Are CVAs here to stay?
There is a war being waged on the high streets of our towns and cities. It is a quiet war, being conducted between landlords and tenants but the battle lines are being drawn and we will help you navigate the battlefield.
Major retail casualties 2018/2019
Bricks and mortar retailers are facing some of the toughest trading conditions they have ever seen. The rise in online shopping, the rapidly changing face of consumer retail and the way that businesses interact with their customers means that traditional high street stores are increasingly struggling to maintain profitability and manage the significant fixed cost base that their physical stores represent.
Looking at the better-known retail failures of the last two years you could pick out some common themes. For example, changes in leisure activities (Evans Cycles, Fishing Republic etc), struggling department stores, the decline in the casual dining sector and, some brands that have simply become stale and lost relevance to their target audiences.
Whilst the factual matrix that explains why these brands failed is complex, what these do all share is an unmanageable fixed cost base – over-leveraged, under-invested and lacking in liquidity.
As consumers continue to desert the High Street in favour of shopping from the comfort of their own homes, many retailers are actively looking for ways to reduce their store portfolio and rid themselves of underperforming and over-rented stores.
Since the financial crisis in 2009, the use of a Company Voluntary Arrangement, or “CVA”, has come to be seen as something of a quick fix for struggling retailers to achieve these goals, providing a simple tool that can reduce the rent roll liability without disturbing the existing corporate structure.
There is a growing backlash to this solution, however, and 2019 has seen some determined efforts by landlords to draw some clear boundaries around when and how this tool can be used by tenants to reduce their property liabilities.
What is a CVA and why use it?
The basic idea of a CVA is that it is a binding agreement between a company and its unsecured creditors, where the creditors agree to compromise their debts and allow the company to continue to trade on a largely “business as usual” basis.
To pass a CVA, the company will put together a formal proposal, setting out how they wish to compromise their debts. That proposal is then signed off by the Company nominee, who is a qualified insolvency practitioner, and filed at Court.
The unsecured creditors will then receive formal notice of the proposal and a date for all creditors to have a formal vote on the proposal.
Provided 75% or more in value of unconnected creditors vote in favour of the proposal, then it is passed and becomes binding on all unsecured creditors, even the 25% who may have voted against it.
What are the benefits of using CVA?
One of the great benefits of a CVA is the flexibility that this solution provides. Since it is a contract, you can include virtually any provision in it. As long as the Company gets the 75% creditor approval necessary, the terms then become binding on everyone.
There are a number of perceived benefits to using a CVA, as against placing a company into administration:
- It is far less disruptive, since the legal entity continues to trade forward, so existing shareholdings and security is unaffected.
- Management remain in office and in control (although this can be seen as a negative if creditors consider management at fault).
- All contracts and leases remain in the name of the trading entity, so there are no issues around assignment or transfer.
- It is generally seen as a more consensual process and therefore less damaging to goodwill.
A CVA typically represents a “least worst” outcome for many landlords, since they are presented with a stark alternative - vote in favour of the CVA and receive perhaps 25p in the £ for what you are owed, or the alternative is administration or liquidation, where they will typically receive perhaps a penny in the pound, or less.
What is not advertised is how often CVAs fail, even with overwhelming creditor support. From experience, a “good” CVA, which has decent prospects of success, will normally involve a capital injection from an investor to meet the promised return, allowing for an early “one off” dividend payment and an early exit from the CVA. Unfortunately, many are structured to operate over a 3-5 year period, with payments into the creditor pot being funded from trading receipts. Often trading is insufficient to meet even the reduced obligations and the CVA fails, resulting in the Company entering into formal insolvency, most likely administration. Recent research by PWC has found that over half of retail CVAs have failed, resulting in the Company going into an insolvency process.
A typical retail tenant CVA will leave most trade creditors undisturbed and focus more or less exclusively on the landlords. The property portfolio will be divided into 4 or 5 categories ranging from Category 1, which are stores that the retailer very much wants to keep, down to Category 5, which are stores the tenant wants to vacate immediately. In the middle will be underperforming or marginal stores, where the tenant may want some rent reduction, or perhaps a move to turnover rent for a period of time, to try and improve profitability.
