Powerhouse - still powerful?

In June 2007 we reported on the decision in Prudential Assurance Company Ltd v PRG Powerhouse Limited. Although the case has given rise to a great deal of debate, until now there has been no subsequent reported case in which the court has had to consider whether and how a company voluntary arrangement (CVA) might fairly effect a compromise of a landlord's claim against a guarantor of its tenant.

The High Court has now had an opportunity to consider the issue again in Mourant & Co Trustees Limited v Sixty UK Limited.

Background

Sixty UK Ltd (Sixty) trades under the names Miss Sixty and Energie. It has 11 stores and a number of concessions. Having traded at a loss for several years, the company became insolvent and administrators were appointed in September 2008. The administrators put forward proposals for a CVA. Under the proposals, four stores were to close, but the others would continue to trade.

The CVA was approved at a meeting of creditors in April 2009. The landlords of two stores at a shopping centre in Liverpool, which had been earmarked for closure, challenged the CVA. The challenge was made on the same basis as that brought by the landlords in Powerhouse - that the CVA was unfairly prejudicial within the meaning of section 6 of the Insolvency Act 1986.

The Liverpool leases were for a term of 10 years from 2006, and were guaranteed by Sixty's Italian parent company; Sixty SpA. The landlords of the other two stores which were to be closed did not benefit from the parent company guarantee.

The terms of the CVA

The CVA provided that:

• Sixty SpA would be released from all liability under the guarantees
• the landlords of the closed stores with no parent company guarantee would receive 21% of Sixty's estimated liability had the relevant leases been surrendered
• the landlords of the Liverpool stores would receive an amount which was said to represent 100% of Sixty's estimated liability on a surrender of the leases. The increased amount was to compensate for the loss of Sixty SpA's guarantee
• all other creditors would receive payment in full.

The proposal document stated that, by contrast, the landlords could expect to receive a dividend of no more than 13 pence in the pound if Sixty was put into liquidation. The document noted that the proposals would avoid the risks and delay in bringing proceedings in Italy to enforce the guarantee.

Powerhouse - a reminder

Powerhouse established that a CVA could lawfully be structured so as to deprive a creditor landlord of the benefit of a third party guarantee. This is because, were the guarantee to be enforced, the guarantor might then have a right of recourse against the debtor company, which could defeat the objective of the CVA. However, on the facts, the CVA in that case was found to unfairly prejudice certain of Powerhouse's landlords, and was struck down by the High Court.

The Sixty case - the valuation evidence

In the Sixty case, the passing rent under each of the Liverpool leases was c.£109,000 per annum, exclusive of service charge, insurance and rates. On the grant of the leases in 2006, Sixty had been granted a 12-month rent-free period, and a reverse premium of £183,000 on each store.

Valuation evidence had been obtained by Sixty in August 2008 which showed that the loss which would be suffered by the Liverpool landlords on a surrender of one of the stores was £490,000. This sum was made up of: dilapidations liability, a 12-month void period (including empty rates), a three-month rent-free period for a new tenant, an incentive of £275,000 payable to a new tenant, and marketing and legal fees.

Although the CVA purported to give the Liverpool landlords 100% of what they would receive on a surrender of the leases, in fact the sum attributed to these landlords was just £300,000. This sum had to cover both stores. The Liverpool landlords had therefore been offered less than a third of what the CVA appeared to entitle them to.

The High Court ruled that the amount offered to the Liverpool landlords was not based on valuation evidence as to the loss which they would suffer, but was simply dictated by the amount which Sixty SpA was prepared to pay. Evidence given to the court by an expert valuer supported, and indeed went further than, the report obtained by Sixty in 2008, and found that the loss suffered by the Liverpool landlords by virtue of an "enforced surrender" would be over £1.1 million.

Was the CVA unfair?

In Powerhouse the court held that there is no universal test for judging whether the prejudice caused to a creditor by a CVA is unfair, and that it will depend on the circumstances of each individual case. A number of different comparisons may be made.

Vertical comparison

A "vertical comparison" is a comparison between the position that the creditor would be in if the company were in liquidation, and its position under the CVA. On a liquidation the Liverpool landlords would still have had the benefit of the parent company guarantee. There was no reason to doubt the ability of Sixty SpA to honour this. The landlords would also have had the option, following a disclaimer of the leases, to require the guarantor to take up new leases of the stores for the remainder of the term.

The court ruled that it was unreasonable and unfair in principle to require the Liverpool landlords to give up their guarantees. It noted that, in times of commercial and financial turmoil, the ability to enforce the existing leases against the guarantor was a valuable right and there was no sufficient justification for requiring any of the guaranteed landlords to accept a sum of money in lieu. At a time of market uncertainty it would be difficult to determine what sum would compensate the landlord for the loss of those rights, and the landlord should not be forced to accept a sum which was based on numerous assumptions (e.g. about the time it would take to re-let the premises), which may or may not prove to be well-founded. To hold otherwise would be to undermine the basic commercial function of the guarantee.

In any event, the valuation evidence showed that a figure in the region of £1 million was the least that could fairly be regarded as appropriate.

Horizontal comparison

A "horizontal comparison" is a comparison between the position of the particular creditor as against other creditors, or other classes of creditors. Differential treatment of creditors will not be automatically unfair, but it calls for justification. For example, is the different treatment necessary in order to secure the continuation of the company's business, by paying essential suppliers?

In this case, the CVA only imposed a compromise on landlords of the four closed stores. It did not compromise the claims of other landlords, or indeed other creditors in general. The administrators argued that the differential treatment was justified because those four stores were loss-making. However, it became apparent that even between the landlords of the closed stores, treatment had not been equal.

Although the landlords of two of the closed stores did not benefit from a guarantee from Sixty SpA, those landlords did have the benefit of the covenant from the original tenant; Muji, which had remained liable following the assignments to Sixty. This meant that in practice these landlords were able to recover in full from Muji. Muji in turn had a right of indemnity from Sixty, and this right of indemnity was not limited by the CVA, so that Muji was entitled to be fully reimbursed under the CVA.

The court ruled that parity of treatment would have required Muji to be released from its contractual liabilities to the landlord, and the landlord to be compensated by a cash payment, in the same way as the Liverpool landlords were to be compensated for the loss of the parent company guarantee. As it was, the landlords of the other two stores were better off than the Liverpool landlords, even though they had not had the benefit of the guarantee from Sixty SpA. There was no justification for this disparity in treatment, and the CVA was therefore unfair to the Liverpool landlords.

Things to consider

The court noted that the reasoning of the judge in Powerhouse was highly apposite to this case. On a winding-up, the Liverpool landlords would still have had the benefit of the parent company guarantee. The guaranteed landlords would have formed a separate class for the purposes of a formal scheme of arrangement under the Companies Act, which they would have vetoed. The CVA was passed by the votes of the unsecured creditors, who stood to lose nothing by it. The only difference between Powerhouse and Sixty was that the Liverpool landlords had (ostensibly) been offered the full amount of the value placed on their rights.

It is interesting that the court found that there was no sufficient justification for requiring any of the guaranteed landlords to accept a sum of money in lieu of the parent company guarantee. Powerhouse established that it is possible to use a CVA to compromise a landlord's claim against a guarantor of its tenant, and this was not disputed in Sixty. However, applying the court's reasoning, it appears that, even if the administrators had offered the Liverpool landlords the magic £1 million figure, the landlords still may not have been required to accept it. It seems that the uncertainty created by market conditions at the time of the CVA weighed heavily in the court's decision.

Welcome news for landlords indeed, and proof that, three years on, Powerhouse remains a powerful tool for landlords.