Full reasoned judgment in Lehmans waterfall case

Full reasoned judgment in Lehmans waterfall case
  What's the reasoning behind the decision in Lehmans on the ranking of creditors and shareholders/members claims where there is a surplus of monies available for distribution? What obligations do members have to contribute to the assets of the company?


Original news

Re Lehman Brothers International (Europe) (in administration) [2014] EWHC 704 (Ch), [2014] All ER (D) 153 (Mar)

In the course of proceedings concerning the administration of companies connected to the Lehman Brothers group, the Companies Court made a number of rulings to determine the claims that might be made against a surplus of assets before any return to the creditors.

What did the court decide?

David Richards J gave a full reasoned judgment following his earlier statement of conclusions (see News Analysis: Lehmans waterfall decision):

  • LBIE's members (two other Lehman group companies, LBHI2 and LBL) have a very wide obligation to contribute on liquidation under the Insolvency Act 1986, s 74(1) (IA 1986) as LBIE is an unlimited company. He found it impossible to discern the policy reason for saying that members are liable to contribute assets for the payment of the principal amount of provable debts, but are not liable for the interest on those debts which is payable to compensate the creditors for being kept out of their money until a distribution is made in the liquidation (para [163]). Accordingly, the members must contribute to:
  1. proved debts
  2. statutory interest on the proved debts
  3. un-proved liabilities
  • the (i) contributory rule (that a contributory/member can't recover anything until he has fully paid any obligations as contributory) and (ii) equitable rule in Cherry v Boultbee (which produces a netting-off effect that is similar to set-off and applies in circumstances where set-off itself is not applicable, because there is not the necessary similarity in claims) do not apply in administration (only liquidation). The fundamental difficulty in applying the contributory rule in an administration is precisely because there is no statutory mechanism for making calls on contributories in an administration. If it was contemplated or intended that the contributory rule should apply in a distributing administration, either administrators would have been given the same power to make calls as liquidators or provisions would have been spelt out in the legislation (para [188])
  • LBIE can lodge a proof of claim in the distributing administration or liquidation of either of its members, LBL or LBHI2 claiming those contingent liabilities under IA 1986, s 74(1) which may arise if LBIE went into liquidation, however the mandatory rules of set off would apply. It is clear that the contingent liability of a member to pay calls which may be made in a future winding up of the company satisfies the general characteristics necessary for a provable debt (para [196])
  • creditors (whose contractual or other claims are denominated in a foreign currency) which suffered a loss due to currency movements between the date of commencement of the administration and the date of payment can claim that loss, but only as an unprovable debt (payable after all proved debts and statutory interest). It would be contrary to principle and justice that the debtor, or the members receiving the surplus, should be able to deny the foreign currency claimants their full contractual rights (para [110])
  • if the administration of LBIE is immediately followed by a liquidation, interest falling in the period of the administration which has not been paid before the liquidation commences will not be provable as a debt in the liquidation nor as statutory interest. However, creditors whose contracts/judgments specify an interest rate (often higher than the statutory interest rate of 8%) may claim in any subsequent liquidation of LBIE for the interest accruing during the administration as an un-provable claim (payable after all proved debts and statutory interest)
  • the intercompany debt between LBIE and one of its members, LBHI2, is deeply subordinated under the subordinated loan agreement not only to provable debts, but also statutory interest and unprovable debts (LBHI2 filed a proof of debt for £1.29bn). Richards J noted that the subordinated facility agreements are largely based on templates provided by the Financial Services Authority (as it then was) and the subordination and other provisions contained in the standard terms were not tailor-made to LBIE or the particular facilities into which it entered but are generally applicable to all subordinated loans which are relied on by institutions to meet their capital adequacy requirements (para [60]). This is consistent with the concept that subordinated loan capital qualifying as part of the institution's regulatory capital is, as against creditors, to be treated as part of the capital of the institution. It is not of course part of the share capital of the company and it ranks ahead of any share capital in terms of repayment (para [63])

How did the problem arise?

