. Not all companies will be in a position to grant security. And even if a company could do so, it may be very reluctant if this would affect its ability to borrow, or the cost of its borrowing (by, for example, reducing its credit rating). However, it would be reasonable for trustees to ask for some form of security or other protection if they are being asked to agree to funding a deficit over a prolonged period, or to adopt a more risky (equity based) investment strategy than they might otherwise choose.
This is a rapidly developing area, and trustees should be keen observers. Examples of forms of security which have been or could be granted to pension schemes are:
- Charges over fixed assets
- Bank guarantees and letters of credit
If security is not available, the trustees and employers might consider other techniques which have been developed by unsecured lenders to protect their position. Banks and bond holders have developed protection in a number of ways, often combined in a powerful cocktail. Examples include:
- Negative pledges, by which an employer agrees not to grant priority to other creditors
- Change of control provisions, which trigger (accelerated) payment obligations when a borrower is subject to a change of control
- Financial covenants (such as permitted levels of gearing), breach of which would trigger accelerated payment obligations
- Credit rating covenants which would accelerate a company’s obligation to repay in the event of its credit rating falling below a specified level (for example investment grade)
- Disposal covenants, where a significant disposal would trigger accelerated payment obligations (or a right to receive a certain proportion of disposal proceeds by way of repayment)
- Information covenants, which require ongoing information about a company’s financial position, or information if certain trigger points are breached
- Material adverse change provisions, which trigger accelerated payment obligations in the event of an adverse change in the borrower’s position.
- Covenants from other substantial entities in a group (e.g. the parent company if it has not already covenanted).
These are just some examples of provisions which can improve the position of a creditor if the borrower’s financial position deteriorates. This is achieved in two basic ways. First by the company agreeing that it will not allow its financial position to deteriorate (so far as it can). Secondly, by bringing forward (accelerating) wholly or partly the company’s obligation to pay if the position deteriorates beyond a certain point.
Many of these covenants could be granted more or less readily when a company is in strong financial health, and provide protection against a downturn. Employers who, understandably, stress their current robust health might well be prepared to agree that the pension scheme should be protected in the event of an (unexpected) deterioration.
Obtaining agreement to such protection is not easy, and will not be appropriate or possible in all cases. It is also important to maintain trust and goodwill between an employer and the trustees. But given the very substantial obligations of companies to their pension schemes, and the associated risk which members face, trustees will be increasingly expected to open discussions with companies and to apply the know how of other creditors.
Approached in the right manner, asking such questions should not elicit the enraged response of a Mr Bumble. Trustees may have to continue to be
unsecured creditors – but they can be made less
insecure.
Mark Ashworth
Law Debenture
August 2004
Pension Trusteeship
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