Home > Negotiating Retail CVAs – where are we now? Amanda Eilledge considers the recent decision in Discovery (Northampton) Limited v Debenhams [2019] EWHC 2441 (Ch).

Negotiating Retail CVAs – where are we now? Amanda Eilledge considers the recent decision in Discovery (Northampton) Limited v Debenhams [2019] EWHC 2441 (Ch).

14th October 2019

Negotiating Retail CVAs – where are we now? Amanda Eilledge considers the recent decision in Discovery (Northampton) Limited v Debenhams [2019] EWHC 2441 (Ch).

2018 was seen by many as the ‘year of the CVA’ and the year of the so -called ‘Retail CVA’ in particular. Such CVAs have been used in an attempt by companies operating in the retail and casual dining sector with burdensome leases to reduce the cost of their premises whilst continuing to trade.

2019 was widely expected to be the year in which there was a challenge by a landlord under s.6 of the Insolvency Act 1986 (‘the Act’) to the use of CVAs to force a rent reduction, without comparable cuts to other creditors and so it has proved.

In this recent case, 6 landlords challenged a standard model retail CVA which attempted to compromise Debenhams’ liability for future rent and business rates. 4 of the 5 grounds of challenge were rejected and although Norris J upheld 1 ground, namely, that the right of forfeiture by a landlord was a proprietary right that could not be altered by a CVA, he also decided that under the standard severance clause in the CVA the attempt to block the right to forfeit could be severed and thus the CVA was enforceable.

The decision in more detail

Under the CVA proposal rents payable to some landlords and the business rates payable to local authorities: were affected but it did not impinge the claims of other unsecured creditors such as suppliers.

5 categories of leases were identified, each of which were to be treated differently under the proposal. The landlords of Category 1 leases would be paid in full and the other terms of these leases were unchanged.

The First and Second Applicants  were landlords of Category 3 leases; the Third, Fourth and Sixth Applicants were landlords of Category 4 leases; and the Fifth Applicant was a landlord of a Category 5 lease (together, the “Leases”).

The principal effects of the CVA on the Leases was:

  • To reduce the rent payable under the Leases by between 35% and 50% during a rent concession period. Following the end of that period, the rent payable was to be adjusted to the greater of the reduced rate of the rent under the CVA or the market rent at that time (so that it may or may not be restored to the reserved rent);
  • To prevent the landlord from exercising any forfeiture rights triggered by the CVA;
  • To grant the landlord an initial, one-off right to terminate the lease.

The 5 challenges were as follows:

Ground 1: that it was not possible to compromise a landlord’s claim for future rent in a CVA since landlords do not have a claim for rent to be paid in future at the time the CVA becomes effective, and therefore, are not “creditors” within the meaning of s. 1 of the Act.

Ground 2: that in reducing the rent payable under the Leases, the CVA was unfairly prejudicial to the Applicants under section 6(1)(a) of the Act (which the Applicants refer to as the “Basic Fairness Argument”); or, alternatively, the attempt to do so takes the CVA beyond the jurisdiction conferred by s.1 of the Act because it had the effect of changing the terms of the Leases (which the Applicants refer to as the “New Obligations Argument”).

Ground 3: there is no jurisdiction under s.1 IA of the Act to remove any right of the landlords to forfeit which would arise as a result of the CVA or any CVA related event.

Ground 4: that the Applicants were treated less favourably than other unsecured creditors without any proper justification.

Ground 5: that the CVA failed to comply with the contents requirements set out in rule 2.3(1) of the Insolvency Rules 2016 (“IR”), by failing to disclose potential claims under ss. 239 and/or 245 of the Act if the Company were to enter into administration. The Applicants argued that this was a “material irregularity” under section 6(1)(b) of the Act.

Norris J held that all challenges failed apart from Ground 3. He decided (without hearing argument from the Applicants on the point who had the right to revisit the point in written submissions) that the provisions removing the right to forfeit were severable under the standard severance provision contained in the CVA and thus should be deleted.

Whilst Norris J’s decision on all grounds is interesting, here I focus on 2 issues which may influence the future negotiation of CVAs.

Firstly, the judge’s analysis of the concept of fairness and secondly his finding that a right to forfeit cannot be compromised within the CVA.

Fairness

The judge applied the two well-known techniques for assessing whether a CVA is “unfairly prejudicial” under section 6(1)(a) established in Prudential Assurance Co v PRG Powerhouse Ltd [2007] BCC 500 and followed in The Miss Sixty case [2010] EWHC 1`890 (Ch) namely the vertical comparison of fairness and the horizontal comparison of fairness.

The former compares the projected outcome of the CVA with the projected outcome of a realistically available alternative process e.g. a liquidation and generally identifies the “lower bound” below which the creditor’s return in the CVA cannot go: see at [75]-[81] per Etherton J.

The latter compares the treatment of creditors under the CVA inter se.

The comparators are not to be treated as a statutory test; it is necessary to consider the particular facts of each case when deciding whether a given CVA is unfair: see Powerhouse at [74]-[75]. Whilst there is no prohibition on differential treatment, any differential treatment must be justified; see Powerhouse at [88]-[90].

Norris J also made clear that just because the vertical comparison is satisfied, this does not of itself make the scheme fair: “Fairness” must be judged in the round [76]”.

