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The Lehman Administration Surplus and the High Court Ruling in Waterfall IIC

A recent UK High Court ruling in Lehman Brothers International (Europe) (In Administration) ("Lehman Waterfall IIC") considers the application of statutory interests on proven debts in an administration and in particular the proper interpretation of "Default Rate" in the 1992 and 2002 versions of ISDA Master Agreements.


Rule 2.88 Insolvency Rule 1986 — Interest

(A1) In this Rule, "the relevant date" means the date on which the company entered administration or, if the administration was immediately preceded by a winding up, the date on which the company went into liquidation.

(1) Where a debt proved in the administration bears interest, that interest is provable as part of the debt except in so far as it is payable in respect of any period after the relevant date.

(2) In the following circumstances the creditor's claim may include interest on the debt for periods before the relevant date, although not previously reserved or agreed.

(3) If the debt is due by virtue of a written instrument and payable at a certain time, interest may be claimed for the period from that time to the relevant date.

(4) If the debt is due otherwise, interest may only be claimed if, before the relevant date, a demand for payment of the debt was made in writing by or on behalf of the creditor, and notice given that interest would be payable from the date of the demand to the date of payment.

(5) Interest under paragraph (4) may only be claimed for the period from the date of the demand to the relevant date and for all the purposes of the Act and the Rules shall be chargeable at a rate not exceeding that mentioned in paragraph (6).

(6) The rate of interest to be claimed under paragraphs (3) and (4) is the rate specified in section 17 of the Judgments Act 1838 on the relevant date.

(7) Any surplus remaining after payment of the debts proved shall, before being applied for any purpose, be applied in paying interest on those debts in respect of the periods during which they have been outstanding since the relevant date.

(8) All interest payable under paragraph (7) ranks equally whether or not the debts on which it is payable rank equally.

(9) The rate of interest payable under paragraph (7) is whichever is the greater of the rate specified under paragraph (6) and the rate applicable to the debt apart from the administration.



The High Court of Justice Chancery Division Companies Court in October 2016 delivered a judgment in the case of Lehman Brothers International (Europe) (In Administration), Re. ("Waterfall IIC"[1]). This is the third tranche of what has become known as the Waterfall II case which concerns the application of statutory interest pursuant to rule 2.88 of the Insolvency Rule 1986 ("Rule 2.88") on debts proved in the administration of Lehman Brothers International Europe ("LBIE"). Waterfall IIC deals with the particular issue of the construction and effect of pre-administration agreements in various standard form master agreements governed variously by English, New York or German law on the terms of which LBIE and its claimant counterparties undertook derivatives transactions before LBIE's insolvency. These agreements contain (amongst other things) provisions entitling a counterparty of a defaulting party (such as LBIE) to interest on amounts payable under the relevant agreements.

The principal question to be addressed in Waterfall IIC is whether under the 1992 (Multicurrency – Cross Border) and the 2002 ISDA Master Agreements (the "ISDA Master Agreements") and the German Master Agreement for Financial Derivatives Transactions (the "German Master Agreement"), LBIE's counterparty creditor is entitled to interest at a "rate applicable to the debt apart from the administration" within the meaning of Rule 2.88(9) which exceeds the rate of interest otherwise payable under Rule 2.88(7). The latter is the rate specified in section 17 of the Judgments Act 1838 (the "Judgments Act Rate"). Rule 2.88(9) provides for statutory interest under Rule 2.88(7) to be payable at the greater of: (a) the Judgments Act Rate on the date when the company entered administration and (b) the "rate applicable to the debt apart from the administration".


Key Ruling

The "Default Rate" is defined in the ISDA Master Agreements as "a rate per annum equal to the cost (without proof or evidence of any actual cost) to the relevant payee (as certified by it) if it were to fund or of funding the relevant amount plus 1% per annum."

1. "Cost of funding"

It was held in Waterfall IIC that the "cost of funding" should be certified by reference to the cost which the relevant payee is or would be required to pay in borrowing the relevant amount under a loan transaction, whether actual or hypothetical, and "cost" means the price required to be paid in return for borrowing the funds over the period they are required. Other costs and losses, such as (a) the cost of equity funding; (b) the cost of funding the relevant payee's assets; (c) the costs associated with carrying a defaulted LBIE receivable on the balance sheet; (d) the actual or asserted cost to the relevant payee of funding a claim against LBIE; or (e) any other financial detriment or consequential loss, are not included. A hybrid means of funding could be included on the condition that it was possible to segregate the interest rate element from the funding cost of another nature. The relevant payee's certification was conclusive as to its cost of funding, save if irrational or in the case of bad faith or manifest numerical or mathematical error. This could be calculated in light of hindsight, by reference to relevant circumstances, or on a fluctuating basis taking into account relevant market conditions and other relevant facts or circumstances.

