Carillion Plc (Carillion) Shareholder Dividends vs. Pension Deficit Repair Contributions (DRC) – who is responsible for this mess?
I thought it would be useful to use the recent Carillion collapse as a case study in determining the complex problem of determining the appropriate level of DRC contributions into a scheme and the competing interests of other stakeholders for the employers operating cash flow. In this particular case I am focusing on the level of dividends to be paid to shareholders vs. DRC.
I have given the background numbers below, I will then review the Pensions Regulator (tPR) guidance over the years, apply the guidance to this case, try and identify who may be responsible and then suggest how to fix the problem within the existing framework.
Carillion pension’s scheme (Carillion Scheme) members are likely to receive a substantial reduction to their anticipated benefits and receive Pension Protection Fund (PPF) level of benefits instead. Some may say this is a better outcome than the sub-contractor and suppliers of Carillion who will probably receive nothing.
Carillion dividends to shareholders v. contributions to the Carillion Scheme
The table below outlines some high level numbers for Carillion 2010-2016. For the past 7 years Carillion has had an average annual Profit Before Tax (PBT) of £147 M, average annual dividends of £75 M and average annual pensions deficit contribution of £40 M. The Carillion Scheme is large with over £2.5 Billion of assets and a Section 75 deficit of £2.6 Billion (4 times larger than BHS). Its DRC period finishes in 2029. It had an average scheme deficit of £431 M over the 7 year period. The 2017 deficit in the half yearly accounts is shown at £587 M. Press reports are estimating a PPF deficit of £900 M.
Over the past 7 years the shareholders of Carillion have pocketed over £524 M in dividends versus the Carillion Scheme which only received £280 M. The basic premise should be that the scheme as a creditor should get paid ahead of shareholders as equity holders. With Carillion it appears that the shareholders have jumped the queue? If no dividends were paid out and instead the cash went to the Carillion Scheme, the loss to the PPF would be reduced by £524 M. If the Carillion Scheme was treated equally to the shareholders, the Carillion Scheme/PPF would be £122 M better off. One would think the Pensions regulator (tPR)/PPF would be very interested in who caused the Carillion Scheme’s loss?
Government promises and public interest
Prime Minister Theresa May has said that “executives who try to line their own pockets by putting their workers’ pensions at risk“, is “an unacceptable abuse that we will end”. She was talking about a new fines regime for directors where there is a loss to the pension scheme members. Pensions Minister Esther McVey has said she will review the priority of pensions in insolvency. Apparently, the Department of Work Place Pensions (DWP) select committee chairman Frank Field MP is in favour of penal damages against top executives who short – change company’s pension schemes. Let’s disregard these PR soundbites from our politicians for the moment and come back to them later.
There is not a public face to the collapse of Carillion. Unlike with BHS the popular press cannot print pictures of Sir Phillip Green sunning himself on his Yacht on the Mediterranean. Even though in this case the Carillion Scheme is 4 times larger than BHS and BHS did not pay a dividend at all during 2010 to 2016. As there is no discernible scape goat there is less public interest in the Carillion and potentially less call for the government to put pressure on those responsible.
So who is responsible for the loss and what can be done about it?
The Carillion Scheme trustees are responsible for ensuring that the Carillion Scheme members receive their benefits so let’s start with them. The Pensions Act does not give trustees any assistance on dealing with deficits so we must look at tPR guidance. tPR has produced some excellent guidance’s over the years but they seem very reluctant to provide guidance on employer covenant and DRC. A specific Employer Covenant Guidance paper was only released in 2015 and there is no specific guidance paper on dealing with deficits and recovery plans.
The tPR 2006 Code of Practice 03 Funding Defined Benefits states that trustees should aim for any shortfall to be eliminated as quickly as the employer can reasonably afford. What is possible and reasonable will depend on the trustees assessment of the employer’s covenant. They are only simple sentences however it is a start.
A bit further on in the guidance we also get the following assistance: When trustees consider the structure of a recovery plan and the contributions required, they should take account of the following; the employer’s business plans and the likely effect that any potential recovery plan would have on the future viability of the employer, the scheme’s membership profile, whether a longer recovery period may be appropriate for a relatively immature scheme and vice versa; and the ability of the trustees to recover the scheme deficit in the event of the insolvency of the employer, taking the domicile of the employer into account and the employer’s expenditure commitments.
The structure of a recovery plan should recognise, for instance, necessary capital expenditure or debt repayments: reports of industry regulators, if appropriate; the value of any contingent asset security provided by the employer (bearing in mind both its term and its enforceability); the likely benefits available to members should the employer be subject to insolvency procedures in the short term; whether any impending member movements would have a significant effect on funding e.g. major retirements or bulk transfers; the level and nature of any employer related investment; the effect of the recovery plan assumptions not being borne out by experience and the anticipated level of the PPF risk based levy and how this is to be paid by the employer.
Carillion had a PBT of £147 M. The employer used these funds to pay its debt principal/interest, tax obligations, capital expenditure, deficit recovery payments and dividends. In this case the deficit repair contributions were 27% of the PBT. This is at the top end of my range of what I consider an “employer can reasonably afford”.
