Challenge of the covenant

July/August 2010

In Raiders of the Lost Ark, Indiana Jones had the daunting task of finding the mythical Ark of the Covenant. Let’s be thankful he wasn’t a trustee trying to find something far more elusive – the Employer Covenant. All Indiana Jones had to do was run from a rolling boulder, avoid lethal booby traps, dive onto a seaplane, shoot a man with a big sword, foil a kidnapping and outwit an army of Nazis. Plain sailing compared to the lengths a trustee must go to ensure they have properly evaluated the financial power of their scheme’s sponsoring employer.

There are four kinds of employer covenant situation:

(a) CAN’T PAY

(b) CAN PAY and WILL.

(c) CAN PAY and MIGHT

(d) CAN PAY and WON’T

During the valuation process, the trustee has to find out what the situation is. The first two scenarios lead to clear outcomes, although the trustee may have to go a long way to be convinced of a CAN’T PAY scenario.

The last two situations – might and won’t – will be similar missions right up to the last stage of the negotiation. However, the end games will be vastly different. The former should result in a credible recovery plan that can be presented to the Regulator. The latter will not. Regulator involvement beckons.

Covenant negotiation is difficult and trustees need advice, which can be costly. The better the employer understands the pressures and regulatory constraints a trustee board is under and the advisory resources required for negotiations, the more a CAN PAY/MIGHT PAY situation turns into a CAN PAY/WILL PAY.

The outcome, in terms of cash commitments, guarantees etc, is likely to be the same in both scenarios. However, the MIGHT PAY scenario can chew up more advisory resources – on both sides of the table. Often, after the event, an employer regrets the cost and wishes they’d gone to the table more quickly. Hence, always try to achieve a spirit of openness from the start and never assume that both parties understand the position of – and constraints upon – the other.

The WON’T PAY scenario is the one that all trustees fear. The consequent battle of wills can be draining and the advisory costs massive. Unlike Indiana Jones, who could quit his mission at any stage and return to his job as a university professor, the trustee cannot give up. They not only have to pursue their goal with vigour, but also have to be seen to do it. They must demonstrate to The Pensions Regulator that they have battled hard and secured a prize, however small, for their efforts. This prize needs to be demonstrably the most one could get – even if that is zero. At this point, it could all be down to the Regulator. We have recently seen the Regulator snarling a little with the Bonas contribution Notice. It will probably have to roar over the next year given the suspect valuations and stalemate situations that are surely out there.

Steve Delo is chief executive of PAN Governance LLP and was voted Engaged Investor’s independent trustee of the year