CVAs: Unwilling to be fleeced

In the second of two articles summarising their recent Blundell lecture, Stephen Jourdan QC and Mathew Ditchburn address possible ways for landlords to challenge a retail tenant’s CVA. In our first article (“Volunteering to be fleeced”, 14 September 2019, p50), we explained some of the principal features of a typical landlord company voluntary arrangement (CVA). In this article, we discuss the possibility of a challenge on the basis of (1) unfair prejudice or (2) material irregularity deploying the good faith principle. Unfair prejudice ■ Differential treatment of creditors can be justified if necessary to save the company’s business There can be no objection in principle to a CVA which provides for the tenant to cease to be liable to pay the rent and perform the tenant’s obligations under a lease of an unprofitable property, provided the landlord is entitled to the same rights in respect of the loss suffered as a result as all other unsecured creditors, as in Cazaly Irving Holdings Ltd v Cancol Ltd [1995] EGCS 146. The landlord CVA that has emerged in recent years, however, does not take this approach. Rather, the trade creditors are paid in full, while landlords of exited premises generally receive only a small fraction of the loss suffered by them. This is contrary to the pari passu principle in insolvency – that unsecured creditors should share in whatever assets are available to meet the company’s debts in proportion to the value of their claims: see Express Electrical Distributors Ltd v Beavis [2016] EWCA Civ 765. The company will defend the differential treatment on the ground that it needs to pay the trade creditors in full to preserve their goodwill and willingness to deal with the company in order to continue trading, whereas the commercial realities with the landlords are different. This defence is in principle capable of being a valid one. If it is true that payment in full of all the trade creditors is necessary for the survival of the company’s business, and anything less will lead to the company inevitably going into liquidation with all the unsecured creditors getting nothing, the differential treatment is not unfairly prejudicial. It does not in reality cause any prejudice to the landlords as, if the arrangement is not put into effect, they will end up in just as bad a position – the only difference being that the company’s business will fail, its employees will be out of work and its suppliers and customers will be adversely affected. The courts have correctly recognised that differential treatment of different classes of creditors may be justifiable. In Commissioners of Inland Revenue v Wimbledon Football Club Ltd [2004] EWHC 1020 (Ch), Lightman J (whose judgment was approved on appeal) said “differential treatment may be necessary to secure the continuation of the company’s business which underlies the arrangement”. The real question is as to the intensity of the scrutiny that the court should apply to the assertion that differential treatment is necessary. ■ The key question is the degree of scrutiny the court should apply to such an arrangement In Wimbledon, Lightman J also said: “…in determining whether or not there is unfairness, it is necessary to consider all the circumstances including, as alternatives to the arrangement proposed, not only liquidation but the possibility of a different fairer scheme.” That is right. And it should be for the court, not the company or the insolvency practitioner it is paying to act as nominee, to scrutinise the arrangement and determine if the differential treatment is justified and whether a different, fairer scheme was possible. However, in two High Court decisions subsequent to Wimbledon, a very different approach has been adopted. In Sisu Capital Fund Ltd v Tucker [2006] BCC 463 the CVA was proposed by administrators. Warren J said: “If an administrator or liquidator puts forward a proposal which he considers to be fair then, unless it is established that he acted other than in good faith or that he is partisan to the interests of some only of the creditors, the court should not speculate about what other proposals might have gained acceptance and been capable of implementation…” In Prudential Assurance Co Ltd v PRG Powerhouse Ltd [2007] EWHC 1002 (Ch); [2007] 3 EGLR 131, Etherton J took the same line, in a case where the CVA was proposed by the directors of the company: “…it is not for the court to speculate whether the terms of the proposed CVA were the best that could have been obtained, or whether it would have been better if it had not contained all the terms it did contain.” This approach arguably abdicates the question of fairness to the insolvency practitioner, which seems contrary to what Lightman J had in mind in Wimbledon and wrong in principle. Warren J and Etherton J also stated the general approach to the court’s review of fairness in terms that need to be critically examined, particularly in the case of Etherton J. Warren J said in Sisu: “…if I judge that this reasonable and honest man in the same position as the applicants might reasonably have approved the CVAs which are challenged, the applicants fail.” Etherton J went even further, saying in Powerhouse: “So, although I agree with Warren J that, if a reasonable and honest man in the same position as the claimants might reasonably have approved the CVA, that would be a powerful, and probably conclusive, factor against the claimants on the issue of unfair prejudice… the fact that no reasonable and honest man in the same position as the claimants would have approved the CVA is not necessarily conclusive in favour of the claimants.” It is arguable that both statements of principle are unduly favourable to a company proposing a CVA. The test as to whether a CVA is unfairly prejudicial is the same as the test applied by the court in deciding whether to approve a compromise or arrangement under the legislation originally enacted by the Joint Stock Companies Arrangement Act 1870 (the 1870 Act), which is now contained in Part 26 of the Companies Act 2006: see Re T&N Ltd [2004] EWHC 2361 (Ch). In three cases decided by the Court of Appeal under the 1870 Act – Re Alabama New Orleans Texas & Pacific Junction Railway Co [1891] 1 Ch 213, Re English, Scottish, and Australian Chartered Bank [1893] 3 Ch 385, and Sovereign Life Assurance Company v Dodd [1892] 2 QB 573 – which are still cited today as laying down the applicable principles, three safeguards were established to prevent the oppression of the minority of creditors by the majority. They shed light on how the fairness test under section 6 of the Insolvency Act 1986 (the 1986 Act) should be applied to a CVA. The safeguards are as follows. First, creditors whose interests were so different as to make it impossible