Canadian legislation aimed at protecting pension plans may mean significant changes for lenders, borrowers and employees

It is common practice for a lender to require that a fixed or floating charge be held over assets of a borrower to secure a loan. Logically, the higher the likelihood of a lender being unable to recover the amount of the loan, the less likely a lender is willing to provide capital to the borrower at a low cost.

Canadian insolvency legislation sets out the scheme of distribution that dictates how the proceeds of an insolvent party's assets will be distributed. Generally, secured creditors have priority over the proceeds of their collateral. However, certain liabilities are afforded super priority within insolvency proceedings, putting them ahead of the interests of secured creditors. Currently, pension benefits and entitlements for solvency deficiencies in defined benefit pension plans are not captured by this super priority.

As the current Canadian insolvency statutes stand, super priority is only afforded to an employer's pension liabilities to the extent that these liabilities are:

• unpaid amounts that were deducted from employees' remuneration for payment to the pension fund; or
• unpaid "normal costs", defined contributions, and certain other ordinary course amounts.

On February 3, 2022, Bill C-228 was introduced as a private members bill and has now made its way to the third reading in Canada's Senate. The purpose of Bill C-228 is to greatly expand the pension liabilities that are afforded super priority status by amending bankruptcy and insolvency legislation. As currently drafted, the Bill will grant priority for a pension plan's unfunded liability or solvency deficiency claims over the claims of the majority of creditors -- including secured creditors -- unless specifically enumerated otherwise in the statutes.

The "unfunded liability" is the amount necessary to enable the fund to continuously pay member benefits as they come due, on the assumption that the fund will operate for an indefinite period of time. The "solvency deficiency" includes the amount necessary to ensure the fund meets its obligations if wound up. As these amounts are constantly fluctuating, a fixed value cannot be ascribed to either of these requirements other than through a single point in time calculation by an actuary.

What does this mean for borrowers with pension plans?

Clearly, Bill C-228 would substantially increase the opportunity for recovery of pension entitlements within insolvency proceedings by way of super priority. The issue is whether it remains viable for lenders to provide capital to borrowers with defined benefit pension plans given the increased risk profile that may be created by Bill C-228 expanding the pension claims that take priority over a secured creditor in an insolvency case.

In all likelihood, Bill C-228 will minimally effect borrowers that have defined-contribution pension plans as the employer's liability is restricted to predefined contributions. As this type of plan is subject only to ordinary course known contribution requirements, and given that the employer does not guarantee a certain amount of income in retirement, the liability afforded super priority in insolvency proceedings should be predictable in most circumstances.

Conversely, Bill C-228 will significantly impact defined-benefit pension plans. These types of plans commit to providing a specified level of income in retirement based on a variety of factors. As such, an employer must diligently manage the pension fund to ensure it is in a position to pay the benefit to the employee for the remainder of their life, once retired. The inherent challenge with these plans is the uncertainty of the liability of the employer at any given time and the potentially large scope of that liability based in part on external factors such as interest rate fluctuations.

Bill C-228 has therefore created a conundrum. Although the intention of the Bill is to protect pension plans, it may potentially cause a shift that results in even more employers moving from a defined-benefit pension plan to a defined-contribution pension plan. Plainly, this shift may be caused by lenders' concerns regarding the uncertainty surrounding the amount necessary to liquidate an unfunded liability or solvency deficiency at any given time. In other words, a lender will not be able to determine prior to the lending decision, with any great certainty, the amount of the unfunded liability or solvency deficiency in a future insolvency proceeding. At a minimum, a secured creditor wants to know the quantum of obligations that will take priority over their interests. This is essential information in deciding the quantum of a loan, the terms of such loan, any reserves and whether the creditor will agree to loan any money to the borrower.

Given this risk and uncertainty, lenders may limit the granting of credit and/or increase the cost to borrowers that maintain defined-benefit pension plans. As such, if Bill C-228 is passed, we may see employers shifting from defined-benefit pension plans to defined-contribution plans to secure more desirable financing options. If an employer fails to make this switch, we may see a heightened refinancing risk for these borrowers.

What lenders need to know

If Bill C-228 is passed, the transitional provisions provide that the amendments to the insolvency legislation will not come into force until four years following its enactment. During this time, it is prudent that financial lenders determine whether their borrowers have defined-benefit pension plans. If so, a lender may wish to evaluate the increased risk profile that may be caused by this enactment to assess whether new covenants, reserves or limits should be imposed. This may include covenants that require enhanced reporting mechanisms in respect of pension plans or increased interests rates to balance the additional uncertainty or additional default triggers related to pension plan deficits.

Alternatively, a lender may raise the issue with its borrowers to put them on notice that additional covenants and limits may be implemented for employers that have defined-benefit pension plans. This dialogue may encourage a discussion on whether the borrower will be taking steps to shift their pension plan to a defined-contribution plan, thereby eliminating the need for additional restrictions and covenants.

Progression of Bill C-228

Bill C-228 completed the second reading on December 14, 2022. The Standing Committee on Banking, Commerce and the Economy presented a report without any amendments on March 7, 2023. The final step is for the Senate to complete one more reading. If the Senate adopts the Bill without further amendments, royal assent will be granted shortly thereafter.