CVAs still in fashion as New Look successfully defends challenge

In the hotly anticipated judgment of Mr Justice Zacaroli in the case of Lazari Properties 2 Limited and Ors and New Look Retailers Limited ("New Look") [2021] EWHC 1209 (Ch) New Look has successfully defended a challenge to its CVA on the grounds of jurisdiction, material irregularity and unfair prejudice. The judgment confirms once again that differential treatment of creditors does not on its own establish unfair prejudice but that it will be a matter for determination based on all the circumstances of the case.

In this article we summarise the key points of the judgment and provide our takeaways from a real estate perspective in the commentary below.

Background

New Look proposed its CVA on 24 August 2020 as part of a wider group restructuring. The purpose of the CVA and wider restructuring was to help the Group restructure its primary liabilities as follows:

• a £100 million revolving credit facility ("RCF"), which was fully drawn, and a £65 million trade finance facility agreement ("TFFA"), under which £54 million was outstanding
• guarantor liability under two series of senior secured notes due 3 May 2024 (the "SSN") issued by New Look Financing Plc ("NLF") under which £441 million was owing
• obligations to pay rent, service charge and other amounts under numerous long-term leases of its stores.

The liabilities under the RCF, TFFA and SSN were secured by a debenture over the assets and business of New Look. Under an intercreditor deed, the RCF and TFFA had priority over the SSN.

The restructuring involved, inter alia:

• a scheme of arrangement (the "Scheme") between NLF and the holders of the SSN (the "SSN Holders"), under which:
  • the SSN Holders released all claims against NLF and against New Look (as guarantor) in return for participation rights in New Look Retail Holdings Limited (the "Parent") and (ii) a subordinated shareholder £40 million loan to an intermediate holding company ("Midco") on a cashless basis
  • SSN Holders were entitled to participate pro rata in a new £40 million term loan to Midco in return for a pro rata share in 80% of the equity in the Parent
• a CVA of New Look principally in order to amend the terms of leases with those landlords who did not opt to terminate their lease(s) with New Look (the "Proposal").

The terms of the Proposal were not altogether uncommon, particularly in the current climate and given the impact of COVID-19, with the main categories of landlords being as follows:

• Category A – critical sites which were unimpaired by the terms of the CVA with rents being switched from a quarterly to monthly payment cycle
• Category B – stores where property costs were considered above market rates with rents, accordingly, moving to a turnover based rent model for a period of three years or until the termination of the lease. Rental arrears were compromised in full. Landlords were given the right to terminate within the first 150 days on 60 days' notice. New Look was given an additional termination right exercisable by giving notice not more than 90 days and not less than 60 days before the day before the third anniversary of the effective date of the CVA (the "Final Break Date")
• Category C – stores which had been vacated or would be vacated by New Look because they were underperforming. These landlords were paid full rent and service charge for a period of 2 months after which the entitlement to rent would cease. Rental arrears were compromised in full. Landlords were given the right to terminate the lease at any time on 60 days' notice. New Look was given an additional termination right exercisable by giving not less than 60 days provided the notice expired within the three year rent concession period.

Ordinary unsecured creditors whose claims totalled approximately £72.7 million, where unaffected by the CVA save for compromising termination rights which were triggered by the CVA. The justification for this treatment being that these were business critical creditors which would need to be paid in full to keep the business operating.

At the creditors meeting on 15 September 2020 the CVA was approved by a majority of 81.6% by value of those attending and voting. Crucially a significant proportion of those creditors voting in favour of the CVA were not impaired by it (100% of Category A Landlords (c£6.5m), virtually 100% of ordinary unsecured creditors (c£72m) and 100% of the SSN Holders (c£273.4m). The votes in favour by those landlords that were affected by the CVA were significantly lower (58.27% of Category B Landlords (c£119m of a total c£204m) and 30% of Category C Landlords (c£14.4m of a total c£48.4m). The CVA was challenged by certain of the landlords (the "Applicants").

