Lehmans waterfall II A and B—Lomas v Burlington Loan Management Ltd; Re Lehmans Brothers International (Europe)

Lehmans waterfall II A and B—Lomas v Burlington Loan Management Ltd; Re Lehmans Brothers International (Europe)

We look at the two recent waterfall II judgments (waterfall II A and waterfall II B) in Lehmans to see what guidance the court gives on statutory interest and rule 2.88 of the Insolvency Rules 1986, SI 1986/1925 (IR 1986) and also whether various post-administration agreements entered by the administrators and creditors release claims to statutory interest and/or currency conversion claims.

Original news

Lomas v Burlington Loan Management Ltd; sub nom Re Lehman Brothers International (Europe) (in administration) [2015] EWHC 2269 (Ch), [2015] All ER (D) 11 (Aug) (Waterfall II A).

In the administration of Lehman Brothers International (Europe) (LBIE), the Chancery Division addressed the administrators' application for directions regarding the entitlement of creditors to interest on their debts for periods after the commencement of that administration. The court construed IR 1986, r 2.88 and its provisions for the payment of statutory interest.

Lomas v Burlington Loan Management Ltd; sub nom Re Lehman Brothers International (Europe) (in administration) [2015] EWHC 2270 (Ch), [2015] All ER (D) 20 (Aug) (Waterfall II B).

The Chancery Division addressed the construction and effect of agreements made since the commencement of the administration. It held that the agreements did not have the effect of releasing currency conversion claims or claims to statutory interest under IR 1986, r 2.88.

What are the key take-aways from Waterfall II A and Waterfall II B?

The key points to note from Waterfall II A are:

  • IR 1986, r 2.88 provides a complete code for the payment of post-administration interest on proved debts-there is no additional non-provable claim for further interest
  • where the statutory interest is calculated at the judgment rate (currently 8%), it is payable on a simple, not compound basis
  • when calculating the daily rate of statutory interest at the judgment rate in a leap year, the calculation should use 366 days (see para [242])
  • with statutory interest, dividends are taken as discharging the outstanding principal before the interest element (Bower v Marris (1841) 41 ER 525 does not apply)
  • the words 'rate applicable' in IR 1986, r 2.88:
    ◦ refer to the mode of calculation, so can include compound interest (and not just the numerical rate of interest)
    ◦ do not include a foreign law judgment rate, unless it has been obtained before the start of the administration
    ◦ when compared to the judgment rate, involve a comparison of the total amounts of interest payable rather than merely the numerical rates
  • statutory interest is payable on future debts and contingent debts from the date of the commencement of the administration
  • currency conversion claims (claims resulting from the depreciation of sterling against the foreign currency in which the claim was denominated in the period between the start of the administration and when dividends were paid) shouldn't take into account any statutory interest which has been paid out
  • currency conversion claims are entitled to interest at the contractual rate

The key points to note from Waterfall II B are:

  • various agreements entered into by the administrators to speed up claims resolution (the claims resolution agreement (CRA) and claims determination deeds (CDD)) did not release currency conversion claims nor statutory interest claims
  • these agreements did not, of themselves, create any currency conversion claims
  • even if the CRA or CDDs did release the currency conversion claims, the court would have directed the administrators under Ex parte James (1874) LR 9 Ch. App. 609, [1987-80] All ER Rep 3 (or alternatively under para 74 of Sch B1 to the Insolvency Act 1986 (IA 1986)) not to enforce such releases

How did the issues arise?

The issues arise because of the relatively unusual fact that a substantial surplus (of around £7.99bn) remains after the administrators have paid all the proved debts against LBIE in full (ie admitted claims have all received a 100% dividend).

It was not disputed that statutory interest is payable out of the surplus for the period since the commencement of the administration on 15 September 2008 and that payment is governed by IR 1986, r 2.88. The judgment rate of 8% far exceeds recent market rates and certain creditors were potentially entitled to a substantial amount of interest. The unsecured creditors (respondents 1-3) generally ran arguments to try to maximise the interest payable under IR 1986, r 2.88 and argued that the post-administration agreements didn't release such claims. In contrast, the subordinated creditors (the fourth respondent, Wentworth, which ranks after all interest and non-provable claims) generally ran arguments seeking to minimise the value of statutory interest and currency conversion claims and argued that they were released by the post-administration agreements.

