CVAs in the Retail Sector
June 11, 2018
By Restructuring and Insolvency Partner, Jeremy Goldring
House of Fraser is the latest multi-site retailer to propose a CVA. It follows the recent CVAs of ToysRus, Mothercare, Carpetright, New Look, Prezzo and Jamies Italian. The national press has run stories questioning the use of CVAs but has failed to properly explain what the issues are. In this summary, gunnercooke partner Jeremy Goldring puts that right.
What is a CVA?
Created by the Insolvency Act 1986, it provides an opportunity for a company which is running out of cash to avoid entering an insolvency procedure. A company can make a proposal to its shareholders and creditors which, if approved by the requisite majorities, will be binding on the minorities.
What can be proposed?
Practically anything. Common examples are that creditors forgive some of the debt owed to them in return for a share of future profits, or that shareholders transfer shares to creditors in return for forgiveness, or to a new investor who will inject some cash. The effect would be to improve the balance sheet and enable the company to pay new debts. In simple terms, a proposal for a CVA involves rights people have against the company being impaired in a way which the company believes will be sufficient to ensure its survival.
Isn’t there a limit?
Yes. A CVA proposal can be set aside by the court if it is unfairly prejudicial or involves a material irregularity. Someone who wishes to challenge a CVA on these grounds must apply to the court within 28 days of its approval.
So what is unfair prejudice and what constitutes a material irregularity?
Ah. There have been a few cases on these questions but not very many. The textbooks tend to describe the law in this area as “underdeveloped”. We can at least say that in order to decide if there is unfair prejudice, the court will need to consider how the complaining party’s rights are being impaired compared to the rights of others under the CVA proposal. In other words, it is a relative concept to be assessed in the context of that particular CVA proposal. A material irregularity is something which concerns the process by which the proposal has been made.
What are the requisite majorities?
A simple majority (over 50%) of shareholders, and 75% in terms of value of creditors. There must also be an over 50% majority in value of creditors excluding claims of those who are “connected” with the company (such as other group companies, directors and their close families). In all cases, entitlement to vote is restricted to those who attend the meetings (in person or by proxy) convened to consider the CVA proposal, and the majorities are calculated with reference only to those who do so.
What’s all the fuss about?
The CVAs employed by multi-site retailers are based on the premise that if the company could reduce its rent burden, by closing stores and landlord’s agreeing to reduce rents, then it could be a viable enterprise. However, the company won’t be able to afford paying landlords in return for surrendering unwanted leases, because the cost of walking away from a lease commitment is expensive. And the leases will not contain a right to seek a reduction of the rent.
These CVAs typically propose that unwanted leases are surrendered, but the landlords will be paid nothing or a nominal sum only; that other leases continue but at reduced rent; that rent which is payable quarterly under leases which are not otherwise changed at all be paid monthly (easing uneven cash flow for the company); the rights of no other party are impaired; and that for voting purposes, (a) the value of all landlords’ claims are deemed for voting purposes to be one years’ rent and (b) all creditors can vote for the value of their claims, whether or not the CVA proposes to impair their rights.
Do these features amount to unfair prejudice or material irregularity?
Lawyers will not agree. Some say case law supports this approach, others that even if it does, that does not rule out a challenge succeeding. This latter group argue:
- How is it possible that a CVA can force a contractual counterparty to supply premises at less than the contractual bargain? If it can, then it could do the same for contracts for the supply of goods and services, so why is the rent burden singled out as the only liability of the company to be impaired?
- Looked at another way, how is it fair that landlords or certain landlords are singled out as the root cause of a company’s financial problems? What about other costs, such as interest on loans, salaries to management, fees or dividends paid to parent companies?
- How can it be right that creditors who will not be impaired can count in the voting to impair others?
The other criticism is that these CVAs are opaque. By failing to provide sufficient and clear information, it is impossible to properly consider if the treatment of landlords is unfairly prejudicial compared to how and the extent to which others stand to gain if the CVA is approved.
Who stands to gain if a CVA is approved?
Well, the obvious is answer is the shareholders. They will own a viable company which is valuable, rather than an unviable one with a zero share value. But who will be the shareholders if the CVA is approved?
In Café Rouge a couple of a years ago, the CVA was a play by a hedge fund which had bought the secured bank debt at a massive discount, which was to be converted to equity if the CVA was approved.
Prior to that, In Fitness First, compromising the company’s lease liabilities let the parent company guarantor off the hook – that company was also the parent of an Australian subsidiary and was thus able to hang on to the profitable Australian business. The shares of the Australian parent company had been acquired by a hedge fund well-versed in making money from distressed assets.
While the identity of the shareholders does not determine whether or not a CVA is unfairly prejudicial, information of this kind may be important in deciding whether a challenge should be upheld, and its omission may well constitute a material irregularity.
Why have there been no challenges to these CVAs?
There have been some, but they have been settled, usually by a payment made by the company to the party threatening to apply to the court. While a “side deal” of this kind must be disclosed if made before the meeting to consider the CVA proposal, after the votes are in there is nothing to prevent it.
But there are four reasons why landlords don’t challenge:
- Cost and uncertainty of outcome. The legal issues are difficult and the stakes are high, it could be a drawn out expensive litigation.
- Victory would be pyric, in that an award of costs would be against the company which would most likely enter an insolvency procedure before paying the bill.
- However, the main reason is that it makes little commercial sense. Victory would entail the company going bust; and even if there was to be an acquisition of the business and assets, the buyer would seek assignments only of the profitable premises. Landlords of stores which the CVA proposed would be closed would get nothing and have a vacant property to deal with. Regarding those premises for which the CVA proposed rent reductions, if the buyer was at all interested in taking an assignment of the existing, or taking a new lease, in all likelihood landlords would have to agree the same rent reductions proposed by the CVA.
- Prior to the CVA proposal becoming public, there will have been a dialogue and the landlords will have indicated that they will accept the terms to be proposed by the CVA.
So is the criticism of CVAs justified?
Yes and no. Yes because the targeting of landlords as the villains in the piece appears unfair. There are many reasons why a company is or has become unviable. , a “proper” CVA should see a fairer distribution of pain for the common good. There should also be a clear explanation of how what is proposed will actually cure the problems encountered, and a means by which future prosperity is equitably shared between those whose rights are being impaired. And yes because full information on what is really going on is often lacking.
But no, because impaired parties do have legal rights to seek information, consider what is going on holistically and apply to the court if sufficiently aggrieved. That the end result of a challenge is not commercially attractive is not a function of inadequate law (although clarification of what a CVA can and can’t achieve would be welcomed), but of the fact that the premises are, by current market conditions, over-rented.
What is certain is that there is often more to a CVA than meets the eye. Without studying the CVA and the company’s accounts, and asking pertinent questions, it may not be possible to identify a sensible strategy for an affected party to adopt.
If you have any questions or queries regarding this subject or any other matters, contact Jeremy directly and he will be more than happy to help.
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