High Court rejects landlord challenge to Debenhams’ CVA

Following an expedited trial, the High Court has rejected an application brought by a group of landlords known as the Combined Property Control Group (“CPC”) to challenge the company voluntary arrangement (“CVA”) proposed by Debenhams Retail Limited (“Debenhams”).

CPC challenged the CVA on five grounds. The judge in the case, Mr Justice Norris, held that four of the five grounds failed and directed certain “Forfeiture Restraint Provisions” be removed from the CVA as a result of the fifth.

In short, the key takeaways from the judgment are as follows:

1. Claims for “future rent” fall within the broad meaning of a “debt” for the purposes of a CVA.

1. A CVA that reduces rent to a level not below market value is not automatically unfair as breaching some fundamental principle of common sense and ordinary justice. On the other hand, the fact that the vertical comparator is satisfied does not automatically make the reduction fair. Fairness must be judged in the round. In the present case it was held the reductions in rent did not transgress the requirements of common justice and basic fairness, even where other creditors’ claims were not compromised.

1. A CVA cannot modify a landlord’s right to re-entry/forfeiture.

In this Law-Now, we explore these takeaways in more depth and look at Mr Justice Norris’s reasoning for his decision on each ground of challenge.

Background

As was widely reported at the time in the press, control of Debenhams passed to its lenders via a pre-pack administration on 9 April 2019. Following the pre-pack, the lender shareholders proposed a CVA in order to restructure Debenhams’s store portfolio and balance sheet.

The CVA was approved at a creditors’ meeting on 9 May 2019 by 94.71% of Debenham’s creditors. However, on 10 June 2019, CPC launched a challenge to the CVA claiming (among other things) that they had been treated less favourably than other unsecured creditors.

Grounds of challenge

1. Landlords are not creditors for future rent within the scope of the Insolvency Act 1986 (the “Act”) for the purposes of a CVA and they therefore cannot be compromised under a CVA

Section 1 of the Act permits directors to “make a proposal... to the company and to its creditors for a composition in satisfaction of its debts.”

The term creditor is not defined in Part 1 of the Act, however s. 5(2) of the Act provides that a CVA will bind every person who was entitled to vote in the procedure by which the CVA is approved. Rule 15.28(5) of the Insolvency (England and Wales) Rules 2016 (“IR”) states that every creditor who has notice is entitled to vote “in respect of that creditor’s debt.”

In the context of a tenant landlord relationship, this begs the questions of whether future rent constitutes a debt. If the answer is yes, then a CVA is able to compromise future rents owed to landlords. Though this has been popular in numerous “landlord CVAs” this is the first time this point has been challenged in such a way in the courts.

The term debt is not defined for these purposes, but it is in the context of administration and liquidation. Rule 14.1(3) IR states that debt includes:

“(a) any debt or liability to which the company is subject at the relevant date; or

(b) any debt or liability to which the company may become subject after the relevant date by reason of any obligation incurred before that date….”

Rule 14.1(5) IR expands on the above, stating that “it is immaterial whether the debt or liability is present or future” and “‘liability’ means… liability to pay money or money’s worth” (IR 14.1(6)).

So, is a claim for future rent a debt for the purposes of a CVA?

It was argued that a CVA is unable to compromise “future rent”, as future rent is “not a debt at all” but only an “unearned future payment under an executory contract.” On this point, Mr Justice Norris stated that the term debt “has a meaning that extends well beyond a debt strictly so called. It includes pecuniary liabilities (obligations that may turn into debts strictly so called) that might spring out of an existing legal relationship.”

He went on to say that ““future rent” is a pecuniary liability (although not a presently provable debt) to which the company may become subject in the future by reason of the covenant to pay rent in the existing lease: whilst the term endures the company is “liable” for the rent, and the fact that in the future the landlord may bring the term to an end by forfeiture does not mean that there is no present “liability.” Mr Justice Norris characterised this form of liability as “a contingent claim or… as a contingent claim that the Insolvency Rules require to be treated in a special way.”

Accordingly, the first ground of challenge failed.

