Implications of CVAs and new restructuring plan on real estate finance lenders during coronavirus (Covid-19)
The Insolvency Service records that between the first UK lockdown on 23 March 2020 until the end of November 2020 there were 150 CVAs. That represents a significant drop compared to 2019. For example, between April 2019 and November 2019 there were 240 CVAs. At first glance that may seem surprising given the upheavals of the pandemic and lockdowns. Nonetheless, this is consistent with a broader drop in the number of formal insolvencies. This is largely due to extensive government support such as the furlough scheme and restrictions on landlords’ ability to forfeit leases, exercise commercial rent arrears recovery or petition for a tenant’s winding-up (see Practice Note: Reform of UK insolvency laws).
However, the overall numbers also disguise a marked increase in the use of CVAs in the hospitality, retail and fashion sectors. According to PwC, 19 CVAs were launched by companies in these sectors between June 2020 and November 2020 compared to just four in the same period in 2019, a 375% increase. These sectors have been among the hardest hit by coronavirus and the associated lockdowns. The companies in these sectors also tend to have extensive leasehold portfolios, and so greater fixed unsecured liabilities, where there is greater potential for a CVA to be effective.
When the government reduces the support and protection currently given to tenants (which it surely must at some point) there will be pressure on tenants to deal with accumulated arrears and what, in the light of reduced revenue, are overrented premises (in the short term at least). Many larger retailers have sought to get ahead of the curve by launching CVAs in 2020 but many struggling small and medium-sized enterprises (SMEs) will have put off a restructuring because of the costs involved. Perhaps in anticipation of a wave of SME restructurings R3 have published a standard form CVA precedent to help reduce the costs of a CVA (see News Analysis: R3 announces new standard form Covid-19 CVA proposal and standard conditions and Precedents: R3 Standard Form Covid-19 CVA Proposal and Covid-19 Standard Conditions for Company Voluntary Arrangements). It is still to be seen whether this will take off in the same way that the individual voluntary arrangement (IVA) protocol has made IVAs more standardised and cheaper. In any case it is likely that larger companies will still use a more bespoke CVA proposal for their restructurings.
What are CVAs and why are they particularly relevant to REF transactions in times of financial difficulty?
A CVA is a procedure in the Insolvency Act 1986 that allows a company to reach a compromise with its creditors if the arrangement is approved by 75% by value of unsecured creditors and not opposed by more than 50% of unconnected creditors. There is no statutory stipulation of what kind of arrangement a CVA must contain so a company has considerable flexibility when making its proposal.
A CVA cannot compromise secured or preferential creditors such as HMRC (in relation to certain taxes such as VAT) without their consent so they are used where a company has substantial unsecured liabilities that need to be restructured. Accordingly, a CVA is most useful where a company has significant unsecured liabilities, for example, a large number of leases.
A typical retail sector CVA will divide the company’s landlords into various categories depending on the performance of the premises. Landlords of high performing premises may be left unaffected, except perhaps for a switch from a quarterly to a monthly rent payment cycle. At the other end of the spectrum the CVA may allow for the company to exit low performing premises by including an offer to surrender the lease. A CVA cannot force a surrender of a lease but the landlord is incentivised to accept the offer to surrender as the tenant’s obligations under the lease (including the paying of rent) will be “switched off” by the CVA (see Practice Notes: Retail sector insolvency—use of CVAs and Property law aspects of Company Voluntary Arrangements (CVAs)).
In the middle will be leases of premises that could be attractive for the tenant company to retain so long as they are restructured. The CVA may seek to reduce rent for a certain period, rebase the rent to market rent and/or add in break rights. Arrears of rent and dilapidations may also be compromised by the CVA.
A popular feature of CVAs in 2020 was attempts to mitigate a tenant’s risk of subsequent lockdowns and forced closures as a result of coronavirus. Many CVAs (for example New Look and Buzz Bingo) imposed turnover rents in place of fixed rents in order to make the landlord share some of this risk. Pizza Express’ CVA dealt with the risk of lockdowns in a more direct manner as it gave Pizza Express a right to cut its already compromised rent further if a lockdown forced it to close the relevant restaurant.
What is the new restructuring plan under the Corporate Insolvency and Governance Act 2020 (CIGA 2020)?
Part 26 Schemes of arrangements and the newly introduced Part 26A restructuring plan are procedurally similar processes for implementing a restructuring. They both involve the court to a greater extent than a CVA does.
