Case Study on Interest Owed to Liquidating Swap Counterparty

The determination of a default interest rate should be based on principles of equityand fairness in cases where the contract refers to a rate which does not exist or isimpossible to determine. As we have seen in our examination of the Master Agreement,the contract specifies a default interest rate of the counterparty’s “cost of funds” plus1% in certain cases. In most cases, the cost of funds will be ascertainable, and in theabsence of bad faith or a clear error, the counterparty may certify its cost of funds,with the cost of funds plus 1% becoming the default interest rate. In the case of a company in liquidation, however, there is no cost of funds because liquidatingcompanies do not borrow to fund themselves, and have no future as going concerns. Insuch cases, parties to disputes have come up with different theories regarding a correctmeasure of cost of funds. One rate that has been asserted by parties such as the LehmanBrothers bankruptcy estate is a high rate based on credit default swaps or bond yieldsof the liquidating company. This rate, however, is fictional, and not fair or equitablebecause such a calculation yields very high interest rates in cases of bankrupt companies(whose bankruptcy caused the event of default in the first place). We have alsoconsidered DIP financing rates, but unless there is an actual DIP facility in place, DIPfinancing rates would not be the best reference because of the unique characteristics ofDIP loans. Finally we have the concept of statutory interest as applied in English law. Statutory interest is a useful guide and strong persuasive authority to determine a fairinterest rate, but to avoid becoming punitive, a lower rate should apply in cases wherethe payor has disputed an amount in good faith. Furthermore, statutory interest is anEnglish law concept that can only technically be applied in cases governed by Englishlaw. However, judges can still find a just and equitable rate. In determining the equities,we suggest that courts also consider that the real parties in interest are the creditors ofthe bankruptcy estate, not the liquidating company itself. Therefore the interest rateapplied should be a modest one to compensate the creditors of the bankruptcy estate forthe delay in payment, rather than a very high rate linked to the destroyed credit of theliquidating company.