Extinction is the rule. Survival is the exception.
Carl Sagan
The UK’s retail industry has been fragile for some years, with problems peaking following the global financial crash in 2008. This spurred uncertainty among many retail businesses, resulting in the UK retail market suffering from thousands of insolvencies. During the financial crash, many consumers relied on brick and mortar stores when shopping; however – due to advances in technology – this is increasingly no longer the case.
In light of this, retailers have struggled to increase the foot traffic to their brick and mortar stores. Instead, consumers have been moving their shopping to the digital sphere. This has forced retail businesses to diversify to suit modern consumer trends, and to keep afloat in a highly competitive market.
This is not an easy task. In the last couple of months, major retail stores such as House of Fraser, Mothercare, and New Look have been facing financial struggles. The increase in online shopping, the weakness of the overall economy, and punitive business rates have caused retail and restaurant groups to try and enter into alternative insolvency procedures known as Company Voluntary Arrangements (CVAs). This involves the creation of a rescue proposal that is used by a company to enable it to enter into an agreement with its creditors. This gives the company the ability to restructure their business model, control its company debts and ultimately avoid administration.
However, these proposals have the potential to cause detriments to landlords who could face a number of disadvantages if the proposals are passed and approved by the company’s creditors. Among these include the possibility of unfavourable terms being implemented in lease agreements, such as restrictions on future rent demands to be paid by tenants and the potential for landlords being unable to forfeit the lease in the event of rent arrears. It is of no surprise therefore that CVAs are rarely welcomed by landlords.
What is a CVA?
In England and Wales, a Company Voluntary Arrangement (CVA) is the formal restructuring procedure for insolvent companies. The law governing CVAs is set out in the Insolvency (England and Wales) Rules 2016 (the IR 2016), which confirm that a CVA is a legally binding arrangement between a company and its creditors with the aim of repaying a proportion of the company’s debt over a fixed period of time.
A CVA is essentially a rescue plan to help companies that are facing financial difficulties; it allows them to devise alternative arrangements with their creditors in order to settle their debts. A CVA can be a good strategic plan for a company: it buys the company time to restructure its business model and continue trading while allowing the directors to remain in control of the company.
As Section 1(1) of the Insolvency Act 1986 (IA 1986) provides, the directors of any company – so long as it is not in administration or being wound up – may appoint an insolvency practitioner (a licensed professional, typically with an accountancy background) to propose a CVA to its creditors. This must be proposed within one month of their appointment. For the proposed CVA to be approved and its terms to have binding effect on all the company’s creditors, it will need to receive votes in favour from the creditors who are owed at least 75% of the outstanding debt and must also not be opposed by more than 50% of the creditors as individuals.
Recently, a large number of retailers and solvent companies in the UK have resorted to using CVAs as a restructuring model for their businesses. The procedure has been particularly popular among those companies that operate on a mass scale across the country. A major effect of these arrangements that makes them so attractive for businesses, particularly retailers, is that a CVA allows for the collective restructuring of rent obligations on a mass scale without the need to negotiate lease terms with each individual landlord. This mechanism is therefore a cost-effective way of facilitating the closure of under-performing stores and cutting a company’s rent obligations on a large scale.
The Impact of CVAs on Landlords
House of Fraser, a retail business which has been running in the UK for 169 years, recently announced that they would propose a CVA for the approval of its creditors; this was intended to overhaul the company and potentially to shut 31 of its 59 stores. It was also aimed at cutting the rent payable to the landlords of their remaining stores. Given that failing to agree to the CVA could see House of Fraser wound up completely, many of its landlords were left with no option but to accept the financial impacts they could face as a result of reduced rent, in order to safeguard at least some income.
A landlord, as a creditor, has the power to vote and therefore approve a CVA proposal. As a result, when a company proposes to use a CVA, it is crucial for landlords to consider the potential impacts they could face and to act quickly in reviewing the terms of a CVA. This allows them to gauge whether its terms could potentially cause an impediment to their commercial position. Once a CVA is approved, it will bind all unsecured creditors who had the right to vote on the CVA proposals. Therefore, a landlord need not be present at a CVA proposal in order for its terms to be binding as long as the proposals are approved by the requisite 75% majority; if this happens, the landlord will be bound by the arrangements nonetheless.
