UK: The Bluebrook/IMO Restructuring: A Wash Out For The Mezzanine Lenders

Last Updated: 15 December 2009
Article by Richard Baines and Andrew Johnstone

This article was originally published in the September 2009 issue of In-House lawyer.

Every downturn brings in its wake a series of restructuring cases, when the mistakes made during the previous boom are called to account and hard lessons learnt. Last month Mr Justice Mann gave judgment in the High Court in the Bluebrook/IMO case1. The matter came to court on the application to sanction three schemes of arrangement2 and was opposed by the Mezzanine Lenders on the basis that their interest was unfairly prejudiced. The case provides a useful insight into the Court's approach to the use of schemes of arrangement in restructuring. It also deals in some detail with the issue of determining where value 'breaks', a crucial issue in a restructuring for the purpose of deleveraging a business overburdened with debt.

Outline facts

Bluebrook was the holding company for the largest carwash business in the world. It had borrowed about £315 million from a group of Senior Lenders. An indirect subsidiary, Spirecove had borrowed about £120 million from another lending group, the Mezzanine Lenders.

Both the Senior Lenders and Mezzanine Lenders took security in the form of a range of cross-guarantees and debentures. There were various subordination arrangements contained in an Intercreditor Agreement, which 'firmly' subordinated the Mezzanine Lenders to the Senior Lenders. Under the terms of the Intercreditor Agreement the Mezzanine Debt could not be repaid, or repayment sought, until the Senior Debt had been paid and any proceeds of enforcement were to be applied in accordance with the Intercreditor Agreement.

The group got into severe financial difficulties and was unable to make repayments of interest due to both the Senior and Mezzanine Lenders. Group companies at operating level were able to pay their debts as they fall due but the trading prospects were not good as credit insurance was being withdrawn and difficulties with suppliers were emerging.

The restructuring proposals

The directors' proposals for the restructuring involved the creation of three new companies to which all of the assets and most of the Senior Debt of the old group would be transferred. Some £12 million of the Senior Lenders' debt was to be left in the old group to enable the Senior Lenders to pick up any unexpected asset realisations. There would then be a debt for equity swap in favour of the Senior Lenders. No assets would be available in the old group companies with which to pay the Mezzanine Lenders who were excluded from any rights over the new group. The Mezzanine would be effectively shut out on the basis that they had no economic interest in the group, whose value was significantly less than the Senior Debt.

The schemes of arrangement were to deal only with the mechanism of the release of the Senior Lenders' debt in the old group in anticipation of the issue of majority equity stake in the new group and the transfer of part of the senior debt to the new group by novation. The transfer of the assets in each case was not part of the formal scheme but was to be effected subsequently by prepack administration sales. The Intercreditor Agreement permitted the compulsory release of security and guarantees held by the Mezzanine Lenders, on the exercise by the Senior Lenders of their own enforcement rights under their security.

The scheme companies took the view that they were free to select the creditors with whom they wished to enter into the scheme of arrangement and therefore sought only to compromise with the Senior Lenders and not the Mezzanine Lenders. The right to exclude creditors whose rights are not altered by the scheme is a principle long established in case law3. The scheme companies also took the view that they need not compromise with any class of creditors which had no economic interest in the restructuring.

The issue as to whether a class of creditors has an economic interest is determined by where value 'breaks' . The dispute in this case centred on whether the value of the group broke in the Senior Lender's debt or whether the Mezzanine had an economic interest in the group which would allow them to argue that the schemes were unfairly prejudicial to their interests.

The scheme companies obtained a valuation report, using three different methodologies, all of which showed that the value of the group was less than the Senior Debt. They took these as evidence that the Mezzanine Lenders had no genuine economic interest in the group. All three methodologies valued the companies on a going concern basis assuming zero growth in the terminal year (for the discounted cash flow approach) or making certain assumptions as to the weighted average cost of capital. The first method, called the 'income approach', was done on a discounted cash flow basis. The second, the 'market approach', made a comparison with comparable publicly traded companies. The third was a leveraged buyout analysis which considered how a potential private equity purchaser would look to fund a deal by performing a high level debt capacity analysis. In addition, the scheme companies produced evidence that the business had been marketed by Rothschild, resulting in no interest at an acceptable price and another valuation exercise of the sites by property valuers produced a low overall figure.

The objections to the schemes

The Mezzanine Lenders produced a report at a very late stage. Its lateness, methodology and conclusions were severely criticised in court. It relied on a method called the Monte Carlo simulation (a computer simulation involving repeated calculations using random assumptions) and concluded that the value of the group was in excess of the value of the Senior Debt and that value 'broke' in the Mezzanine debt. The report attacked the valuations presented by the Senior Lenders on the grounds that the market price valuation was artificial since there was no market for the assets; the market conditions would, in any event, have deterred any bids; and one of the valuation methods suffered from the absence of proper comparables. However, the Mezzanine report's methodology was more appropriate in specialist industries where earnings are uncertain, such as pharmaceuticals. In addition, the conclusion which the report came to, that the car wash business was 'extremely sound and profitable', seemed at odds with the reality that interest falling due was unable to be paid and the group was balance sheet insolvent.

The Mezzanine Lenders claimed that the scheme unfairly prejudiced their interests because the value of the group's assets was not less, they maintained, than the value of the Senior Debt. They argued in court that the fair thing to do would be to allow the Senior Lenders the first right to have their debt repaid but without absorbing all the equity in the business. As proposed, the scheme shut out the Mezzanine Lenders from any prospect of benefiting from the assets following their transfer to the new group.

