Lehman "Waterfall IIC" Judgment Handed Down - Meaning of Default Rate in ISDA Master Agreements

Date: 05/10/2016

Mr Justice Hildyard today handed down judgment in the latest instalment of the Lehman “Waterfall” litigation arising out of the collapse of Lehman Brothers International (Europe) (LBIE).   The judgment addresses the interpretation of key provisions in the 1992 and 2002 ISDA Master Agreements concerning interest on sums due following the close-out of transactions upon early termination.  It also addresses similar issues arising under a German law governed form of master agreement.

The Issues

In both the 1992 and 2002 ISDA Master Agreements interest on sums due by the defaulting party (in this case LBIE) is due at the Default Rate for much of the period since LBIE’s collapse in September 2008.  The Default Rate is defined in both 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”.

The Judgment deals with two principal issues (and a number of sub-issues) arising from this definition.  First, whether the “relevant payee” (whose cost of funding is to be certified) is confined to LBIE’s contracting counterparty, or includes those who acquired by assignment the right to payment of the close-out amount subsequent to LBIE’s collapse.  Second, whether the phrase “cost … if it were to fund or of funding the relevant amount” is confined to cost of borrowing the relevant amount or includes costs of and associated with raising money by any means.  As Hildyard J commented at paragraph 53, the sharpest division between the parties was whether the phrase was confined to cost of borrowing or extended to the cost of issuing equity.

The first issue was of particular importance in the LBIE administration, because a large proportion of LBIE debt had been purchased in the secondary market by hedge funds and other entities whose cost of funding, generally speaking, was likely to be of a different order to the cost of funding of the original counterparties.  The second issue was of importance taking into account the assumption that if counterparties could certify a cost of funding that included their cost of raising equity then it was likely that the rate so certified would be significantly higher than if they were confined to certifying their cost of borrowing the relevant amount.  The significance of this point in connection with LBIE administration is that creditors are entitled to statutory interest on dividends (once all proved debts were paid in full) pursuant to Insolvency Rule 2.88 at the higher of the Judgments Act rate of interest (8% throughout the period of LBIE’s administration to date) and the rate applicable to their debt “apart from administration”, including any contractual rate such as the Default Rate under the ISDA Master Agreement.  Hildyard J, at paragraph 11, noted that statutory interest on all ISDA claims at the Judgments Act rate would result in an aggregate amount of statutory interest payable of £1.7 billion, but if interest was payable at a compound rate of 8%, 12% or 18%, then the aggregate amount of statutory interest payable would be £2.1 billion, £3.7 billion or £6.8 billion respectively.

Given the widespread use of the ISDA Master Agreement throughout the world (at the end of December 2014 the total notional amount of over the counter derivatives in existence was US$630 trillion), the issues are of considerable importance to the whole derivatives market.

The relevant payee

Hildyard J concluded that ‘relevant payee’ meant the original contracting counterparty, and thus did not include the persons who had acquired the right to payment under Section 6 of the Master Agreement via an assignment under Section 7.  Putting it figuratively, “the transferee is entitled to the tree planted by the transferor and such fruit as had grown and would grow on it when transferred, and not to fruit of a different variety or quantity which might have grown had the transferee planted the tree.”  Accordingly, what has to be certified pursuant to the definition of the Default Rate is the cost to the original counterparty of funding the relevant amount irrespective of whether that original counterparty has sold its debt in the secondary market.

Cost of funding

Hildyard J concluded that the phrase “Cost … if it were to fund or of funding the relevant amount” is confined to the cost to the relevant payee of borrowing the relevant amount. It does not include, therefore, the cost of raising equity.  Nor does it include costs to the relevant payee of raising money beyond that required to fund the relevant amount.  Hildyard J summarised the test, at paragraph 174, as “‘cost’ is the price which the relevant payee paid, or would have to pay, to a counterparty to a transaction to borrow an equivalent sum, taking into account all relevant considerations.  That leaves a broad margin, confined by certification, but which is tied to a borrowing transaction (actual or hypothetical) rather than the activities of the relevant payee as a whole”.  In rejecting the possibility that equity funding could form part of the certification, he said, at paragraph 136, “Interest is payment by time for the use of money: it is an obligation imposed as the cost of being afforded the use of money over the relevant period of time.  The obligation is in the nature of a debt established by the transaction under which the use of the money is provided.  That obligation is plainly a cost, equal to the rate of interest charged” and, at paragraph 137, “A share has very different characteristics … A share confers an interest, measured by the participation and any voting rights, in the issuer; any return is in right of that interest.”

German Master Agreement

Hildyard J also considered similar questions arising in relation to a German law governed master agreement (the GMA).  He held that s.288(4) of the German Civil Code, which provides for a claim for “further damage” for a default in payment, was not available as a basis for a claim for Statutory Interest in excess of 8% pursuant to Rule 2.88(9) of the Rules.  He held, first, that no default had occurred as at the date of LBIE’s administration because the termination payment under the GMA did not become due until after it had been calculated and, further, because LBIE had not “seriously and definitively” refused to perform the GMA as at the date of its administration (as would have triggered a default under s.286 of the German Civil Code).  Secondly, he held that no default under German law could occur following LBIE’s bankruptcy and, relatedly, that a proof of debt in LBIE’s administration did not constitute a “warning notice” under s.286 of the German Civil Code and could not therefore be relied upon to trigger a default.

Further, as matter of English law, Hildyard J held that a claim for “further damage” under s.288(4) was not a rate “applicable to” the proved debt apart from the administration within the meaning of Rule 2.88(9) of the Rules. It was in the nature of a damages claim to be pleaded and proved and assessed by the court.  It was not, therefore, “applicable to” the debt proved as at the date of LBIE’s administration.

As to the separate issue of whether a “further damage” claim (if it had been a rate applicable under Rule 2.88(9) of the Rules) could be assessed by reference to an assignee’s circumstances, rather than those of the assignor, Hildyard J found that the claim was limited to the rights of the assignor.

South Square

The following eleven members of South Square appeared in the case, representing four different parties:  William Trower QC, Robin Dicker QC, Antony Zacaroli QC, David Allison QC, Tom Smith QC, Daniel Bayfield QC, Richard Fisher, Stephen Robins, Adam Al-Attar, Henry Phillips, Robert Amey.

For a copy of the judgment click here.

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