Interpreting the main provisions in ISDA Master Agreements (Waterfall IIC)

Christopher Robinson, partner at Freshfields Bruckhaus Deringer LLP, assesses the key takeaways from the judgment in the Lehman ‘Waterfall’ litigation, which addresses the interpretation of the main provisions in the ISDA Master Agreements concerning interest on sums due following the close-out of transactions upon early termination.

Original news

Re Lehman Brothers International (Europe) Lomas and others v Burlington Loan Management Ltd and other [2016] EWHC 2417 (Ch), [2016] All ER (D) 40 (Oct)

The Companies Court ruled on a number of issues concerning the application of statutory interest, under rule 2.88 of the Insolvency Rules 1986, SI 1986/1925, on debts proved in the administration of Lehman Brothers International (Europe) (LBIE).

What are the key takeaways from the Waterfall IIC case?

Subject to any appeal, the case provides important guidance on legal issues relating to default interest under the ISDA Master Agreement (and certain other agreements), although it does not address the facts of individual claims for default interest.

The ISDA Master Agreement provides that, when a party to an ISDA Master Agreement defaults on a payment obligation, the person to whom the payment is due (known as the ‘relevant payee’) is entitled to interest at the ‘default rate’ on the amount of that payment. The default rate is defined (in summary) as the rate the relevant payee certifies to be the cost to it if it were to fund or of funding the amount of the payment, plus 1% per annum.

The case provides guidance on the way in which a default rate can be calculated by a relevant payee in accordance with this contractual definition.

There are three key takeaways from the decision.

First, the judge decided that cost of funding is to be determined by reference to the cost which the relevant payee is, or would be, required to pay in borrowing the amount in question under a loan transaction. The non-defaulting party cannot calculate interest by reference to his cost of equity funding.

However, the case leaves the non-defaulting party significant discretion (subject to the constraints of rationality and good faith) in calculating their borrowing rate. The borrowing rate can be an actual rate, where the relevant payee has in fact borrowed the amount due to it, or a hypothetical borrowing rate. Overnight or term funding may, depending on the facts, be used to calculate the borrowing rate. The borrowing rate need not be the lowest borrowing rate available to the relevant payee, although the judge held it must not ‘exceed that which the borrower knows to be or which could be available to it in the circumstances pertaining to its business, having regard to the permitted object of the borrowing’.

Second, the judge decided that the ‘cost of funding’ relevant to the determination of default interest under the ISDA Master Agreement is the cost of funding of the non-defaulting party at the time of default. Although the ISDA Master Agreement permits the assignment of claims to third parties following a default, the judge rejected the argument that a person who obtained a claim from a non-defaulting party could claim his own cost of funding from the defaulting party.

Third, the judgment illustrates the highly fact-sensitive nature of claims for default interest under the ISDA Master Agreement. Although the judgment contains extensive guidance on legal issues, it recognises the importance of factual issues in determining the default rate that can properly be certified. For example, the judge recognised that in some factual circumstances it might be possible to identify a borrowing cost in the cost of funding associated with an instrument with debt and equity characteristics (such as a convertible bond).

How did the issues arise?

The issues arose in the administration of LBIE, which commenced in September 2008.

Although the process of paying the principal of LBIE’s proved debts was completed in 2014, creditors have still not received any interest in respect of the delay in paying those debts. Under the UK Insolvency Rules 1986they are entitled to interest at the greater of 8% and the ‘rate applicable to the debt apart from the administration’. The latter includes default rate interest under ISDA Master Agreements. Many of LBIE’s creditors have claims under ISDA Master Agreements, and are entitled to default rate interest.

The administrators of LBIE therefore sought guidance from the court on certain legal issues relating to the ISDA Master Agreement Default Rate, to assist them begin quantifying the interest due to creditors.

What are the practical implications for IPs dealing with claims for statutory interest under ISDA Master Agreements?

Subject to any appeal, the case provides guidance that may, in some circumstances, make clear that claims can be rejected. This could be the case, for example, where they are clearly asserted on the basis of a cost of purely equity funding. In other situations, the case will provide comfort that claims should be paid, because they are framed in a way that clearly accords with the guidance.

However, the case does not address every factual scenario relating to the calculation of default interest, given that it is concerned with issues of legal principle. In many situations the position may therefore be unclear. In such circumstances the officeholder may consider it appropriate to agree a reasonable rate with the creditor by way of compromise. In other cases, the officeholder may consider that the only appropriate course is to issue proceedings in order to have the rate in the relevant factual circumstances determined by the court, so that the officeholder has an answer on the facts of the case (and potentially other similar factual cases).

Interviewed by Susan Ghaiwal.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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