On 31 July 2015, the English High Court delivered its judgments in the ‘Waterfall IIA’ and ‘Waterfall IIB’ cases. The decisions are important to stakeholders in determining key questions about how, following payment in 2014 of all the provable claims, the estimated £7.39-billion surplus (the ‘Surplus’) in Lehman Brothers International (Europe) (in administration) (‘LBIE’) will be shared amongst them. For others, the decisions may be of general interest in probing some rarely aired legal issues relating to the lower levels of the insolvency payment waterfall. The parties to the cases included certain senior creditors of LBIE (the ‘Senior Creditor Group’ or ‘SCG’) and the subordinated creditors (‘Wentworth’).1 This Alert first examines some of the details that the court addressed in the decisions and then briefly lists the decisions.
Waterfall IIA and Waterfall IIB followed the Court of Appeal’s decision in ‘Waterfall I’ ( EWCA Civ 485, 14 May 2015), which determined that the broad distribution of payment of the Surplus should be sequentially as follows:
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- SRZ represents one of the members of the Senior Creditor Group.
- The right of an unsecured creditor to Statutory Interest arises under Insolvency Rule 2.88(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 company entered administration.
The rate of Statutory Interest is set out in Insolvency Rule 2.88(9):
The rate of interest payable under IR.2.88(7) is whichever is the greater of the rate specified in [Section 17 of the Judgments Act 1838 on the date when the company entered administration] or the rate applicable to the debt apart from the administration.
- A currency exchange loss is a claim resulting from a depreciation of sterling against the currency in which creditors’ contractual claims were payable between the commencement of the administration and the date on which dividends were paid on such claims.
Waterfall IIA concerned the meaning of Statutory Interest and CCC. Waterfall IIB concerned whether certain post administration agreements resulted in Statutory Interest or CCC being released or waived. Given their ranking in the waterfall, the SCGs made submissions the effects of which were:
- To favour maximising the value of Statutory Interest and CCC; and
- To result in a determination that the post administration agreements did not release such claims.
Wentworth argued the opposite.
The court thus addressed the following questions.
- Should interest under Insolvency Rule 2.88(7) be calculated on the basis of allocating dividends:
- first to the payment of accrued Statutory Interest at the date of the dividends and then in reduction of principal (‘Method A’); or (2) first to reduction of the principal and then to payment of accrued interest (‘Method B’)?
Putting this question into economic context, if Method A were held to apply, Statutory Interest would amount to £6.4 billion, whereas if Method B were held to apply, the Statutory Interest would only amount to £5.1 billion.
The SCG, in arguing for Method A, pointed to a principle of general application known as the ‘rule in Bower v. Marris’ (Bower v. Marris (1841) Cr&P 351, 41 ER 525). Bower v. Marris describes an equitable principle (applicable by extension in administration of insolvent estates) that amounts applied by a debtor to a creditor are applied first to payment of interest, and then to repayment of principal.
Whilst the court accepted this as a rule of general application and said that there were ‘powerful’ reasons to accept its application in the context of Insolvency Rule 2.88(7), it ultimately accepted Wentworth’s submission that the various provisions relating to Statutory Interest in the Insolvency Act 1986 pointed to the introduction of a ‘complete code’ for calculation and payment of Statutory Interest which was irreconcilable with Bower v. Marris.
It is yet to be seen whether, if this decision is appealed, the Court of Appeal may be able to reconcile the two, particularly in light of its decision in Waterfall I upholding the existence of CCCs as a non-provable claim, existing outside the framework of the Insolvency Act 1986.
- Is a creditor that is entitled to Statutory Interest due compensation for the time taken in discharging that claim, and if so, what form should the compensation take?
This question arose because the last dividend paid in discharge of provable debts was in April 2014, but as yet, no Statutory Interest has been paid. The starting point for the SCG’s submission was the general philosophy of insolvency law that no person should be prejudiced by the delay which, in consequence of the insolvency process, takes place in realising assets. The natural consequence of this principle, so argued the SCG, is that, where sums paid to a creditor
pursuant to the insolvency process have not satisfied its claims in full, it has a non-provable claim for the shortfall. However, consistently with his decision on the first point, that a creditor’s right to Statutory Interest is exhaustively stated in Insolvency Rules 2.88(7)-(9), the judge held in Wentworth’s favour, finding that there is no room for such a claim.
