Lehmans waterfall decision

Lehmans waterfall decision

Does the recent decision in Lehmans clarify the ranking of creditors and shareholders' claims (ie waterfall of payments) where there is a surplus of monies available for distribution?

In the matter of Lehman Brothers International (Europe) (in administration) (LBIE) and Lehman Brothers Limited (in administration) (LBL) and LB Holdings Intermediate 2 Limited (in administration) (LBHI2) Mr Justice David Richards announced on 21 February 2014 his decision in the Lehman waterfall application, which addressed a number of issues arising from the likelihood of a surplus in the estate of Lehman Brothers International (Europe) after payment of all proved debts.

What did the court decide?

David Richards J has issued a statement of conclusions stating that:

• LBIE's shareholders (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—the shareholders must contribute to:
◦ proved debts
◦ statutory interest on the proved debts
◦ un-proved liabilities
• the (i) contributory rule (that a contributory can't recover anything until he has fully paid any obligations as contributory) and (ii) equitable rule in Cherry v Boultbee do not apply in administration (only liquidation)

• LBIE can lodge a proof of claim in the distributing administration or liquidation of either of its shareholders, 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

• 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)

• 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 shareholders, 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)

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 shareholders (LBL and LBHI2) and LBIE have sought clarification on whether this surplus is payable to the shareholders 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%) 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.

The situation here was complicated by several factors, including:
• 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
• the question of the date from which the creditors claim for post-administration should be calculated—is it:
◦ 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 happens next?
The full reasoned judgment of David Richards J on this waterfall application is expected in late March (see the LBIE administrators' press release and the LBIE Statement of Conclusions).

The administrators indicated in their latest report that they planned to model various scenarios to develop a post-administration interest resolution mechanism in consultation with the creditors' committee and counterparties. LBIE's administrators also indicated 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.

According to the administrator's 10th report, the next interim distribution for unsecured creditors is expected to be on or around 28 February 2014.

What does this mean in practice?
Applying these principles, the waterfall of payments would be:
• provable debts
• statutory interest on provable debts
• unprovable debts (eg currency claims)
• subordinated claim of LBHI2
This decision is good news for ordinary unsecured creditors of LBIE as their recoveries should not now be diluted by the considerable shareholder claims of LBHI2 and LBL. This is also a stark warning to shareholders 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.

For further details, see Practice Notes: Waterfall of payments in liquidation, administration and administrative receivership and Lehmans—case calendar (for hearings across the globe).

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About the author:
Kathy specialises in restructuring and cross-border insolvency. She qualified as a solicitor in 1995 and has since worked for Weil Gotshal & Manges and Freshfields. Kathy has worked on some of the largest restructuring cases in the last decade, including Worldcom, Parmalat, Enron and Eurotunnel.