Outside view of RPC's transparent glass building.

Competing subordinated debts – the lessons learnt from Lehmans' insolvency

08 July 2022. Published by Jake Hardy, Partner

Some 13 years ago, Lehman Brothers' sudden and unexpected insolvency sent ripples across the banking and financial services market, some of which are still felt today.

The Court of Appeal's decision in the consolidated cases of Lehman Brothers Holdings Scottish LP 3 v Lehman Brothers Holdings plc (in administration) and others1 [2021] EWCA Civ 1523 was the latest in a long line of cases seeking to unwind the issues arising from Lehman Brothers' unexpected collapse. 

The background

At the time of the Lehman collapse, the applicable capital adequacy requirements under the umbrella of the Basel II regime permitted three tiers of capital to count towards a bank's qualifying capital. Tier 2 and 3 requirements could be fulfilled by entering into loans, which could include intra-group loans. Various Lehman Brothers entities entered into a number of subordinated loan facility agreements both intra-group and with external investors which met with those requirements. The question that arose for determination is how these differing types of loan instruments ranked in the distributing administration of LB Holdings Intermediate 2 Limited (LBHI2), a UK company in the Lehman Brothers group, given that there were insufficient assets in LBHI2 to satisfy all claims by subordinated creditors. At its core was an issue as to whether external lenders had any better claim in the administration than the Lehman lending entities engaged in the intra-group arrangements.

The Court's analysis divides the claims that were the subject of the appeal into four categories: Claims A, B, C and D. Very broadly, Claim A arose under internal subordinated facility agreements between Lehman Brothers Holdings plc (LBH-PLC) as lender and LBHI2 as borrower. Claim B arose under an internal transaction involving floating rate subordinated loan notes issued by LBHI2 which were held by Lehman Brothers Holdings Scottish LP3. Claims C and D were both claims against LBH-PLC and could be satisfied out of what LBH-PLC received from LBHI2 under Claim A.  Claim C arose under subordinated intra-group loan facility agreements with Lehman Brothers UK Holdings Limited as lender and LBH-PLC as borrower. Claim D arose out of subordinated loan notes issued by LBH-PLC on the market and was advanced by LB GP No 1 Limited and Deutsche Bank as an external investor.

The issue before the Court of Appeal: what is the order of priority for the payment of subordinated debt?

The main issue for the Court was to construe the various debt instruments to determine whether they demonstrated an intention by any of the creditors to subordinate their interests to other creditors that would otherwise either rank in the same category or be junior to their interest. In doing so, the Court had regard to the following standard principles. Firstly, a creditor cannot improve its ranking in the insolvency waterfall by contract – all it can do is put itself further down the queue than it would otherwise have been. Secondly, if there is nothing in the contractual arrangements to indicate priority amongst members of the same class of creditors, the presumption is that the creditors in the group will all rank pari passu, irrespective of whether those words are used in the contractual arrangements. Thirdly, as the debt instruments were drafted by skilled professionals and were at the high end of sophistication, a textual analysis was the principal method of interpretation as opposed to more purposive approaches.

The Court also found that those who put the instruments in place took the view that the relative priority between subordinated debt instruments was a question that was not going to arise because the possible insolvency of the Lehman group was simply not something that was contemplated at the time. 

The Court of Appeal's decision on subordination

The analysis of the subordinated debt instruments is complex, but suffice to say the Court held that Claim A was to be paid in priority to Claim B.  An argument that the Claim B documents ought to be rectified to make it clear that they were not subordinated to Claim A failed on the basis that there was no clear shared intention between the parties to alter the priority between the subordinated debt instruments as no-one had really thought about it. The result was that LBH-PLC took priority.

Claims C and D were claims against LBH-PLC, which were (to the extent they could be from the funds available) to be satisfied from the proceeds of Claim A. The question then was what the relative priority of Claims C and D should be. Utilising a detailed analysis of the precise wording of the debt instruments underpinning Claims C and D, and in particular the definition of "Subordinated Liabilities", the Court concluded that Claim C (by the internal lender) was subordinated to Claim D (by at least in part Deutsche Bank as an external lender).  It followed that Claim D would be paid before Claim C, rather than Claims C and D ranking pari passu which would have been the default outcome. In terms of recoveries, this was significant, as the claims under Claim C were extensive, and would have significantly reduced the Claim D claimants' recovery if treated as pari-passu. The Court considered this to be an appropriate outcome given the loan notes in Claim D had been sold on the open market to external investors, whereas Claim C arose out of sub-debt distributed within the Lehmans group.  

The effect of guarantees in an insolvency context

One further issue that arose for determination concerned the quantum of the debt that could be proved under Claim C. When LBH-PLC entered into administration, its obligations were guaranteed by Lehman Brothers Holdings Inc (LBHI), which is the ultimate US holding company of the group.  The lender under Claim C, Lehman Brothers UK Holdings Limited (LBUK), had claimed under the guarantee and obtained a partial payment from LBHI (to whom LBUK's claims were then assigned under a settlement agreement). The question was whether LBHI (as successor to LBUK's interests under Claim C) could prove in LBH-PLC's administration for the entire amount which LBUK originally advanced to LBH-PLC, or whether it had to give credit for the payment which it had itself made to LBUK in its capacity as guarantor of LBH-PLC.

The Court considered a long line of authorities from which it concluded that, under normal circumstances, where a surety pays part of the debt guaranteed, the liability of the principal debtor is discharged to the extent of the part payment. The creditor is only entitled to claim the balance from the principal debtor. 

The question was then whether the rule against double proof in insolvencies altered that analysis. This is a rule that is intended to prevent the same debt being claimed twice – for example where the principal debtor is insolvent, the creditor has a claim against the principal debtor in respect of the debt, and the guarantor may claim indemnity from the principal debtor for any payments made to the creditor on behalf of the principal debtor in respect of the same debt. 

The Court concluded that the rule against double proof was a judge-made rule and was not intended to be rigidly applied. It considered it was important to keep in mind the purpose of the rule – which was to avoid making distributions in respect of the same debt twice.

In the context of these particular arrangements, the Court found it important that the effect of the settlement agreement between LBHI, LBH-PLC and LBUK was to discharge any claim to an indemnity that LBHI might have had against LBH-PLC. That meant there was no prospect of LBHI proving in the administration of PLC in its capacity as guarantor of PLC, and accordingly the rule against double proof did not apply. In the circumstances, Claim C was reduced by what the guarantor paid.


The key takeaway from this decision is that although the construction of complex sophisticated debt instruments will be determined largely by reference to the actual words used, this does not mean that the Courts will not find a way to a construction that is consistent with the apparent equity of providing restitution to external investors in preference to lenders in what appear to be more artificial intra-group transactions. 

The Court also adopted a purposive approach to the rule against double proof to consider the mischief that the rule was intended to prevent. Where there was no prospect of a claim being made by the guarantor, and therefore no competing claims to be policed, there was no justification for allowing the creditor to prove for the entire debt without giving credit for any part payment received.



1Full citation: Case No A3/2020/1787 between Lehman Brothers Holdings Scottish LP3 v (1) Lehman Brothers Holdings plc (in Administration) , (2) Deutsche Bank A.G. (London branch), (3) The joint administrators of LB Holdings Intermediate 2 Limited (in Administration and Case numbers A3/2020/1810 and A3/2020/1811 between (1) The joint liquidators of LB GP No 1 Limited (in Liquidation), (2) Deutsche Bank A.G. (London Branch) v (1) The joint administrators of Lehman Brothers Holdings plc (In Administration), (2) Lehman Brothers Holdings Inc.