Category 1 leases will simply continue, with rents etc being paid in full on existing terms.
Those Landlords in Category 5 will be offered a lump sum payment calculated to be broadly in line with what they would have received if the Company had gone into liquidation and the lease had simply been disclaimed. This often looks like 6 months’ rent plus a sum for dilapidations. Correct valuation advice is crucial in properly categorising the properties and assessing the correct compensation sum.
Category 3 leases will provide for a 6-12 month window of trading at a reduced rent. The landlord will usually have the right to call for the delivery up of the premises during this time. In effect, it creates an extended marketing period for the landlord and avoids empty rates liability.
The CVA will also usually attempt to compromise out parent company guarantees and claims under authorised guarantee agreements.
What is the difference between a pre-pack and a CVA?
A pre-pack administration is a sale negotiated before the appointment of administrators and implemented immediately on appointment. Where the sale is of business and assets rather than of shares, this will allow the business to be sold free from any legacy liabilities of the old company, save for those the buyer elects to assume, or is required to assume to ensure continuity of business.
On the other hand a CVA restructures liabilities within the existing company. It is a general compromise with creditors which is binding on all creditors provided it receives the requisite level of support and that it is not challenged as "unfairly prejudicial" to certain creditors within 28 days of being approved. The requirement to avoid unfair prejudice does not mean that all creditors must be treated equally. Case law has shown that there may be different deals for different classes of creditors, provided that all classes have a better position than they would in the alternative situation of a formal insolvency process.
To compare the two processes, a pre-pack allows for more specific tailoring of the business being taken forward. This is because there is only a requirement to purchase the assets and assume the liabilities that are required. It also means that a more specific approach can be taken on a creditor by creditor basis. It also allows for liabilities to simply be left behind in the old shell, whereas a CVA would require some level of compromise payment. Similarly, an administration can be used to leave behind other liabilities which might be difficult to deal with in a CVA, such as employment claims relating to employees of closing stores who will not TUPE across.
A CVA has a broader brush approach, as it needs to deal with categories of liabilities. Theoretically the same level of differentiation could be achieved but this would make the CVA complicated and hence more open to challenge. As an example, lease liabilities in a CVA would be put into general groups with the same adjustment being made, say a switch to monthly rent from quarterly for performing stores, compared with termination of leases where not performing.
The timing of the two processes also differs. A pre-pack is notionally quicker to implement and delivers certainty up front, compared to the need with a CVA to convene meetings and obtain shareholder and creditor approval, followed by a 28 day creditor challenge period. This however is only half the picture. If the pre-pack involves a sale back to existing management it is usually appropriate, and prudent, to make an application to the pre-pack pool before execution of the transaction. Also, because a pre-pack requires a transfer of assets and leases individually where third party consents are required, this can be a lengthy post-closing process to implement. There is also a risk on a pre-pack that if a store is under rented, the need to assign will give the landlord the opportunity to exert leverage to increase rent, to the extent the lease terms enable this.
Indeed there is a risk that landlords or other vital suppliers or customers may refuse to deal with the new business.
Another advantage of the pre-pack is that as a restructuring tool, it lends itself to the delivery of the business to a third party through a distressed M&A process.
One final area where both processes have had their challenges is in relation to perception. In the past CVAs have been subject to criticism and challenge, particularly from landlords. Now terms offered to landlords are carefully drafted and have been tested, and they are reluctantly accepted and seen as a necessary evil. Greater scrutiny is being given to pre-packs, particularly to related parties, where the pre-pack pool has been established as a partial mitigant of perceived unfairness.
