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CVAs – landlord pain for shareholder gain

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Summary: A recent spate of retail CVAs have caused disquiet amongst the landlord community.

On the morning that Mothercare announced its CVA, its share price went up by 35% (from 20p to 27p) and now sits at 35p (up 75%) from the price the day before the CVA was launched.

The restructuring of Mothercare contemplates an equity raise and new shareholder loans alongside a landlord compromise. But landlords’ compensation is capped at just £1m for those being exited (and is conditional upon Mothercare not going into administration within the two years following approval of the CVA). In contrast, the return for new investors appears to be unfettered.  This is meaningful when you consider that “at least £10m cash” is expected to be realised within 18 months with future cost reductions of at least £10m per annum as a result of this compromise levied on the landlords of the 71 sites being exited, combined with generalised “working capital improvements” and a head office restructuring,

The landlords of the 21 sites where a 50% rent reduction is being imposed have been given a right to take back their sites within six months following the approval of the CVA, but the rationale given for the compromise was not solely that the sites are overrented but also that certain sites are “underperforming by virtue of being marginally profitable” and/or “on unfavourable lease terms”.

Is the level of the bar to proposing a compromise to landlords falling, and does this mean that landlords will now have to bear the consequences of management mistakes, strategic inflexibility in the changing retail arena and PE-sponsored over-expansion?

Landlords of a retailer’s most profitable stores will typically only be compromised into monthly, instead of quarterly rent under the CVA. But they must also give up their contractual rights to forfeit the lease as a consequence of the CVA being proposed by the retailer, and the financial difficulties encountered by it which resulted in the proposal being made in the first place. This is a fundamental right reserved by landlords to protect themselves when a tenant’s ability to meet its obligations under the lease is in jeopardy. This does not seem a fair bargain for landlords when the patchy track-record of CVAs in achieving a successful turnaround is factored in (for example, Toys R Us, when a “poor December” of sales, immediately following the approval of a CVA, was enough to cause the business to fail). No Mothercare landlord has been given a break right or any compensation in return for this compromise.

Surprisingly, this contrasts favourably with a pre-pack administration where the landlord’s consent to assign to any Newco is preserved (with a landlord having the option of a financially viable assignee).  The CVA can enable negotiated liabilities to be compromised and contractual rights avoided, with no upside potential for landlords and no compromise to any other interested party.  You might say, “well, what’s the alternative?”. The answer is that in order to achieve a successful turnaround to secure long-term financial stability, these businesses often need a holistic restructuring of their balance sheet, and CVAs are too often used as an easy way to reduce costs, leaving the real fundamentals not addressed (e.g. over-leverage). The New Look CVA is a prime example of this: an estimated outcome statement produced by the nominee revealed that after the CVA had become effective and rents been compromised, the company expected to have a net book value asset position of minus £950m on EBITDA of an adjusted EBITDA of £43.8 million (based on the latest available figures from February 2018).

3 years ago, the BCLP team wrote about the challenge risk to “landlord-only CVAs”.

Those concerns around the fairness of compromising only one creditor or one creditor group remain as pertinent as ever and have been heightened by the recent retail CVAs that have pushed the envelope even further. Certain obligations placed on landlords that we consider are unenforceable such as the provisions seen in Toys R Us relating to forcing negotiations on store downsizes and to the practical issues of how surrenders are dealt with.

Recent government consultations envisage a more US-style insolvency regime for the UK, to make sure that our insolvency system remains competitive in the global market. But the current operation of CVAs is anathema to the protections that landlords would get in a Chapter 11, which would not permit bondholders and other financial creditors to vote on landlord compromise, would respect the absolute priority rule (if unsecured creditors take pain, so must shareholders) and would ensure landlords receive some compensation for the claim they have had compromised – i.e. their claim to future rent.

It seems to us that time is now right for a challenge to CVAs and, with sources suggesting that more than ten household names are seriously considering them over the next few months, we suggest it is only a matter of time before someone bears the risk to take on a CVA.

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