Insolvency: Closing time

As the economic downturn continues to bite, landlords need to be vigilant to ensure tenants do not attempt to reorganise their way out of making good on their rental obligations. By Wayne Parker and Amy Wright

Insolvency: Closing time In the halcyon days of the economic boom of the past decade, people happily spent their disposable income in the country’s many pubs and nightclubs. The global credit crunch has meant people are tightening their belts to cope with increasing fuel and mortgage costs, and a night on the town may be one of the first things to be sacrificed.

The past 12 months have been difficult for pubs and nightclubs. The smoking ban and the poor weather have dampened appetites for a night out, with recent casualties ­within the leisure industry including Candu ­Entertainment (operator of Po Na Na), Jumpin Jaks and The Sports Cafe.

Share prices in other well-known operators have also fallen as a result of the recent ­economic downturn.

Previously profitable nightclub venues are now struggling, leaving the tenant ­companies with substantial long-term rental, liabilities they are unable to satisfy. The 2007 Powerhouse decision found that although in theory a company voluntary arrangement (CVA) can have the effect of removing a creditor’s ability to bring claims against third parties such as guarantors, they cannot be used to strip away guarantees that were freely negotiated between the ­distressed company’s creditor and a solvent third party, such as a parent company. Any attempt to remove such rights of guarantee will not be fair unless full compensation is offered to the creditor.

Faced with lower profits, tenant ­companies are now using increasingly ­complex means by which to avoid long-term rental liabilities. An approach we have seen recently involves the reorganisation of a tenant group – for example, by a series of name changes or transfers of assets and shareholdings within the group. If such a process involves a parent company ­guarantor, its covenant strength too can be weakened, thereby devaluing the strength of the guarantee and jeopardising further the landlord’s investment.

While a reorganisation takes place, the rent may be paid by a group company. Should payment subsequently cease, it will only be at this point that the landlord will discover that its tenant has become nothing more than a shell. While there may be perfectly ­legitimate commercial explanations for such group reorganisations, it must not be overlooked that there could be unscrupulous directors of tenant companies faced with significant rental liabilities in a struggling industry who are seeking a way to rid themselves of ­payments they may not be able to make in the long term.

If the tenant enters into some sort of insolvency process, the landlord joins the list of other creditors seeking recompense and will be forced to challenge any reorganisation retrospectively under the provisions of the Insolvency Act 1986. Judging by the level of complexity of reorganisations that are taking place, this could prove to be an expensive and time-consuming exercise for the landlord.

With the limited exception of pursuing the reorganisation as a potential transaction to defraud creditors, remedies for the ­landlord under the Insolvency Act 1986 are largely retrospective. However, the ­difficulty of challenging a transaction under Section 423 of the Insolvency Act 1986 is the requirement to prove an intention to put assets beyond the reach of creditors.

Powerhouse raised uncertainty as to how much comfort a landlord can take from a parent company guarantee in the event that the tenant company enters into a CVA. The attempt by the guarantor to compromise its claim in the Powerhouse case failed, but landlords now face the risk of complex, multi-stage group reorganisations to remove the covenant strength of a tenant or a parent company guarantor.

As a direct consequence of such a risk, landlords are now increasingly being advised to request rent deposit deeds from their ­tenants, creating the additional burden on tenants of providing cash sums when they enter into leases. But while a rent deposit may give a landlord some peace of mind, it will not help tenant companies in an already cash-strapped and struggling industry.

A cautious landlord that does not have the benefit of a rent deposit should make sure it monitors which entity is paying rent in order to spot early warning signs of a potential problem and address the issue at that stage by, for example, taking security.

We should not lose sight of the fact that the original tenant’s long-term plan might ­actually be to divest itself of its assets to other parts of its group and leave a shell company behind. The landlord might be receiving rent from another company within the group, while the tenant divests itself of its own assets by way of a reorganisation.

As a consequence landlords should be vigilant in their dealings with their ­tenants and watch out for subtle changes and any telltale signs that its tenant’s assets are being dissipated, possibly for genuine ­commercial reasons, but perhaps for more sinister purposes.

Wayne Parker is a partner and Amy Wright a trainee solicitor in the banking and finance team at Pinsent Masons