Update – Waterfall II Part C Application - preliminary guidance for certification in respect of contractual interest rate claims for ISDA and other creditors – 31 May 2017

The Joint Administrators are pleased to set out below their preliminary guidance for creditors who may wish to make a certification for a contractual interest rate (a “CIR Claim”) that will apply to admitted claims arising under an ISDA Master Agreement or similar agreement. CIR Claims may be relevant for statutory interest calculations in the LBIE administration where the creditor believes it has an entitlement arising from its contractual rights which results in an interest rate in excess of 8% simple per annum.

The key points of principle relevant to CIR Claims were considered by the English High Court in the Waterfall II Part C application. A comprehensive first instance judgment was handed down in October 2016 by the Honourable Mr Justice Hildyard. The Joint Administrators are not presently seeking to commence a certification process for CIR Claims using the practical guidance given in the judgment, because an appeal of some of the matters contained in the Part C application is in progress. However, the Joint Administrators do believe the comprehensive judgment of the Honourable Mr Justice Hildyard provides a complete and suitable framework to oversee the certification process for CIR Claims.

The Joint Administrators believe an early indication of their views as to how CIR Claims can be certified will be helpful to creditors generally. In the 17^th Progress report dated 10 April 2017, the Joint Administrators noted that their assessment was that only a small number of counterparties might have a CIR Claim, with a total impact of around £200m. This announcement has been prepared with those underlying assumptions.

The purpose of this announcement therefore is to set out the Joint Administrators’ preliminary guidance and observations about what rates they expect could be certified for CIR Claims and the process likely to be followed for making and reviewing certifications so that creditors may consider their own position in that regard. Moreover, the Joint Administrators consider that it is imperative in the context of ongoing development of distribution proposals (interim or otherwise) that creditors can fully understand the Joint Administrators’ current perspective on CIR Claims, on both the evidence that they expect to be provided to support CIR Claims and (as set out below) what is expected to constitute a reasonable approach to certification (see end of this announcement for guidance about LBIE’s grounds for challenge).

Events which took place on or around 15 September 2008 when LBIE entered into administration may have a significant relevance in a creditor’s CIR Claim certification where LBIE’s original creditors did in fact borrow in order to have available to them cash in the same amount as that payable by LBIE pursuant to the close-out of the relevant ISDA contracts and amounts that may have been payable in respect of related hedging contracts. Given the increasing age of the administration, preservation of relevant material should be undertaken by creditors where possible because the provision of contemporaneous evidence of the borrowing and associated interest rates will expedite the certification process. If this information is not available, that may materially impede the Joint Administrators’ review of a CIR Claim based on actual borrowing. Therefore the Joint Administrators consider it helpful to give an early indication of their position if a CIR Claim cannot be substantiated by sufficient and contemporaneous evidence of actual borrowings.

If alternatively, no relevant close-out amount was borrowed by the creditor and instead the counterparty wishes to certify what it, hypothetically, would have done to borrow that sum, then the Joint Administrators would expect counterparties to share all of their data, assumptions and calculations to enable a proper and complete review of the asserted CIR Claim. It is important to emphasise that the costs of funding are the costs of the original creditor and not any subsequent assignee of that original creditor’s rights following the termination of the ISDA. All data, assumptions and calculations must therefore be based on the circumstances of LBIE’s original counterparty in each relevant contract. Please note that this issue is no longer under appeal and so the Joint Administrators will not be accepting any certification of a CIR Claim other than in respect of LBIE’s original counterparty’s cost of funding.

The Joint Administrators believe it will ultimately be the responsibility of all relevant creditors to provide a certification for their CIR Claims. In making their certifications, creditors will need to provide sufficient evidence so the Joint Administrators are in a position to review and assess the certification. In the absence of sufficient evidence or where the Joint Administrators believe the certification is not rational and/or not made in good faith then the Joint Administrators will challenge the CIR Claim (see below for a more detailed explanation of the Joint Administrators’ rights to challenge CIR Claim certifications) and this may lead to a delay in resolution and payment of such claims.

The Joint Administrators’ guidelines are not intended to be prescriptive or exhaustive but aim to provide clarity of approach around how different types of counterparty might be expected to present a rational and good faith certification. Accordingly, if a counterparty were to certify adopting the approach outlined below together with supporting evidence then the Joint Administrators consider that there would be less scope for a challenge than in the case of a CIR Claim for a rate of interest higher than indicated below. This preliminary guidance is nevertheless subject to revision in light of the appeal of the Waterfall II Part C judgment as to what sort of funding costs may be claimed and/or in light of feedback received.

The Joint Administrators have identified five groupings of creditor to cover the majority of generic types of counterparties that might have a CIR Claim. For each grouping, the Joint Administrators have considered what might be expected to be a reasonable methodology and rate for a CIR Claim certification which is compliant with the judgment in Waterfall II Part C.