The grounds of challenge

The grounds of challenge were as follows:

• The Proposal, or aspects of it, did not constitute a composition or arrangement within the meaning of section 1(1) IA 1986 (the "Jurisdiction Challenge"), specifically because:
  1. it did not constitute a composition in satisfaction of the company's debts or a scheme of arrangement of its affairs, by reason of the fact that on a true analysis it involved separate arrangements (on fundamentally different terms) with different groups of creditors.
  2. there was insufficient "give and take" as between New Look and various of the creditor groups.
  3. the new termination right granted to New Look in respect of leases with Category B and Category C Landlords improperly sought to interfere with property rights of those landlords.

• There were material irregularities (the "Material Irregularity Challenge"), specifically:
  1. in relation to the calculation of the landlords' claims for voting purposes.
  2. by reason of omissions and inaccuracies in the Proposal.

• The Applicants were unfairly prejudiced (the "Unfair Prejudice Challenge"), because:
  1. the requisite majorities at the creditors meeting were secured with the votes of creditors whose claims against New Look were unimpaired by the CVA.
  2. creditors whose claims were compromised received differential treatment from those that were not.
  3. various of the modifications to the terms of leases were unfair.

The judgment

Mr Justice Zacaroli rejected each of the Jurisdictional Challenge, the Material Irregularity Challenge and the Unfair Prejudice Challenge on the following bases:

The jurisdiction challenge

The term "arrangement" in the context of s.1(1) of the Insolvency Act 1986 (the "IA 1986") contained no reference to or a jurisdictional requirement for an arrangement between the company and a class or classes of creditors. The fact that creditors were treated differently within the CVA did not stop it from being an arrangement for the purposes of the IA 1986.

There is sufficient give and take in an arrangement which "takes" from the creditors their contractual rights and "gives" them a return which is at least as good as that which the company could give in the relevant comparator (in this case administration). Since it was common ground that the CVA offered the compromised landlords a better return than they would achieve in the relevant alternative, the jurisdictional hurdle that there be give and take (which is a relatively low hurdle) was satisfied.

It was accepted that a CVA could not interfere with a landlord's proprietary rights. The terms of the CVA gave landlords the opportunity to agree a surrender but did not oblige them to do so, nor did it result in a situation where a lease was surrendered by operation of law. As such, the CVA did not interfere with the proprietary rights of the landlords.

Material irregularity challenge

The Applicants contended that the discount applied to landlord votes (25%) was not justified. The starting point is that under Rule 15.31(3) of the Insolvency (England and Wales) Rules 2016 ("IR 2016") a claim of an unliquidated or unascertained amount is to be valued at £1 unless the chair decides to put upon it an estimated minimum value for voting purposes. If the chair has sufficient available evidence to safely attribute an estimated minimum value to a claim they must do so. The number and range of uncertainties involved in estimating the quantum of future liabilities under leases is such that identifying the appropriate discount is not an exact science. The 25% discount here was applied with the benefit of advice from experts and was applied consistent with the duty to place an estimated minimum value on claims. There was accordingly no material irregularity in the discount applied.

The Applicants argued that the CVA did not disclose details of the wider restructuring or disclose the value of the equity interests being given to the SSN Holders which was in contravention of the duty to disclose sufficient information to reach an informed decision on the Proposal. What is sufficient information will turn on the facts of each case. Non-disclosure in this case was not sufficient to constitute material irregularity as having the information sought would not impact on the way creditors voted, in particular the SSN Holders who had already committed to voting in favour.

Non- disclosure of the exact equity interests being given to the SSN Holders was relevant but not material in this case. The CVA disclosed the material point that the SSN Holders would, because of the priority afforded to the RCF and TFFA, suffer a significant shortfall on their secured debt of £272m, giving a recovery of £160m under their security by implication. The CVA creditors were informed that as a consequence of the restructuring the SSN Holders' position would change from being entitled, under their security, to all remaining assets of New Look after satisfaction of the RCF and TFFA liabilities, to holding an indirect minority stake in the equity of the company. The equity interest to be acquired by the SSN Holders was the quid pro quo of the release of their security right. Its value was of less relevance to other creditors than if, for example, it was part of the allocation of the company's assets available to all creditors, i.e. if there was a possibility of an enhanced return to the SSN Holders under the CVA which could have materially impacted on returns to other creditors. This was not the case here.