Other objections of the Mezzanine Lenders

Aside from the key issue of valuation a number of other objections were made on behalf of the Mezzanine Lenders. It was submitted that a compromise or arrangement within the relevant statutory provisions must involve an element of reciprocity which was missing in the case, because one party (the group) was giving up everything. The judge did not accept that and decided that the debt/equity swap was not a complete surrender on the part of the scheme companies, which would benefit from the removal of most of the Senior Debt. Further, the judge noted that the Mezzanine had a safeguard in the form of clause 12 of the Intercreditor Agreement. If they thought that the assets were being sold at an undervalue, they were entitled to buy out the Senior Lenders and do the restructuring themselves, thereby obtaining the benefits they claimed would flow to the Senior Lenders under the scheme.

It was also argued that the directors of the scheme companies were in breach of duty to the companies and/or to creditors as a whole. The judge accepted that it was a point which related to the issue of fairness. It was suggested that the discharge of the duty to creditors meant that the directors ought to have bargained with the Senior Lenders for something to be provided to the Mezzanine. However, on the facts the judge decided that the Mezzanine Lenders had been negotiating on their own behalf and had in no way expected the directors to do it for them.

Mann J anyway found that the directors had no real bargaining position in these circumstances. The group was technically insolvent and the companies could not keep down further debt as it arose. Events of default under the credit agreements had been triggered. In the circumstances, the directors properly engaged the two creditor groups in discussions. It was even suggested by Counsel for the Mezzanine that as part of that bargaining the directors should have threatened to carry on trading. That submission was clearly rejected by the judge, as in those circumstances the directors, having recognised the companies' inability to repay debts as they fell due, would have been trading wrongfully. In that context the judge decided that whilst the board did not have to do whatever the Senior Lenders wanted, they were clearly not in a position to bargain for additional return to other creditors if the Senior Lenders resisted that.

The Court's Decision

Mann J noted that it was accepted by all parties that the group's financial position was such that the only alternative to a successful restructuring was a formal insolvency procedure. He decided that a going concern basis was the appropriate valuation methodology and indeed none of the reports considered a liquidation or fire sale valuation. He rejected the Mezzanine Lenders' valuation as being mechanical, when the facts required "real world judgments as to what is likely to happen". His doubts about the report also derived from the Mezzanine Lenders' reluctance to co-operate with the Senior Lenders in discussing the report and their reluctance to provide supporting material. He therefore decided not to give the report as much weight as the Senior Lenders' valuations. Overall the weakness of the Mezzanine Lenders' valuation evidence proved to be a fatal flaw, particularly against Senior Lenders armed with three valuations based on clear methodologies and assumptions and appropriate expert judgments.

Having decided that the value of the group was less than the Senior Debt on a going concern basis, the Judge decided that the Mezzanine Lenders could have no economic interest. Given the statutory majority in favour of the schemes at the creditors' meetings there was no reason the schemes should not be sanctioned.


This case is significant because it highlights the trend towards the growing use of Companies Act schemes of arrangement in the restructuring of large groups, for example, MyTravel and more recently Crest Nicholson. The scheme of arrangement procedure is an expensive procedure involving a lengthy timetable, the holding of creditors' meetings and at least two applications to court. However, schemes have the key advantage over a company voluntary arrangement that once approved by the statutory majority of creditors (a majority in number and 75% by value of each class entitled to vote) and then sanctioned by the court they are binding on all creditors including those not entitled to vote for lack of economic interest. They are therefore able to achieve a cram down effect similar to a plan under Chapter 11 of the US Bankruptcy Code. From a legal point of view the case provides confirmation that this type of debt equity swap does constitute a 'compromise' within the meaning of Section 899(1) of the Companies Act 2006.

The Judge accepted the Senior Lenders' valuation reports that the business was worth less than the Senior Debt, but the case arguably does not really deal with the issue of inherent future value, particularly at this extraordinary time when values have plunged and given the current uncertainty surrounding most business sectors. Consequently, it is possible that this case will be distinguished in future where it can be shown by convincing valuation methods that the value of the business has inherent potential going forward. Although the Judge said that he was adopting the going concern valuation it does seem that, in reality, this was closer to a valuation on a fire sale basis because of the extraordinary market conditions.

It should be noted that one of the main grounds of the decision that it was not unfair to exclude the Mezzanine Lenders was by reference to the Intercreditor Agreement itself which provided that they were entirely subordinated to the Senior Lenders. The harsh reality for mezzanine lenders is that lending made in the boom times is inevitably now vulnerable given that properly drafted subordination agreements are clearly enforceable.

The Judge's comment that it would have been open to the Mezzanine Lenders to take over the Senior Lenders' Debt, although legally sound, does seem commercially unrealistic. Mezzanine Lenders faced with a write-off of approximately £120 million of debt would surely not seriously consider investing approximately three times that amount in trying to preserve their position - that would be truly a case of good money after bad.

The case also ticks the box in relation to pre-pack sales by an administrator, if such were needed any longer. Following the sanction of the scheme of arrangement the proposal was that the business and assets were to be transferred to the new companies in each case by an administrator of the Oldco, which process would provide an added reassurance as to value, in that the administrator himself would have to be independently satisfied as to the valuation of the assets to be sold.

As the market begins to move and in different circumstances, mezzanine lenders may be able to provide more convincing valuation evidence that there is potential value to which they ought to have access in future restructurings. The Judge did allude to the pre-scheme negotiations, but commented that it was not his role to facilitate the bargaining between the Mezzanine and the Senior Lenders. That seems to suggest that the commercial opportunity for the Mezzanine Lenders had already been missed before the schemes of arrangement were proposed.


1 In the matter of Bluebrook Ltd and others [2009] EWHC 2114 (Ch).

2 Under Part 26 of the Companies Act 2006.

3 In re British & Commonwealth Holdings plc [1992]1 WLR 672.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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