High street CVAs: has the right balance been struck?

2018 was a bumper year for leasehold company voluntary arrangements (CVAs), principally in the retail and casual dining sectors. As we also approach the 10-year anniversary of the first “modern” leasehold CVA – proposed by JJB Sports, which Herbert Smith Freehills LLP advised – it’s a good time to take stock of how leasehold CVAs have evolved, emerging trends and whether a sensible balance has been struck between distressed tenants and landlords. Why do we have CVAs? Given the strongly held views on CVAs (on both sides), it is worth a refresher on why parliament decided to allow companies to propose voluntary arrangements in the Insolvency Act 1986 reforms of UK insolvency law. CVAs allow a company to put a compromise proposal to its creditors. The compromise must be a better alternative than the bleak outlook for creditors in an administration or liquidation. The policy reason behind allowing this is that a compromise, while it involves creditors giving some ground, is a better overall outcome than administration or liquidation. There are two statutory protections for creditors: the proposal must be approved by 75% by value of creditors present and voting; and creditors can challenge a proposal within 28 days where the proposal is unfairly prejudicial or there is a material irregularity. The “unfair prejudice” test means, among other things, that a CVA should always offer a better outcome than an administration. How are CVAs applied to large leasehold portfolios? For a tenant, a lease is a fixed cost, generally for a long period of time with (generally) upwards-only rent reviews. Landlords like the relative certainty in the long-term commitment. Retail tenants sign up to the arrangements because they believe they can trade profitably from the store and the terms are market standard. When a company with a large leasehold portfolio encounters distress, rent is often one of its largest costs. Reducing this cost consensually by way of bilateral deals with landlords across a large portfolio is often not practical in the time available. With a CVA, tenants have a single statutory mechanism to apply a compromise to some or all of its leases in a fixed timetable. In a CVA all creditors vote as one with no concept of “classes” of creditors voting separately. A company can legitimately propose a CVA affecting one group of creditors only and all creditors have the ability to vote on that proposal. The key control is that there must be good, objective reasons for singling out that group of creditors and the affected creditors must be offered a better outcome than on an administration or liquidation. Evolution of CVA proposals As the climate on the high street has deteriorated over the last decade, it is natural that more tenants have sought to use this lifeline to respond to the current financial environment and that more landlords have grudgingly voted in favour, as it has become harder to find good quality replacement tenants. Traditionally, most CVAs followed the same commercial and legal structure: only landlords are asked to take a “haircut” in the proposal; stores are treated differently based on a “red, amber, green” categorisation to apply different compromises based on store performance; liabilities for accrued and future rates are unaffected, ie even if the rent was reduced to zero the tenant would still be in rateable occupation and obliged to pay rates; and other stakeholders often agree other parallel arrangements (rights issues, other capital raisings, debt for equity swaps, operational changes, etc) contingent on a successful CVA. A key feature is that the distressed company controls the terms of the proposal put to creditors. Creditors are asked to vote on the terms offered. The terms offered by distressed companies have therefore evolved over time and, as a result, in 2018 a number of CVAs have departed from the more traditional format, including for example: more complex proposals with different compromises being applied to more categories of leasehold premises – requiring the company to make increasingly fine distinctions between various leases as a justification for the different treatment; imposing haircuts on all “non-critical” creditors (rather than only landlords), principally as a way in which to compromise accrued rates; and introducing a break clause or a requirement for landlords to accept a surrender, both of which appear designed to have the effect of passing liability for future rates to the landlord. Increasing comfort and frequency of CVAs has also given rise to the concern that CVAs are being used opportunistically, as “nice to have” rather than as a last resort, or that CVAs are being proposed without the necessary parallel arrangements from stakeholders to enable companies to turn around – for example, right-sizing the capital structure, making new money available, or operational changes. These factors have contributed to increasing landlord disquiet – as evidenced by the challenges filed in response to the proposals from House of Fraser (ultimately withdrawn prior to the administration when it became apparent the wider restructuring had failed) and Supercuts/Regis (pending). Have CVAs been taken too far? CVAs are inherently flexible and it is natural that proposals will evolve to respond to changing commercial challenges. As proposals evolve, so have the approaches of certain creditors. The Pension Protection Fund (PPF), for example, issued guidance that its starting position is that an affected pension scheme must receive an “anti-embarrassment” upside of at least 33% of the equity and the company and its advisers must satisfy the PPF they have addressed around 11 core areas of concern in the CVA and wider restructuring. Landlords have been vocal in criticising issued proposals not supported with adequate parallel arrangements and