- Is a creditor that is entitled to a CCC also entitled to any form of compensation for the time taken to discharge such claim?
In contrast to his decision in respect of point 2 above, the judge reasoned that this question raised ‘rather different issues’. The judge agreed with the SCG that this is because a CCC is a non-provable debt and therefore Insolvency Rule 2.88 (which applies to payment of interest on proved debts) does not apply. Thus, in answering this question, the court determined that the underlying terms of the contract must be applied — if the contract provides for interest on any unpaid part of the debt, interest will form part of a creditor’s non-provable claim.
This decision follows naturally from the technical reasoning of the Court of Appeal in Waterfall I.
- Must a creditor entitled to a CCC set-off against his CCC claim any amounts received by way of Statutory Interest?
This question arises where a payment of interest in sterling (referable to the Statutory Interest accruing on the provable part of the claim from which the CCC derives) which, when converted at the prevailing rate of exchange on the day of payment, produces a higher amount than the CCC itself. The court gave an example as follows: If the contractual right of the creditor was to receive US $1 million on a particular date, and it received dividends equivalent to US $900,000, then there remains outstanding a debt of US $100,000. In such circumstances, the question put to the court was whether that payment of Statutory Interest on the claim as converted into sterling goes towards discharging the unpaid CCC. The court held in favour of the SCG that no discharge or set-off is merited.
Consistently with its approach to the previous question, the court reasoned that the creditor of a CCC claim (which the court held is a claim for payment of the unpaid portion of the debt (not a claim for damages)) has separate claims for payment of the principal component and the interest component.
- Does a contingent debt or a future debt accrue interest from the date of administration or, in the case of a contingent debt, on the occurrence of the contingency or, in the case of a future debt, on the date falling for payment?
In holding in favour of the SCGs — that Statutory Interest on contingent or future debts should accrue from the date of administration — the judge looked at the Insolvency Rules for clues to his answer. In doing so, he observed as follows:
- The Insolvency Rules provide that future and contingent debts are ‘debts’ for the purposes of proof and distribution.
- All debts rank pari passu for the purposes of dividends (Insolvency Rule 2.69).
- A single date for the ascertainment of claims, even though account may be taken of subsequent events through the hindsight principle, is essential for a pari passu distribution. The date chosen by the Insolvency Rules is the commencement of administration.
- Insolvency Rule 2.88(7) provides that interest is to be paid ‘on those debts’ in respect of the periods during which they have been ‘outstanding’ since the company entered administration.
- ‘On those debts’ must refer to the debts as admitted to proof. This is because the surplus to which Insolvency Rule 2.88(7) refers can only arise after the admitted and proved debts have been paid.
- The judge referred to other anomalies that would arise if a different construction was given.
- Does the CRA or any CDD release in whole or in part claims to Statutory Interest or CCC?
In the administrators’ efforts to accelerate and simplify the ascertainment of claims made by thousands of entities to trust property and by way of unsecured claims, and to accelerate the return of trust property to trust claimants and the payment of distributions to unsecured creditors, the administrators developed certain agreements (the ‘post administration agreements’).
These post administration agreements comprised essentially two different forms of agreement:
- The Claims Resolution Agreement (the ‘CRA’). The CRA ascertained and facilitated the return of trust assets. In excess of 90 percent in value of eligible claimants became a party to the CRA.
- Claims Determination Deeds (the ‘CDDs’). CDDs calculated (pursuant to LBIE’s simpler house calculations) creditors’ quantification of, and facilitated the distribution of payments for, unsecured claims. CDDs were bilateral agreements in largely standard form. In excess of 4,000 unsecured creditors entered into CDDs.
Each of the CRA and the various forms of CDD contained extensively drafted release clauses which, on their face, could be argued to have released the signatories’ claims to Statutory Interest and CCCs.
However, in arriving at his decision, in favour of the SCG, that neither the CRA nor the CDDs released any such rights, the judge focused less on the literal terms of the post administration agreements, and more on the purpose and context in which they were entered into. In doing so, the judge relied on well-settled decisions on contractual construction such as Rainy Sky SA v. Kookmin Bank  1 WLR 2900:
… [T]he exercise of construction is essentially one unitary exercise in which the court must consider the language used and ascertain what a reasonable person, that is a
person who has all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract, would have understood the parties to have meant. In doing so, the court must have regard to all the relevant surrounding circumstances. If there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense and to reject the other.
