Court of Appeal overturns High Court's high-profile Italian swaps decision

The Court of Appeal has overturned the High Court's decision that interest rate swaps entered into between the appellant banks and an Italian local authority were void for lack of capacity: Banca Intesa Sanpaolo and Dexia Credit Local SA v Comune di Venezia [2023] EWCA Civ 1482.

The High Court previously found that the swap transactions were void because they were speculative and involved recourse to indebtedness, on the basis of the 2020 Italian Supreme Court judgment in Banca Nazionale del Lavoro SpA v Comune di Cattolica (8770/2020). The Court of Appeal comprehensively rejected the High Court's reasoning, concluding that structuring the transactions to cover the costs of winding up an existing swap did not amount to speculation or indebtedness.

There has been a wave of disputes relating to swaps entered into by Italian public authorities which the authorities have sought to unwind on the basis of lack of capacity (for example, see our previous blog post here). The High Court's decision in this case was an outlier as the only decision of an English court to find that the relevant swaps were invalid as a result of Cattolica. Accordingly, the Court of Appeal's decision is a welcome development for banks both in the context of Italian swaps litigation and for derivatives claims involving allegations of lack of capacity more generally. It has already been considered and followed in Banca Nazionale del Lavoro, Commerzbank and Dexia Credit Local v Provincia di Catanzaro [2023] EWHC 3309 (Comm), with the High Court applying the test identified by the Court of Appeal in this case. The present judgment also includes an interesting analysis of the correct approach to appeals on findings of foreign law.

Further, the Court of Appeal gave some helpful guidance in respect of the defences available in response to the local authority's counterclaim for restitution of sums paid to the banks under the swap transactions. It confirmed that, in principle, a defence of change of position in respect of payments made under back-to-back hedging arrangements was available to the appellant banks on the basis that they had entered into those arrangements in anticipatory reliance on the payments to be made under the transactions. This finding is of potentially broader significance to banks, who typically hedge their market risk of derivative transactions with clients, meaning that even if those transactions are later found to be void, the liability to repay any sums received under the derivatives may be substantially reduced or extinguished.

We consider the decision in further detail below.

Background

In 2002, the Italian local authority Comune di Venezia (Venice) issued a 20-year floating rate bond (the Rialto Bond). It also entered into an interest rate swap with Bear Stearns (the Bear Stearns Swap) for the same notional amount, in order to hedge Venice's interest rate exposure under the Rialto Bond. The Bear Stearns Swap was an interest rate collar, which provided a cap on the variable rate payable under the Rialto Bond and a floor below which it would pay a fixed rate.

In 2007, the Rialto Bond was restructured by extending its maturity date to 2037, with an amended coupon (the Amended Rialto Bond). As a consequence of the restructuring, the Bear Stearns Swap was no longer aligned with Venice's exposure to interest rate risk under the Amended Rialto Bond. However, Bear Stearns was unwilling to amend the Bear Stearns Swap, so Venice agreed to a restructuring with the appellant banks (the Banks), whereby the notional amount of the Bear Stearns Swap was novated to the Banks in return for novation fees paid by the Banks to Bear Stearns. The novation fees reflected the value to Bear Stearns of the Bear Stearns Swap at that time (ie, the mark to market (MTM) in its favour).

The restructuring also involved Venice agreeing the terms of a new interest rate swap with each of the Banks (the Transactions), which together replaced the Bear Stearns Swap. The Transactions were interest rate collars which again provided for a cap and a floor rate to be paid by Venice. The terms of the Transactions matched the Amended Rialto Bond as to termination date, interest rate paid by the Banks, notional amount and amortisation schedule. Separately, the Banks also entered into "back to back" swaps with other banks that hedged their exposure under the Transactions.

Until 2019, Venice did not seek to dispute the validity of the Transactions but continued to pay sums which fell due under them. However, in June 2019, Venice commenced proceedings against the Banks in Italy claiming damages for breach of various alleged advisory duties. In August 2019, the Banks commenced proceedings in England seeking declarations that the Transactions were valid and binding.

In May 2020, the Italian Supreme Court issued its decision in Cattolica, holding that a local authority did not have capacity to enter into speculative derivatives and that certain types of swaps could constitute indebtedness (the Italian constitution does not permit local authorities to incur indebtedness except for the purpose of investment expenditure). This represented a significant change from what Italian law had previously been thought to be. Although the Transactions themselves were governed by English law under the terms of a 1992 ISDA Master Agreement, the question of Venice's capacity to enter into the Transactions was determined by reference to Italian law (in accordance with the usual conflict of laws analysis).

