Duke Street's pensions hit

Duke Street Capital's recent payment of £8 million into the Focus DIY pension fund almost a year after it sold its holding has raised concerns that the Pensions Regulator (the Regulator) is readier to use (or threaten use of) Financial Support Directions (FSDs) in relation to under-funded pension schemes. The Regulator's power to use FSDs is in part a response to the perceived risk of companies abandoning under-funded pension schemes, which would leave a shortfall for the Pensions Protection Fund.

In fact, this is not a new threat, as the Regulator has been able to exercise "moral hazard" sanctions retrospectively since April 2005. These sanctions let the Regulator look back at actions over 12 months and are used to require a company to put financial support in place for its pension scheme. While the most common example would be a parent company guarantee, these powers are of particular interest to investors, because an FSD can be issued against a company which is connected with the pension scheme's sponsoring company. This will include a company which controls a third or more of the sponsoring company's shares.

One of the Regulator's key concerns is transactions which reduce the asset base of the pension scheme's sponsoring company. In the case of Focus, while no FSD was actually made, several factors improved the Regulator's negotiating position:

(a) the 2005 sale by Focus of the Wickes group, followed by a significant return of capital to shareholders (including Duke Street) and a highly leveraged refinancing;

(b) the increase in Focus' scheme deficit from £26m in 2005 to around £32m in 2007;

(c) Focus' weakened financial position, as shown by its sale to Cerberus Capital in 2007 for £1;

(d) lack of clearance from the Regulator before the return on capital (even though in this case, the clearance system may not have been in operation at the relevant time).

Looking back at deals done during over the last few years, none of these factors are unique to Focus. Now that the Regulator has intervened once, it may well be do so again if highly geared companies start to struggle in a downturn. This risk can be reduced by:

(a) extending financial or actuarial advice to cover the effect that any new transaction may have on a company's financial health (and by extension, its ability to support its pension scheme);

(b) incoming investors and potential purchasers increasing their diligence on past transactions which may have affected any pension scheme;

(c) early involvement of scheme trustees on new transactions, since the trustees' approval will be a significant consideration for the Regulator;

(d) seeking clearance from the Regulator that a transaction will not result in an FSD being imposed.

While these steps will increase time and costs on a transaction, they may be justified by the savings made in avoiding intervention by the Regulator. A worsening economic climate means that the settlement with Duke Street may not be a one-off, but the Regulator will have to balance the use of its increased powers to protect pension scheme members against the interests of companies and investors.

Given the likely increase in defaults, historically high leverage on existing deals and a political background which may encourage protecting dwindling public funds at the expense of out-of-favour private equity, it remains to be seen just how well the Regulator manages this balancing act.

- Richard Garvan is banking & finance partner at Denton Wilde Sapte LLP and Andrew Patten is pensions partner.

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