LBIE is (rather unusually) a private unlimited company and was the UK subsidiary of Lehman Brothers Holdings Inc (the ultimate parent of the Lehman group). It acted as its main European broker dealer and was placed into administration on 15 September 2008.

The issue arises due to the fairly unusual fact that a surplus is likely to be available after payment of LBIE's creditors in full. LBIE's members (LBL and LBHI2) and LBIE have sought clarification on whether this surplus is payable to the members and where their claims rank in the waterfall of payments.

This ranking will have a large effect on the amount of principal and interest unsecured creditors of LBIE will obtain as LBL and LBHI2 have claimed substantial amounts against LBIE as an unsecured creditor (£1.29bn and £0.36bn respectively).

Generally, the Insolvency Rules 1986, SI 1986/1925, r 2.88 allows creditors to claim interest at the statutory rate (8%—at the time, this was substantially in excess of market rates and explains why unsecured debt claims were trading at a premium) for the period when the debt is outstanding. However, if the underlying contract contains a higher rate of interest, that higher rate may be claimed. Richards J explained that the policy behind statutory interest is to compensate creditors for the delay in payment to them of their debts on account of the insolvency process, even where they had no contractual or other legal right to interest. If it were not for the insolvency process, creditors would be entitled to seek to enforce their debts against the debtor company and its property (para [86]).

The situation here was complicated by several factors, including:

  1. many claims being based on ISDA master agreements which typically specified the interest rate as the counterparty's cost of fund plus 1% per annum
  2. the question of from what date the creditors claim for post-administration should be calculated:
  • the date of termination under the close-out netting provisions (termination date)? or
  • the date on which the net amount was determined and notified to LBIE (notification date)? or
  • the date of administration?

What's the impact on distributions to unsecured creditors?

On 28 February 2014, LBIE's administrators announced their intention to make a further interim distribution on 30 April 2014 at a dividend rate of 7.8 pence in the pound to unsecured creditors, taking the total cumulative dividend rate declared and paid to 100 pence (see Press release from LBIE's administrators).

LBIE's administrators also announced that further distributions are unlikely to be made until creditors’ rights to the surplus beyond 100 pence are resolved. This includes issues relating to the waterfall application and is likely to require compromise among creditors and/or further litigation to achieve this. The administrators indicated in their report (see LBIE administrators' 10th progress report) that the interest resolution mechanism may be implemented by a company voluntary arrangement (CVA) or scheme or other consensual solution, to help accelerate payment and reduce the administrative burden and associated costs.

They are also continuing to review taxation matters, principally US withholding tax, and this may reduce or delay the interim dividends paid to certain creditors.

What does this mean in practice?

Applying these principles (which were previously set out in Re Nortel GmbH), the waterfall of payments in a liquidation or administration (where there is no question of trying to save the company or its business) is:

  1. fixed charge creditors
  2. expenses of the insolvency proceedings
  3. preferential creditors
  4. prescribed part creditors
  5. floating charge creditors
  6. unsecured provable debts
  7. statutory interest on provable debts
  8. unprovable debts (eg currency claims)
  9. subordinated claim of LBHI2
  10. shareholders/members

This decision is good news for ordinary unsecured creditors of LBIE as their recoveries will not be diluted by the considerable claims of LBHI2 and LBL. This is also a stark warning to members of unlimited companies that they may be liable to contribute not only to the subsidiary's proved debts on a liquidation, but also to statutory interest and un-provable liabilities.

If you are a LexisPSL Subscriber, click the links below for further information:

 Waterfall of payments in liquidation, administration and administrative receivership (Subscriber access only)

Lehmans—case calendar (for hearings across the globe) (Subscriber access only)

 Not a subscriber? Find out more about how LexisPSL can help you.

Kathy Stones, solicitor in the Lexis®PSL Restructuring & Insolvency team.

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