An analysis of the High Court’s decision in Waterfall IIC on the meaning of Default Rate in the ISDA Master Agreements

In brief...

On 5 October 2016, the High Court provided clarity on the meaning of "Default Rate" in the ISDA Master Agreements. The Court held that the cost of funding in the definition of Default Rate is limited to the cost to the original counterparty to the agreement of borrowing the relevant amount for the period it is required. Cost of funding does not extend to the cost of funding of a transferee who has taken an assignment of an Early Termination Amount or to the cost of other types of funding (such as equity funding).

While the decision remains subject to appeal, it is significant for all users of the ISDA Master Agreements, as it provides direction on what can be certified as cost of funding for the purpose of Default Rate, when this rate applies. In addition, proposed transferees should consider the potential effect on them of being entitled to a Default Rate calculated on the transferor's cost of borrowing, which could be significantly lower than their own.

The decision is one of a series in the Lehman Waterfall II litigation, which seeks to determine how a large surplus in the insolvency of Lehman Brothers International (Europe) (In Administration) should be distributed. The issues determined by Mr Justice Hildyard in this case, known as Waterfall IIC, are significant to the parties as they go to the rates of post-insolvency interest which creditors will receive.

Definition of Default Rate

Under the ISDA Master Agreements, interest is payable from one party to another in a variety of situations and at a variety of different rates, including the Default Rate.

Default Rate is defined in the 1992 and 2002 ISDA Master Agreements 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".

Meaning of `cost of funding'

The judgment considers the meaning of "cost... to the relevant payee... if it were to fund or of funding the relevant amount". It was argued that the "cost" could refer to the cost of raising funds, however that was achieved, and that it could include the cost of funding a larger sum than the relevant amount. Mr Justice Hildyard, however, did not accept that the words went that far and concluded that only the cost of borrowing the relevant amount is covered. Accordingly, "cost" does not include the cost of raising funds other than through borrowing; for example it would not include the cost of raising equity, nor does it include the cost of raising a sum beyond that required to fund the relevant amount.

The parties gave an example where the average cost of debt was 6.1% whereas the average cost of equity was 10.4%. Mr Justice Hildyard said this illustrated how different the proposition of borrowing an amount for a limited time is from equity where a person is funding in return for a reward by participation in the fortunes of the company. In his view, "risk capital" is not funding within the purview of the cost of funding language".

Meaning of "relevant payee"

Mr Justice Hildyard concluded that "relevant payee" means the original counterparty to the ISDA Master Agreement and not a third party to whom the original counterparty had transferred its interest in an Early Termination Amount. He reached this conclusion as a matter of construction of the transfer provisions in section 7 of the ISDA Master Agreements, which prohibits transfer without the prior written consent of the other party with two exceptions, being (1) change of control of one party and (2) transfer by a party of its interest in any Early Termination Amount payable to it by a Defaulting Party together with interest and other associated rights or remedies. He agreed with the submission that the purpose of the restrictions on transfer in those provisions is to protect the parties against unknown credit risks on assignment, which would be undermined if the Default Rate could refer to an assignee's cost of funding.

Accordingly, for the purpose of Default Rate, it is the cost to the original counterparty of funding the relevant amount that needs to be certified, irrespective of whether or not that original counterparty has sold its interest in any Early Termination Amount in the secondary market. This can be significant as there may be a large discrepancy in the costs of funding of the original counterparty and that of the assignee, as was the case with the parties involved in the Lehman Waterfall II litigation.

Application of the judgment to New York law governed ISDA Master Agreements

The parties to the Waterfall II litigation were agreed that their positions on interpretation of the relevant provisions of the ISDA Master Agreements would be the same if the ISDA Master Agreements were governed by New York law, as opposed to English law. The parties' New York law experts were largely in agreement on the principles of contractual interpretation that would apply in New York law.

The Court adopted the parties' agreed position and accordingly, the judgment applies to both the English law governed ISDA Master Agreements as well as to the New York law governed Master Agreements. Subject to appeal, the judgment has, therefore, set a precedent for the English courts to follow and will be of persuasive value for the New York courts if they were going to consider the meaning of Default Rate.


Clarity in interpretation of contractual terms is never more important than in a default situation. While this judgment remains subject to appeal, it provides some clarity as to what can be certified as the Default Rate, which will be helpful to prospective ISDA parties and prospective assignees of the Early Termination Amount in assessing their negotiation and risk positions.