Venice served its defence in the English proceedings after the Cattolica decision had been issued, relying on the decision to allege that the Transactions were void for lack of capacity. Venice also counterclaimed for restitution from the Banks of the sums it had paid to them under the Transactions (which amounted to more than €70 million), alleging that the Banks were unjustly enriched by receipt of sums paid under contracts which were void.

High Court decision

In its judgment in February 2023, the High Court found in favour of Venice. In its judgment, the Transactions were void because Venice had no power to enter into them under Italian law on the basis that they were speculative and involved recourse to indebtedness in breach of the Italian constitution. As such, Venice lacked capacity to enter the Transactions as a matter of English law.

The High Court also found that Venice's counterclaim for restitution of sums paid under the Transactions was not time-barred, but that the Banks were in principle entitled to raise a defence of change of position to that counterclaim.

Court of Appeal decision

The Court of Appeal overturned the High Court's decision. It did so on the basis of the Banks' first two (of five) grounds of appeal, which concerned whether the Transactions were (1) speculative, and (2) involved recourse to indebtedness.

Status of the findings of foreign law at trial

An important initial question in relation to whether the Transactions were speculative and/or constituted indebtedness was how the Court of Appeal should treat the first instance findings of foreign law in this case.

The Court of Appeal noted that there is a spectrum of circumstances in which a trial judge can use their skill and experience of domestic law/rules of statutory interpretation to ascertain the foreign law and apply it to the case in question, per Perry v Lopag Trust Reg [2023] UKPC 16. At one end of the spectrum there will be considerable scope for the judge to use their experience where the foreign law is a common law system applying the same/analogous principles as English law. At the other end of the spectrum are cases of disputed foreign law, in which the skill/experience of the judge in domestic law has a minimal role, and the court is dependent on expert evidence of foreign law. In the latter type of case, the trial judge's findings on the content and application of foreign law are akin to other findings of fact and the first appellate court should be slow to intervene in the judge's assessment.

The Court of Appeal considered that the trial judge's analysis in the present case did not involve conclusions of Italian law based on the expert evidence, but the judge's own evaluation of where an Italian court would conclude that the Transactions were speculative and/or constituted indebtedness. This involved, in effect, the judge's own application of Italian law to the facts. Accordingly, the case was at the end of the Perry spectrum which made the trial judge's conclusions more amenable to review by the Court of Appeal, provided that some error of principle by the judge could be identified (which the Court of Appeal then went on to consider, as discussed below).

Speculation vs hedging

The Italian Supreme Court in Cattolica found that a local authority did not have capacity to enter into speculative derivatives. However, Cattolica did not provide a definition of what constitutes a speculative derivative.

The key reason why the High Court concluded that the Transactions were speculative was because they were structured to cover the costs of winding-up the Bears Stearns Swap with its substantial negative MTM. To achieve this, the negative MTM was rolled over into the terms of Transactions, with the value to the Banks of the interest rate floor being more than five times the value to Venice of the cap. The High Court agreed with Venice that structuring the Transactions in this way was akin to borrowing money (ie the sum to cover the MTM costs) but instead of repaying it on predictable terms, entering into a bet with a range of possible outcomes depending on what happened to interest rates.

The Court of Appeal disagreed. It considered that the High Court's "root error" was the failure to factor into its analysis that the Bear Stearns Swap was a valid contract which amounted to hedging. In particular, the Court of Appeal highlighted the following:

• Validity of original Bear Stearns Swap. Venice did not argue before the High Court that the Bear Stearns Swap was speculative. The High Court should therefore have concluded that the Bear Stearns swap was hedging and was valid, binding Venice at the time of the restructuring of the Rialto Bond.
• Restructure of Bear Stearns Swap needed to take account of existing negative MTM. In order to align with the new terms and extended maturity date of the Amended Rialto Bond, Venice needed either to renegotiate and restructure the Bear Stearns Swap or enter into a new swap with another bank. If Bear Stearns had agreed to restructure the Bear Stearns Swap to align to the Amended Rialto Bond: (a) it would have been just as much a hedge as the swap it replaced; and (b) any restructuring by Bear Stearns would have necessarily taken account of the existing negative MTM.
• Restructuring did not convert valid hedging into speculation. The disparity between the value of the cap and the floor in the new Transactions corresponded to the negative MTM as it had been under the Bear Stearns Swap. Contrary to the High Court's conclusion, that negative MTM was an existing exposure of Venice, not a new exposure or risk which Venice had taken on as a result of the Transactions. If that existing exposure had remained to Bear Stearns, it would not have somehow converted a valid hedging swap into something speculative when the swap was restructured. It was difficult to see how, merely because the same exposure or risk was now to the Banks, what would otherwise have been hedging became speculative. The novation and entering of the Transactions, and rolling over the negative MTM which was a pre-existing non-speculative risk, could not turn what had previously been hedging into speculation.

