Power to the landlords

Proclaimed by the judge as an issue of 'general importance to the commercial property market', the High Court's 1 May judgement in Prudential Assurance Co Ltd and others Luctor Limited and others v PRG Powerhouse Limited and others Anthony Murphy and others [2007] EWHC 1002 Ch brought a huge sigh of relief to many landlords relying on guarantees as security and scrutinised the purposes for which Company Voluntary Arrangements (CVAs) may be justified.

Background

In February 2006 the electrical retail giant Powerhouse experienced liquidity problems, and proposed a CVA under which it would close 35 under-performing stores. A number of the landlords of those stores (affected landlords), held guarantees from Powerhouse's parent company, Pacific Retail Group (PRG), a solvent company listed in New Zealand.

In summary, the terms of the proposed CVA were:

• affected landlords would receive a 28 pence in the pound dividend (funded by PRG) on any current arrears. They would also receive the same dividend paid out on eight months' rent if their leases had five to eight years remaining, or on 12 months' rent if their lease had more than eight years remaining;
• release of PRG from all guarantees with the affected landlords; and
• all other creditors would be paid back in full (not least the trading creditors who provides the goods that Powerhouse would continue to sell from its other locations).

Understandably perhaps the affected landlords were not happy with these proposals.

Despite the affected landlords' objections to the CVA, it was approved by the requisite majority of creditors at the creditor's meeting held in February 2006. Two groups of aggrieved landlords (including Prudential Assurance) brought proceedings to have the CVA declared invalid.

Issues before the Court

The two main issues before the Court were:

• Was the CVA effective in releasing PRG from its liabilities to the affected landlords as guarantor of Powerhouse's leasehold obligations; and
• Was the CVA unfairly prejudicial to the affected landlords and therefore invalid?

Ironically, by the time of the hearing Powerhouse had ceased trading. Administrators were appointed on 1 August 2006 but as the CVA had not been terminated, the hearing continued.

Could the CVA release PRG?

If the affected landlords were prevented by the CVA from pursuing Powerhouse, they would then want to claim under the PRG guarantees. PRG would then want to, in turn, look to Powerhouse to indemnify it against the affected landlords' claims, and so Powerhouse would be back where it started. Powerhouse therefore needed to ensure that PRG was released from its guarantor obligations if the CVA was to work. The Court held that the CVA did, and could, achieve this.

Mr Justice Etherton reasoned that on the true construction of the terms of the CVA and the guarantees, the CVA was effective in allowing Powerhouse to treat the guarantees as released. It was perfectly proper for a CVA to prevent a creditor from enforcing his rights against a third party or, as here, to require the affected landlords to treat the PRG guarantees as being released.

Was the CVA unfairly prejudicial?

Under the insolvency legislation, if a creditor believes that he has been unfairly prejudiced by the CVA's terms, he can apply to have it set aside on that basis. The affected landlords were seeking to do precisely that.

In examining the question, Mr Justice Etherton noted the difficulty in assessing whether something is actually 'unfair' in the absence of a single and universal test in this context. In broad terms, the case law suggests one method of identifying unfairness is a comparison of the CVA's effect on all the creditors. That comparison is looked at in two ways:

• Vertically '“ what the position of each creditor would be if the company was liquidated.
• Horizontally '“ comparing the CVA's effect between each group of creditors (e.g. affected landlords, trading creditors, etc).

Vertical comparison

The judge found that had Powerhouse been liquidated, the affected landlords would have been able to rely on their guarantees against the solvent PRG. In a liquidation, the affected landlords would be much better off than the other creditors. The latter had no security for their debts and would receive nothing in a liquidation, yet were to be paid in full under the CVA.

Horizontal comparison

The fact that a CVA involves differential treatment of creditors is 'a relevant factor', although it is not necessarily sufficient in itself to establish unfair prejudice. Here there was a clear disparity between the treatment of the affected landlords with their dividend of 28 pence in the pound, and all the other creditors who would be paid back in full. The judge said that this disparity was great indeed, even if you ignored the fact that the affected landlords would also then be prevented from claiming under their PRG guarantees.

The guarantees were of obvious value to the affected landlords, who would otherwise have been able to enforce them. However, the release of PRG's guarantees left the landlords without any leverage to negotiate compensation for their loss of these rights.

Mr Justice Etherton concluded that he was in 'no doubt' that the CVA is unfairly prejudicial to the affected landlords and therefore that the CVA was invalid.

Implications

The decision has not precluded a CVA from theoretically procuring the suspension, or even release, of third-party obligations such as guarantees. However, it is likely that a CVA will be unfairly prejudicial if those who benefit from the those third-party obligations are not properly compensated (compared with the other creditors) for losing their rights to them.

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