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Lehman Brothers "waterfall application" in the Court of Appeal

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26 June 2015

Litigation from the collapse of Lehman Brothers continues to break new ground in English insolvency law. In Lehman Brothers International Europe (in administration) [2015] EWCA Civ 485, 14 May 2015, the Court of Appeal clarifies several aspects of the "insolvency waterfall" (ie the order in which creditors are paid from the assets of an insolvent company) and deals with some unusual issues arising from the insolvency of an unlimited company in the Lehman Brothers group.


In Re Nortel GmbH [2013] UKSC 52, [39] Lord Neuberger summarised the order of priority in which creditors are paid from the assets of a company in administration or liquidation:

(1) Fixed charge creditors

(2) Expenses of the insolvency proceedings

(3) Preferential creditors

(4) Floating charge creditors

(5) Unsecured provable debts

(6) Statutory interest

(7) Non-provable liabilities

(8) Shareholders

This order of priority is called the insolvency waterfall. Re Lehman Brothers International Europe (in administration) was widely known as the "Waterfall Application" because it raised a number of important issues concerned with the order of priority in which creditors of Lehman Brothers International Europe (LBIE), including the principal shareholder Lehman Brothers Holdings Intermediate Ltd (LBHI2) which held certain subordinated debt issued by LBIE, would be paid out from LBIE's estate.

Many of the issues raised in the Waterfall Application were relatively untested because, typically, a company's assets run dry before creditors at stage (5) of the waterfall are paid in full. There is nothing left to flow down to stages (6)-(8). However, the LBIE estate will have a surplus after paying all creditors in full at stage (5). As such, the focus has shifted to the lower stages of the waterfall.

Some of the other issues at stake in the Waterfall Application arose from LBIE's status as an unlimited company. This also took the Court of Appeal into waters that were, as Briggs LJ put it, "either uncharted or for which the available charts are very old indeed" because (to mix his judicial metaphor) "the unlimited company has, for the last hundred years at least, been such a rare species".

Currency conversion claim

This aspect of the appeal was concerned with stage (7) of the waterfall. Non-provable liabilities are liabilities of a company in administration or liquidation which either do not fall within the definition of "provable debts" under the Insolvency Rules or which are otherwise barred from the proof process (eg claims arising or lodged after the cut-off date for admitting proofs in an insolvency).

Some of LBIE's creditors were owed debts in foreign currencies but, as creditors in an English administration process, were now to be paid out in sterling using the exchange rate on the date that LBIE had entered into administration, ie 15 September 2008 (the Insolvency Rules, r2.86(1), see also r4.91 for liquidations). In economic terms, these creditors suffered a loss where sterling depreciated against the contractual currency post insolvency.

The issue is best illustrated by an example. Imagine a creditor who has a right to payment in dollars and has a claim of USD 150 which is fixed at GBP 100 at the date of the debtor's insolvency (ie using an exchange rate of USD 1.5 to GBP 1). If sterling then depreciates to a rate of USD 1.2 to GBP 1 when the insolvency dividend is paid, then the GBP 100 claim will only be worth USD 120 at the date of payment. In that case, the creditor will have suffered a shortfall of USD 30 as a result of the currency movements in the intervening period.

The question before the Court of Appeal was whether creditors could claim for this shortfall as a non-provable liability.

As Lord Hoffmann noted in Wight v Eckhardt Marine Mmbh [2003] UPKC 37, insolvency processes are "a process of collective enforcement of debts. …. The winding up leaves the debts of the creditors untouched. It only effects the way in which they be enforced." An insolvency process thus affects creditors' substantive rights only to the extent that they are paid out or in certain defined cases (eg insolvency set-off). In the Waterfall Application, the Court of Appeal judges split on whether the two provisions in the Insolvency Rules that stipulated the use of the sterling exchange rate on the date of a company entering administration or liquidation should be construed as either (i) a procedural insolvency requirement or (ii) a substantive change to the rights of creditors.

The majority in the Court of Appeal held that the relevant provisions of the Insolvency Rules fell into category (i). They noted that both provisions in the Insolvency Rules used the same formula: "…for the purpose of proving…". The conversion was therefore for a "specific limited purpose" and not intended "as a substantive permanent alternative of the creditor's contractual rights".

Lewison LJ gave a strong dissenting judgment: "it is impossible to support than when [the provisions of the Insolvency Rules] were introduced that Parliament intended to split a unitary obligation to pay a sum of money in a foreign currency into two claims, one of which was provable and the other of which was not". The majority's decision bucked the approach of Parliament and the courts in widening the scope of provable liabilities (ie stage (5) in the waterfall) and narrowing the scope of non-provable liabilities (ie stage (7) in the waterfall). It also went against the grain of various official reports (including the Cork Committee) published before the passing of the Insolvency Act 1986 (the 1986 Act). Moreover, previous authorities suggested that the conversion was not merely procedural but substantively replaced the company's debt.

Post-administration interest

The next issue related to stage (6) of the waterfall. Statutory interest in an administration is payable on debts "outstanding since the company entered administration" (r2.88(7)). Statutory interest in a liquidation is payable on debts "outstanding since the company entered liquidation" (the 1986 Act, s189(2)). The question was whether, if LBIE were to shift from administration into liquidation, the right to recover interest accrued since September 2008 would be lost.

At first instance, David Richards J held that the right to recover interest would be lost upon a move to liquidation. On a "straightforward reading" of the provisions, statutory interest in a liquidation was only payable from the date that the company entered liquidation. The resulting "black hole" would have to be resolved by legislative amendment.

