In a decision that will have important repercussions for creditors with the benefit of guarantees, the High Court this week has held that a company in financial difficulties may not propose a voluntary arrangement which is unfairly prejudicial on its terms to certain creditors.
In early 2006 PRG Powerhouse Limited (Powerhouse) proposed a controversial company voluntary arrangement (CVA) with a view to achieving the future viability of its business. The proposals at the heart of the dispute, involved the closure of a number of loss making stores whilst paying the landlords of those stores only a small fraction of the sums that they would have received in rent if the leases were to continue. The point of greatest concern to the landlords of the discarded sites was that the CVA provided that the parent company of Powerhouse, who had supplied guarantees in respect of the full rent, would be released from its obligations to the landlords. All the other creditors would be paid in full.
Company Voluntary Arrangements
A CVA is a compromise agreement between a company and its unsecured creditors for a composition in satisfaction of its debts or a scheme of arrangement of its affairs. The statutory provisions are contained in Part 1 Insolvency Act 1986.
A proposal for a CVA may be made by the directors of the company in financial difficulty; they prepare the CVA's terms, supply a statement of the company's affairs and nominate an insolvency practitioner to act as supervisor of the CVA. If the nominee is satisfied that the proposed CVA has a reasonable prospect of being approved and implemented, he must report to the court that he supports the proposals and give with details of any meetings he recommends between the company and their creditors and members to consider, and if agreed, approve the proposals.
It is not possible to use a CVA to modify any rights of a secured creditor to enforce his security without his consent or to alter the priority of payment of any preferential creditor.
However the statutory provisions for CVA's do not contain any provisions for the treatment of any other type of creditor: there is no obligation to treat unsecured creditors equally, nor are there any provisions for the treatment of guarantees. It is open to the directors to propose and the members and creditors to agree any terms for payment of creditors they wish. A landlord, whilst having rights against a tenant company under the lease for non-payment of rent, is not a secured creditor, nor is a guarantee a security interest, merely an obligation of a third party to the creditor.
If approved by the creditors and members of the company at duly convened meetings, the CVA binds every person who was entitled to vote at the meeting (whether or not present or represented at the meeting), or would have been entitled to vote if he had notice of the meeting, as if he were a party to the agreement.
The Insolvency Rules 1986 provide that any creditor who has notice of the meeting is entitled to vote at it and his votes will be calculated according to the amount due to the creditor at the date of the meeting. It is not necessary for the proposals to obtain the unanimous approval of the creditors and members: only a simple majority of members is necessary. For creditors' approval only 75% in value of the creditors' present or represented by proxy at the meeting and voting is required for the terms of the CVA to bind everyone, including those who object.
The landlords' claims
It is possible to challenge a CVA, and seek its revocation, suspension or revision, on one or both of two grounds, either:
- It is unlawful; i.e. there has been a material irregularity at one of the meetings; or
- It is unfairly prejudicial to the interests of a creditor, member or creditor of the company.
The Powerhouse landlords argued that the CVA was ineffective or invalid insofar as it purported to affect the rights of the landlords against the guarantor or to constitute a release of the guarantees. Further, they argued, the CVA was clearly unfairly prejudicial to their interests: it had been voted for by creditors who would be paid in full, whereas they would only receive partial payment and, in addition, no compensation was offered for the loss of the guarantees. Unlawful
The court confirmed that a CVA is a contract between a company and its creditors and cannot have effect on any arrangement involving third parties. The court held that there was nothing in the Powerhouse CVA which made the provisions for the release of the guarantees binding and enforceable between the landlords and the parent guarantor.
However, it should be noted that the court did find that it is legally possible for a CVA to provide that a creditor cannot take steps to enforce any right it has against a third party which if exercised would give rise to a right of recourse for the third party against the company. This was held to form part of a company's arrangement of its affairs. Consequently, the terms of the CVA which provided that Powerhouse could enforce the obligation contained in the CVA on the part of the landlords not to claim under the guarantees were held to be valid.
The High Court confirmed that a CVA which provides for different treatment for different creditors will not automatically mean there has been unfairly prejudice. The court could envisage situations where different treatment between creditors would be fully justifiable. In determining whether or not there has been unfair prejudice, the court considered that it would be necessary to both compare the position of the claimant creditor under the CVA with that under a liquidation or scheme of arrangement and consider the treatment of a particular creditor with that of other creditors under the CVA.
On this point the court found for a number of reasons the Powerhouse CVA was unfairly prejudicial to the landlords of the closed stores:
- The landlords were put in a worse position by the loss of their rights against the guarantor; the CVA prevented them from entering negotiations with the parent guarantor and although the guarantees were demonstrably of value, the CVA did not provide for any compensation for the loss of this value.
- There was no merit in the argument that the earlier possession of the closed stores would be valuable to the landlords as an opportunity to re-let them on potentially more advantageous terms.
- If Powerhouse had entered liquidation, the landlords would be in a substantially better position: they would have retained the benefit of the guarantees but, given the extent of Powerhouse's debts, the other creditors would have received nothing.
- If Powerhouse had entered a scheme of arrangement, the landlords would have formed a separate class from other creditors and the creditors who were to be paid in full would be excluded. The result of the voting would have been entirely different. The Powerhouse result could only be achieved using a CVA as there is a single class of creditors where the landlords were outvoted by those who were to be paid in full.
- The terms of the CVA provided that all the other creditors would be paid in full; the landlords' claims would be discharged at a fraction of their value in order that the other creditors could be paid.
The future for creditors with guarantees
This case has been a hot topic in the commercial property world since its inception last year. The consequences of a financially distressed tenant being able to put terms in place with its creditors that would effectively release guarantees obtained in respect of the unpaid rent have been seen as disastrous for investment property values. Allowing this so called “guarantee stripping” would cause problems for businesses generally who would find themselves unable to lease premises or obtain finance other than on more onerous cash terms.
To a large extent this danger has been averted by the High Court's judgment, which will be widely welcomed by commercial landlords and finance creditors alike. However there are two important points in the Powerhouse decision that creditors with guarantees should note:
1. Whilst a CVA cannot be used to release guarantees or other third party obligations as it can only relate to arrangements between the company and its creditors, it may be possible to achieve the same effect where a third party has rights of subrogation against the company by providing that the creditor may not make any claims against the third party which could trigger the third party's rights of recourse against the company.
2. What constitutes unfair prejudice is to be determined on a case by case basis. The court confirmed that there is no automatic presumption of unfair prejudice merely because the proposals for creditors are different.
After such a scare, and with the residual risk that a 'fair' CVA could effectively prevent a creditor with the benefit of a guarantee from recovering his full claim, landlords and finance creditors may wish to review their position against their debtors and any third party obligors to try and ensure they have the greatest possible rights of recovery in the event of the debtor experiencing financial difficulties.
- With the possibility of vulnerable parent or group guarantees, it may no longer be sufficient to look only to the guarantees or recovery of debts, but also consider other alternative security such as larger rent or cash deposits which can be drawn down before any creditors' meeting in the event of the debtor company proposing a CVA.
- Review the terms of guarantees. It has been confirmed that a guarantee cannot be released by a CVA between the primary debtor and the creditor. One would expect to find such a provision in any commercial guarantee. However, it is possible under a CVA to limit the creation of third party rights of recourse against a debtor that may arise under a guarantee. Would the suspension in the guarantee of all rights of subrogation between the primary debtor and the guarantor ensure that the creditor could enforce his rights against the guarantor without any interference by a CVA proposal, or could the guarantee provide for compensation to the creditor in the event he was prevented by a CVA from making a claim?