The English High Court in Lehman Brothers International (Europe) (In Administration) [2016] EWHC 2417 (Ch), in one of a series of cases arising from the Lehman insolvency, has had to consider (among other issues) the meaning of “Default Rate” under the ISDA Master Agreement.

The background was somewhat unusual: there is a substantial surplus in the estate of Lehman Brothers International Europe which is in administration (LBIE) – at the same time admitted claims under transactions based on ISDA Master Agreements exceed £4.4 billion and are over 5 years old. The proper meaning of “Default Rate”, for the purpose of calculating interest for overdue amounts, was therefore very material in determining how much should be paid out by the administrators from the surplus in respect of these admitted claims.

It was also relevant to the facts on which the judge had to make his decision that many of these claims had been purchased from third parties.

The 1992 and 2002 ISDA Master Agreements

“Default Rate” is defined in Section 14 of both the 1992 and 2002 versions of the ISDA Master Agreement as “a rate per annum equal to the cost (without proof or evidence of any actual cost) to the relevant payee (as certified by it) if it were to fund or of funding the relevant amount plus 1% per annum.”

The court’s decision

(i) Only the (actual or hypothetical) cost of borrowing the relevant amount under a loan transaction may be used.

The judge (Mr Justice Hildyard) decided that in determining the “cost of funding”, only the cost of borrowing the relevant amount under a loan transaction (i.e. interest for borrowing) may be used. This may be the actual cost (where the relevant payee goes into the market to raise funds) or (where the relevant amount is not in fact borrowed) a hypothetical cost. The “cost of funding” therefore did not include the cost of raising equity finance or any other financial detriment or consequential loss. The cost of funding should not exceed what the borrower knows to be or which could be available to it in the circumstances, having regard to the object of the borrowing (to cover the relevant amount).

The judge said that a payee’s certificate could be challenged if the amount it certified fell outside the above scope, contained a manifest error, or on grounds of irrationality or lack of good faith, but the burden of proof is on the challenging party, on the balance of probabilities.

(ii) Only the payer’s original counterparty was relevant for the purposes of the expression “relevant payee”.

The judge also held that the “relevant payee” for the purposes of the definition of Default Rate in the ISDA Master Agreements, was the original counterparty of the payer. The expression “relevant payee” did not extend to a third party to whom the right to payment under the ISDA Master Agreements had been transferred under Section 7. It was therefore the cost of funds of LBIE’s original counterparty that was relevant, however long ago the benefit of the transaction had been transferred by it. The judge noted that this was consistent with the principle of English law that an assignee can be in no better position than his assignor. Therefore when calculating the cost of funding, a payee who is a transferee must do so by reference to the cost of the original counterparty rather than by reference to its own cost.


In view of the size of the OTC derivative market (the judge noted that according to the Bank of International Settlements the total notional amount of outstanding derivatives as at the end of December 2014 stood at US$630 trillion), the judgment is a useful addition to parties’ understanding of the consequences of the ISDA Master Agreement.