Unfair prejudice challenge

This head of challenge was premised on the allegations of inherent unfairness in, primarily, the permanent reduction in rent; (2) the differential treatment afforded to (a) the SSN Holders and (b) the ordinary unsecured creditors; and (3) the fact that the requisite majority at the creditors' meeting was secured with the votes of those groups of creditors.

The rent reduction

Following the Debenhams case the Applicants sought to argue that the judgment of Norris J required that a CVA could only escape a finding of unfair prejudice if at least market rent was paid and the interference was the minimum necessary to achieve the purpose of the CVA. Mr Justice Zacaroli disagreed that the decision in Debenhams laid down such a rigid test as the question of whether a term is unfairly prejudicial can only be answered by reference to all of the circumstances.

The answer to the argument that long term rent reductions were unfair was the landlords' right to terminate the relevant leases, provided that the terms offered to landlords upon exercise of that termination right are at least as beneficial as in the relevant vertical comparator.

In this case the comparator was an administration in which there would be no material financial return to unsecured creditors, but there was a core business which is viable, albeit only if operated from fewer stores. Accordingly, the CVA offered all compromised landlords the choice between (1) terminating their lease and accepting a financial return that was better than in the relevant comparator or (2) continuing the lease but on reduced rent and modified terms. The reduction in rent and modified terms were not forced on compromised landlord. The inability to pay full rent was the consequence of New Look's insolvency and the reduction in rent and other modifications only applied if the relevant compromised landlord did not opt to terminate its lease.

The differential treatment of creditors

In considering whether the test for unfair prejudice was met in this case Mr Justice Zacaroli applied the principles summarised by Lightman J IRC v Wimbledon Football Club Ltd [2004] EWHC 1020 (Ch): (1) the unfairness must be caused by the terms of the arrangement; (2) unequal or differential treatment of creditors of the same class will not of itself constitute unfairness, but may give cause for inquiry and require an explanation; (3) it is necessary to consider all the circumstances including, as alternatives to the arrangement proposed, not only liquidation but the possibility of a different fairer scheme; (4) differential treatment might, in some circumstances, be required to ensure fairness. Differential treatment may be justified where necessary to ensure the continuation of the business that underlies the arrangement.

The SSN Holders had, as they were entitled to under the IR 2016 voted in respect of the unsecured shortfall of their secured debt. The Applicants contended that they were unfairly prejudiced because their rights were impaired in circumstances where the statutory majority was achieved with the votes of creditors who were not, namely the SSN Holders. Mr Justice Zacaroli did not accept this argument as it was necessary to view the CVA in the context of the wider restructuring and, considering the proposed impact of the Scheme, the SSN Holders rights were being impaired as they were releasing secured debt for a minority equity interest in New Look where the value of that interest was uncertain.

It was also important to note that as part of the subsequent Scheme the SSN Holders were releasing all claims against New Look in exchange for equity. The SSN Holders were accordingly giving up their secured claim and receiving nothing in respect of the unsecured shortfall on their secured debt by contrast to compromised landlords who were receiving rent, albeit ad reduced rates. A creditor who receives something under a CVA is not unfairly prejudiced if another creditor or group of creditors receives nothing in respect of their unsecured debt. This was not a case of a creditor using its voting power to extract a greater share of the assets. The benefits afforded to the compromised landlords were only available because the SSN Holders consented to the release of their security. Taking into account all the circumstances, whilst the SSN Holders were incentivised to vote in favour of the CVA by benefits the compromised landlords did not share the differential treatment was not such that the compromised landlords were unfairly prejudiced.