The Court of Appeal disagreed. The right to statutory interest survived the transition to liquidation as the surplus after stage (5) of the waterfall was "burdened" with the "statutory instruction" to pay interest from the date of the earlier administration.

It is worth noting that these provisions of the Insolvency Rules have now been amended to remove this "black hole" but this amendment does not take effect retrospectively so as to cover LBIE's administration.

LBIE's subordinated debt

A large part of LBIE's regulatory capital comprised USD 2.225 billion of subordinated loans from its principal shareholder LBHI2. LBHI2 was therefore a significant creditor of, as well as a shareholder in, LBIE. The loans were made by way of a standard form agreement referred to in the FSA rules in force at the time that LBIE went into administration in 2008.

There is no policy reason against creditors agreeing to move their debt down the waterfall. The question before the Court of Appeal was simply the extent of the contractual subordination, ie whether LBHI2, as creditor, had agreed that it should be paid out at the end of (or below) stages (5), (6) or (7) of the waterfall. The answer turned on construction of the subordination clauses.

The standard form loan made repayment contingent on LBIE otherwise being able to pay its liabilities. The contractual definition of "liabilities" was extremely wide but LBHI2 submitted that it had only been intended that LHBI2's position as creditor should be moved to the bottom of stage (5) and not out of that stage altogether. However, the Court of Appeal, heavily influenced by the regulatory capital purpose of the loans, held that the debt had been subordinated until creditors at stage (7) had been paid out.

Shareholders' contributions with respect to the waterfall

Under s74(1) of the 1986 Act, when a company is wound up in a liquidation shareholders must contribute to its assets to allow for the payment of its debts and liabilities, expenses of winding up and the "adjustment" of contributions between the shareholders themselves. For historical reasons, these provisions do not apply in an administration. The liability of shareholders in limited companies is limited to the amount unpaid on the shares (the 1986 Act, s74(2)(d)). Liability of shareholders in unlimited companies is, however, unlimited.

LBIE was an unlimited company. Its shareholders were LBHI2 and Lehman Brothers Ltd (LBL, together the Shareholders), both of whom were limited companies that were also in administration. The question before the Court of Appeal was concerned with the extent to which the Shareholders' liability ran all the way down the waterfall, if LBIE were to move from administration to liquidation. The Shareholders disputed that they were required to make contributions with respect to stages (6) and (7), ie statutory interest and non-provable liabilities. This was, essentially, on the basis that s74 used the word "liabilities" to mean provable liabilities only.

The Court of Appeal rejected this limited reading of "liabilities", noting that liquidators were under a duty to pay a company's non-provable liabilities if possible. Moreover, it was not realistic to suggest that statutory interest was not a liability. The relevant provisions provide "that statutory interest "shall be" paid. I can see no good reason why a statutory requirement for payment of a sum out of assets of a company to persons entitled to it should not be regarded as a liability of the company". The Shareholders must therefore contribute with respect to the whole insolvency waterfall if LBIE is placed into liquidation.

The Contributory Rule

The final issue in the Waterfall Application considered the converse position. Could the Shareholders recover anything (including in their capacity of creditors) in LBIE's administration until they had discharged their potential liabilities under s74 (were LBIE to go into liquidation and make a call)?

In liquidations, there is a rule preventing shareholders from proving in the insolvent company's estate until they have discharged their liabilities as contributories under s74 (the Contributory Rule). LBIE sought an extension of this rule to distributing administrations. The Court of Appeal regarded this as a "radical extension" and declined to do so. Should LBIE want to resist making distributions to its Shareholders, "all that needs to be done is to put the company into liquidation and thereby enable to liquidator to make a call upon the insolvent contributory. The contributory rule would then disable the insolvent contributory from receiving anything in that liquidation until the call had been fully paid".

Comment: This Court of Appeal judgment is to be welcomed. It clarifies the nature of insolvency processes, the residual importance of non-provable liabilities and the scope of shareholders' obligations to contribute to the assets of a company in liquidation. It only overturns David Richards J's sensible first instance decision with respect to the recoverability of post-administration interest in a subsequent liquidation, which on a practical level is to be commended. After the first instance decision, the creditors stood to lose 8% interest running since 2008 on their provable claims in the event of LBIE entering liquidation on the basis of what was accepted to be a drafting oversight in the Insolvency Rules. Conversely, LBIE staying in administration prevented the insolvency officeholders from making calls on the Shareholders to provide assets to meet all of LBIE's provable debts and accrued statutory interest. It also allowed the Shareholders to prove in LBIE's administration before meeting any potential calls, thereby reducing the assets available to LBIE's other creditors. LBIE's administrators and creditors were therefore left stuck between a rock and a hard place. The Court of Appeal has rescued them from that position.

The most interesting dicta in the Court of Appeal decision arose from the split within the court on the question of the currency conversion claim. Though Lewison LJ's position was perhaps the better supported by precedent, the preferable approach is that taken by the majority. Where there remains a surplus of company assets after stages (1)-(6) of the waterfall, as a matter of policy it is right that they are first applied to meet any amounts still owed to creditors as regards non-provable liabilities before any payments are made to shareholders.

Further information

This case summary is part of the Allen & Overy Litigation Review, a monthly update on interesting new cases and legislation in commercial dispute resolution.  For more information please contact Sarah Garvey, or tel +44 20 3088 3710.