Challenging CVAs as a creditor

June 30, 2023

Karen Morean and William O’Brien outline how creditor local authorities can challenge a company voluntary arrangement.

Local authorities contract with a vast array of suppliers of goods and services, and like any market participant, they are exposed to the risk that those suppliers become insolvent.

This risk is particularly acute in relation to contracts of significant value, such as construction contracts, where a single main contractor becoming insolvent, particularly mid-project, can result in losses for the local authority of hundreds of thousands if not millions of pounds. It is not unusual for local authorities to be especially exposed to contractor insolvency where the contractor is procured on framework-type arrangements and is appointed on several projects concurrently.

Whilst there are a variety of mechanisms that a local authority can employ to protect itself at the outset of a construction procurement process (such as due diligence checks, insurance arrangements and parent company guarantees) there is no way to prevent contractor insolvency altogether.

When a company is in financial difficulty, the directors are required to act in the best interests of creditors. Several options are open to the directors. One of these is the statutory Company Voluntary Arrangement (CVA). CVAs almost always are a bad deal for unsecured creditors, which likely include local authorities.

CVAs

A CVA is a deal between a company and its unsecured creditors. It is commonly put forward in an attempt to avoid a formal insolvency process (such as liquidation or administration). The CVA must be approved by 75% of unsecured creditors by value to take effect, so while it is imposed by statute on any objectors, it is based on the consent of the majority of creditors. It usually involves the payment of a small sum to unsecured creditors over a period of time – a Supervisor is appointed to oversee this.

Creditors are persuaded to agree on the basis that the CVA outcome would be better than if the company was put into liquidation or administration immediately. That better outcome is usually pence in the pound and inevitably is a nominal amount. Further, the CVA need not treat all unsecured creditors in the same way; some creditors can be given more, for example, because their continued engagement of the company is critical to its viability as a business.

Each proposed CVA is bespoke to the organisation and therefore each proposal needs to be assessed on its own terms.

CVAs can be challenged and overturned where they are unfairly prejudicial or irregularly put in place as the recent case of (1) Newlon Housing Trust (2) Peabody Construction Limited v Mizen Design/Build Limited^[1] (the Challenge) demonstrates.

Challenging a CVA

The Insolvency Act 1986 provides two bases for challenging a CVA:

If the CVA is unfairly prejudicial to the interests of a creditor, member or contributory; and
If there was a material irregularity in the decision process by which the CVA was approved.

Both grounds were put forward in the Challenge. The first-instance decision found there was both unfair prejudice and material irregularity. On appeal, no decision on unfair prejudice was made, but the finding of material irregularity was upheld.

The challenge

In this case, a construction company, Mizen Design/Build Limited (the Company) put forward a CVA proposal which estimated outcomes of payment of the following:

2-1.3% of the sums due to unsecured creditors without Parent Company Guarantees (PCGs);
5% of sums due to unsecured creditors with the benefit of PCGs; and
100% of sums due to certain listed unsecured creditors who were said to be critical to the ongoing trading of the company.

The impact of the CVA proposal was that not only were claims against the Company compromised for pence in the pound, but claims against the Company’s parent company (the Parent) were also compromised on a similar basis.

The CVA justified this course as the Company alleged that the Shareholder was bound to enter insolvency itself if the PCG claims proceeded against the Shareholder and were not compromised by the Company’s CVA.

Devonshires acted for both applicants in the Challenge. The second applicant, Peabody Construction Limited (Peabody) was a creditor who held a PCG and expected to make a significant recovery from the Parent if the Company became insolvent; certainly more than 7.5% offered in the CVA. After all, the risk of contractor insolvency is one of the reasons developers procure PCGs at the outset of a project.

Unfair prejudice

The proposal gave very little information about the Parent’s financial position. In addition, its year end accounts had not been filed on-time with Companies House. Further, late disclosure was provided during the course of the trial. Concerns emerged in relation to a number of transactions:

Shortly before circulation of the CVA proposal, the Parent sold a subsidiary for unclear consideration which did not seem to be reflected in the information provided.
There may have been other similar transactions based on information available at Companies House.
The level of PCG claims appeared to be inaccurate.
Days after the conclusion of the trial, the Parent’s accounts were filed at Companies House, and showed that during the financial year when financial difficulties emerged, the Parent had in fact declared a £2m dividend.

The first-instance judge held that there was unfair prejudice because Peabody would likely have been better off if the Parent entered into administration than if the CVA was approved, because of the inaccuracies in the financial information provided. Peabody and other PCG creditors also suffered unfairly because they shared one fund with creditors without PCGs.

The appeal judge did not agree with this decision but decided it was moot because he agreed that the challenge to the CVA succeeded on grounds of material irregularity.

Material irregularity

As we say above, the CVA proposal provided very little information about the Shareholder’s position and what was provided, it turned out during the challenge, was inaccurate as to the assets and the liabilities of the Parent.

In previous case law, the test for material irregularity has been equated to “whether, had the truth been told, it would be likely to have made a material difference” to the creditors’ voting decisions on the CVA.

In the Challenge:

The first-instance judge agreed there had been material irregularity because there should have been greater disclosure as to the Parent’s financial position, even though it did not relate to the Company’s financial position. The voting creditors should have had the information as to the Parent’s position and regarding the potentially reviewable transactions.
The appeal judge also found there had been material irregularity because the estimated outcome statement for the Shareholder failed to disclose the potentially reviewable transactions. Further, the additional evidence of payment by the Parent of a dividend also amounted to material irregularity affecting the outcome for PCG creditors, and affecting how they might have voted in the Company’s CVA meeting.

The CVA was ultimately set aside and the Company entered administration.

Conclusion

Given that CVA proposals are bespoke to suit each individual company’s specific circumstances, each instance of a contractor or supplier entering into a CVA has to be looked at on its own merit. There are however a few key takeaways for local authorities.

Local authorities should continue to mitigate the risk of the insolvency of those they contract with. Procurement, contract monitoring, bonds, guarantees and before the event insurance policies can reduce loss.
Look for warning signs of financial distress from contractor and suppliers. Take advice early and actively investigate whether steps can be taken to stave off insolvency.
If a creditor is in financial difficulty and proposes an CVA, local authorities will need to complete proof of debt forms and decide how it intends to vote at the CVA meeting. The CVA proposal will contain information about where forms should be sent.
If the CVA is approved, local authorities may wish to consider whether there may be valid grounds of challenge. Again, it is extremely important to get specialist advice at an early stage. If there is scope to challenge the CVA, you only have 28 days from the date the court is informed of the CVA vote to do so. Prompt action will be required.

Karen Morean is a Partner and William O’Brien is a Solicitor at Devonshires Solicitors LLP.

^[1] [2023] EWHC 127 (Ch) and Mizen Design/Build Limited -v- Peabody Construction Limited [2023] EWHC 973 (Ch)