The Court of Appeal therefore found that the Italian Supreme Court would have concluded that the Transactions were hedging. They gave Venice the benefit of an extended maturity period and other terms to correlate with the Amended Rialto Bond, without altering the economic effect of the Bear Stearns Swap.

Indebtedness

As noted above, under the Italian constitution, a local authority is not permitted to have recourse to indebtedness other than for the purpose of investment. The Italian Supreme Court found in Cattolica that a swap can constitute indebtedness if it amounts to an upfront loan or payment. An upfront payment in the context of derivatives (in Italian law) is an amount of money paid by one party to another to rebalance the financial situation of the parties in "non-par" swaps, ie swaps whose value at inception is not equal to zero.

The Court of Appeal overturned the High Court's decision that the novation fees paid by the Banks to Bear Stearns and then "embedded" into the terms of the Transactions constituted an "upfront payment" for the purposes of the Cattolica principles. The basis for the High Court's conclusion was that, although the novation fees were paid to Bear Stearns (rather than to Venice as the other party to the Transactions), those payments had the same economic effect as an upfront payment by the Banks to Venice. That was because Venice benefitted from the payment by the Banks through the Bear Stearns Swap being discharged, but was expected in effect to repay it through the terms of the Transactions.

The Court of Appeal held that this analysis overlooked the fact that the Bear Stearns Swap was valid hedging, under which the negative MTM was an existing exposure which Venice faced. If Bear Stearns had agreed to renegotiate its swap, it could not be said that, in rolling over the negative MTM into a restructured swap, Bear Stearns was making an upfront payment. Similarly, in circumstances where the Banks took over the Bear Stearns Swap and paid the novation fees to stand in its shoes, it could not be said that the novation fees somehow became an upfront payment.

The Court of Appeal also overturned the High Court's conclusion that the novation fees were not "for the purpose of financing investment expenditure". This followed from the fact that the High Court was wrong to find that the Transactions were speculative. The restructuring of the Rialto Bond itself was clearly for the purpose of financing Venice's investment expenditure and so too were the Transactions, given that they were an integral and necessary part of that restructuring.

The Court of Appeal therefore upheld the Banks' appeal on their first two grounds, finding that Venice did have capacity to enter into the Transactions, which accordingly were valid and binding on it.

Other issues

The Court of Appeal dealt more briefly with the parties' other grounds of appeal, which were all predicated on the Banks' first two grounds failing and so were academic given that the first two grounds succeeded. Although obiter, the Court of Appeal made a number of comments which may be important for other derivatives cases. These included the following:

1. Applicable law. The High Court was right to conclude that Venice's unjust enrichment claims were governed by English law. The Court of Appeal considered that there is an obvious very close and real connection between the law which determines whether the Transactions are void (which was English law in this case) and the law which determines whether unjust enrichment claims can be brought as a result of finding that they were void. This means that a claim in unjust enrichment to recover payments made under a void contract will usually be governed by the law applicable to the putative contract, a point on which there had previously been some uncertainty.
2. Limitation. The High Court had misapplied the law in concluding that Venice could not with reasonable diligence have discovered that it had a worthwhile claim prior to the Cattolica decision in May 2020 (such that time did not start running until that date). In fact, Venice should have recognised that it had a worthwhile claim justifying preliminary steps towards issuing proceedings from around 2010 when many Italian local authorities (including Prato) did just that. Although Prato's claim subsequently failed (see Dexia Crediop SpA v Comune di Prato [2015] EWHC 1746 (Comm)), for limitation purposes this was irrelevant. Venice did not need to know that its claim would succeed, just that it would be able to plead a proper case. Accordingly, the High Court should have concluded that Venice's claims for payments made more than six years before the issue of the claim form were time barred.
3. Change of position defence. The High Court was correct to hold that, in principle, a defence of change of position in respect of payments made under back-to-back hedging arrangements was available to the Banks on the basis that the Banks had entered into those arrangements in anticipatory reliance on the payments to be made under the Transactions.

Note: In May 2024, the Supreme Court refused permission to appeal.