Snipping away at unfair prejudice in landlord CVAs

Tim Reid offers his analysis of the High Court decision to revoke the Regis hairdressing group CVA on the basis that it favoured shareholders at the expense of landlord creditors. In 2020, there were 33 so-called “landlord” company voluntary arrangements in the UK market. Retailers have increasingly used the restructuring mechanism of a CVA to reduce lease liabilities (reducing rents, writing off arrears and closing stores) with a view to returning their business to profitability. Often, that seems to be for the benefit of their shareholders, finance creditors and trade suppliers at the expense of landlords. The number of landlord CVAs had tripled in the space of a year, leading the British Property Federation to call for an end to “the abuse of CVAs”. The BPF urged the government to intervene in a practice which in its view is transferring money from the owners of UK commercial property (who very often are ultimately pensioners, taxpayers and savers) to the private equity-backed owners of retail businesses. In the absence of legislative change, some of the biggest commercial landlords in the UK have applied to the High Court to challenge what they identified as the worst excesses of the landlord CVA, including in Carraway Guildford (Nominee A) Ltd and others v Regis UK Ltd and others [2021] EWHC 1294 (Ch). Unfair to favour shareholders at the expense of impaired landlords Under the terms of the Regis CVA, landlords’ rights were significantly impaired, with rents reduced by between 25% and 75%, and arrears compromised at just 7% of their value. For the purpose of the vote at the creditors’ meeting (at which a majority of 75% of creditors by value had to approve the CVA) the value of landlords’ claims was reduced by 75%. In contrast to the impairments imposed on landlords, a long list of “critical creditors” – including the company’s shareholder, International Beauty Ltd – were left entirely unimpaired. Mr Justice Zacaroli observed that “IBL was… wholly owned by Regent, a global private equity firm… and to the extent that the company’s debt burden, in particular to landlords, was reduced, Regent as equity holder stood to benefit”. As an unimpaired creditor, IBL would receive payment in full of a £600,000 debt. By contrast, a compensation fund of just £330,000 was provided to meet the claims of all impaired creditors. The judge held that there was not sufficient justification for leaving IBL unimpaired. Compromising IBL’s debt would not have jeopardised the effectiveness of the CVA. It appeared to have been given favourable treatment because it was the company’s shareholder, rather than for any objectively justifiable reason. This was unfairly prejudicial against the impaired creditors, including the applicant landlords. On this basis, Zacaroli J held that the CVA should be revoked, meaning that it should be treated as never having taken effect. In connection with that favourable treatment given to IBL, Zacaroli J also said that the absence of a profit share fund under the CVA (that is, a fund from which impaired creditors can share in future profits of the business) is not automatically unfairly prejudicial, but is something to weigh in the balance when looking at the differential treatment of creditors. Having already ordered revocation of the CVA on the basis of the favourable treatment given to IBL, Zacaroli J decided that he did not need to consider whether the existence of only an “illusory” profit share fund under the Regis CVA was unfairly prejudicial. A landlord break option will sometimes negate the unfairness of lease modifications In addition to the preferential treatment of shareholders and other creditors, the landlords complained that long-term lease modifications imposed on them by the Regis CVA, including rent reductions, were unfair. Echoing his earlier decision in relation to the CVA of New Look – Lazari Properties 2 Ltd and others v New Look Retailers Ltd and others [2021] EWHC 1209 (Ch); [2021] PLSCS 96 – Zacaroli J said that where a CVA introduces a lease termination right for landlords, it gives the landlord a chance to “get off the bus” rather than bear the effect of lease modifications under the CVA. He held that the termination right can therefore negate the unfairness of any lease modifications in the CVA, on the basis that the landlord can exercise the termination right and avoid such unfairness. However, the new termination right will only compensate the landlords for unfair terms if, by exercising the right, the landlord ends up in no worse a position than if the CVA had not been approved. This is what is known as the “vertical comparator”. In other words, if exercising the termination right results in a lower return from the tenant company than the landlord would have received if the company had instead gone into a formal insolvency process then that will not negate any unfair lease modifications. Where the vertical comparator is liquidation followed by an immediate disclaimer of the lease then this should be relatively easy to satisfy. However, if it is an administration, such as a pre-packaged sale of the business, then it may be more difficult. Breach of professional duty by CVA nominees Zacaroli J held that the conduct of the nominee, the insolvency practitioner appointed by the company to supervise the implementation of the CVA, fell below the professional standards required of him. That was because the nominee had made no attempt to question or investigate the propriety of IBL being left unimpaired and being paid in full. The judge was critical of the nominee for having allowed that to go unchallenged. The nominee’s submission that he was “not responsible for the proposal, only for his report” was found by the judge to understate the responsibilities of a nominee. The creditors are entitled, he said, to rely on the fact that an independent professional nominee has applied an appropriate level of scrutiny to the proposal. Although Zacaroli J concluded that the nominee had fallen below the standards expected of his office, the judge declined to make an order under s6(6) of the Insolvency Act 1986 for repayment of the nominee’s fees to the company. There have been no recorded cases of such sanctions being made against CVA nominees, and Zacaroli J said that it is a penalty reserved for cases of particularly egregious conduct, fraud and bad faith. An arbitrary 75% discount on landlords’ voting power is irregular The CVA nominees argued that it was “typical market practice” to apply a 75% discount to landlords’ claims for voting purposes at the creditors’ meeting, but Mr Justice Zacaroli held that such a discount was irregular. If that discount was capable of having a material impact on the outcome of the vote, it would have amounted to material irregularity and further grounds for revoking the CVA, but on the facts of this case the judge found that the irregularity was not material. A blanket discount may be justified if it constitutes a reasonable method for estimating a minimum value for landlords’ claims, and in New Look, Zacaroli J had decided that the 25% discount applied under that CVA was not irregular. The new landscape The Regis decision represents a rare victory for landlords when it comes to CVA challenges. The Regis CVA was found to be unfairly prejudicial and was revoked by the judge. Companies proposing CVAs in future will have to steer clear of terms which leave group companies and shareholders entirely or substantively unimpaired, especially when they stand to benefit from the upturn of the business at the expense of the company’s landlords. It is also more difficult now than before for companies to impose CVAs on dissenting landlords, because it is irregular to apply a discount on landlords’ claims for voting purposes which does not represent a reasonable method for estimating a minimum value. Zacaroli J’s finding that landlord termination rights can negate the unfairness of any lease modifications in the CVA meant that the landlords’ complaints about unfairly prejudicial lease modifications were unsuccessful. But one of the overriding points to come out of his two judgments is that, where lease modifications at the landlords’ expense have the effect of increasing value for the benefit of shareholders, that benefit should be shared with the impaired landlords to avoid unfair prejudice. With at least one case now going in favour of the landlords, the effect of the Regis judgment has been to set some clearer parameters for how far future landlord CVAs can go without being deemed unfair. Tim Reid is a counsel in real estate disputes at Hogan Lovells International LLP Photo © Engin Akyurt/Pexels