Waterfall I (first instance)

The court resolved a set of novel insolvency questions arising from the fact that Lehman Brothers International (Europe) (LBIE) is an unlimited company with two corporate members and substantial subordinated loan capital that formed part of its regulatory capital. The principal legal conclusions were:

• Subordination: the subordinated loan agreements (standard FSA-derived templates) subordinated the lenders’ claims not only to provable unsecured debts but also to statutory interest (rule 2.88 / s.189 IA 1986) and to non-provable liabilities. Accordingly the subordinated claims rank behind statutory interest and non-provable liabilities.
• Foreign-currency claims: creditors with contractual claims in foreign currency who suffer exchange losses between the administration commencement date and actual payment are entitled to pursue non-provable currency-conversion claims once all proved debts and statutory interest have been paid in full; such claims rank as non-provable liabilities.
• Interest across administrations/liquidations: where an administration is immediately followed by a liquidation statutory or provable interest does not become provable or payable in the liquidation for the period of the earlier administration, unless the administrator has already paid it; however creditors whose contracts entitle them to interest may recover interest for the administration period as non-provable claims in the liquidation.
• Members’ liability: under s.74 IA 1986 contributories of an unlimited company are liable to contribute for payment of not only provable debts but also statutory interest and non-provable liabilities.
• Contributory rule and proofs: the contributory rule (a contributory cannot share as creditor until he has discharged his liability as contributory) and the equitable rule in Cherry v Boultbee apply in a liquidation but do not apply in administration; administrators must admit proofs by members and cannot refuse on the basis that calls might be made only in a later liquidation.
• Proofs by the company and set-off: LBIE (acting through its administrators) may prove in a distributing administration or liquidation of its corporate members for their contingent liability under s.74; mandatory insolvency set-off applies in the members’ insolvencies and in LBIE’s administration between cross-claims, and such set-off will be applied subject to the nature of contingent claims and estimation rules.

The court’s conclusions were founded on construction of the subordinated loan agreements in their regulatory context, a purposive reading of the Insolvency Rules and IA 1986 (in particular rule 2.88 and s.189 and s.74), and established authorities on proofs, subordination, currency conversion and contributories.

Background and parties: This was an application by the joint administrators of three Lehman Bros. group companies (LBIE, Lehman Brothers Limited (LBL), and LB Holdings Intermediate 2 Limited (LBHI2)). LBIE, an unlimited company, had unexpectedly emerged as likely to have a surplus after payment of unsubordinated proved debts. Its two corporate members (LBL and LBHI2) held claims against LBIE; LBHI2 held substantial subordinated loan debt which had been used as regulatory capital. Lehman Brothers Holdings, Inc and an unsecured creditor (Lydian) were respondents. The parties agreed the facts and presented legal argument on a list of issues.

Nature of the application / relief sought: The administrators sought declarations and determinations of the rights to the surplus (who may be paid and in what order) and the nature and extent of the potential liabilities of members of an unlimited company in insolvency, including the ranking of subordinated loan claims, the availability of foreign-currency conversion claims, the treatment of interest where administration is followed by liquidation, and the operation of the contributory rule and set-off.

Issues framed by the court: The court focused on several principal legal questions: whether LBHI2’s subordinated claim ranks ahead of or behind statutory interest and non-provable liabilities; whether foreign-currency conversion losses can be asserted as claims payable out of available assets; whether post-administration interest is provable or payable where administration is immediately followed by liquidation; the scope of contributories’ liabilities under s.74 IA 1986; and the operation of the contributory rule and insolvency set-off in administrations and subsequent liquidations.

Reasoning and resolution: The judge construed the subordinated facility agreements in their regulatory and insolvency context (noting their FSA-derived template form) and held that their broad definitions of "Liabilities" meant subordinated claims were intended to rank behind all other liabilities, including statutory interest and non-provable liabilities. The court rejected arguments that rule 2.88(7) (and s.189) were mere directions to office-holders that could not give rise to liabilities for subordination purposes.

On foreign-currency claims, the court examined the authorities (Miliangos, Dynamics, Lines Bros, Brightman LJ’s observations) and the Insolvency Rules conversion provisions (rule 2.86 / rule 4.91) and held creditors may pursue non-provable currency-loss claims against a solvent surplus after all proved debts and statutory interest are paid.

On interest across regimes, the judge analysed rule 2.88 and s.189 and concluded that interest accruing in an administration is not provable nor payable as statutory interest in a subsequent liquidation (unless already paid by the administrator), but creditors may claim such interest as non-provable liabilities in the liquidation.

On members’ liability and the contributory rule, the court held s.74 exposes present and past members of an unlimited company to contribution for proved debts, statutory interest and non-provable liabilities. The contributory rule and Cherry v Boultbee operate in a liquidation only; they do not prevent a member from proving in an administration. The administrators of LBIE may therefore prove in the insolvency of its members for contingent calls; mandatory insolvency set-off applies in members’ insolvencies and in LBIE’s administration to cross-claims, subject to estimation rules for contingent claims.

The judgment resolved all principal legal questions raised and invited the parties to agree the form of consequential orders.

The court determined the issues raised by the administrators’ application. It held (inter alia) that the subordinated loan agreements subordinated the lenders’ claims to provable debts, statutory interest (rule 2.88 / s.189 IA 1986) and non-provable liabilities; that foreign-currency conversion losses may be pursued as non-provable claims once proved debts and statutory interest are paid; that interest accruing during an administration is not provable or payable as statutory interest in a subsequent liquidation (absent prior payment) but may be claimed as a non-provable liability; that s.74 IA 1986 exposes members to contributions for provable debts, statutory interest and non-provable liabilities; that the contributory rule and Cherry v Boultbee apply only in liquidation and do not prevent proofs in administration; and that administrators may prove in members’ insolvencies for contingent calls and mandatory insolvency set-off will apply. The court’s rationale combined textual construction of the subordinated agreements, purposive regard to the regulatory capital context, and interpretation of the Insolvency Rules and IA 1986 in light of authority and practical policy considerations.