One area of negative perception that may take longer to dispel is that whatever process is used, it is rarely seen as a complete rehabilitation of the business. There is often a perception that a pre-pack or CVA is merely delaying the inevitable failure of the business. This can be the case where the proposed restructuring deals with superficial issues but does not take the opportunity to resolve deeper seated problems in the business, and if a restructuring is not fully worked through to establish a robust business able to withstand further shocks, then the fault is with the implementation, not the tool used to deliver the restructuring.
Challenges to CVA proposals
Whilst retail CVAs of this nature initially received a cautious welcome from the landlord community back in 2009, when we first started to see a lot of them, attitudes are hardening and the current trend is that landlords are increasingly hostile to such proposals. Consider, for example, the difficulties that the Arcadia Group had in getting their CVA proposals approved earlier this year.
It is not hard to understand why – as landlords continue to lose tenants and struggle to replace them, this impacts negatively on their own borrowing covenants. Loss of anchor tenants can decimate a shopping centre scheme and drive down rent reviews for remaining tenants. For those institutional landlords with heavy exposure to secondary or tertiary schemes, these losses cumulatively can be devastating - consider the position of Intu, for example. There is also a real North-South divide emerging, with stores in Scotland far more likely to be targeted for closure than those in London or the South East.
Likewise, for those tenants that are performing well, they feel that the use of CVAs are creating an unfair and uneven playing field, where they are effectively subsidising underperforming tenants and being penalised for running their businesses well.
As the votes of affected landlords are often swamped by those of other, less affected, parties, they can often find the terms of the CVA effectively imposed on them against their wishes.
It is possible to challenge a CVA, even if it receives the requisite number of votes. The two usual grounds for challenge are unfair prejudice and material irregularity.
The leading case on unfair prejudice challenges remains the Miss Sixty decision from 2009, which established the concept of “vertical” and “horizontal” tests of unfairness. The Miss Sixty CVA involved a very aggressive proposal that only affected four landlords and sought to compromise out a parent company guarantee at well below market value. The two worst affected landlords sough to challenge the proposal as unfairly prejudicial to them.
The Vertical Approach
In the vertical approach, the position of the creditor is compared with the position it would find itself in if the company was simply put into liquidation. It is established case law that for a CVA proposal to be “fair” on this basis, the proposal ought to place the creditor in a better position than it would have been had the company simply been liquidated. In this case, the rights of the landlords under the parent company guarantees would have been unaffected by a liquidation of Sixty UK Ltd.
They would therefore have had full recourse against the parent company for all of their losses under the leases, including the rights to require the parent company to take a lease for the remainder of the term. The loss of this valuable right in return for an unsatisfactory financial lump sum payment was held by the court to be unfairly prejudicial.
The Horizontal Approach
An examination of the creditor’s position on a “horizontal” basis involves comparing the position of the creditor against the position of other creditors or classes of creditors who are also able to prove within the CVA. In this instance the position of the landlords of the units was compared with the position of the landlord of another store, where Sixty UK Ltd operated as assignee from Muji Ltd. Muji Ltd were liable as original tenant under the lease for all of the liabilities under that lease and therefore stood in a quasi-guarantor position. The CVA allowed Muji to claim in full for any losses they may suffer as a result of the closure of that store and this in turn meant that the landlord of that store retained the benefit of the Muji “guarantee”. This position differed significantly from the position of the Met Centre landlord, as it was effectively being stripped of the benefit of its parent company guarantee. The Court concluded that there was no justification for treating the Met Centre landlord differently from Muji’s landlord and that the CVA was also unfairly prejudicial on a horizontal basis.
Recent years have seen a more concerted effort by landlords to challenge proposals. The challenge to the House of Fraser proposal settled out of court, so details are sparse and there is an ongoing challenge to the Regis CVA, which is likely to come before the Courts by the end of the year.
The most recent decision, however, is in relation to the Debenhams failure, where Mr Justice Norris in the High Court gave judgment at the end of September 2019 in relation to a challenge mounted to that CVA by a group of landlords known as the Combined Property Control Group. The group's challenge was effectively bankrolled by Sports Direct.
What was decided for Debenhams?
