How should "moral hazard" obligations owed by an employer (or a member of its corporate group) to trustees of a defined benefit pension scheme be treated if the employer becomes insolvent? In a judgment that brought relief throughout the pensions and insolvency industries, the Supreme Court has decided that obligations arising from financial support directions (FSDs) or any subsequent contribution notice (CN) rank as unsecured debt, whether the FSD or CN was issued before or after the commencement of insolvency.

What's the issue?
The basic rule when dividing up the assets of an insolvent company is that obligations incurred before the outset of the insolvency proceedings may be claimed (or "proved") in the insolvency but those arising after insolvency commences may not. Provable debts are then paid in accordance with the statutory priority order:

• fixed charges
• insolvency expenses
• preferential debts, including obligations to unsecured creditors (to a maximum of £600,000)
• floating charges
• unsecured debts.

Nortel/Lehman
In the long-standing cases of Nortel/Lehman, The Pensions Regulator sought to impose FSDs on companies in the Nortel and Lehman groups when they were already in administration. Two questions arose:

• Would the obligations under an FSD or CN ("moral hazard" obligations) be a provable debt?
• If so, where would they rank in the insolvency priority order?

These questions are of wide concern as, in all but one case, FSDs issued to date have been imposed on companies already in insolvency. If such FSDs did not give rise to provable debts, it would be bad news for pension trustees and, of course, for the regulator. There was speculation that the regulator might be inclined to issue FSDs earlier on in the process of investigating companies in financial difficulty to get its claim in before the company became insolvent.

Previous judgments – a conundrum
The High Court and the Court of Appeal ruled that the obligations arising from FSDs and CNs issued after the start of the administration ranked as expenses of the insolvency. These judgements, in effect, gave the moral hazard obligations "super-priority" and caused consternation amongst insolvency practitioners and lenders. As pension deficits can be extremely large, an obligation to pay a significant part of an insolvent company's assets to pension scheme trustees ahead of meeting the company's other debts would have serious implications for the company's creditors. It was illogical that an FSD or CN arising before the insolvency would be an unsecured debt but one arising afterwards would be given priority over floating charge holders.

Reassurance from the Supreme Court
In a victory for common sense, the Supreme Court overturned the earlier decisions and held that liabilities from FSDs (or subsequent CNs) issued after the start of insolvency ranked as unsecured debt, to be paid after obligations to fixed and floating charge holders and preferred creditors have been discharged. In reaching this conclusion it was relevant that: the targets had been members of the corporate group for over two years (the look back period for issuing FSDs); the sponsoring employers were either a service company (Lehmans) or insufficiently resourced (Nortel) at the relevant time; and it would be consistent with the FSD regime to impose the liability. The Supreme Court commented that, if the obligations had not been considered unsecured debts, they would not have been an expense – and so would not be provable in the insolvency.

Although pension trustees might regret the Supreme Court's decision, it is reassuring for those financing employers (or seeking to rescue distressed ones) that that they will retain the benefit of any priority attaching to debts owed to them should the borrower become insolvent.

Written by Jill Clucas, of counsel, Hogan Lovells

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