A fashion retailer and wholesaler, part of an Italian group, had 11 retail shops and 14 concessions in department stores in the UK, through which it sold garments supplied from Italy by its parent company. The company got into financial difficulties and considered a restructuring involving the planned closure of some of its stores and the surrender of leases with several years left to run. This was clearly going to be an expensive exercise, given that the shops were in upmarket locations and let at relatively high annual rents. Eventually, it was decided to put the company into administration so that the administrators could propose a company voluntary arrangement (CVA), with the intention that four stores would be closed and the leases would be effectively surrendered by the terms of the CVA. The CVA was seen as a mechanism through which the Italian parent company would be released from its obligations under the guarantees given to the landlords of two of the stores. This ‘guarantee stripping’ had been attempted previously by the Powerhouse group, although in Prudential Assurance Company Ltd & ors v PRG Powerhouse Ltd & ors [2007] its CVA was overturned by the court on the basis that the release of the parent company from guarantees given to its subsidiaries’ landlords constituted unfair prejudice under s6 of the Insolvency Act 1986 (the 1986 Act).
POWERHOUSE
However, somewhat controversially, the judgement in Powerhouse decided that the mechanism in the CVA for releasing the parental guarantees was effective. This is rather surprising because, on broad contractual principles, it would seem to be contrary to logic that a CVA can release a third party guarantor from its obligations to the debtor’s creditors, particularly since the guarantees in question contained provisions making the guarantor a principal debtor and prohibiting the release of the guarantor because of any variation or waiver in relation to the tenant’s obligations under the lease. The basis of the decision revolved around the idea that unless the debtor company had a right to compel the landlords not to pursue their claims against the guarantors, the latter would be able to claim against the debtor by subrogation, thereby defeating the objective of releasing the guarantees. The administrators, funded by the Italian group, apparently decided to rely on that principle to put forward a CVA that would have the desired effect of unilaterally surrendering the leases of four stores and also releasing the parent company from its guarantee obligations, in return for a compensatory payment. The outcome was to turn on the amount of compensation offered to the landlords with guarantees.
Terms of the CVA
The basic structure of the CVA was simple. All creditors except for the landlords of the closed stores were to be paid in full. The landlords of two of the closed stores were to be paid 21% of the debtor company’s estimated liability to them. Neither of these landlords had the benefit of guarantees. The landlords of the two stores with the benefit of parental guarantees were ostensibly to be paid 100% of their loss, which was stated in the CVA to be £300,000, on the basis of expert valuation evidence. The parent company apparently agreed to defer a loan of about £15m owed to it and, although not clearly stated, this was later taken to mean that it would be subordinated to the claims of all other creditors until the CVA was terminated. An intermediate holding company in the group was owed approximately £7m and it was a flaw in the CVA that its debt was not similarly deferred.
At the statutory creditors’ meeting, the creditors voted to approve the arrangement, which was entirely predictable because no creditor except the landlords had anything to lose. The statutory majority of 75% of creditors by value voting in person or by proxy was easily achieved. The landlords were the only creditor to vote against the CVA, and they subsequently applied to the court to have it set aside on the basis of material irregularity and unfair prejudice. It is the unfair prejudice claim that was decisive and is of most interest.
Mourant & Co Trustees Ltd & anor v Sixty UK Ltd & ors [2010]
Sixty came before Henderson J in the High Court in July this year. The administrators did not contest the hearing. The debtor company was Sixty UK Ltd (Sixty), trading as ‘Miss Sixty’ and ‘Energie’. Sixty was ultimately owned by the Italian company Sixty SpA. The application by Sixty’s landlords (the landlords) related to the leases of two retail outlets in the Metquarter shopping centre in Liverpool. The grounds were that the landlords were unfairly prejudiced by the terms of the CVA, in particular by the removal of their rights under guarantees given by Sixty SpA. The guarantees related to the tenant’s obligations for the remaining term of the leases and included provisions requiring the guarantor to take up new leases of the retail units in the event of a disclaimer by a liquidator of the tenant.
The landlords maintained that they had been unfairly prejudiced by the inadequate compensation of £300,000 and the compulsory deprivation of the benefit of Sixty SpA’s guarantee. They submitted expert evidence that the minimum sum required to fairly compensate them for their loss of contractual rights against Sixty SpA would be about £1.2m. The evidence indicated that the administrators had access to a professional valuation obtained by Sixty as to the landlord’s loss by the closing of the two retail stores in question, but they had been unable to persuade Sixty SpA to make a compensation payment for the landlords that was close enough to the valuation. The CVA proposal stated that the amount of compensation to be paid to the landlords was in accordance with the professional valuation, which was revealed to be inaccurate by the evidence given at the hearing. Henderson J said he had no hesitation in accepting the evidence of the landlord’s expert valuer, as opposed to the level of compensation proposed in the CVA, and he made an order under s6 of the 1986 Act revoking the decision taken by the creditors to approve the CVA on the basis of unfair prejudice.
Vertical and horizontal comparisons
Henderson J’s judgment applied the principles set out by Etherton J in Powerhouse, in particular on the question of whether the prejudice suffered by a creditor was unfair. Henderson J accepted that there was no single, universal test of unfairness and that the court has to consider all the circumstances, including the alternatives available to the company and the practical consequences of setting aside the CVA. The court has to base its analysis on both the ‘vertical’ comparison – which is the position of the creditor in a hypothetical liquidation compared to the position under the proposed CVA – and the ‘horizontal’ comparison – which is the position of the challenging creditor compared to other creditors, or classes of creditor. Powerhouse confirmed that treating creditors differentially is not automatically unfair, provided that it is proportionate and justified; for example, when paying employees and suppliers in full so that the business can continue to trade.