have threatened – and issued – challenges. The problem is that once a proposal is issued, disgruntled landlords’ options are either to vote against the proposal (possibly leading to an administration) or issue a challenge application (entailing cost risk and, if successful, likely leading to an administration). Landlords have not made serious attempts to organise themselves earlier in the process as a cohesive creditor group with a voice at the table in restructuring discussions – perhaps because of commercial concerns in liaising with competitors or competition concerns. By not joining forces (as lenders or bondholders do) landlords have traditionally weakened their voice in any restructuring. There have been some attempts to change this. The British Property Foundation (BPF) has, for example, issued a best practice protocol that, in effect, requires a draft of the proposal to be shared with the BPF with three business days to comment. In reality, this is too little time to enable a proper critical review of the proposal – not to mention the likely absence of the relevant background financial information and legal analysis – and is far less onerous for distressed tenants than the PPF’s guidance. The obvious way for the landlord community to ensure the evolution of CVAs is proportionate is to engage with distressed companies in advance of proposals being published to seek to shape the terms ultimately offered to them. After all, why should landlords take a back seat and allow a restructuring to happen around them, when other creditors, particularly financial creditors and the PPF, are at the table protecting their own interests? This would require more management time from the larger affected landlords, including in setting up an ad hoc committee of landlords and working through any competition concerns. If successful, however, this would enable that landlord committee to assess and seek to shape the commercial terms proposed, test whether the parallel arrangements are satisfactory and also form a view as to whether the alternative to a CVA is really administration or liquidation. We have seen landlords in the market consider being more proactive but we are yet to see this type of arrangement implemented. Landlords will know (or be able to find out) which retailers may be in financial difficulty and the other larger landlords of that chain. Key landlords could therefore group together and demand a seat at the table in any restructuring discussions, setting the direction of what is acceptable in any property restructuring. There is absolutely no reason why landlord groups could not form and become a critical voice at the restructuring table. Unless landlords organise themselves and have a voice in a restructuring, the landlord community will continue to be presented with a binary choice of two unattractive options (the CVA or administration) while distressed companies continue to innovate in the commercial terms of their CVA proposals. Where does this leave us? Perhaps the Regis challenge will prove to be the test case that sets the boundaries of what is and is not acceptable in a leasehold portfolio restructuring. A note of caution is that even a challenge that succeeds on the facts may also signpost how any particular issues identified can be solved in future CVAs – and may therefore embolden future distressed tenants. One thing, however, is certain regardless of any challenge: if landlords continue to decline a seat at the restructuring table then distressed companies will continue to push the boundaries of CVAs to landlords’ detriment. Landlords’ options in relation to a CVA Take action before a CVA is approved and becomes binding (such as forfeiture, if available) Once a CVA is approved, forfeiture, commercial rent arrears recovery proceedings and other legal proceedings against the tenant will typically be restricted Other options include pursuing a previous tenant or guarantor (if available) Explore whether a new tenant can be found Take appropriate legal advice quickly CVA timeline 1986: CVAs were introduced by the Insolvency Act 1986 1996: Courts clarify that a CVA can compromise landlords’ claims 2003: Mister Minit, a shoe repair chain, proposed one of the first successful leasehold CVAs. Landlords were offered a share in a fund in lieu of future rent, and the relevant leases would be terminated. In the relatively buoyant property market, the proposal was sufficiently attractive to landlords, and was approved. 2007-8: Courts uphold challenge to the Powerhouse CVA on the basis of “guarantee stripping” February 2009: Stylo Barratt CVA proposals rejected April 2009: JJB Sports successfully proposes the first “modern” leasehold CVA to move rents from quarterly to monthly and compromise future rent liabilities for a number of less profitable stores August 2009: Focus DIY CVA November 2009: Blacks Leisure CVA February 2010: Speciality Retail Group CVA July 2010: Courts uphold challenge to Miss Sixty CVA where landlords would have been better off in a liquidation March 2011: Second JJB Sports CVA December 2013: Tie Rack CVA March 2016: BHS CVAs proposed, ultimately terminated when BHS entered administration in December 2016 December 2017: Toys R Us CVA proposed, ultimately terminated when Toys R Us entered administration in February 2018 January 2018: Jamie’s Italian CVA, Byron Hamburgers CVA March 2018: New Look CVA, Prezzo CVA, Select/Genus CVA April 2018: Carpetright CVA May 2018: Carluccio’s CVA, Mothercare CVA July 2018: House of Fraser CVA, challenge issued and subsequently dropped, administrators ultimately appointed August 2018: Homebase CVA December 2018: Regis/Supercuts CVA, challenge issued by a group of landlords Kevin Pullen is a partner and John Chetwood is a senior associate in the restructuring and insolvency team and Paul Chases is corporate real estate partner at Herbert Smith Freehills LLP