Post by Moulton on Aug 30, 2009 8:46:08 GMT 4
As the recession settles deeper into the global economic fabric, pension plan sponsors and the governments that regulate them are looking for relief. For some private pension plans, that relief may come in the form of letters of credit.
“In challenging economic times, the key advantage from the employer’s perspective is that the use of a letter of credit will assist the employer in dealing with its cash flow priorities,” said Daniel Hayhurst, a partner with Gowling Lafleur Henderson LLP in Toronto.
Indeed, the use of a letter of credit can be beneficial to both sponsors and members, said Mary Picard, a partner in Fraser Milner Casgrain LLP’s Pensions & Benefits Group in Toronto, “It’s good news for pension plan sponsors to be relieved of having to contribute real money to their pension plans. And if the letter of credit is properly established, there’s no downside for plan members.
“An added benefit for plan sponsors, which isn’t top of mind these days, is the fact that a letter of credit reduces the risk of surplus building up in the pension plan in future,” she noted.
According to the final report of the Ontario Expert Commission on Pensions, a letter of credit from a bank is a promise to pay the pension fund an agreed sum if the sponsor defaults on a scheduled contribution payment. If the sponsor is unable to renew the letter of credit because it cannot pay the bank charges or because its credit rating has deteriorated, the bank becomes legally obliged to pay the full value of the letter of credit into the fund.
Letters of credit are not new. “The idea has been around for several years now,” said David Vincent, a senior partner with Ogilvy Renault LLP in Toronto. “The concept was first promoted by large federal pension plan sponsors. They argued that funding a plan on a termination basis was unlikely at a time when interest rates are low.”
That argument resurfaces in a consultation paper released earlier this year by the federal department of finance. In “Strengthening the Legislative and Regulatory Framework for Private Pension Plans Subject to the Pension Benefits Standards Act, 1985,” the government pointed out that, “The advantage of properly structured letters of credit is that they permit employers to provide increased security to plan members in the event of, for example, insolvency, while providing greater funding flexibility to plan sponsors.
“Letters of credit also respond to the ‘trapped capital’ issue that has been raised by sponsors: in situations of volatility — particularly in discount rate levels — funded positions can change dramatically in a short period of time,” the paper stated.
“As pension liabilities are long term, 50 [years] plus obligations, and markets rise and fall, causing full cash funding can result in trapped surpluses,” said Kathryn Bush, a partner with Blake, Cassels & Graydon LLP in Toronto.
The ownership of surplus on pension plan termination is a hotly debated issue in Canada. Many employers would argue that the courts have consistently taken a harsh position in surplus ownership cases such as Schmidt v. Air Products, [1994] 2 S.C.R. 611 and in the interpretation of the wind-up rules as in Monsanto v. Ontario, [2004] 3 S.C.R. 152, said Hayhurst. “The result is that employers generally do not want their pension plans to go into a surplus position, out of fear that the surplus may never be recovered. A letter of credit assists employers by reducing the actual cash contributed to the pension plan while at the same time providing security for promised pensions.”
Despite the advantages, letters of credit are not for everyone — and they are not a panacea for all that ails pension funds in this country, said Mitch Frazer, a partner with Torys LLP in Toronto and an adjunct professor of law at the University of Toronto and York University. “They are best for companies that could get a decent interest rate to fund their letter of credit. If you’re a large company and you have a triple-A rating, it’s going to be easier to get a letter of credit.”
Cost and availability are two key issues. “Clients may be surprised by the cost of putting a letter of credit in place,” noted Picard. “It’s more than just the fee paid to the issuer of the letter of credit. There are legal and consulting expenses in negotiating the terms of the letter of credit, amending the existing trust agreement or creating a new one, and revising the statement of investment policies and procedures for the pension plan.”
“The federal pension regulator (OSFI) has already identified one cost issue, by saying that the letter of credit fee is not an expense that can be charged to plan assets,” she added.
Letters of credit can also be difficult to come by, especially in the current economic reality.
“Letters of credit exist as a common banking instrument, but they are more difficult to get today,”said Vincent. “Banks are only going to extend a letter of credit to those most likely to be [secure]. The bank is at risk for the amount of the letter of credit.”
Lawyers must also take care when dealing with letters of credit. “Lawyers must ensure that the letters of credit, and in particular the events of default, i.e. what causes the letters of credit to be called and turned to cash, are properly drafted and consider all relevant contingencies,” said Bush.
“The main issue is the fact that they typically expire after a year,” said Vincent.
In addition to deadlines, there are the nuances of the agreement itself. “You have to be sure that the letter of credit has language in there... that states it remains in effect until there is a surplus or earlier,” noted Frazer.
“Ensure base amounts of credit are included,” he added, “and make sure it’s clear who is responsible for paying the letter of credit fees.”
Letters of credit can be time-consuming to develop, noted Hayhurst. “There are fairly strict regulatory requirements that need to be met to enable the use of a letter of credit in the jurisdictions that permit them.
“As such, there is a fair bit of work that needs to be done to put such letters of credit in place,” he said. “For example, for federally regulated plans, the trust agreement that governs the plan needs to be amended to incorporate specific regulatory requirements.”
That investment in time may be well worth the effort, especially for companies struggling to fully fund pensions in a market that is hitting record lows.