2. "Relevant payee"

A second key aspect of the ruling was in relation to the definition of "relevant payee" on the true construction of the term "Default Rate". It was held that "relevant payee" referred only to LBIE's original contractual counterparty and did not extend to a third party to whom LBIE's counterparty has since transferred or assigned under Section 7 of the relevant ISDA Master Agreement its interest in any amount payable to it under Section 6(e) of the relevant ISDA Master Agreement. Justice Hildyard notes:

It turns on whether section 7 of the relevant ISDA Master Agreement permits and enables the transfer of a bundle of rights exercisable by and to be calculated according to the position of the transferee, or (more restrictively) only such rights as the transferor had calculated according to that transferor's position …[2]

The better conclusion is that section 7, in both versions of the [ISDA] Master Agreements, restricted the right of transfer to the amounts which had become payable and would become payable to the transferor as at the time immediately before the transfer, in each case measured according to the position of the transferor. Put figuratively, the transferee is entitled to the tree planted by the transferor and such fruit as had grown and would grow on it when transferred, and not to the trust of a different variety or quantity which might have grown had the transferee planted the tree.[3]

The wording in each of the versions [of the ISDA Master Agreements] … more naturally refers to amounts receivable as distinct from rights exercisable, and confines that which can be transferred to amounts which would have been payable to the transferor … the transferee cannot usually recover more than the transferor could have recovered.[4]

What is also clear from the court's language above is that the Default Rate continues to run after the point of transfer or assignment provided that the transferee would be entitled to claim the relevant amount any Default Rate applicable to such amount provided that the interest is calculated based on what the transferor could have claimed based on the transferor's cost of borrowing, not interest based on the transferee's own costs.

3. Date of administration

The words "the rate applicable to the debt apart from the administration" in Rule 2.88(9) include, in the case of a provable debt that is a close-out sum under a contract, a contractual rate of interest that began to accrue only after the close-out sum became due and payable because of action taken by the creditor after the date of administration. If a creditor had contractual rights, whether actual or contingent, which were in existence at the date of administration and those rights included a right to a particular rate of interest, then when such right was exercised, that was the rate applicable for the purposes of Rule 2.88(9). This was the case whether or not the contractual right could be described as having "accrued" before the date of administration.

4. Others

Interpretation of agreements would largely be the same under New York law. The Court also determined issues concerning (a) creditors' entitlement to compensation following automatic termination of the German Master Agreement; and (b) the effect of assigning compensation entitlement to a third party.


Waterfall I, Waterfall IIA and IIB issues

Waterfall I[5] is on its way to the Supreme Court. It was held at first instance and at the appeal level, that the surplus was to be distributed in the order of, first, statutory interest payable under Rule 2.88; secondly, non-provable claims of creditors, including claims to currency exchange losses resulting from a depreciation of sterling against the currency in which creditors' claims were payable between the commencement of the administration and the date on which dividends were paid on such claims; and thirdly, to the payment of some US$2.27 billion subordinated debt.

Waterfall II consists of three separate hearings for the three separate issues. The first part (Waterfall IIA[6]) examined the entitlement of creditors to interest on their debts for periods after commencement of the administration of LBIE. It was held by the High Court that statutory interest pursuant to Rule 2.88 accrues on all debts, including contingent and future debts, from the commencement of the administration and ceases to accrue after payment of the final dividend. The second part (Waterfall IIB[7]) is not of substantial relevance to Waterfall IIC but concerns the construction and effect of various agreements made since the commencement of the administration between LBIE acting by the administrators and very significant numbers of its creditors.


Derivatives Newsletter
January 2017

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[1] [2016] EWHC 2417 (Ch).
[2] Ibid [259].
[3] Ibid [261].
[4] Ibid [262].
[5] Reported in [2014] EWHC 704 (Ch); [2015] Ch 1; [2015] EWCA Civ 485.
[6] [2015] EWHC 2269 (Ch)
[7] [2015] EWHC 2270 (Ch)


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