2. A CVA cannot operate to reduce rent payable under leases because it is unfairly prejudicial to do so, or because there is no jurisdiction to do so

It was argued that a CVA cannot reduce rent payable under leases for a CVA’s duration for two reasons:

1. as a matter of law and basic fairness (the basic fairness argument); and

1. as it is beyond the scope of a CVA’s jurisdiction to do so (the new obligations argument).

The basic fairness argument

It was submitted that a company which makes beneficial use of premises let to it must pay the full contractual rent referable to that period of occupation, relying on the Lundy Granite principle.

Mr Justice Norris rejected this. Whilst the principle was relevant to administration and liquidation, CVAs were introduced to provide greater flexibility. He describes this argument as straightforward and states that the fundamental question is whether compromising “full contractual rent” is fair. In answering, he compares the treatment of landlords to other past creditors:

“suppose that past creditors consisted of suppliers who provided goods under “one-off” contracts or “short-term supply” deals that would naturally reflect the current market price for such supplies: and suppose the landlord could under the lease charge a rent fixed at a historic high or which automatically escalated by a fixed percentage unrelated to the value of money or the state of the market, so that what was actually chargeable very substantially exceeded the market rent (say by 100%). Would it not be “unfair” for the suppliers to be unable to receive the market price for their goods in order that the landlord should receive a 100% premium over the market price for his supply? … As a matter of principle I would not have though it “unfair” that a landlord might receive less than his contracted-for rent in such circumstances.”

None of the applicants said that the CVA compromised their rent to less than current market rent. Mr Justice Norris observed that “common justice and basic fairness require that the landlord should receive at least the market value of the property he is providing”. To that, he said, should be engrafted the principle that “a contractual rent should be interfered with to the minimum extent necessary in the circumstances”.

Mr Justice Norris also observed that just because the “vertical comparator” is satisfied, does not necessarily mean the reduction is fair. In considering the vertical comparator issue, it was argued that the liability to pay rates which may fall on the landlord should be taken into account. Mr Justice Norris stated that this liability is “not a direct outcome of the implementation of the CVA; it is a financial consequence of a landlord electing to opt out of the CVA and then to offer his property to the market on terms such that it does not attract a new tenant”.

In summary Mr Justice Norris was satisfied that a CVA that reduces rent is not automatically unfair as breaching some fundamental principle of common sense and ordinary justice. But the fact that the vertical comparator is satisfied does not automatically make it fair. Fairness must be judged in the round. In the present case it was held the reductions in rent did not transgress the requirements of common justice and basic fairness.

New Obligations

It was submitted that the CVA imposes new obligations which are outside the scope of Part 1 of the Act. In his judgment, Mr Justice Norris stated the CVA does not impose “new obligations”, save in the sense that it varies existing obligations. He says what is proposed here is “a variation of an existing obligation binding the company and its creditor, not the creation of a new contract requiring the assumption of fresh liabilities to some new third party.”

Ground 2 also, therefore, failed.

3. The right of forfeiture is a proprietary right that cannot be altered by a CVA

The Debenhams CVA contained a stipulation that any provisions of the leases that provide a right of early termination, forfeiture or “irritancy” as a result of the terms or effects of the CVA are waived by the landlords, except for certain rights introduced by the CVA.

It was argued that under section 1(2) of the Law of Property Act 1925 a right of re-entry/forfeiture is a proprietary interest / interest in land and is therefore a property right. It is a right as between landlord and tenant and not one between debtor and creditor, and as such it cannot be altered by a CVA.

In Mr Justice Norris’s judgment, he stated that the authorities give a negative answer to the question of whether a CVA can deal with such a property right. They clearly point to a conclusion that a CVA cannot vary a right of re-entry. A CVA is able to modify any pecuniary obligation upon breach of which the right of re-entry may be exercised; and the right will then be exercisable only in relation to the pecuniary obligation as so modified. But it cannot modify the right of re-entry itself.

Mr Justice Norris held that the challenge on this ground is therefore successful. Consequently and in accordance with the severance provisions in the CVA, he directed that the “Forfeiture Restraint Provisions” in the CVA were in excess of the jurisdiction conferred by Part 1 of the Act and that they be deleted.