The landlords challenged on five grounds. First, they sought to argue that future rent was not a “debt” and as such could not be bound by the terms of the CVA. Norris J gave this short shrift and concluded that the meaning of “debt” has a wide meaning in this context and would extend to future liabilities.
Second, they advanced two new arguments. The first, the idea of “basic fairness” – essentially an argument that if the Company is continuing to use the premises to trade, then it must pay the contractual rent in full. Here they sought to draw a comparison with the expenses provision that operates in an administration or liquidation (the Lundy Granite principle). Again, the Court rejected this, although it did give rise to interesting comment around how far the rent could be compromised. The Court thought that: “…common justice and basic fairness require that the landlord should receive at least the market value of the property he is providing”.
The second, this does create some new ground for challenge, if a landlord can show that the compromised rent is below market value. This goes back to the vertical argument – if the lease were simply terminated, what value might the landlord be able to obtain for the property?
The “new obligation” argument was that the terms of the CVA sought to impose new obligations on the landlord (effectively creating a new contract), which was outside the scope of the Act. Again, this was rejected – the Court determined that the CVA merely modified the existing lease contract obligations.
The third ground of challenge did succeed. The landlords argued that provisions in the CVA that sought to alter the landlord’s forfeiture rights were contrary to the Law of Property Act 1925. The Court agreed that the CVA could not alter proprietary rights – all it could do was modify the pecuniary obligation that might trigger those rights. Or put another way, the CVA could reduce the amount of rent payable but couldn’t take away the landlord’s right to forfeit if that revised rent was not paid.
The solution to this was simply to strike the offending section from the proposal, allowing the remainder of it to stand.
Fourth, the landlords sought to argue that they were being unfairly prejudiced, compared to other unsecured trade creditors –the “horizontal” test. Justice Norris has little difficulty in finding justification for this differential treatment, in that trade creditors were short-term suppliers and the loss of their supply would be damaging to the business in a way that compromising a long-term lease liability would not be.
The final challenge was technical in nature, arguing that certain details that ought to have been included in the proposal were missed. The Court considered this and found that the material irregularity complained of was not material, in that it would have made no difference to creditors voting decisions.
CVAs: The Future
While the challenge in the Debenhams case could hardly be described as a resounding victory for landlords, it does mark an increasing determination to try and staunch the flow of tenant CVAs.
Too many CVAs still fail and are simply seen as a precursor to an inevitable insolvency. Too many do not fix the underlying problems but simply buy a bit of breathing space, whilst value is further eroded.
We expect to see that landlords will look to tighten up their forfeiture clauses, to allow termination on receipt of notice of a proposal, not the passing of one.
We also expect to see larger tenants seeking concessions from landlords if they find themselves involuntarily underwriting the failure of other tenants on schemes that they are anchoring. Both Primark and Next have already started down this road.
More fundamentally, in the medium term we expect to see fundamental changes in the way that High Street leases operate. There is still ample opportunity for forward looking tenants to establish themselves on the High Street – we expect to see a growth in smaller independent operators, franchise models and retailers using the stores to offer brand experiences, rather than simply transactional hubs.
Tenants will demand greater flexibility, shorter terms, variable payment structures and enhanced rights. Landlords, faced with extended void periods and lack of appetite for their space, will have little option but to accede to these requests. The face of the High Street is changing fast and lease arrangements will need to move to reflect that.
CVAs remain a valid restructuring tool but are not a quick-fix solution and are far from guaranteed to work. Unless the CVA addresses the underlying operational/brand issues, all it achieves is a temporary respite from liquidity issues. We expect to see landlords being more vocal in challenging proposals that do not address these concerns.
We also expect to see ever greater pressure mounting from both landlords and tenants lobbying to change the business rates model, to create a more even playing field with online retailers.
A top tip for landlords and tenants
The face of the High Street is changing, and the way retail space will be used is changing rapidly. Now more than ever, landlords and tenants need to work as a partnership to find mutually workable arrangements that allow greater flexibility, otherwise this problem will simply perpetuate.
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