On the vertical comparison, Henderson J decided that the challenging landlords would be in a much better position in a hypothetical liquidation than under the CVA, as they would have been able to pursue Sixty SpA under the guarantee. Sixty SpA was a substantial company and it was apparently able to honour its obligations under the guarantee. On the horizontal comparison, treating the landlord of the closed stores differently from the other creditors could not be justified, particularly as the other creditors were to be paid in full. Another landlord whose lease was surrendered by the CVA had the benefit of payment by the original tenant, which was able to claim and recover in full in the CVA by virtue of a subrogated claim. This appeared to be permitted under the terms of the CVA because of an oversight by those preparing it, but the CVA nevertheless treated creditors of the same class differently and therefore failed the horizontal test.
ADMINISTRATORS’ DUTIES
Henderson J was satisfied that, on the expert valuation evidence put forward by landlords to the court, the true loss suffered by the landlords was around £1.2m. He described the payment of £300,000 proposed in the CVA as ‘derisory’ and not a genuine estimate of the value of the landlords’ claim but an amount dictated to the administrators by Sixty SpA. This led Henderson J to consider the role of the administrators in detail and he referred to the following comments by Warren J in Sisu Capital Fund Ltd & ors v Tucker & ors [2005]:
‘It is not for the office holders to advocate the interests of one group of creditors as against another group, nor to engage in brinkmanship, or attempt to extract ransom payments, on their behalf by refusing to put forward what he, the office holder, regards as a fair proposal in order to extract a better proposal…They simply put forward proposals (which, if they are acting properly, are ones which they must consider to be fair to all the creditors… and to the company itself).’
In Powerhouse Etherton J observed that if an administrator or liquidator puts forward a proposal that he considers to be fair, then in the absence of evidence that they did not act in good faith or favoured the interests of particular creditors, the court should not speculate about what alternative proposals might have been made and accepted.
However, in Sixty Henderson J severely criticised the administrators (who were also the supervisors of the CVA). He said that the administrators had allowed themselves to side with the Sixty SpA group against the interests of the landlords and were therefore not acting in accordance with their duties towards the creditors. They had permitted Sixty SpA to dictate the crucial terms of the CVA and misrepresented the true position to the creditors, meaning that the landlords’ only method of protecting its interests was to embark on lengthy, expensive and uncertain litigation proceedings. Henderson J emphasised that it is the duty of insolvency office holders to take an independent stance, act in good faith and only propose a CVA if they are satisfied that it will not unfairly prejudice the interests of any creditor.
In an apparently unprecedented move, the judge directed that copies of his judgment should be sent to the administrators’ regulatory bodies, as he believed there had been ‘a prima facie case of misconduct’ by the administrators and their behaviour was ‘impossible to justify’. He went so far as to say that the CVA ‘should never have seen the light of day’, as he considered that the administrators had not taken the necessary steps to act in the interests of the creditors as a whole and ensure that the CVA would not unfairly prejudice any creditor of the company. He also expressed the view that it is not impossible to propose a fair guarantee stripping CVA, but the greatest care needed to be taken to ensure fairness to minority creditors in both the substance of the proposals and the procedure adopted.
Although Powerhouse established that, in theory, it is legally possible to structure the removal of parental guarantees by a CVA, there has been no subsequent reported case demonstrating how this could be done without causing unfair prejudice to the landlords whose guarantee rights are removed. Arguably, another fundamental flaw with the Sixty CVA was that it did not constitute an arrangement at all because the only creditors who were not to be paid in full under the proposals were the landlords.
SUCCESSFUL RETAIL CVAs
Since Powerhouse, several CVAs of large retail companies, including JJB Sports, Focus DIY and Blacks have been approved by sizeable majorities of creditors, including landlords. These successful CVAs were carefully structured to ensure that no creditors were unfairly prejudiced. This can be achieved by the debtor company setting aside a fund for the benefit of the landlord creditor group in respect of closed stores, to provide pro rata compensation to the landlords for the loss of rent for a sufficient period (calculated in accordance with principles of the landlords’ rights in the liquidation of its tenant, as established by case law), as well as for the cost of business rates (which can be greater than the passing rent). If independent professional valuation advice is taken and followed, it is possible to ensure that the landlord creditors as a group will be significantly better off than they would have been in the event of the liquidation of their tenant. However, it is believed that none of the CVAs mentioned above attempted guarantee stripping to the landlords’ detriment.
LESSONS FROM SIXTY
The key message for landlords and other creditors is that CVAs can be set aside, even where an overwhelming majority of creditors has voted in favour of them. For that reason, it is worth analysing the terms of a CVA proposal to see whether any creditor or class of creditors has been treated significantly worse than others (the horizontal comparison), or their position is worse than it would have been in a liquidation of the debtor (the vertical comparison). There is a further test referred to in Powerhouse, which is the comparison with the Companies Act 2006 scheme of arrangement procedure and the determination of whether creditors who would together constitute a class in a scheme of arrangement would be likely to vote against the proposals, which under the scheme procedure would result in the rejection of the scheme. If the CVA fails these comparisons, it is likely that it will be found to be unfairly prejudicial to one creditor or group of creditors and capable of being set aside by the court.