Strategy & Operations » Governance » How Kodak got out of its pensions trap

Anne-Marie Winton, a partner at ARC Pensions Law, explains how Kodak shed its huge pension scheme liability after it came back from the brink of bankruptcy.

 

In the 1950s, the UK was the second largest car manufacturer in the world. The boom was linked in part to the government’s support of the steel industry, which prioritised the supply of steel to exporters.

This meant that by 1950, 75% of the cars produced in the UK were exported, providing around half of cars worldwide. Now, whilst still a significant exporter, the UK no longer features in the list of top 10 manufacturing countries. The “gold plated” defined benefits (DB) pension schemes provided for the workforces of traditional manufacturing industries, like motor and steel, have now become a key business risk. The very existence of the pension scheme can bring the sponsoring employer to the brink of insolvency.

One of the earliest entrants into the Pension Protection Fund (PPF), the industry funded lifeboat for distressed schemes following employer insolvency, was the MG Rover Group Pension Scheme in March 2007. Since then, there has been a steady trickle of other schemes linked to the automotive trade being transferred into the PPF.

It was announced recently that the British Steel Pension Scheme is expected to be restructured this year, to scale back its pensions promises to current and former employees. This is through a legal process only available to employers whose insolvency is inevitable within 12 months.

Other areas of the manufacturing sector have also had to face up to the challenge of long term pension scheme liabilities dwarfing the sponsoring company’s ability to meet these costs.

Business change can take place over far shorter timescales than the duration of the scheme liabilities, in particular where new technology fundamentally disrupts and/or destroys an existing business model. This can mean that at just the point a business may need to become agile and streamlined to survive, its legacy pension liabilities can weigh it down, making survival seem impossible.

In 1997, Kodak Limited reported that business was booming. Annual sales had increased to £1.2 billion with a £60 million dividend paid to its parent company (up from £44 million the previous year). In its annual report, the company explained that its reputation was based on having been in business for more than 100 years.

The UK was a key manufacturing site and its product range included not just films and cameras, but also motion picture films, printing plates and microfilms.

In 2013, just 16 years later, Kodak in America exited Chapter 11 bankruptcy protection and restructured as a technology company. This was after carrying out extensive internal changes, including the disposal of its document imaging and personalised imaging business, Alaris, to the trustees of the Kodak Pension Plan. This deal was ground-breaking for a number of reasons.

Kodak Limited sponsored the Kodak Pension Plan (KPP), a large and significantly underfunded defined benefits scheme with approximately 15,000 members in the UK and assets of around £900 million.

In 2009, the company had sales of £113 million and had not paid any dividends to its parent company for that or the previous year. Kodak limited had agreed to pay £33 million a year into the KPP, and as part of actuarial valuation discussions in 2007 and 2010, the trustees of the KPP also secured a parent company guarantee from Eastman Kodak Company (EKC).

It was this guarantee that provided the basis of the trustees’ claim in the Chapter 11 bankruptcy proceedings that started in 2012, in which they claimed the full cost of buying out the scheme’s liabilities with an insurer (around $ 2.8 billion).

Although Kodak Limited was solvent, if the US parent company entered liquidation, it was likely that Kodak Limited would follow and the KPP would enter into the Pension Protection Fund with a substantial shortfall.

During the Chapter 11 process, EKC had unsuccessfully sought buyers for its profitable document imaging business, Alaris. However, a buyer came from a very surprising source – the trustees of the KPP, who considered that the future cash flows from this business would be a good match for those needed by the pension scheme.

A deal was struck and, in return for the trustees releasing EKC from its guarantee, the trustees took ownership of Alaris at a cost of $325 million. This was paid from scheme assets and Kodak Limited was, with the agreement of the Pensions Regulator and the PPF, released from any further liability to contribute to the KPP, through a rarely used legal process called a Regulated Apportionment Arrangement (RAA).

Generally a RAA can only take place where the mitigation to the scheme is significantly more than the recovery to the scheme (as an unsecured or occasionally a secured creditor) on the insolvency of its sponsoring employer.

Here, even with the trustees using scheme assets to buy Alaris and foregoing any potential recovery under the EKC guarantee, an RAA was considered the way to get the best outcome for scheme members and the PPF.

Around 14,750 scheme members voluntarily agreed to transfer to a replacement scheme with lower benefits, in effect relying on the future success of the trustees’ investment in Alaris and the scheme’s other assets to fund their pensions in future.

Agreement was reached with the Pensions Regulator that the new scheme could continue for as long as it is viable. Members’ clearly expect that in joining the new scheme, they will receive greater benefits than PPF levels of compensation.

It is also an RAA that is intended to be used to separate Tata Steel UK from the British Steel Pension Scheme later in 2017. The wider Tata Steel group is reported to be funding a settlement payment of £550 million, as mitigation for the deal. Existing security in favour of the scheme, over group assets, will be released and the trustee will take 33% of the equity of the UK business after its separation.

This is a typical “PPF anti-embarrassment” shareholding in the circumstances. The RAA – if approved – will remove the barrier to merger talks in relation to Tata’s European steelmaking operations.

However, the circumstances in which a company can legitimately be separated from its obligations to fund a pension scheme using an RAA are rare. The process of achieving that separation may take a number of years, during which time, a CVA or pre-pack may become necessary for a distressed employer. Both of these could cause the scheme to enter the PPF and see the Pensions Regulator launch an investigation into the abandonment of the scheme.

Detailed, time consuming, negotiations with the scheme’s trustees will be needed, who will be separately advised and may therefore have different views on the viability of the business and the company’s ability to make contributions.

The Pensions Regulator and PPF will not agree to the separation if they think that the inevitability of the insolvency of the scheme’s sponsoring employer has been “created”, Examples of this are by deliberate group action taken to reduce its financial strength (such as paying out dividends), or if the Regulator could use its moral hazard powers throughout the corporate group (wherever based) to secure a better recovery for the scheme.

There is necessarily a balancing act on whether an RAA should be implemented. The risk of wrongful trading is a real concern if a company continues to trade in the knowledge that there is no reasonable prospect of avoiding insolvent liquidation – for example, if it is unable to meet its current and contingent pensions liabilities as they fall due.

 

Anne-Marie Winton is a partner at leading pensions law firm, ARC Pensions Law. Anne-Marie has extensive experience advising on corporate transactions.