Judgment on BAILII at: http://www.bailii.org/ew/cases/EWCA/Civ/2017/1462.html
This is the latest decision in the litigation following the collapse of Lehman Brothers in 2008 (and, specifically in this jurisdiction, Lehman Brothers International (Europe) (“LBIE”)). The administration has led to a surplus of £7.4bn and, unsurprisingly, a significant amount of litigation between creditors claiming to be entitled to elements of the surplus.
The litigation has been generally referred to as Waterfall I, Waterfall II and Waterfall III. The Supreme Court’s decision in Waterfall I was important, particularly for those with an interest in the theoretical underpinnings of English insolvency law.
As the Court of Appeal noted in Burlington (at ), “following the Supreme Court’s decision in Waterfall I, it is clear that the…reversion to contract analysis in general, no longer prevail in the way they had previously done”.
The “reversion to contract” analysis is the view that, once the statutory insolvency scheme has run its course and resulted in a surplus, a creditor can revert to his or her contractual rights and be entitled to payment out of the surplus in accordance with those contractual rights (where the creditor’s contractual rights were worth more that he or she received in the statutory insolvency scheme). That analysis appears to be gone, not without controversy. Indeed, it appears from Lord Neuberger’s comments in Waterfall I that the effect of payment in full of a provable debt in an insolvency is to extinguish a creditor’s underlying contractual rights and replace those with a set of statutory rights under the insolvency legislation.
That analysis influenced the Court of Appeal in Burlington, which was dealing with a number of issues on appeal.
Issue 1: Application of dividends for purpose of calculating interest entitlement
Rule 2.88(7) of the Insolvency Rules 1986 (now rule 14.23(7)(a) of the Insolvency Rules 2016) provides that: “any surplus remaining after payment of the debts proved shall, before being applied for any purpose, be applied in paying interest on those debts in respect of the periods during which they have been outstanding since the company entered administration”.
The question was whether such statutory interest is calculated by allocating dividends to: (i) first the payment of statutory interest and then principal; or (ii) first to the payment of principal and then statutory interest.
At first instance, the Judge preferred option (ii). The Appellants appealed and said that option (i) was the proper approach because it was consistent with ordinary commercial contracts, was in accordance with the judge-made rule in Bower v Marris (1841) Cr&P 351, 41 ER and better ensures that shareholders do not receive that which, apart from the insolvency, would have been paid to creditors.
The Court of Appeal dismissed the appeal. The rule is clear and “built-in assumption that the whole of the principal of the relevant debts will already have been paid by dividend since, otherwise, there will be no relevant surplus” (at ). Further, the fact that option (i) would likely produce a result closer to the creditors’ contractual rights could no longer be a factor of any real weight following the Supreme Court’s rejection of the “reversion to contract” approach in Waterfall I.
Issue 2: Continuing accrual of interest after payment of dividends
By rules 2.88(7)-(9) IR 1986 (now rule 14.23(7) IR 2016), in a surplus, a creditor is entitled to interest on the debt from the date of administration at the higher of the Judgments Act 1838 rate or the contractual rate. The Applicants argued that where the contractual rate is a compounding rate, the accrued statutory interest should continue to compound even after payment of the debt through dividends.
The Court of Appeal rejected that argument and said that in the statutory scheme “there is no room for the concept of interest, let alone compound interest, being payable in respect of [the period after payment of dividends]” (at ).
Issue 3: Compensation for late payment of statutory interest
Issue 3 was similar to issue 2. The Appellants argued that in the period from payment of dividends to payment of statutory interest in a surplus, the court should recognise a common law entitlement to compensation following Sempra Metals Limited v IRC  1 AC 561.
The Court of Appeal also rejected that argument. Rule 2.88 IR 1986 specifies no time at which a payment of statutory interest must be made. The general right to compensation following Sempra Metals only arises when there is a cause of action for non-payment of money owed. Where there is no allegation that the administrators have been guilty of unreasonable or culpable delay (in this case), there is no cause of action against which a common law claim for interest can hang (at ).
