These are challenging times for retailers, landlords and their lawyers.
Earlier this year Jamie’s Italian went into administration and Debenhams entered a CVA. Paperchase also announced a CVA which involved the landlord accepting a cut in rent. They are said to have struck a deal whereby they negotiated turnover based rents in relation to half of their shops. Other high street chains are said to be teetering on the brink of administration or corporate restructuring which could wipe out the value of their shares.
Mike Ashley has also continued his march on the high street, usually at the expense of existing shareholders and the landlords of those companies. Interestingly, he is currently the landlord’s friend as in September 2019 he announced that via his Sports Direct Group he is challenging the CVA entered by Debenhams with its landlord Combined Property Control (CPC) in relation to six of its sites.
So, what is the basis for these challenges and what are the prospects of landlords successfully defeating proposed CVA’s by tenants? And how can legal advisers who act for landlords continue to provide relevant and up to date advice to their clients?
Having conducted a series of short seminars on the topic earlier this year, I thought it helpful to identify some of the points that came out of those seminars especially the points made by delegates with a view to identifying points to look at when advising landlords.
The threat of departure from the EU and the perceived risk of a recession only adds to the general atmosphere of gloom prevailing in the retail sector, but in reality the difficulties facing this sector run much deeper and include the internet, changing shopping habits and the disparity between the overheads borne by online retailers as compared with their more traditional relations in the high street.
Overheads for traditional retailers include high business rates and an onslaught of other burdens including the national minimum wage, auto-enrolment pension rights and a squeeze in sterling caused by Brexit adding to import costs. While internet-based retailers also face some of these challenges they are often minimised by their efficient tax status, use of cheaper out of town distribution sites and use of casual staff. These are often important factors in reducing the squeeze on margins identified.
Research has shown a long-term decline in capital values of retail property as well as fixed or declining rental yields (see for example the Q2 2019 RICS UK Commercial Property Market Survey). This is a very challenging environment for commercial property landlords, especially those specialising in the retail sector. Unfortunately, however, the impact is much wider than the retail sector.
The CVA conundrum
Part I of the Insolvency Act 1986 makes provision for proposals to be presented at a participating creditors meeting and if effected, although in the case of small companies such a CVA acts in certain circumstances as a moratorium on the presentation of new debts, in most cases the company can continue to trade and incur new liabilities. Three quarters of the creditors must vote for a CVA (see IRs 2016 r 15.34) but unlike other insolvency procedures a CVA leaves the management team in place and often disadvantages landlords, who have a wider interest in the value of their security in addition to the need to maintain their rental stream. They might put this above the short term need to get a tenant over a cash flow problem. The CVA is binding if the creditor would have been entitled to object had the creditor had notice of it (see section 5(2) IA 1986). Secured creditors, on the other hand, are protected in that they have to consent to the proposal.
Often, the landlords only alternative to “going along” with the CVA is to forfeit, on grounds of non-payment of rent where there are rent arrears, or in other cases, on grounds of the tenant’s insolvency which normally gives rise to a right to forfeit. Like any other creditor, the landlord can push the tenant into insolvency, e.g. administration or liquidation. At least liquidation as the value of certainty in the sense that it crystallises the loss and enables the landlord to re-market the premises. This is usually following a disclaimer of the lease. Administration is sometimes followed by a CVA which may result in a company getting back on its feet.
The CVA is often an unattractive outcome for the landlord, however, who is often in conflict with other creditors. These may include suppliers who have an interest in keeping the trading relationship going. Shareholders are also likely to be in favour as the CVA is proposed by the company’s directors, who owe duties to the members to ensure promotion of the company’s interests. The effect of a CVA is to preserve some shareholder value whereas every other forms of the insolvency procedure wipe out that value, indeed fast exacerbate the decline in trading fortunes. All creditors are treated equally but in practice a CVA will be used to reduce the overall rent bill, typically by abandoning premises which are no longer required. There is no doubt that in practice the CVA has on occasions been abused to gain commercial advantage. The increase in the use of the use of the CVA over other insolvency procedures in recent months is marked. According to Sealey and Milman’s Annotated Guide to the Insolvency Legislation, 22nd edition, there were 356 in 2018 whereas , according to the Retail Gazette, there has been a seven-fold increase in retail CVA’s in 2019, although a full analysis of these figures will need to await the end of 2019. Some names have already been mentioned but one could add BHS, Comet, Homebase and Blacks Leisure – all well-known high street names who utilised CVA’s for various reasons. Carluccio’s and Byron Hamburgers are big players in the branded restaurant business but both of them, , are in CVA’s at present.
Landlords are not the only ones affected by the widespread use of CVA’s.
What does it mean for banks and other lenders who depend on the stated value of the asset on which they are advancing a loan? In theory their capital interest is secured but there can be a rapid reduction in capital value.
Banks which lend money to landlords are also going to be concerned in the reduction of freehold values as well as potentially being saddled with a lease with a reduced or stagnant rent. So far, they have not been particularly active at placing landlords into insolvency procedures but in a recession, this could all change and many think a recession is close.