When examining the purpose of the post administration agreements, the judge referred to the administrators’ aim in simplifying and accelerating the claims process. He held that a release or modification of rights to Statutory Interest or CCC was ‘wholly irrelevant’ to the achievement of this purpose.
In looking at the context in which they were made, he observed that they were not that of an ordinary commercial context (i.e. of a contract being negotiated between parties with competing interests). Rather, the court referred to the special role of the administrators and their duty of performing their functions so as to achieve a better result for the creditors as a whole. He also noted that in none of the explanatory memoranda or recitals to the post administration agreements were references to such releases made. The decision is to be welcomed for its common sense approach.
- If, as a matter of construction, the CRA or CDDs were to have been determined to have had the effect of releasing CCCs, would the court have directed the administrators not to enforce such releases?
Given the court’s answer to the first question, there was no need to determine this question. However, because of the length of argument at the trial on the point, the judge did canvas and decide on the issue.
The judge gave a resounding decision in favour of the SCG that, had he held differently on the substantive construction questions, he would have exercised the court’s discretion under the principle known as the ‘rule in Ex parte James’ (Ex parte James (1874) LR 9 Ch App 609) or under paragraph 74 of Schedule B1 to the Insolvency Act 1986 to have directed the administrators not to enforce such rights against creditors or trust claimants. The court held that the touchstone to the exercise of its discretion was ultimately a question of unfairness. Given the context in which the CRA and CDDs were entered into and the duties of the administrators to perform their functions in the interests of creditors, the judge determined that it would have been ‘grossly unfair’ to have enforced any release of their rights.
Further Questions for Determination in the ‘Waterfall’ Series
In November a further trial is scheduled to hear additional questions about the scope of Statutory Interest insofar as they relate to claims arising under ISDAs and the similar master agreements governed by German law and French law.
It remains to be seen whether any of the decisions in the Waterfall IIA and Waterfall IIB cases will be appealed. From a purely legal perspective (let alone an economic one) it would be welcome to have the Court of Appeal’s decision on the question of the application of Bower v. Marris to Insolvency Rule
2.88(7), particularly if the indications given by it on the questions arising out of the non-provable CCC in the Waterfall I appeal can be said to provide a clue to the way it might view the issue.
The Decisions at a Glance
- Where the applicable rate of Statutory Interest is the rate specified in the Judgments Act 1838 (the ‘Judgments Act Rate’), interest is payable on a simple (not compound) basis.
- In computing the daily rate of Statutory Interest at the Judgments Act Rate in a leap year, the calculation should be made by reference to a year of 366 days.
- When calculating Statutory Interest, dividends already paid to creditors are to be treated as having been paid in discharge of principal first (not interest).
- The words ‘the rate applicable to the debt apart from the administration’ in Rule 2.88(9) of the Insolvency Rules refer to the mode of calculation, including the compounding of interest (and not only to a numerical rate of interest).
- A foreign law judgment rate is not a ‘rate applicable to the debt apart from the administration’ in Rule 2.88(9) of the Insolvency Rules unless it has been obtained before the commencement of the administration.
- When establishing, under Rule 2.88(9), ‘whichever is the greater’ of the Judgment Act Rate and the ‘rate applicable apart from the administration’, the comparison must be of the total amounts of interest that would be payable rather than only the numerical rates themselves.
- Statutory Interest is payable on future debts and contingent debts from the date of the commencement of the administration.
- Calculation of CCCs should not take into account the Statutory Interest paid.
- CCCs accrue interest at the contractual rate.
- Neither the CRA nor any CDD releases in whole or in part claims to Statutory Interest.
- Neither the CRA nor any CDD releases in whole or in part CCCs.
- The CRA does not create a CCC.
- If, as a matter of construction, the CRA or CDDs were determined to have had the effect of releasing CCCs, the court would have directed the administrators not to enforce such releases. Paragraph 74 of Schedule B1 to the Insolvency Act 1986 and the principle in Ex parte James would have been invoked.