Brief consideration was given to the treatment of Category A Landlords and ordinary unsecured creditors who were also substantially unimpaired. It was common ground, however, that payment in full of these creditors was justified on the grounds they were essential for business continuity which was justified in the circumstances of this case. Mr Justice Zacaroli did note however, when setting out circumstances which were relevant to the question of unfair prejudice on the facts of this case, that if assets that would, in the relevant alternative, have been available for all unsecured creditors are allocated in a greater proportion to other creditors (e.g. where critical creditors are paid in full), then the fact that the requisite majority was reached by reason of the votes of those creditors may point towards the CVA being unfairly prejudicial, even if there was an objective justification for their payment in full. In other words, the justification for paying unsecured creditors on the grounds of business continuity will need to be assessed carefully as part of the vertical comparator test and may not be an answer to a challenge of unfair prejudice in all cases.

Commentary

Commercial tenants, particularly those in the retail sector, will no doubt be breathing a collective sigh of relief at the outcome of this judgment as a validates what appears to be a shifting of a market approach towards the use of turnover based rents in CVAs which many retailers will see essential to ensure their continued survival.

The key points to note for landlords and tenants alike are:

• Landlords need to be aware that CVAs continue to be a powerful means for tenants to restructure their rent debts and that, in particular, using them as a means to implement a turnover based rent model is not inherently unfair
• Norris J's judgment in Debenhams should not be construed as applying a rigid test that a CVA can only escape a finding of unfair prejudice if at least market rent was paid and the interference of lease terms proposed is the minimum necessary to achieve the purposes of the CVA. Whether or not particular terms imposed on landlords are unfair will be a matter for determination in each case based on all of the circumstances. In view of this, CVAs do not necessarily have to ensure that reduced rents do not fall below current market values (albeit the question of "what is market" may well be moving in the direction of turnover rents). If landlords have the option to terminate leases where the rent imposed by the CVA might fall below market value, that will generally answer any suggestion that the rent terms imposed are unfair, in particular where it is also ensured that the outcome for landlords would be no worse than the alternative insolvency outcome (i.e. administration or liquidation) which might lead to the end of a lease or little to no prospect of the landlord recovering rent in any event (i.e. the vertical comparator test)
• It remains common ground that CVAs cannot alter a landlord's proprietary rights and that as such they cannot oblige landlords to accept surrenders of leases. The practice of offering landlords the opportunity to agree a surrender in a CVA does not constitute an alteration of proprietary rights as there is no obligation to accept the surrender, albeit the landlord may then be left with a reduced rental liability (which it could avoid by accepting the offered surrender). Equally, removing the obligation for tenants to Category C premises (i.e. premises the tenant wishes to walk away from) to pay rent does not constitute a surrender by operation of law as the underlying lease and its terms remain on foot (i.e. there is no automatic alteration of proprietary rights either)
• The starting point for valuation of a claim of an unliquidated or unascertained amount is £1 unless the chair decides to put upon it an estimated minimum value for voting purposes. The value a chairperson of a CVA ascribes to landlords' future claims under leases for the purpose of weighting voting rights depends on the available evidence. As the calculation of the likely shortfall between the net present value of a landlord's contractual right to future rent for the remainder of the lease and the net present value of the likely rent that the landlord could recover in the market over the same period in the future is inherently uncertain and will vary from lease to lease the value given to landlord claims for voting purposes is an art not a science, but it as long as it is based on expert valuations the methodology will likely not be challenged. The current market practice appears to be applying a discount of 25% on landlord claims for voting purposes.

This judgment may well mitigate against the risk of future challenges being mounted on similar grounds. The court has been clear to express, however, that while there are underlying principles there are no hard and fast rules as to what will constitute unfair prejudice in any given case and this will fall to be assessed looking at all the circumstances of the relevant case. This point may well arise, therefore, in future cases. We await the outcome of the challenge applications for the Regis and Clarks CVAs.