What does the Debenhams decision mean for retail CVAs?

Julie Gattegno looks at the detail of the recent High Court decision on the Debenhams company voluntary arrangement, and considers what grounds it leaves for landlords to challenge CVAs in future. The High Court recently handed down its eagerly anticipated decision in Discovery (Northampton) Ltd and others v Debenhams Retail Ltd and others [2019] EWHC 2441 (Ch); [2019] PLSCS 186 – a challenge to the Debenhams CVA on grounds of unfair prejudice and material irregularity, which follows the significant trend for “landlord” company voluntary arrangements (CVAs) that have been dominating headlines. The essence of “landlord CVAs” is the compromise of future rent and rewriting of leases, while all other trade suppliers are paid in full. Effectively, the reduction in future rent is seen as funding payment for the company’s past debts. Adding insult to injury, landlords’ claims for voting purposes are calculated in a way which often means those creditors being paid in full hold sufficient voting rights to sway approval of the CVA, while impacted landlords have limited, if any, influence. It is this approach to CVAs, rather than the concept of using CVAs as a means to rescue distressed companies, which landlords regard as “unfair”. Whether or not this approach constitutes “unfair prejudice” or “material irregularity”, giving landlords grounds to challenge a CVA is, however, a different question – one that landlords recently, as in Debenhams, have been motivated to pursue. The Debenhams CVA challenge The Debenhams CVA was a fairly typical landlord CVA, compromising landlords’ claims for future rent and varying the lease terms, including the right to forfeit, while all other unsecured creditors (except rating authorities) were paid in full. The landlords’ grounds of challenge (see box on following page) raised some of the fundamental questions specifically arising from “landlord” CVAs, so this decision has been closely followed and, subject to appeal, will have wide effect. The right to compromise future rent • Ground 1 The landlords’ argument that future rent is not a “debt” and so landlords are not “creditors” within section 1(1) of the Insolvency Act 1986 (the 1986 Act) – because debt is pecuniary and does not include future rent, which is “an unearned payment under an executory contract”, ie dependent on future performance – failed. Norris J, bound by previous cases with which he agreed, held that “debt” should be given a wide meaning and included pecuniary contingent liabilities which will (or may in the future) become payable as a debt. The landlords were therefore creditors entitled to receive notice of, and vote on, the CVA. • Ground 2 The landlords raised two distinct arguments. The first was that reducing future rent was in breach of a basic fairness principle of insolvency law, in that a company which makes beneficial use of premises should pay the full contractual rent for that period of occupation regardless of what the market rent might be. While the landlords acknowledged the right to give notice to vacate, this ignored the effect of business rates if it exercised this right. Debenhams agreed that, if the CVA reduced future rent without giving landlords the opportunity to recover their property, unfair prejudice might be arguable. But here the landlords had a right to terminate the leases, so they were not compelled to provide property in the future at a reduced rent. Also, the company was not obliged to consider third-party liability, which might arise if the landlords exercised this right. Secondly, the landlords argued that the obligation to provide exclusive possession of the properties at a “new” rent and on different terms imposed new obligations and was therefore outside the 1986 Act. Liability for business rates (if they took possession) also imposed new obligations. Debenhams maintained that the CVA was not imposing new obligations, but merely varying existing ones. Liability for rates was not a new obligation imposed by the CVA, but by statute. Debenhams won on both points; a CVA which reduces rent under an existing lease is not automatically unfair as breaching some fundamental principle of common sense and ordinary justice. The landlords’ right to determine the leases, and the finding that the reduced rents were at market value, meant the landlords were receiving full value and the CVA was fair. Nor did the CVA impose new obligations; it merely varied existing ones. The argument that the proposal did not take account of business rates liability failed. However, Norris J said the fact a CVA may pass the “vertical comparator” test (see box on following page) does not of itself mean the rent reduction is fair: “Fairness must be judged in the round.” • Ground 4 Ground 4 looked at whether the different treatment of the landlords in comparison with other unsecured creditors was justified – the “horizontal comparator” test (see box). The landlords argued that the unfair prejudice test was met, as there was no justification for treating them differently to other unsecured creditors, namely trade suppliers who were paid in full whether or not they were critical or non-critical suppliers. Differential treatment was only justified if it was necessary for the survival of the company, and Debenhams’ argument that there was a risk of contagion, which might affect critical supplies if they did not pay all trade suppliers, did not add up; creditors are only concerned with their individual position. Debenhams maintained that there was strong justification for treating landlords differently, due to the long terms of the leases and onerous terms compared with short-term supply contracts, while the risk of contagion justified paying non-critical trade suppliers in full, in case critical suppliers got spooked and ceased supplying. This was business reality; international suppliers couldn’t be expected to understand CVAs or international law. The judge agreed with Debenhams that there was justification for treating landlords differently to short-term suppliers, given the nature of the long-term leases at above market rates, compared with goods and services supplied by order at market rates. This was necessary for the survival of the company’s business. However, importantly, he said there would have been unfairness if landlords were expected to take reductions below market value. Debenhams’ evidence that the properties were