The problem in this case is the £75 M going out the door as dividends. The most prudent approach here would have been that no dividends be paid. Instead the Carillion Scheme should have received an extra £75 M until the Carillion Scheme was better funded. Of course the employer would probably not have agreed to that. At this stage I would have recommended that the trustees argue that the employer could “reasonably afford” to pay more and the split should be more like £75 M into the Carillion Scheme and £40 M to shareholders.
The Guidance set out above is all that the trustees had to rely upon until the Code of Practice 03 was updated in 2014. This is strange as one would think that getting cash into a scheme as fast as possible to secure members benefits is a key objective of the trustees, TPR and the PPF. I would expect tPR to have provided more guidance in relation both is.
I have extracted the 2 sections on funding recovery plans in the 2014 Code of Practice 03 below:
Section 142 – Although affordability of deficit repair contributions is a factor to consider, this does not mean that an employer should be expected to pay deficit repair contributions at a particular level simply because it would be able to afford to contribute at that level or because it has been paying them at that level. Instead, trustees can use the flexibilities available in recovery plans to ensure that they are appropriately tailored to both scheme and employer circumstances. They should recognise, for example, that a longer recovery plan period may be appropriate where technical provisions reflect a particularly low risk approach. Conversely, the impact on scheme risk of adopting weaker technical provisions may result in the need for a proportionately shorter recovery plan period.
Section 143 – When considering the affordability of deficit repair contributions the following are some of the relevant factors:
- the forecast cash flow of the employer after essential business expenditure and investment;
- the employer’s plans for sustainable growth – its proposed use of its free cash flow after essential spend and investment;
- the difference between temporary factors restricting cash availability and longer-term structural trends;
- the employer’s debt structure and debt service obligations;
- the employer’s capital structure and resources; and
- the employer’s dividend policy.
The above is useful however it appears to me to be a weakening of the “reasonable affordability” concept. I am particularly interested in the last bullet point on dividend policy. It appears to me that the trustees need to take the dividend policy into account and the affordability of DRC after the dividend is determined. If that is true then in this case if the dividend is set in stone at £75 M, DRC of £40 M appears to be quite reasonable.
The 2015 tPR Guidance on assessing and monitoring employer covenant provides the following:
Example 15: Request to reduce DRCs when dividends are being paid.
Fact: The sole participating employer is proposing that DRC’s be reduced to support investment in the employer. The employer pays a large proportion of its cash flows as dividends each year and does not intend to reduce the level of dividends to help to finance the investment.
Guidance: As the employer is not reducing its dividends, the proposal does not appear to treat the scheme equitably compared to shareholders. Therefore, the trustees should consider making a counter-proposal whereby all stakeholders contribute equitably to investment in sustainable growth and share in its benefits.
tPR has therefore introduced the concept of “equitably”. The question is what is equitable or fair?
The DB Annual Funding Statement 2016 says the following about affordability and managing deficit: tPR expects trustees to seek higher contributions where there is sufficient affordability for the sponsor, without a material impact on its sustainable growth plans. If investment in an employer’s business is being prioritised, constraining the level of contributions to the scheme, it is important that the scheme is treated fairly.
We now have a concept of fairness? What does that mean in the Carillion case? Paying dividends does not appear to fit within the definition of investment in the employers business?
tPR Annual Funding Statement in 2017
The relevant section in tPR’s statement is headed: Fair Treatment between schemes and shareholders.
We are likely to intervene where we believe schemes are not being treated fairly, particularly in circumstances where:
- recovery plan end dates are being extended unnecessarily (for example where the recovery plan end date has been extended but there is sufficient affordability to increase contributions to the scheme).
- where the employer covenant is constrained and total payments to shareholders (including dividends and share buy backs) are being prioritised and therefore are restricting or reducing the level of contributions being paid to the scheme.
One aspect we will consider is the impact of dividend payments on the employer covenant.
Trustees need to ensure that contributions to the scheme feature prominently in their employer’s considerations and that the trustees legal obligations to the scheme as a creditor are recognised ahead of shareholders with no legal entitlement to dividends, but who may exert pressure on the employer to obtain them. We expect schemes where an employer’s total distribution to shareholders is higher than deficit reduction contributions being paid to the pension scheme to have a relatively short recovery plan and that the recovery plan is underpinned by an appropriate investment strategy that does not rely excessively on investment outperformance.
Where this is not adhered to, we would consider opening an investigation to assess whether the levels of contributions being paid to the scheme are too low and whether the level of payments to shareholders suggests that the employer has greater affordability. Where we believe there is sufficient affordability to increase contributions to the scheme, we will take steps to ensure that an appropriate balance is struck between the interests of the scheme and shareholders by the employer.
This guidance seems to be useful for the Carillion Scheme. Once again we have the concept of fairness. I would argue that the Carillion Scheme was not treated fairly and that it should have received a greater contribution and the dividend reduced. The employer covenant is constrained through its level of dividends and the large deficit and large scheme the employer is supporting.