On the face of it, a CVA provides retailers with greater flexibility to enable them to keep their stores open. However, at the same time, the proposals have left some landlords in a position where they may be required to compromise their rights in order to comply with the terms implemented in a CVA agreement. For example, a landlord may be required to agree to a limitation or abolition of their right to forfeit the lease – a right usually present in leases which enables the landlord to terminate the lease prematurely and take possession of the premises in the event a tenant breaches the terms of a lease. A landlord can exercise the right to forfeiture if the lease expressly provides a right for the landlord to do so. However a CVA might be a convenient tool in revising such terms. Consequently, the landlord is unable to avail of such right – usually available – if their retail tenant falls into arrears with its rent.
Adding to the risk of a landlord losing certain rights, there is the risk that a CVA may not succeed. If the plans to rescue a struggling business do not work, then a company will have no option but to enter into formal insolvency procedures, as was recently witnessed in the collapse of Toys R Us. In the short term, a failing CVA could burden a landlord with even bigger financial losses: both the right to recover the property and the possibility of it finally recovering its rent would have significantly decreased. In the shorter term, the landlord is obviously put in an uncertain and precarious position as it cannot be guaranteed a steady stream of rental income.
There is, of course, the option for a landlord to re-let its premises. However, with the increase in the number of online stores, expanding businesses, and an increasingly competitive market, it has become somewhat of a challenge for premises to be re-let. This is compounded by the fact that, given what has happened to the previous owner, the premises might now be perceived by potential future tenants as being a location which is unlikely to offer good profit returns and likely to provide little consumer foot traffic. An institutional landlord may well prefer to have a tenant in occupation of a property – albeit one in rent arrears – rather than a vacant property where no rent is paid at all.
Protections for Landlords
One possible solution may be to promote greater transparency between a company and its creditors. This serves the very purpose of ensuring that the provisions in a CVA do not place undue pressure on landlords. In short, landlords would be better able to exercise some bargaining power in their negotiations with these tenants.
Furthermore, while a CVA is a binding arrangement, statute does offer creditors a form of protection. Under Section 6(1) of the IA 1986, creditors can apply within 28 days of the approval of the decision to the court to challenge it. This challenge can be made on two grounds: that a voluntary arrangement unfairly prejudices the interests of a creditor, member or contributory of the company; and/or that there has been some material irregularity at or in relation to the meeting of the company or in relation to the relevant qualifying decision procedure.
When seeking to bring a claim under unfair prejudice, it is not enough for the applicant to demonstrate that the terms were simply prejudicial to their interest; any CVA proposal which places a creditor in a less favourable position can obviously be considered as prejudicial to the interest of that creditor. Instead, what will need to be shown is that the prejudice in question is 'unfair'. The court will therefore undertake a holistic examination of the overall impact of the CVA on the creditors, having regard in particular to the alternatives available and the practical outcomes of the arrangement.
This form of statutory protection can, therefore, offer a landlord (as a creditor) a way by which they may be able to protect their interests from the CVA proposals. Indeed, this occurred in Prudential Assurance v PRG Powerhouse [2007], which featured a CVA proposal that anticipated that Powerhouse – an electrical goods chain – would close 35 of its stores. The terms of the CVA forced landlords to accept the release of a parent company guarantee. The landlords brought a claim under Section 6(1)of theIA 1986 on the basis that their position had been compromised by the removal of the benefit of this guarantee.
The landlords’ claim succeeded. Etherton J held that the landlords were unfairly prejudiced by the terms of a CVA, as the proposals stripped away the landlords’ rights to pursue a tenant’s guarantor in the event of non-payment of rent, and offered those guaranteed landlords little compensation for the loss of these rights.
Commentators have heralded the decision in Prudential Assurance v PRG Powerhouse [2007] for showing that there remains an avenue of protection for landlords, provided they can satisfy the court that the relevant grounds have been met. Case law can, therefore, offer a landlord assurance in knowing that a form of remedy may be available to them.
Conclusion
A CVA mechanism offers retail tenants an opportunity to keep their doors open and potentially restructure and transform struggling businesses. However, with the increase in businesses opting to choose this restructuring method, many landlords question whether the process is being exploited at their expense. Many landlords have suggested that companies are abusing the CVA process, using it merely as a method to terminate leases and close down underperforming stores at the expense of a landlord’s interest.
In theory, the long term result of a CVA is to provide the potential to rescue a business while still providing a landlord with a steady income stream. However, a CVA process is not always effective to keep a business afloat: there is still the risk of a business ending up in liquidation.
And, from a landlord’s perspective, the arrangements could put them under significant financial stress and compromises their rights and obligations. With the increasing number of CVAs emerging – 2018 has been described as the ‘year of the CVA’ – the CVA cycle looks set to continue. As a result, landlords should consider both the benefits and risks that a CVA could offer them, both in the long and short term.
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Tagged: Commercial Law, Company Law, Land Law
