When Lehman Brothers’ European trading company entered administration, few expected it to pay ordinary creditors in full. Once a surplus appeared, a different question mattered. Who was entitled to the money left over? The seven issues in the “Waterfall I” appeals concerned creditors who had agreed to be paid last, creditors owed foreign currency, and shareholders who were themselves both lenders and potential contributors.
Lehman Brothers International (Europe), or LBIE, was an unlimited company. Its two shareholders also entered administration. One, LB Holdings Intermediate 2 Ltd (LBHI2), had made subordinated loans to LBIE. Both shareholders claimed money from it as creditors. Because LBIE was unlimited, a future liquidator might also call on them to contribute to its liabilities.
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The administrators asked the courts for directions. A proof is a creditor’s formal claim to participate in a distribution. A liability can remain payable from a surplus even though its holder cannot lodge a proof for it. The distinction mattered at several different points in the appeals.
The subordinated loans
Once ordinary provable debts had been paid, the usual order placed statutory interest first, then non-provable liabilities and finally the shareholders. The question was where the loans fitted under the terms LBHI2 had agreed.
About £1.254 billion remained due under the subordinated loans. LBHI2 accepted that ordinary provable creditors came first. It argued that its loans nevertheless ranked ahead of statutory interest and non-provable liabilities because of the language used in the agreements.
Statutory interest is paid out of a surplus for the period after the insolvency began. Although a creditor could not sue LBIE for it in the ordinary way, the interest was payable out of the company’s assets and counted as its liability under the agreements.
Non-provable liabilities also counted. A liquidator must deal with the company’s outstanding liabilities before returning anything to shareholders. For the purposes of these agreements, the Court reached the same conclusion in a distributing administration.
LBHI2 therefore ranked behind both statutory interest and non-provable liabilities. Nor could it lodge an immediate proof valued at nil and have that value revised later. It could prove only once the non-provable liabilities had been paid or could clearly be met even after allowing for the subordinated proof and interest on it.
Foreign-currency debts
Debts owed in a foreign currency were converted into sterling at the exchange rate when the administration began. By the time creditors were paid, sterling had fallen. A creditor paid its proved sterling amount could therefore buy less of the currency originally promised. Could it recover the difference from the surplus?
By four votes to one, the Court held that it could not. The conversion rule fixed the extent of a foreign-currency creditor’s entitlement. Allowing an additional claim when exchange rates moved one way, without a corresponding reduction when they moved the other, would give those creditors a one-sided advantage.
Lord Clarke dissented. He considered that conversion is only for proof, and that any unpaid contractual balance remains a non-provable liability. Otherwise shareholders of a solvent company would take ahead of a creditor still unpaid in the contract currency.
The Court did not decide whether, generally, payment in full of a proof extinguishes the underlying contract. Lord Neuberger was inclined to think that it does. Lord Sumption provisionally thought that insolvency suspends remedies rather than destroying rights, except where the legislation so provides. Both left that question open, as did Lord Clarke.
Interest after a later liquidation
The rules directed an administrator to pay statutory interest out of a surplus during the administration. If the company went into liquidation before the administrator had paid it, the liquidator had no equivalent power to pay that earlier period’s interest. Statutory interest in the liquidation ran from the start of the liquidation itself.
Nor could a creditor paid on its proof in the distributing administration fall back on the original contract to recover interest for that period. The majority regarded the statutory scheme as a complete code on interest on proved debts. The gap between the two procedures was for the legislature to address.
Calls on members who are also creditors
Section 74 requires present and past members, in a winding up, to contribute what is needed for the company’s debts and liabilities, the winding-up expenses, and adjustment of the members’ rights. In a company limited by shares the call cannot exceed the amount unpaid on the shares. LBIE had no such cap. LBHI2 and LBL were both members and creditors and had proved in LBIE’s administration.
Section 74 of the Insolvency Act 1986 allowed a call to meet provable debts and non-provable liabilities. It could not be used to create a surplus so that statutory interest would become payable. Money raised specifically to meet outstanding liabilities did not become free surplus merely because the liquidator received it.
Only in a winding up could the liquidator make a call on the members. Its proceeds would form a fund for the liquidator’s statutory purposes. The administrators could not prove in the shareholders’ administrations for contributions a future liquidator might require.
For the same reason, the administrators could not set off a prospective call against the amounts due to the shareholders as creditors.
The Court nevertheless allowed administrators making distributions to retain part of what a shareholder-creditor would otherwise receive. The amount had to be based on a cautious but realistic estimate of the shareholder’s potential contribution and the expected dividend. The retained money could be released when the relevant claims were covered or security was given. This protected other creditors without forcing LBIE straight into liquidation.
Verdict: The subordinated loans ranked behind statutory interest and non-provable liabilities. No further exchange-rate claim or carry-over of unpaid administration interest was allowed. The Court limited the purpose of calls on members, ruled out proof and set-off for prospective calls, and allowed a retention from distributions to shareholder-creditors. Only the currency ruling drew a dissent.