These findings and groupings are set out below:

Category	Counterparty types	LBIE view	Approach adopted
A	Counterparties with regular, observable funding rates (typically Banks, Corporates, Governments and Municipals)	An adjusted weighted average yield calculated from publicly available market data (e. g. Bloomberg) of senior unsecured debt issued by the creditor (and relevant entities) under a set of eligibility criteria for the relevant period.	The yield for each debt issuance is calculated from the coupon rate adjusted by the price at issuance and any relevant currency features. A weighted average yield is calculated for every day using all the outstanding issuances on that day. The eligibility criteria exclude non-vanilla and hybrid features such as embedded derivatives, credit linked structures and/or equity and subordinated elements. The relevant period consists of the period from the date of administration up to the date that the cumulative distribution payments reached 100% of a creditor’s admitted claim value.
B	Affiliates	The benchmark 3M interbank offered rate, or equivalent, for the relevant contractual termination currency, plus a 25bp spread (e.g. 3M USD Libor + 25bp)	The benchmark rate reflects the typical cost of borrowing over the period, given its re-fixing nature. The 25bp spread is intended to cover the typical credit charges that a lender would apply to a loan referenced to this benchmark. The spread applied is based on the fact that in the unlikely event entities in insolvency/ Chapter 11 proceedings (such as LBIE’s affiliates) would be required to borrow funds over the relevant period, lenders to an insolvent entity would most likely have priority over all other creditors. Therefore, any credit risk would be significantly reduced.
C	Funds	The benchmark 3M interbank offered rate, or equivalent, for the relevant contractual termination currency (e.g. 3M USD Libor) plus a spread which is based on the ratio of the LBIE debt to the total assets under management as follows: Ratio <=1% = 25bp 1% < Ratio <= 5% =75bp 5% < Ratio <=10% = 200bp 10% <Ratio = 350bp	The benchmark rate reflects the typical cost of borrowing over the period, given its re-fixing nature. The step-up structure of the spread to be applied for a given creditor is intended to replicate the different levels of additional credit charge that a lender would likely apply as a result of concentration risk. We note that typically funding for these counterparties would almost exclusively have been short term transactions that are related to their prime brokerage relationships. Prior to the administration, LBIE acted as prime broker for a significant number of counterparties and typically charged between 20bp and 50bp over the benchmark rate to fund any short positions.
D	SPVs	The benchmark 3M interbank offered rate, or equivalent, for the relevant contractual termination currency, plus a 25bp spread (e.g. 3M USD Libor + 25bp)	The benchmark rate reflects the typical cost of borrowing over the period, given its re-fixing nature. The 25bp spread reflects the typical credit charge that a lender would likely charge to make the loan. The spread applied reflects the fact that many SPVs have no unencumbered assets (other than the claim into the LBIE estate) and therefore would be unlikely to borrow in the external market.
E	Other (typically Asset Managers, Charities, Brokerage Houses, Insurance Companies, etc)	The benchmark 3M interbank offered rate, or equivalent, for the relevant contractual termination currency, plus a 50bp spread (e.g. 3M USD Libor + 50bp)

Notes

i. M = Month, bp = basis points

ii. The benchmark 3M interbank offered rate is used in preference to the overnight rate or a 1M or 6M rate because this tenor is the most widely used for borrowing. The 3M interbank offered rate is less volatile and less likely to be impacted by other elements such as liquidity than a 1M rate. As a result, we consider the shorter tenor to be less appropriate as a benchmark for longer term borrowings.

iii. Entities which cease to exist during the relevant period (e.g. on a dissolution) are deemed to have survived for the full term of the outstanding debt.

Further guidance provided by the Judgment: Can LBIE challenge a certification?

The Judgment states that a certification is conclusive except where:

it is made irrationally (i.e. where it is arbitrary, capricious, perverse or reflects a decision so unreasonable that no reasonable person exercising the relevant discretion could have reached it);
it contains manifest numerical or mathematical error;
the certified cost does not fall within the scope of the expression “cost … if it were to fund or of funding the relevant amount”, as construed by the Court; or
it is made otherwise than in good faith [Judgment paras. 194, 205-207, 210](each a “Ground for Challenge” and together the “Grounds for Challenge”).

LBIE may therefore challenge a certification in circumstances where it considers that one or more Grounds for Challenge may exist. For example, if a counterparty certifies a funding rate which is materially higher than that which LBIE can anticipate based on its own analysis of publicly available market data relevant to the original counterparty, the Joint Administrators believe they are entitled to challenge the certification on the grounds that it is not within the scope of the certifiable cost of funding, as construed by the Court.

LBIE will review and assess each CIR Claim certification carefully. Amongst the points for specific consideration will be the following:

Has sufficient evidence been provided to support the certification?
Does the certification reflect only the original contractual counterparty’s cost of funding?
Does the certification reflect only the cost of borrowing the relevant amount under a loan transaction?
Does the certification solely reflect the cost of borrowing, excluding the cost of equity or other hybrid wider elements?
Is the cost of borrowing calculated on the basis that the lender has recourse to the borrower’s assets generally?
By reference to which date has the cost of funding been calculated?
What term of funding has been certified?
Who has made the certification?
Is the certification reasonable given the prevailing market and the general costs of funding observed?

In the event of a challenge by LBIE on one or more of the bases set out above or any other ground, LBIE will request evidence from the creditor to support its certification. If no evidence, or inadequate evidence, is provided, LBIE will consider those failures as sufficient to demonstrate that the certification has not met the court-sanctioned requirements.

LBIE has not yet developed a process for how challenges to certification might be resolved, whether on a consensual basis or by reference to legal proceedings.

LBIE and its Joint Administrators, and their respective officers, employees and agents disclaim any liability which may arise from this communication, or any other written or oral information provided in connection herewith, and any errors and/or omissions herein or therein.

The Joint Administrators would welcome feedback in respect of this announcement.

Feedback should be provided to the LBIE Administrators at unsecuredcreditors@lbia-eu.com by no later than 4pm on Friday 30 June 2017.