over-rented and that the reduced rents were market value went unchallenged, so landlords are likely to scrutinise valuation evidence in future CVAs intensely. If that evidence shows landlords are not receiving full value for their properties, an unfair prejudice challenge may succeed. Landlord’s right to forfeit • Ground 3 This was the only ground on which the landlords were successful, but the decision on this point will have wider implications for the terms of CVAs. The CVA purported to restrict the landlords’ right to forfeit on grounds of the CVA proposal. The parties agreed that a right of re-entry is a proprietary right. Where they parted was whether that right was one which could be altered by a CVA (Debenhams’ position) or was outside the jurisdiction of the 1986 Act (the landlords’ position). While Debenhams accepted that the right to forfeit is a proprietary right, it argued that leases are contracts, as are conditions to which the right is subject. Therefore, it said the right can be indirectly interfered with, and the scope of section 1(1) of the 1986 Act is so wide that it can affect any of the creditors’ rights. The judge held that a CVA can modify pecuniary obligations, on which the right to forfeit might bite, but not the right of re-entry itself. Therefore, the landlords’ right to forfeit cannot be modified by a CVA, and these provisions were struck from the CVA. In practice, this may have a limited impact on forfeiture. Small companies can already seek a moratorium when proposing a CVA. Non-small companies can go into administration first (albeit with additional cost and complexity) to obtain the benefit of a moratorium, though landlords can seek the administrator’s consent or leave of the court to forfeit. In addition, forfeiture may not be an attractive option even if it is available – but retaining the right at least gives landlords options. However, the implications from the decision that companies cannot interfere with property rights under a CVA are wider. The determination of a legal estate in land, including a lease, is a property right. Therefore, a CVA cannot terminate a lease, as opposed to contractual rights and obligations arising under a lease. The inability for a CVA to interfere with such property rights will benefit landlords who want to keep leases on foot to avoid rates and other potential liabilities. Failure to comply with Insolvency Rules • Ground 5 The landlords’ final ground of challenge was based on a technical point concerning the form of the proposal and compliance with the Insolvency Rules 2016. These stipulate what must be included in a proposal, and include circumstances which might give rise to certain claims under the 1986 Act if the company was placed in administration or liquidation (referred to at the hearing as “clawback claims”). The landlords claimed there was non-compliance caused by the failure to disclose potential clawback claims (the irregularity) and, had creditors been made aware, they would have taken a different approach to the CVA (therefore it was a material irregularity). Debenhams said it was only required to disclose relevant information “so far as known” and of circumstances which might give rise to clawback claims, not the specific claims that might be available. The CVA disclosed sufficient details of the new monies arrangement and security package, and it said there was no desire to prefer creditors but to save the business. In any event, Debenhams said this was not material. Over 90% of creditors voted in favour of the CVA, so even if all category 5 landlords had voted against, the CVA would still have been approved. The judge found that disclosure was adequate and, even if there was an irregularity, it was not material as it would have meant a less than 1% shift in the vote. What next? The decision has important ramifications beyond the Debenhams CVA. As things stand, future rent can be compromised by a CVA, though it remains open to challenge on grounds of unfair prejudice or material irregularity. However, retail tenants have had their wings clipped: n Companies will need to obtain solid valuation advice to ensure that proposed CVA rent reductions are at market rent, as landlords will no doubt look to test valuations. n CVAs cannot modify a right to forfeit, or purport to determine leases, as this is outside the scope of the legislation. Given the importance of this decision, an appeal seems likely, and the court’s expedited timetable certainly factored in the prospect of an appeal. In the meantime, other questions arising from landlord CVAs remain, such as the calculation of a landlord’s future contingent claims for voting purposes. Some of these questions, no doubt, will be raised in other CVA challenges which are currently working their way through the courts. The outcome of these challenges will hopefully lead to a rebalancing of the approach to CVAs by companies, so that the pain that creditors must bear to help rescue an ailing company is more fairly shared. The grounds of challenge at a glance Ground 1 The landlords are not “creditors” for future rent within the scope of section 1(1) of the Insolvency Act 1986. Rejected: The definition of “debt” is broad enough to include pecuniary contingent liabilities, such as future rent. Ground 2 A CVA cannot operate to reduce future rent because it is automatically unfairly prejudicial to do so, or because there is no jurisdiction to do so. Rejected: Compromising future rent liabilities is not automatically unfair. Ground 3 The right of forfeiture is a proprietary right that cannot be altered by a CVA. Upheld: The right of re-entry is property belonging to the landlord and cannot be modified by a CVA. Ground 4 The applicants are treated less favourably than other unsecured creditors without any proper justification. Rejected: Treating landlords differently was justified to secure continuation of the company’s business. Ground 5 The CVA fails to comply with the requirements of rule 2.3(1) of the Insolvency Rules 2016. Rejected: Disclosure was adequate but, even if there was an irregularity, it was not material as it would have meant a less than 1% shift in the vote. Key tests Horizontal comparator test: Is a creditor treated less favourably than other creditors in the same class without justification? Vertical comparator test: Is a creditor in a worse position than on an administration or liquidation of the company? Julie Gattegno is a partner at CMS