On 31 July 2015, Mr Justice David Richards handed down two separate judgments in the Lehmans Waterfall II case (note that the Court of Appeal has previously considered other issues concerning the treatment of the surplus in the Waterfall I case) . Given the number of complex issues involved, Richards J divided the hearing of the Waterfall II application into three parts:

  • Waterfall II A—concerning interest on proved debts
  • Waterfall II B—concerning the effect of post-administration agreements (the CRA and CDDs)
  • Waterfall II C (to be heard later in 2015)—concerning the effect of pre-administration International Swaps and Derivatives Association (ISDA) and other market standard contracts governed by German and French law

What were the main findings in Lehmans Waterfall II A?

What did the judge decide on IR 1986, r 2.88 (payment of post-administration interest)?

Richards J said the purpose of IR 1986, r 2.88 (as set out in the Cork Report) was to introduce a uniform regime for interest in all insolvency proceedings, including interest for periods after the commencement of the insolvency proceedings. By the time of the hearing, the parties had agreed various issues:

  • where the applicable rate under IR 1986, r 2.88(7) is the judgment rate, interest is payable on a simple basis (not compound basis) (see [para 18])
  • the words 'rate applicable' in IR 1986, r 2.88(9) refer not only to a numerical percentage of interest but also the mode of calculating the rate, including the compounding of interest—the expression is meaningless if expressed only as a number without taking into account the period to which that number applies (the contrary position would produce results that cannot have been intended—debt carrying interest at 10% pa would entitle the creditor to a larger interest payment than a debt carrying interest at 8% pa compounded quarterly) (see paras [20-26])
  • it follows that when establishing which is the greater of two rates under IR 1986, r 2.88(9), the comparison is to be made between the total amounts payable based on each method of calculation rather than between only the numerical rates themselves (note that where a proved debt comprises of two or more separate debts and a contractual rate is applicable to some but not others, the composite debt should be broken up into its constituent parts and the appropriate rate of interest paid on each part) (see paras [28-29])

Does Bower v Marris apply?

As regards allocation of the dividends, the question was whether any dividends paid by the administrators should notionally be treated as paying off interest or the principal first. Richards J found that the rule in Bower v Marris (which would notionally attribute the dividends to payment of interest first and then principal) does not apply to the calculation of post-administration interest under IR 1986, r 2.88. In practice, this meant that statutory interest only amounted to £5.1bn (rather than £6.4bn as argued by the unsecured creditors). The principle is incompatible with the regime established by IR 1986, r 2.88. The 1986 insolvency legislation was a new code and the provisions are not to be construed as if the previous law still applied.

The right to interest out of a surplus under IR 1986, r 2.88 is not a right to the payment of interest accruing due from time to time during the period between the commencement of the administration and the payment of the dividend or dividends on the proved debts. The dividends cannot be appropriated between the proved debts and interest accruing due under IR 1986, r 2.88, because at the date of the dividends no interest was payable at that time pursuant to IR 1986, r 2.88—the entitlement is a purely statutory entitlement, arising once there is a surplus and payable only out of that surplus. It is a fundamental feature of IR 1986, r 2.88—and a primary recommendation of the Cork Committee—that all creditors should be entitled to receive interest out of surplus in respect of the periods before payment of dividends on their proved debts, irrespective of whether, apart from the insolvency process, those debts would carry interest.

The purpose of the new regime was to introduce a straightforward regime for the payment of such interest. The regime acknowledges that creditors will not be paid their proved debts in full for a period, which may well be an extended period, after the commencement of the insolvency process. Once their proved debts have been paid in full, and there is a surplus available, they will receive interest on those proved debts for the periods commencing with the start of the administration while they were outstanding (see paras [30-154]).

Compensation for delay in paying statutory interest?

Richards J rejected the unsecured creditors' arguments that creditors who were entitled to statutory interest should also be entitled to compensation for any delay in receiving that compensation.

Here, although the last dividend was paid to creditors with provable debts in April 2014, no statutory interest had been paid. Again, Richards J said that IR 1986, r 2.88 represents a complete code for the payment of post-administration interest. The new approach introduced by the 1986 legislation for post-liquidation interest was intended to replace the previous law. IR 1986, r 2.88 is not a partial measure for dealing with post-insolvency interest. If it was only a partial measure, why provide that interest is payable at the rate applicable apart from the administration, if higher than judgment rate? If the unsecured creditors had been right, the effect of the legislation would be to prescribe one regime for the payment of interest as a first charge out of the surplus remaining after the payment of proved debts in full, leaving without any explicit recognition the possibility of the payment of further post-insolvency interest as a non-provable debt out of the surplus remaining after the satisfaction of creditors' rights to statutory interest. That cannot have been the intention (see paras [155-170]).