My view in reading the above guidance would be that £75 M should have gone to the Carillion Scheme and £40 M to the shareholders to be “fair”. I note tPR states they will open an investigation if the guidance is not adhered to, however from press reports it appears tPR only opened an investigation after the £845 M profit write down last Autumn and not in response to the “unfair” dividends being paid out over the years?
Have the trustees, failed in their duties? What could have they done about it?
The trustees are responsible to agree the valuation and the recovery plan. It is they who may have breached the legislation not the employer. If negotiations on the DRC cannot be agreed the only power the trustees have is not to sign off the valuation within the 15 month time window. tPR is then notified of the breach and tPR will then allow more time to agree with the employer. It will go around in circles before some form of improved deal may be obtained.
This puts the trustees in a very difficult position with the senior management as they may have presented valid reasons why the £75 M dividend needs to be paid ahead of the Carillion Scheme. The most compelling reason would probably include that we need to pay the dividend to shareholders in order to maintain our share price which allows the employer to raise capital in the future. This is certainly a valid reason and is widely used. Management will also argue that the nature of the Carillion Scheme is long term and the liabilities go up and down. Gilt yields are artificially low at the moment and the deficit will be cleared when gilts go back to normal etc.
Most trustees are lay trustees and currently work for the employer. It is tough to negotiate against your ultimate boss. The Carillion Scheme had professional independent trustees who get paid hourly rates to attend to Carillion Scheme business. They are appointed and removed by the employer so they have to be careful in pushing too hard and not be seen to be collaborative in working with the employer.
The trustees may have received professional advice from their covenant adviser on the level of DRC and level of dividends. I find in these types of situation trustees do not seek advice on DRC/dividend payments as they know they will not like the answer if asked. I would not have signed off on this recovery plan.
I am of the view that the trustees should have negotiated a better deal for the Carillion Scheme however it is probably unlikely there will be any come back from the tPR/PPF. If a covenant advisor has signed off the DRC then it is possible that the PPF may investigate a claim against them for the loss. One of my legal friends may be able to give an outline of the trustees duties? I have already been informed by my pensions litigation friends that nearly all professional negligence claims against pensions advisers are settled on the court steps.
Who else might be held accountable?
What about the employers, directors and senior management? Directors have duties to all stakeholders not just the pension scheme. Unless there is a “smoking gun” memo somewhere it appears it would be difficult for the Carillion Scheme to claim against them. They were well paid senior managers but Carillion would argue that they were paid market rates for running a £5 billion turnover business and they did not receive any of the £530 M personally. The liquidator may have a claim against them for breach of their directors duties for misrepresenting the profitability of the contracts and the £845 M subsequent write down when the new finance director undertook a review. This will be hard fought drawn out litigation claim that would be defended by the directors insurer. Any proceeds would go to all creditors including the banks so would be unlikely to directly assist the Carillion Scheme members.
Will a liquidators claim against the auditors help Carillion Scheme members? The auditors did not advise on the level of dividends/DRC payments therefore they do not have any liability to the Carillion Scheme. Any claim would be brought by the liquidator for any negligence in relation to the audit. Once again this would be a hard fought claim. Big Four auditors accept some clients will go bust and they will be chased as they have the deepest pockets. They are professionals in defending such claims and once again any proceeds go to all creditors.
The non-executive directors including the Chairman Mr. Philip Green (not Sir Philip). Mr. Green has received press criticism for a long ago involvement in a pension scheme that sold an asset at undervalue to a related party. Is he and other non-executive directors responsible? Seems like a long bow to draw to me, they are a long way from the day to day action.
tPR anti avoidance powers It is not feasible or practical (or legal) to recover the £530 M in dividends paid out to the public shareholders. tPR does have anti-avoidance powers to recover from connected parties who have caused a loss to the scheme i.e. Carillion directors/senior management. Once again it may not be feasible or practical (or legal) for tPR to go down this route. Maybe my legal friends could give a view in this respect.
Coming back to our politicians soundbites/solutions above, do we need more legislation or are the tools already available?
I believe the following simple plan could be implemented to avoid a Carillion situation happening again:
- tPR review the 200 largest Schemes and compare DRC vs. Dividends in accordance with the 2017 Funding Statement.
- tPR opens an investigation.
- If the employer/trustees do not agree to “fair” treatment a section 71 skilled persons report is prepared.
- tPR refers it to the determinations panel for the DRC to be set under section 231.
- tPR pursues through the court process.
- Section 89 report published.
- Select the next 200 largest schemes.
- Wash, rinse, repeat.
The above plan would be very easy to implement from existing tPR resources and could result in a significant inflow of funds into schemes. tPR has the skillset and ability to implement the above. tPR does require approval from their political masters in DWP and Treasury to do so. I am making the assumption tPR legal powers will be supported by the courts.
This will however divert significant cash resources from dividends, retained earnings and investment in business. tPR and the courts will then have a role in usurping the role of the board of directors of the employer in allocation of capital. This is for the government to decide if it is serious about funding pensions or more interested in PR soundbites. This does not require special legislation /Green papers or White Papers.
Prime Minister Theresa May could make this happen tomorrow with one letter to the Chairman of the Pensions Regulator Mark Boyle instructing him to implement it.
What do you think?
Savants Covenant Advisory