for them to consult together with a view to their common interest were to be regarded as being in different classes, and had to have separate meetings. There could be no question of creditors whose rights were unaffected by the proposed arrangement voting to impose it on creditors whose rights were affected. This was because in such a situation there were, in reality, quite separate arrangements being proposed. If it is right that this form of protection does not apply to CVAs because the 1986 Act does not allow for a scheme of arrangement of the company’s affairs to be proposed to a class of creditors, but only to the company’s creditors as a whole, then the absence of that protection makes it all the more important that the other two forms of protection are strictly insisted on. Second, the court would not sanction an arrangement unless satisfied that the majority had acted in the interests of the class of creditors to which they belonged. In UDL Argos Engineering & Heavy Industries v Lin [2001] HKFCA 19, Lord Millett, giving the leading judgment in the Hong Kong Court of Final Appeal, reviewed a number of cases in various jurisdictions on the jurisdiction deriving from the 1870 Act, and summarised the principles to be derived from them. One was that: “The court will decline to sanction a scheme unless it is satisfied, not only that the meetings were properly constituted and that the proposals were approved by the requisite majorities, but that the result of each meeting fairly reflected the views of the creditors concerned. To this end it may discount or disregard altogether the votes of those who, though entitled to vote at a meeting as a member of the class concerned, have such personal or special interests in supporting the proposals that their views cannot be regarded as fairly representative of the class in question.” Third, the court would not sanction an arrangement unless satisfied that it was a reasonable one with regard to the particular circumstances of the case. In making this assessment, then, provided the majority had acted in good faith, the court would give great weight to the fact that the majority had voted in favour, and would interfere only if no intelligent and honest person acting alone in respect of his interest could have approved of it. It is important to note that this question of reasonableness arises only if the arrangement satisfies the second principle: see UDL Argos. In the light of those principles, it is arguable that the court ought to treat as inherently unfair an arrangement which is not supported by 75% of the creditors whose rights are affected by the arrangement, and is approved only because of votes in favour by creditors whose rights are unaffected. Such an argument was rejected by Mann J in HMRC v Portsmouth City Football Club Ltd (in administration) [2010] EWHC 2013 (Ch). However, his attention was not drawn to the authorities under what is now Part 26 of the 2006 Act and the importance of discounting votes cast because of special interests of some creditors which did not affect others. It is, therefore, arguable that it is inherently unfairly prejudicial for some creditors who will be paid in full to be able to vote through a CVA that affects other creditors only. This argument is also given some support by the decision in Gertner v CFL Finance Ltd [2018] EWCA Civ 1781, which is discussed below. [caption id="attachment_997422" align="alignnone" width="847"] The argument that it is unfair for unaffected creditors to have voting rights was initially rejected in the Portsmouth City FC case[/caption] Whether or not that argument is correct, it should follow in the light of the principles established under the 1870 Act that the court should scrutinise closely the fairness of a CVA that treats different classes of creditors very differently, and not abdicate that issue to the discretion of an insolvency practitioner. Material irregularity deploying the good faith principle It is a long-established principle of insolvency law that creditors of an insolvent debtor owe each other a duty of good faith when entering into compositions with the debtor. A creditor is not permitted to receive a secret benefit from the debtor, or a relative of the debtor, in return for agreeing to the composition: see Cockshott v Bennett (1788) 2 TR 763 and Knight v Hunt (1829) 130 ER 1127. Malins V-C summarised the principle in McKewan v Sanderson (1875) LR 20 Eq 65: “…it is the duty of all creditors who have once taken part in the proceedings of bankruptcy or composition to stand to share and share alike. Equality is the only principle that can be applied, and if one creditor, unknown to the other creditors – not unknown to one or two, but to the general body – enters into an arrangement by which he gets for himself from the debtor, or from any one on behalf of the debtor, any collateral advantage whatever, that is a fraud upon the other creditors…” In Cadbury Schweppes plc v Somji [2001] 1 WLR 615, the Court of Appeal held that the good faith principle applies to voluntary arrangements under the 1986 Act. If a creditor receives a collateral advantage in return for voting in favour of a voluntary arrangement, this constitutes a material irregularity. The principle was applied in Kapoor v National Westminster Bank plc [2011] EWCA Civ 1083 and more recently in Gertner. Gertner is important, as it suggests that a collateral arrangement may constitute a “material” irregularity even if the existence of the arrangement is not concealed. Moises Gertner argued that the secret deal entered into by his family businesses with Kaupthing, by far his largest creditor, made no difference to the outcome of the vote, and so was not “material”, even if it was irregular. Kaupthing’s debt was 90% in value of all of Gertner’s debts and if the other creditors had known about the deal there would still have been more than 75% by value of the creditors voting in favour. The Court of Appeal rejected that argument. Patten LJ said that the objection to the deal was “…that it provided Kaupthing with a collateral advantage not available to other creditors which placed it in a position of conflict with the interests of the other creditors. That was in my view a breach of the good faith principle which disqualified Kaupthing from voting on the proposal to the potential detriment of CFL and the remaining creditors”. It is not clear how far this principle goes, but it is arguable that any substantial advantage offered to one group of creditors and not another, whether or not it is concealed, may be sufficient to justify not counting the votes of creditors in the former group. Main image © Geoff Pugh/Shutterstock Stephen Jourdan QC is joint head of Falcon Chambers and Mathew Ditchburn is head of real estate disputes at Hogan Lovells