Compensation for delay in paying currency conversion claim?

The currency conversion claims were significant (worth around £1.3bn) as LBIE's liabilities were largely incurred in US dollars, but sterling depreciated significantly against the dollar between the date of administration and when dividends were paid to creditors with proved claims.

Richards J decided that currency conversion claims raised rather different issues to claims for statutory interest. He agreed with the unsecured creditors that because currency conversion claims are non-provable debts, IR 1986, r 2.88 does not apply—rather the underlying terms of the contract apply and if they provide for interest, that can form part of the creditor's non-provable claim (see paras [168–169]).

Does statutory interest affect a currency conversion claim?

This issue arose where a payment of interest in sterling is converted (at the exchange rate on the day of payment) and results in a higher amount than the currency conversion claim itself. For example:

  •  a creditor is contractually entitled to receive $1m
  • it receives dividends in sterling equivalent to $900,000, leaving an outstanding debt of $100,000

Richards J found that the payment of statutory interest on the claim as converted into sterling does not discharge/set-off the unpaid currency conversion claim—ie currency conversion claims should not be reduced to reflect the fact that statutory interest is paid out at a rate higher than the contractual rate. As before, Richards J held that the holder of a currency conversion claim (which is a debt claim, not a damages claim) has separate claims for the payment of the principal and the interest (see paras [226–231]).

Dates for calculating interest on contingent/future debts

Richards J found in favour of the unsecured creditors that statutory interest on contingent or future debts accrues from the date of administration (rather than when the contingency occurs or the date when the future debt is due) on the basis that:

  • IR 1986 says that future and contingent debts are debts for the purposes of proof and distribution
  • all debts rank pari passu for the purposes of dividends (IR 1986, r 2.69)
  • a single date is essential for a pari passu distribution and IR 1986, r 2.88(7) specifies this date is the start of the administration (note that subsequent events can still be taken into account through the hindsight principle)
  • the words 'on those debts' means claims which have been admitted, because the surplus only arises after the admitted and proved debts have been paid

See paras [184-225].

What were the main findings in Lehmans Waterfall II B?

Did the CRA/CDDs release currency conversion claims and/or statutory interest claims?

The CRA and CDDs were entered into between the administrators and certain creditors to accelerate and simplify the ascertainment of thousands of trust claims and unsecured claims. The CRA facilitated the return of trust assets and was signed by 90% of eligible claimants. The CDDs were bilateral agreements to simplify calculation of unsecured claims and were signed by around 1,290 counterparties. Both contained clauses which the subordinated creditors (Wentworth) argued released any statutory interest claims and currency conversion claims.

The parties sought to draw a distinction between:

  • agreed claims CDDs—where the agreed claim amount was expressed in the currency or principal currency of the creditor's claims against LBIE (ie a foreign currency), and
  • admitted claims CDDs—where the agreed claim amount was invariably expressed in sterling

Wentworth submitted that creditors who entered into admitted claims CDDs released their currency conversion claims in respect of their admitted claims.

However, Richards J agreed with the unsecured creditors that the CRA/CDDs (both agreed claims CDDs and admitted claims CDDs) did not release these rights and applied Rainy Sky v Kookmin Bank , [2011] UKSC 50, [2012] 1 All ER 1137 to focus on their purpose and context rather than their strict literal terms. He noted the special role of the administrators (and the purpose of the administration to achieve a better result than liquidation for creditors as a whole) and that it was not a normal commercial context, ie not a contract negotiated between parties with competing interests. If releases were intended, he would have expected to see references made in the circular or accompanying documents to the CRA/CDDs, or clear wording in the CRA/CDDs themselves (see paras [114-135, 146-154, 162-170]).

However, if non-provable claims for interest existed, it would be difficult to argue that such claims survived the express release in the CDDs (see para [147]).

Did the CRA itself create a currency conversion claim?

The CRA itself did not create a currency conversion claim.

