[co-author: Camilla Eliott Lockhart]
On 19 September 2019, Norris J handed down judgment in the challenge brought by six landlords against the Debenhams Retail Limited (Debenhams) company voluntary arrangement (CVA) which was approved by 94.71% of Debenham’s unsecured creditors on 9 May 2019. The challenge been watched with significant interest, particularly by the landlord community, which has for some time expressed increasing concerns regarding the use of CVAs as a mechanism to commute leasehold liabilities while other unsecured creditors’ rights remain unaffected. While CVAs have been the subject of legal challenges previously, the Debenhams challenge is the first time certain key elements of CVAs in play in the market have been tested before the court. Norris J’s decision provide welcome clarification on a number of key issues concerning the treatment of leases in retail CVAs.
The grounds for challenge and the decision
CVAs were introduced in the Insolvency Act 1986 (the Act) as a more flexible restructuring option than administration, receivership or liquidation. Under a CVA, the directors of a company can make a proposal to its creditors for a composition in satisfaction of its debts or a scheme of arrangement of its affairs. Creditors have 28 days after the CVA has been approved at the creditors’ meeting to challenge the CVA on the grounds of unfair prejudice or material irregularity.
The applicant landlords (the applicants) claimed unfair prejudice and material irregularity under Section 6(1) of the Act and, in addition, claimed that the CVA went beyond the jurisdiction conferred by Part 1 of the Act. They requested that the court make a declaration that the decision of the creditors’ meeting was void for want of jurisdiction and/or an order revoking the decision of the creditors’ meeting under section 6(4)(a) of the Act.
The applicants argued that future rents could not be compromised under a CVA. The Act provides that the directors of a company can “make a proposal.. to the company and its creditors for a composition in satisfaction of its debts or a scheme of arrangement of its affairs”. “Creditors” and “debts” are not defined. The applicants contended that future rent was not a ‘debt’, since rent is only payable as it falls due and may never become payable at all (Re Park Air Services plc [2000] 2 AC 172 at 181). If future rent was not a debt, the applicants could not be “creditors”. Accordingly, the jurisdiction had been exceeded and the decision of the creditors’ meeting was void.
Norris J disagreed. The term “creditor” had a wide meaning, but a creditor must have a “debt”. While future rent may not be a provable debt, there was no clear requirement that “creditors” for the purposes of CVAs should be restricted to persons with provable debts. Future rent was at least “a pecuniary liability to which the company may become subject in the future by reason of an existing obligation“. Where the lease was being continued, future rent could therefore be considered as a contingent debt and the applicants as creditors in relation to that debt. As a matter of jurisdiction, future rent could be included in (and compromised under) a CVA.
- Waiver and release of forfeiture rights
The applicants argued that the CVA could not compromise landlords’ proprietary rights. They argued that the waiver and release of landlords’ rights of forfeiture contained in the CVA amounted to an abrogation of proprietary interests, which was outside the jurisdiction conferred by Part 1 of the Act. They relied in support on the decision in Re Lehman Brothers International (Europe) [2010] Bus LR 489, in which the court confirmed that a scheme of arrangement could only affect the rights of creditors in their capacity as such, and could not be used to modify proprietary rights.
Norris J agreed. A right of re-entry was a proprietary right which could not be varied by a CVA. While a CVA can vary any pecuniary obligation upon breach of which the right of re-entry may be exercised, it cannot vary the right of re-entry itself.
The applicants raised two arguments concerning variation of rent: that it was automatically unfairly prejudicial (referred to as the “basic fairness argument”) and, in the alternative, that it imposed ‘new obligations’ which were outside of the jurisdiction of S. 1(1) of the Act (referred to as the “new obligations argument”). Both arguments failed.
o Basic fairness
The basic fairness argument rested on the principle expressed in Re Lundy Granite (1870-71) LR 6 Ch App 462, that a company which makes beneficial use of a premises let to it must pay the full contractual rent. The applicants pointed to the fact that in both administration and liquidation, a company remaining in occupation post insolvency is required to pay rent in full as an expense.
Norris J confirmed that whether or not the CVA was ‘fair’ needed to be considered in the round. He considered that “basic fairness” required that the landlords should receive at least market rent for the property they were providing. The valuation advice received by Debenhams indicated that all the stores were over-rented. In addition, as all landlords were able, under the CVA, to terminate the relevant leases within a certain period, no landlord was compelled to accept the reduced rent under the CVA. On that basis the Court found that the reduction in rent was not ‘unfairly prejudicial’.
The applicants also argued that the “vertical comparator” used in the CVA proposal (comparing the projected outcome of the CVA with the projected outcome of a realistically available alternative process – here administration) was wrong as it did not take into account the fact that a landlord which terminated a lease would have to pay business rates, a liability that would not be incurred if Debenhams went into administration. Norris J disagreed. Debenhams could not be expected to anticipate all financial consequences to each creditor for the purposes of constructing and applying the vertical comparator to the scheme as a whole. Debenhams had argued that a CVA should be automatically fair if the correct vertical comparator was used, but interestingly Norris J did not accept this position.
o New Obligations
Norris J found that the variation of rent was a variation of existing obligations which were ‘arrangements’ for the purposes of S.1(1) and not an imposition of new obligations. The variation was therefore within the jurisdiction of Part 1 of the Act.
The applicants argued that they were treated less favourably than other unsecured creditors without proper justification (in other words, the “horizontal comparator” was not satisfied).
Norris J disagreed. After hearing evidence that the properties were over-rented, and that there was a concern that compromising trade suppliers would have led to significant issues for Debenham’s business, he held that “The differential treatment of landlords (providing long-term accommodation at above market rates) from suppliers (providing goods and services on an order-by-order basis which, given competitive pressures, are likely to be at market rates) is justified by the need for business continuity” [paragraph 110] .
The applicants’ key grounds for alleging material irregularity concerned information provided in the CVA proposal regarding potential challenges to security arrangements entered into by Debenhams in March 2019. Additional funding had been provided to the Debenhams group. Debenhams granted fixed and floating security in favour of its lending group, securing both the new funding and existing indebtedness. The applicants alleged that the grant of the security was susceptible to challenge as a preference pursuant to s.239 of the Act and a voidable floating charge pursuant to s.245 of the Act. If the company entered into administration or liquidation and the challenges succeeded, there was the possibility for sums to be ‘clawed back’ for the benefit of the company’s unsecured creditors, including the landlords.
The applicants argued that Debenhams had failed to comply with rule 2.3(1) of the Insolvency 2016 Rules, which provides that the CVA proposal must set out the risks of such challenges being brought should the company go into administration or liquidation. However, although he agreed that the description could perhaps have been clearer, Norris J was not convinced that the risk of claims under s239 and s245 of the Act had been insufficiently described in the proposals. He confirmed that whether an irregularity is ‘material’ will depend on whether, objectively assessed, it would be likely to affect the outcome of the vote. On the facts, he did not consider that had creditors been given more information about the possible challenges they would have been likely to oppose the CVA.
The Court ordered that the forfeiture restraint provisions be deleted from the CVA, and as so modified, the CVA is valid and remains enforceable. Whether or not the applicants will take forward an appeal remains to be seen.
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