Both a scheme of arrangement and a restructuring plan will have a first court hearing at which the court considers the division of creditors or members into separate classes (the convening hearing). If the court approves of the composition of the classes it will order that meetings of each class of creditor should be held (see Practice Note: Schemes of arrangement and restructuring plans—class issues).
Each class of creditor/member will then vote at their respective meeting to approve the scheme or restructuring plan. The threshold for approval is 75% by value of creditors voting. Schemes of arrangement also have an additional requirement that a majority by number of each class of creditor must approve the scheme.
A crucial distinction between schemes of arrangement and restructuring plans is that each class of creditor must approve a scheme of arrangement but it is possible for a restructuring plan to be implemented even if one or more class(es) of creditors rejects the plan (a so called “cross class cram down”) provided that (a) the creditors in a dissenting class are no worse off than they would be under the most likely alternative if the plan was not approved (which is likely to involve formal insolvency proceedings in most cases) and (b) the restructuring plan has the approval of at least one class of creditors who would receive a payment under the restructuring plan or who have a genuine economic interest in the company in the event of the relevant alternative (see Practice Note: Corporate Insolvency and Governance Act 2020—restructuring plan provisions).
The third stage of both a scheme of arrangement and a restructuring plan is a second court hearing (the sanction hearing) in which the court considers whether it should sanction the scheme or plan and in the case of a restructuring plan sanction a cross class cram down (if there is a dissenting class).
Schemes of arrangement’s and restructuring plans’ key advantage over CVAs is that they can compromise secured and preferential creditors (see Checklist: Corporate Insolvency and Governance Act 2020—differences between restructuring plans, schemes of arrangement, and CVAs). This makes them more useful than CVAs for restructuring liabilities owed to financial creditors. It is not usually practical to include landlords in the same scheme or restructuring plan as the financial creditors because the financial debt and the lease liabilities will often sit in different companies within the group. Furthermore, it will not usually be desirable to include landlords in a scheme or restructuring plan as they would likely form their own class. In a scheme of arrangement this would effectively give landlords a veto. A restructuring plan does allow for a cross class cram down that could overcome a rejection by landlords as a class. However, this is still untested, whereas a CVA is a proven means of compromising landlords. Accordingly, where a large group needs a fundamental restructuring of both its financial and rent liabilities we think a combination of a CVA with a restructuring plan or scheme of arrangement will become more common.
What are the practical implications for occupational tenants and, as a result, landlord-borrowers under REF facilities of the expected increased use of CVAs to restructure lease liabilities?
The increased use of CVAs to restructure lease liabilities means landlords and their lenders will need to concern themselves with the health of the tenant’s underlying business rather than simply relying on the value of the property as determined by reference to fixed projected rents. This is especially so if CVAs continue to be used to move fixed rents to turnover rents. It will be much more difficult to set and comply with rent cover and debt yield covenants, and the information and reporting undertakings in REF facilities agreements may become more demanding as a result. In turn, tenants may have to provide more information to landlords about their business than perhaps they are used to, to the extent that landlords are able to require this under lease terms.
A move to a more business-based rather than property-based credit analysis may also see REF facilities adopt restrictions more commonly seen in leveraged finance deals. For example, there may be stricter restrictions on the ability of the landlord to make distributions to its shareholders.
Tenants who have not needed to propose a CVA may feel aggrieved that their competitors who did use a CVA have gained a competitive advantage with lower rents. In 2018 in was widely reported that Next was pushing for provisions in their leases which would match the reduction in rent obtained by a neighbouring retailer through a CVA. Such CVA clauses were not widely adopted in leases. However, the difficulty in reletting properties in the current market mean there has been a significant shift in the tenant’s favour. Moreover, the increased use of CVAs means there is a greater risk of those companies who do not use a CVA being left behind (or at least perceiving this) and so we may see these protections become more common in future (see News Analysis: Latest retail CVA technology: foreign leases, business rates and turnover rents in focus). Naturally, this would have a knock-on effect on the stability of the landlord-borrower’s income stream and their creditworthiness.
Which provisions of a typical REF facility are likely to be affected if an occupational tenant is subject to a CVA?
A REF facility may include an event of default if a “major tenant” enters into insolvency proceedings. A CVA would typically be including as an insolvency proceeding so entry into a CVA by a major tenant would trigger an event of default.