What does the sharp decline in profitability mean for mixed-use developments which typically contain a retail element together with a leisure element and possibly some residential use?
Many developments that will lose one “linchpin” tenant will simply not be able to carry out a project they might otherwise have planned. The development may simply not take place, and this has an impact on the construction sector as well as commercial landlords who are dependent on an increasing range of properties on their books.
Without those strong foundations in place the commercial property market looks much riskier and possibly the whole property market falls into a downward trajectory.
Where does it leave the traditional commercial lease?
A typical traditional commercial lease this will have:
- A lengthy term;
- An upwards only rent review clause;
- An authorised guarantee agreement (AGA);
- A highly restrictive break clause;
- Widespread spread restrictions on user and alienation.
None of these can be taken for granted in the present market and those acting for tenants can expect to play “hard ball” when it comes to negotiating new leases whether negotiated on the open market or with existing tenants.
For landlords security of rental return is likely to be more important than the lure of ever higher rents, although a number of large landlords depend on new shopping centres to drive forward their portfolios and rents tend to be higher in those developments.
Assuming the landlord does not go along with the CVA but 75% of the creditors do, he is generally stuck with it. His only means of challenge is within twenty-eight days on grounds of unfairly prejudicial treatment or a material irregularity under section 6 (1) of the IA 1986. It may be said that the CVA has been “unduly prejudicial” under section 6 (1) (a), where it does not represent a favourable outcome to the creditor over other insolvency procedures, for example liquidation. A material irregularity is largely self-explanatory , for example, it occurred where the votes of certain creditors were allowed even though they were based on sham transactions (Re Gatnom Capital and Finance Ltd  EWHC 3353 (Ch)).
Unfortunately, the mere fact that a CVA differentiates between different creditors or between members of the same class of creditors may not be sufficient to establish unfair prejudice but a case of blatant guarantee stripping whereby a parent company attempted to reduce the value of a parent company to reduce the value of its guarantee was held to constitute unfair prejudice (Prudential Assurance v PRG Powerhouse  EWHC 1002 (Ch)). The High Court in a number of decisions, including the Prudential Assurance case, found such practices to be highly prejudicial to commercial landlords and set aside CVA’s entered for the purpose of reducing the real value of the guarantees given by parent companies.
Otherwise, the supervisor oversees the CVA and the landlord hopes for better times!
There are signs that things are “hotting up” in the courts.
The current practice of utilising CVA’s as a commercially savvy move to reduce liabilities and keep an otherwise insolvent company trading have not been subject to such widespread challenge as may have been expected. This is partly because of the cautious economic background created by Brexit and the slow recovery from the last recession. But this may be about to change as there has been more landlord disquiet in recent times. Particularly since the House of Fraser CVA, which ultimately ended in that company going into administration, there has been a greater appetite for challenge by the landlords. At least one recent case (Regis Supercuts) Hammerson and other landlords have applied to challenge a CVA in 100 of its 232 hair salons. The claim was issued in the High Court last November and it will be interesting to see how far it gets. It is understood the basis for the challenge is that the CVA has been unduly prejudicial. This may well result in an up to date reported case in this increasingly important area.
There is also more guidance from landlord groups, for example, the British Property Foundation has issued guidance on good practice in CVA use.
Good news or bad for lawyers?
Feedback from recent seminars suggests that landlords are doing anything to keep tenants trading as the prospect of a vacant unit with business rates liability as it is commercial suicide. Not only is the landlord left without any rent and with a substantial business rates liability, but word tends to spread quickly amongst other tenants and the general public, which can have a corrosive effect on the viability of a shopping centre, for example.
Clearly there are drafting challenges for those commercial conveyancing solicitors who have to advise their landlord clients to settle for less onerous alienation and user provisions. Rent reviews are often put on hold. However, a landlord will often wish to preserve his position in case better times come.
Where is the Government right now?
When I conducted a series of talks on this topic (in March 2019) the government had other things to occupy itself! Regrettably that is still the case. The government’s only answer so far to the collapse of the high street has been to free up the planning regime to allow more residential use within commercial and office buildings. The wider challenge of reducing government dependence on high levels of business rates has effectively been put “on- hold”, although there have been various reliefs put in place. At present business rates are linked to rental values and ultimately these may be heading downward, which may reduce business rates. However, the experience so far has been that multipliers have increased.
The wider challenge is to wean governments off taxes on bricks and mortar, but it does not appear likely that a government would be prepared to replace a tax with a very high collection rate with a turnover-based tax any time soon! Would a sales tax be a fairer way of doing things?
These are all issues to be considered when normal times return. For landlords and their advisers this is a time when the utmost practicality is called for and legal challenges may not always be the most cost-effective means of achieving economic survival.
By William Hanbury, barrister at Exchange Chambers in Leeds
An accomplished barrister with more than thirty years of experience, William Hanbury practises in most areas of commercial dispute resolution with an emphasis on property law.