Success for LBHI2 and LBL in Supreme Court on Lehman Waterfall I

by DLA Piper
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The Supreme Court's decision in Lehman Waterfall I was handed down this morning. DLA Piper represents one of the successful appellants, Lehman Brothers Limited (in administration) (LBL).

The court was asked to consider certain issues relating to distributions in the estate of Lehman Brothers International (Europe) (LBIE), an unlimited company in administration. Such issues arose due to a substantial anticipated surplus in LBIE and sought to resolve particular lacunas in UK insolvency legislation.

In a leading judgment given by Lord Neuberger, the Supreme Court rejected attempts to extend, adapt and create law by ingenious and elaborate mechanisms. Instead it placed an emphasis on interpreting existing legislation with proper regard to the language of the provision, particularly in areas such as insolvency legislation where a complete code was already provided.

As a result the Supreme Court acknowledged and accepted that there are certain lacunas and faults in the existing legislation and gave a clear direction that the courts should be reluctant to fill them. This more conservative approach may produce interesting consequences in future litigation both within, and outside of, an insolvency context.

In relation to the points at issue in Waterfall I, Lord Neuberger held that:

  • Currency conversion claims do not exist (Lord Clarke dissented on this point, Lord Sumption disagreed with parts of the reasoning, but agreed in the conclusion)
  • Statutory interest payable in an administration, but not paid before commencement of a subsequent liquidation, is not payable in that liquidation (i.e. there is a 'statutory interest lacuna')
  • The contributory rule applies in an administration, but with procedural modifications such that a reserve fund is set up to hold contributories' distributions up to the maximum amount of the potential liability pending a liquidation
  • Contributories are liable to contribute to non-provable liabilities, but not statutory interest
  • Only a liquidator can prove in the insolvency of a contributory for the amount of its contribution
  • Set-off does not apply to contributory liabilities under section 74
  • LBHI2's subordinated debt claims rank behind both statutory interest and non-provable debts

Currency conversion claims do not exist

In order to ensure a pari passu distribution between creditors, debts owed in foreign currencies are required by the Insolvency Rules to be converted into sterling at the rate prevailing on the date of the administration. Distributions are then paid, in sterling, on those debts so calculated. Due to fluctuations in exchange rates between the date of LBIE's administration and the date on which creditors were paid, many foreign currency creditors received less than the sterling equivalent of the foreign currency debt as at the date of payment and sought to recover the difference (a 'currency conversion shortfall') as a non-provable debt.

While Lord Neuberger thought perhaps there should be a provision which enables a proof in respect of foreign currency debt to be adjusted to take account of currency fluctuations after the administration date, he concluded that such a provision does not exist and that it was not his role to create one. It is therefore not open to creditors to claim any currency conversion shortfall.

Lord Neuberger warned that the purpose of the 1986 insolvency legislation was to simplify and clarify the law, in light of that it is "dangerous to rely on judicial dicta as to the effect of an earlier insolvency code".

Statutory interest lacuna

Insolvency legislation provides for statutory interest to be paid in both an administration and a liquidation. Lord Neuberger found that Rule 2.88 of the Insolvency Rules 1986 which provides for payment of statutory interest accruing while the company is in administration, only applies while the company is in administration. Such interest cannot be claimed from a subsequent liquidator. This presents a problem as the provision for payment of statutory interest in a liquidation only applies to interest on debts proved in the liquidation and which has accrued since the date of the liquidation (not administration).

Lord Neuberger recognised that "there seems to be no reason why a creditor of a company in administration should lose what would otherwise be his right to statutory interest… simply because the company goes into liquidation before that interest has been paid" and that it was therefore probably just an oversight in the drafting of the legislation, but he underlined the fact that "it is not normally appropriate for a judge to rewrite or amend a statutory provision in order to correct what may appear to have been an oversight on the part of Parliament."

Liability of contributories

When an unlimited company is wound up, its members are liable to contribute to its assets an amount sufficient for payment of its "debts and liabilities". LBIE's members argued that such debts and liabilities do not include non-provable debts and statutory interest.

Non-provable debts were found to be within the definition of "liabilities" of a company and therefore a contribution from members could be sought to settle such non-provable debts. However, Lord Neuberger found that claims for statutory interest cannot be considered to be "debts" or "liabilities" because the liability to pay statutory interest in an administration only arises if there is a surplus remaining after payment of the proved debts. Section 74 of the Insolvency Act 1986, which requires the members to contribute, cannot be invoked in order to create a surplus from which to pay statutory interest.

Consistent with the theme of the judgment, Lord Neuberger disagreed with the Court of Appeal's analysis on this point, which to him seemed to involve "re-writing the legislative provision to enable it to achieve a more instinctively likely result than if the actual words used in the provision are construed according to the normal principles of interpretation".

Application of the contributory rule in an administration

Lord Neuberger considered that it would be inconsistent with the pari passu principle if the contributories could be paid out on their proofs such that they could distribute funds to their own creditors and, by the time that LBIE was in liquidation, there would be little or nothing to pay LBIE's call.

This could not be resolved by the application of set-off as Lord Neuberger found that insolvency set-off does not apply to the prospective liability of contributories for calls which may be made on them.

Lord Neuberger resolved this by extending the rule in Cherry v Boultbee or the 'contributory rule' (i.e. the rule that a "claimant could recover nothing as a creditor until all his liability as a contributory had been discharged") to apply to distributing administrations. This was one area in which Lord Neuberger thought it appropriate to expand the existing law by extending an existing judge-made (not legislative) rule. He considered it appropriate to extend "an existing rule so that it can apply to what is an analogous, albeit not identical, situation to that to which it previously applied" when "doing so in order to achieve precisely the same end for which it was conceived."

A pure application of the rule in an administration would however be unjust as it would leave the contributories with nothing they could do to meet their obligations and receive their dividends, as a call could not be made, and their contribution paid, until the company enters liquidation. Lord Neuberger therefore held that the rule should apply with procedural modifications which allow administrators to make distributions to creditors which are potential contributories, provided that when doing so they retain an amount equal to that creditor's "reasonable maximum potential liability as a contributory" until such time as the contributories' final liabilities are quantified.

LBHI2's subordinated debt claims rank behind both statutory interest and non-provable debts

LBHI2, one of the members of LBIE, is owed a substantial amount under subordinated loan agreements. The Court found that statutory interest is "payable and owing" by LBIE and both statutory interest and non-provable claims are payable "in the insolvency" of LBIE. The terms of the agreements therefore subordinated claims under them to both statutory interest and non-provable claims. The Court had no objection to giving an effect to a creditor's contractual agreement that its claim would rank lower in the insolvency waterfall than it would have done absent the contract.

Given that unlimited companies are not commonly utilised, it may be some time before we see another administration of an unlimited company which turns out to be solvent. However, Lord Neuberger's comments on the proper approach to statutory interpretation are of much wider interest.

In an insolvency context, Lord Neuberger's cautionary words may come to be considered, perhaps frequently, in the near future when the recently introduced Insolvency (England and Wales) Rules 2016 (which replace the Insolvency Rules 1986, on which this decision is based) come to be considered by the courts.

DLA Piper acts for LBL in relation to the Waterfall I and II litigation on instruction from the administrators of LBL and their staff, in particular Mike Jervis and Robert Munn.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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