Landlord-borrowers and lenders will also need to consider the effect of a tenant’s CVA on the debt yield and interest cover financial covenants (both on an actual and a projected basis). A reduction in rent from a tenant as a result of the CVA is an obvious way in which a CVA could affect these covenants. Furthermore, the facility agreement terms may exclude all rent from tenants in “insolvency proceedings” from the calculation of projected debt yield and interest cover financial covenants. Again, the definition of insolvency proceedings would need to be checked to see if this will include a CVA. If a CVA is included as an insolvency proceeding then the landlord-borrower may not be able to include even the lower rent it is receiving as a result of the CVA in its covenant calculations for the duration of the CVA (which may be a few years).
A loan to value covenant may also be affected by a CVA. The value of the property may be adversely affected by the introduction of new rights to break the lease and a rebasing of rent to market rates (which will affect the lease for the remainder of its term, including after the CVA has ended).
What practical steps should landlord-borrowers take in relation to REF facilities if one of their occupational tenants becomes subject to a CVA?
A landlord-borrower should ensure that they promptly comply with any information undertaking that requires them to share a CVA proposal from a tenant with their lenders. They should also consider whether their vote in relation to the CVA (whether it be for or against) requires prior lender consent.
The landlord should work out what the tenant is seeking to do with their property. For example, is the tenant seeking to exit the premises, obtain a temporary rent concession or make a long term change such as a move to a turnover rent or a rebasing of rent to market rates. This will inform the landlord’s conversation with its lenders especially if the CVA may lead to a breach of the landlord’s REF facility.
The landlord should also consider whether it wishes to forfeit the lease. A commercial lease will typically provide a right of forfeiture if a CVA is proposed or approved and a CVA cannot remove this right of forfeiture. However, if the landlord wishes to preserve its right to forfeit it should ensure it does not take action that may be construed as affirming the continuation of the lease such as accepting the compromised rent from the tenant after a CVA. For further reading, see Practice Note: CVAs—landlord issues and remedies.
At the time of writing, a temporary restriction on forfeiture for non-payment of rent in England and Wales in relation to commercial leases is in place. This captures occupational leases in the context of a typical real estate finance investment facility and the restriction applies from 26 March 2020 to 31 March 2021 (section 82 of the Coronavirus Act 2020). However, this temporary restriction does not prevent forfeiture on other grounds such as the tenant entering into a CVA.
It is worth noting that CIGA 2020 introduced restrictions on ipso facto clauses (being clauses which allow a party to exercise termination rights in relation to a contract for the supply of goods or services when a company enters an insolvency or restructuring procedure). It is likely that a lease, in general terms, would not be caught as a supply of goods or services, but classification of a particular agreement will depend on its specific terms. For most leases, therefore, forfeiture should still be available notwithstanding the introduction of CIGA 2020. For further analysis on this point, see Q&A: Do the "ipso facto" provisions of the Corporate Insolvency and Governance Act 2020 apply to a lease, ie is a landlord a supplier of goods or services for the purposes of the Act?
How might REF lenders change their lending behaviour going forwards in light of the ongoing pandemic and more general long term shifts in consumer habits when it comes to retail and leisure, particularly in light of uptake in use of CVAs in recent years?
CVAs in the retail and leisure sector have undermined the concept of the institutional lease with a relatively long term and fixed rent subject to upward only rent reviews. Consequently, REF lenders in these sectors may lose confidence that they are investing in a steady income stream.
REF lenders who continue to invest in the retail and leisure sectors may find themselves needing to consider the underlying business of the tenants much more closely than they might have had to do in the past. Turnover rents imposed by CVAs or accepted to ward off the threat of a CVA are one way in which the business risks of the tenant are being shared with landlords and ultimately the landlords’ lenders.
Senior lenders, in particular, may feel they are not set up to assess business risk as well as real estate risk nor do their returns compensate for the additional risk they are being asked to take. Such lenders may seek to de-risk their investments by lending at a lower loan to value, creating a funding gap for landlords. More drastically REF lenders may move into other real estate sectors. The logistic sector has been one of the best placed to weather the storm of the pandemic and to benefit from the increased digitisation of retail. Investment in the residential private rented sector will likely also remain a popular choice for lenders.
This article was first published by LexisNexis.