He emphasised the flexibility of the CVA remedy in comparison to an administration or liquidation in rejecting the submission that the court should follow the Lundy Granite principle and treat rent payments as payable in full. In this regard he did not follow the obiter dictum of Neuberger LJ in Thomas v Ken Thomas Ltd [2006] EWCA Civ 1504 at [34] who had stated: “… it would seem wrong in principle that a tenant should be able to trade under a CVA for the benefit of its past creditors, at the present and future expense of its landlord.”(referred to by Norris J at [56]).

Norris J’s view was as follows:

“[71] The Lundy Granite principle has no direct application, though Thomas suggests that it may indicate a norm for CVAs. I do not, however, regard the language used in Thomas as determining the question I have to decide. The principle of “basic fairness” here does not require a choice between full rent as an expense of the insolvency or a dividend at the rate paid on unsecured debts generally. It arises here in the context of a jurisdiction which permits the modification of obligations. Here common justice and “basic fairness” require that the landlord should receive at least the market value of the property he is providing. He should not subsidise other creditors but nor should they be compelled to overcompensate him. To that basic principle should be engrafted the principle that a contractual rent should be interfered with to the minimum extent necessary in the circumstances, the modification being limited to what is necessary to achieve the purpose of the CVA. If those principles are observed the fact that under the exit arrangements in CVA a varied rent is payable during the notice period does not, in my judgment, make the arrangement “unfair”.

Thus as a matter of principle, a reduction in contractual rent will not be automatically unfair.

The learned judge considered fairness in the context of the facts of this case under Ground 4. There are 2 points of particular note.

Firstly, a reduction on rent below the current market value is likely to be unfair. The judge emphasised that in this case there was no evidence that the reductions sought were below market rent and this coupled with the landlord’s ability to terminate the lease if they did not wish to accept the rent reduction was sufficient to render the apparent unfairness justifiable.

Secondly, in this case evidence of the “contagion risk” was highly material in persuading the court that putting all trade creditors and service providers in the same category, even though a few such as accountants and solicitors were not essential per se, did not  render the payment of all trade suppliers and service providers unfair.

Right to forfeit

Norris J held that the right to forfeit is a property right which cannot be compromised within a CVA.  At [100] sub-paragraph (e) he went on to decide that:

“ A CVA can modify the conditions upon which a right of re-entry can be exercised as Naeem and Thomas demonstrate and technical distinctions should not be drawn between different parts of a forfeiture clause. In my judgment a CVA can modify covenants (or at least covenants that require the payment or expenditure of money) and the right to forfeit will then relate to the covenant as modified: but a CVA cannot directly modify the right to forfeit itself. I think the distinction is fundamental and not “technical”.”

In other words his view is that a CVA may modify the covenant to pay rent and the right to forfeit then relates to the covenant as modified.

Comment

The decision may well be the subject of an appeal so this will not be the last word on these issues. It is perhaps also worth remembering that despite the interest in retail CVAs, the number of retail CVAs remain in their 10s – indeed the judge noted at [14] that there have been 40 CVAs of this type since April 2009.

The current position is that “creditor” in s.1 IA 1986 should be construed widely and thus in principle it is possible to compromise a landlord’s right to future rent. The argument that reducing the rent payable under a lease in a CVA is automatically unfair has been roundly rejected.

Any challenge to a CVA must instead focus on whether in the particular circumstances of the case the outcome is a fair one.

Looking at future CVAs, it remains the case that the vertical and horizontal comparisons are useful tools.             Both the company and the challenger therefore will wish to do the following at an early stage in the negotiation and provide evidence in support:

  • compare the position that the landlord would occupy and the benefits he would enjoy in a hypothetical liquidation/administration as compared to his position under the CVA  (“vertical comparison of fairness”).
    • The court’s approach reinforces the importance of calculating as precisely as possible how the challenger landlord would fair in an administration/insolvency situation.
    • It must be borne in mind, however, that whilst identifying the irreducible minimum that any creditor should receive under the CVA appears to be an essential step in establishing fairness, it is not of itself sufficient.
    • in a case that involves guarantee stripping i.e. depriving the landlord of a guarantee from a third party (see the Powerhouse and Miss Sixty cases referenced above for the principles) the compensation offered to the landlord for the loss of his guarantee needs to be assessed carefully by reference to its likely value.
  • compare the landlord’s position under the CVA with firstly, the position of other creditors within the same class and secondly, with other classes of creditors (“horizontal comparison of fairness”).
  • Any reduction of contractual rent payable in the future is only likely to have any prospect of surviving in a challenge if at least market rent will be payable and landlord able to choose whether to accept the terms or terminate the lease.
  • The decision makes clear that treating landlords less favourably than trade suppliers and service providers can be justified, even where some of them may not be, strictly speaking, essential. In a guarantee case are other landlords with or without guarantees better off? What about original tenants? How are associated company creditors treated?

Norris J’s finding that the right to forfeit cannot be compromised within the CVA as it is a property right arising between landlord and tenant rather than a security right arising between creditor and debtor is plainly right. Indeed the decision has been applied as recently as 8 October 2019 in Re Instant Cash Loans Ltd [2019] 10 WLUK 97 by Zacoroli J in the context of an attempt to  force a landlord to accept a surrender of a lease under a scheme of arrangement.

Leases frequently equate the effect of entering into a CVA with insolvency for the purpose of triggering the right to forfeit. It is now clear that the right to forfeit on this ground cannot be restricted under the CVA.

Furthermore, whether the lease contains such a right or not, it is also clear that the right to forfeit for rent arrears compromised within the CVA remains, but for the reduced sum payable. The landlord cannot insist on the payment of the full amount due under the lease as a condition of relief from forfeiture.

 

Amanda Eilledge
October 2019

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