Issue 4: Interest on contingent debt
As explained, “a contingent debt is provable in an administration even though the contingency upon which it becomes payable has not occurred at the date of the administration. Dividends are payable in respect of it regardless whether the contingency has occurred by the time of dividend” (at ). The issue was whether statutory interest is payable in respect of a period when the debt remains contingent.
The Appellants argued that it was not because: (i) if the contingency occurs before dividend, the debt may be proved for and admitted in full; (ii) if the contingency occurred shortly before payment of dividend, and interest was payable on it from the date of administration, the creditor would receive statutory interest in relation to a long period when the debt was neither interest-bearing nor outstanding in the ordinary sense of the word; and (iii) the above would run contrary to the pari passu principle.
Again, the Court of Appeal rejected that argument because “rule 2.88(7) provides the same regime for statutory interest for all provable debts, whether due at the date of administration, due then only in the future, or subject then to a contingency which may, in fact, never occur” (at ). Statutory interest is payable to compensate creditors for the late payment of their provable debt (in the case of a contingent debt, the provable debt is calculated by discounting it by reference to the prospect of the contingency occurring), not the underlying claim.
Issue 5: Foreign judgment rates of interest
The issue was whether “rate applicable to the debt apart from the administration” in rule 2.88(9) (now rule 14.23(7)(c)) can include: (i) a foreign judgment rate of interest applicable to a foreign judgment obtained after the date of administration; or (ii) a foreign judgment rate of interest which would have become applicable to the debt if the creditor had obtained a foreign judgment, when it did not in fact do so.
The Appellants said that it could. The Court of Appeal agreed with the judge at first instance that it could not. As to part (i), “it would be wrong to have regard under rule 2.88(9) to a rate of interest applicable to a foreign judgment obtained only after the cut-off date constituted by the commencement of the administration, unsupported by or by reference to any pre-existing contractual right of the creditor as at the cut-off date” (at ). As to part (ii), “the words “the rate applicable to the debt apart from the administration” cannot be read as including a hypothetical rate which would be applicable to a debt if the creditor took certain steps” (at ).
Issue 6: Application of contingent contractual interest rate
The issue was whether, where the creditor is entitled to an interest rate contingently and the creditor has taken steps post-administration to trigger that contingency, the creditor is entitled to that contractual interest from the date of triggering the contingency (assuming it is higher than the Judgments Act rate). The example used was the default interest payable on sums due from an out-of-the-money party (in administration) to an ISDA governed derivative after close-out triggered by the counterparty creditor.
The Appellants said the counterparty creditor ought not to be entitled to contractual interest. The Court of Appeal disagreed and summed up its views at at  – :
“77. Rule 2.88(9) constitutes a clear but limited departure from the emerging principle (fortified by the majority of the Supreme Court in Waterfall I) that the process of proof of debt and dividend in insolvency, including administration, replaces and extinguishes creditors’ previous contractual rights. So far as concerns interest, the statutory regime permits regard to be had to those rights to enable it to be seen whether, under their contractual (or other) pre-existing rights against the insolvent debtor, creditors would have achieved a higher level of compensation for the delay in distribution after the cut-off date than they would, if compensated at the Judgments Act rate. This is not by way of specific enforcement of those contractual rights. They have been extinguished. Rather it is an examination of the parties’ contractual relationship as at the cut-off date, to ascertain what is the appropriate statutory rate of interest payable thereafter. To that limited extent creditors are not treated equally, although compensation at the Judgments Act rate is an irreducible minimum to which they are all entitled, out of any available proceeds of the administration.
- The yardstick for that examination is by reference to the contractual rate of interest which each creditor would have enjoyed, applied to the proved debt, during the period or periods between the cut-off date and the date or dates of distribution of dividend. For that purpose we can see no good reason why that rate should not be ascertained by reference to all the creditor’s contractual rights to interest, whether current, future or contingent, when viewed from the cut-off date, but having regard to the benefit of hindsight to see what rate of interest those rights would in fact have generated if they had not been extinguished by the administration.”