The English High Court has recently interpreted the term “default rate” under the ISDA Master Agreement in one of a series of cases concerning the administration of Lehman Brothers International (Europe). We consider the outcome of this case and its likely impact.

The case arose in the context of a substantial surplus in Lehman Brothers International (Europe) ("LBIE") administration after paying for the provable debts owed by LBIE.

Although the process of paying the principal of LBIE’s proved debts completed in 2014, creditors have still not received any interest in respect of those debts. Many of LBIE’s creditors have claims under ISDA Master Agreements and this case concerned the scope of their entitlements to default interest under those agreements.

Meaning of default rate

The ISDA Master Agreement provides that where there is default on a payment, the party to whom the payment is due, or relevant payee, is entitled to interest at the default rate. The default rate, in simple terms, is the cost of funding plus 1% per annum.

Cost of funding

The Court had to interpret what is meant by “cost of funding”. It held that a party’s cost of funding means its cost of borrowing the relevant amount whether that cost is actual or hypothetical. The party’s “cost of funding” cannot be calculated by reference to costs associated with any other type of funding, such as the cost of raising equity finance etc.

Original counterparty’s cost of funding

The Court further held that when calculating the cost of borrowing, it is the cost of the payer’s original counterparty under the contract that must be used as a reference. So even if the original counterparty sold the interest in the amount payable to a third party, that third party must calculate the cost of funding based on the original counterparty’s costs and not its own costs.

The outcome of this case will have a significant impact on the amount of the surplus the administrators will be required to distribute in respect of statutory interest. Given that the majority of claims admitted against LBIE arise under an ISDA Master Agreement, and that these claims represent approximately £4 billion, this decision will be closely analysed by those with an admitted claim in LBIE’s administration.