4. Landlords are treated less favourably than other unsecured creditors, without any proper justification (the “horizontal comparator” test)

It was argued that the “horizontal comparator” test is not satisfied as there is no objective justification for treating landlords differently to trade creditors. It was stated that the CVA varies rents payable to some landlords and the business rates payable to local authorities, but it does not impinge on the claims of other unsecured creditors, like suppliers. Citing the case of Prudential Assurance Co Ltd v PRG Powerhouse Ltd [2007] BCC 500, it was submitted that such differential treatment must be justified.

In justifying the different treatment of landlords and trade creditors under the CVA, it was stated:

“compromising trade suppliers in the CVA would… likely have led to the suppliers whose claims were compromised refusing to further supply or only providing such supply on onerous terms. This would also have posed a significant “contagion risk” whereby other suppliers whose claims were not themselves being compromised would have become concerned about supplying the Company in the future.”

It was argued that the market was driven not by logic but by rumour, that fear of non-payment translates into immediate action (e.g. cancellation of delivery). The counter argument was put that if failure to pay suppliers constituted a “contagion risk” then so did a failure to pay landlords. This was rejected. Suppliers were well able to draw a distinction between supplies of goods and services on the one hand and the very long-term liabilities to landlords under historic deals on the other.

Mr Justice Norris was satisfied on the evidence that 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. Mr Justice Norris noted that there would have been unfairness if landlords were expected to take reductions in rent to below market value of the premises concerned.

Mr Justice Norris therefore held that ground 4 failed.

5. In failing to adequately disclose the existence of potential “claw-back” claims, the CVA failed to comply with the content requirement of the Insolvency Rules

Rule 2.3 IR sets out the content requirements for a CVA proposal. Among other things, it states that the proposal must set out “whether, if the company did go into administration or liquidation, there are circumstances which might give rise to claims under section 238 (transactions at an undervalue), section 239 (preferences)… or section 245 (floating charges invalid).”

It was submitted that in order to comply with rule 2.3 IR, the CVA should have set out that if Debenhams were to go into administration or liquidation, circumstances existed (granting of new security to existing financial creditors) that might give rise to claw-back claims.

In delivering judgment, Mr Justice Norris stated that “the self-evident policy of the Insolvency Rules 2016 is to focus on the conveying of content and not on the completion of forms.” Furthermore, that an irregularity will only be considered material if objectively assessed there is a substantial chance that if the irregularity had not occurred it would have made a material difference to the way in which creditors would have considered and assessed the terms of the CVA. Mr Justice Norris was not persuaded that if the CVA had said:

1. that there might be a claim under s.239 of the Act but that no provision for costs or allowance for recovery had been made in the CVA; and/or

1. that there was a claim under s.245 of the Act to which there was no defence but that the CVA anyway proceeded on the footing that the floating charge could secure new money,

then there was any substantial chance that the creditors would have looked at the CVA differently.

Mr Justice Norris held that ground 5 failed.

Comment

A challenge to a “landlord only” CVA in the retail or casual dining sector had been expected for some time. Mr Justice Norris did comment on the motivation behind the challenge in this particular case but nonetheless held it was a challenge that the landlords were entitled to bring and raised important issues that should be heard.

Reflecting on the key takeaways described above, this decision provides companies in the retail and casual dining sector with more certainty when proposing a CVA to deal with unprofitable store and restaurant portfolios in a financially distressed situation where administration is the likely alternative. Holding that future rent was a liability capable of being compromised by a CVA goes to the heart of whether a CVA can be used as a restructuring tool in these situations.

Furthermore, the discussion around the issue of fairness is key and provides a degree of clarity. Whilst Mr Justice Norris was keen to stress that fairness must be judged in the round, the decision that a reduction in rent, in circumstances where other creditor claims are not compromised, and where the reduced level is above market value, was not in itself unfair, will be seized upon. It remains to be seen what impact this has on the retail and casual dining sectors moving forward.

It is worth noting that the possibility of an appeal remains open so watch this space.