The unsecured creditors argued that the effect of the CRA is to substitute for the signatories' existing claims a new obligation on LBIE, including the right to be paid the ascertained claim, which had to be denominated in US dollars. An ascertained claim was defined as an unsecured claim in the winding-up of LBIE or in any distribution of its assets generally to its unsecured creditors and accordingly signatories had a right to the payment of a sum in US dollars which, for the purposes of proof, would be converted into sterling pursuant to IR 1986, r 2.86. It follows from the decision in Waterfall I that the signatories would have a non-provable currency conversion claim in respect of the exchange losses resulting from the depreciation of sterling against US dollars between 15 September 2008 and the dates of payment of distributions on the ascertained claims, even if their underlying contractual claims were in a different foreign currency. The effect, therefore, is to substitute a currency conversion claim based on a claim in US dollars for a currency conversion claim based on a contractual claim in, say, Japanese yen.

However, Richards J rejected this argument as it conflicts with the statutory regime applicable to distributions among creditors. One of the fundamental features of a distribution among the creditors of a company in administration is that it is made ratably in accordance with their admitted claims as at the date on which the company entered administration. The choice of a single date as at which to ascertain and value or estimate the claims of creditors is essential to a pari passu distribution (see Wight v Eckhardt Marine GmbH, [2003] UKPC 37, [2003] All ER (D) 185 (May)).

Clearly the CRA does not provide for a new obligation, it compromises existing claims.

It is not open to an administrator to agree that a debt which was incurred or payable in one currency should be payable in another currency. History cannot be rewritten. Similarly, the administrator could not agree that a debt incurred or payable at the date of administration in sterling should be for all purposes a debt incurred or payable in a foreign currency, thereby giving rise to a potential currency conversion claim in the event of a depreciation of sterling against the US dollar following the commencement of the administration. The unsecured creditors' arguments cannot therefore be accepted—it would give all creditors whose debts were denominated in a currency other than the US dollar a potential currency conversion claim by reference to the depreciation of sterling against the US dollar after 15 September 2008 (see paras [118-127]).

If the CRA/CDDs had released currency conversion claims, does Ex parte James apply?

Although Richards J didn't need to answer this point given his previous conclusions, he did give a view (obiter) given the extensive argument during trial.

Richards J found in favour of the unsecured creditors that even if he had found that the CRA/CDDs had released the statutory interest claims and currency conversion claims, he would have exercised the court's discretion under Ex parte James (or alternately under IA 1986, Sch B1, para 74) to direct the administrators not to enforce such release against the creditors/trust claimants. Given the context of the CRA/CDDs and the administrators' duties to act in the interests of the general body of creditors, it would have been grossly unfair to enforce any such releases.

These agreements were not ordinary commercial bilateral agreements, but were made by the administrators in pursuance of their statutory duty to act in the interests of the creditors as a whole, many of whom were of course the counterparties to these agreements. The release of currency conversion claims was entirely irrelevant to the purposes for which the CRA and the CDDs were proposed. The release of currency conversion claims would be an entirely unintended effect of these agreements. If the administrators had considered that the CRA and the CDDs could have this effect, they would have drawn attention to it in the circular which accompanied the CRA and in their website postings concerning the CDDs.

Above all, the enforcement of any releases of currency conversion claims would involve significant and unintended discrimination between different creditors for no reason in any way connected with the purposes of the administration or the best interests of the creditors as a whole. There would be further discrimination between those creditors entering CDDs which made it clear that currency conversion claims were not waived and those entering CDDs without such terms (see paras [171-189]).

What are the practical implications for claimants?

The Waterfall II A judgment contains some very useful guidance on the treatment of surplus and statutory interest. Although it is fairly unusual to have any surplus in an insolvency—let alone a substantial surplus—the guidance is welcome on these issues.

Although Waterfall II B is fairly fact-specific considering the interpretation of bespoke agreements entered into by the administrators, it still provides useful pragmatic guidance for insolvency practitioners dealing with large scale insolvencies when considering whether to adopt similar mechanisms to simplify large-scale claims resolution.

Overall, both judgments largely found in favour of the arguments run by the unsecured creditors, rather than the subordinated creditors. However, given the amounts at stake here, it will be interesting to see whether either judgment is appealed and also what guidance will be given later this year in Waterfall II C on the effect of pre-administration ISDA and other market standard contracts.

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

Further Reading

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First published on LexisPSL Restructuring and Insolvency

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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.