English Commercial Court upholds the validity of swap contracts entered into by an Italian local authority
The Commercial Court has found that there was no limitation on the capacity of the Italian local authority Busto di Arsizio to enter into a valid swap contracts with Deutsche Bank.
This is the first occasion on which the English Court has had to grapple with the 2020 Cattolica judgment of the Italian Supreme Court which caused some controversy as it had determined , in the context of a similar derivative contract, that the derivative contract was invalid and could not be enforced against the local authority (Deutsche Bank v Busto di Arsizio [2021] EWHC 2706 (Comm)).
No limitation on the capacity of the local authority to enter into mirror swap and interest rate swap
The present case related to a mirror swap and interest rate swap which Deutsche Bank (DB) and Busto Arsizio (Busto Arsizio) had entered into in 2007. The swaps were documented under an ISDA Master Agreement and contained terms providing that the swaps were governed by English law and subject to the jurisdiction of the English Court. In common with many such swaps, the fall in interest rates following the financial crisis of 2007-2008 resulted in the swaps becoming very expensive for Busto Arsizio. DB issued proceedings for declaratory relief, seeking declarations of the sort commonly seen in such cases, including that the swaps were valid and binding and that Busto Arsizio had the necessary capacity to enter into them.
In response, Busto Arsizio raised a number of arguments, including that:
- Busto Arsizio lacked capacity to enter into the swaps as Article 119 of the Italian Constitution only permitted local authorities to resort to "indebtedness" if it was in order to finance investment expenditure.
- Busto Arsizio lacked capacity to enter into the swaps because they were 'speculative' rather than for 'hedging' purposes. Here Busto Arsizio relied upon Cattolica which it said had made it clear that local authorities only had capacity to enter into derivative contracts if they were for 'hedging'.
- Busto Arsizio lacked capacity to enter into the swaps because DB had failed to provide mark to market valuations and probabilistic scenarios at the time the contract was entered into. Again Busto Arsizio relied upon Cattolica in relation to this argument although, as explained below, there was considerable ambiguity as to the scope of the Cattolica judgment's findings in this area.
As to the first argument, which fell to be resolved as a matter of statutory interpretation of Article 119 of the Italian Constitution, the Commercial Court concluded that Article 119 itself did not impose any limitation on the capacity of an Italian local authority to enter into derivatives contracts. The Commercial Court also concluded that the swaps in question did not amount to "indebtedness" for the purposes of Article 119.
Where Article 119 itself did not impose any limitations on a local authorities capacity to enter into derivative contracts, the Commercial Court was then required to assess whether the Cattolica judgment had determined that Italian local authorities lack capacity to enter into derivative contracts that (i) are ‘speculative’, rather than for ‘hedging’ purposes; and/or (ii) do not provide the mark-to-market and probabilistic scenarios of the relevant swap.
On the hedging versus speculative argument, the Commercial Court found that Cattolica had indeed determined that Italian local authorities lacked capacity to enter into speculative derivative contracts (although it was noted that the Italian Supreme Court had not pointed to any authority for this conclusion or provided any guidance on the distinction between speculation and hedging). However, after assessing the relevant mirror swap and interest rate swap in the round, the Commercial Court had no doubt in concluding that they were classic hedging products such that Busto Arsizio had not lacked capacity to enter into them.
Busto Arsizio's further argument was that in Cattolica it had been found that an Italian local authority could only enter into derivative contracts if, at the time they entered into the contract, the relevant financial counterparty had provided them with mark-to-mark values, probabilistic scenarios and details of any hidden costs. There has been considerable debate and commentary in Italy regarding the nature of the findings in Cattolica in this regard and a key question for the Commercial Court to determine was whether the section of the Cattolica judgment dealing with these issues was concerned with the capacity of Italian local authorities to enter into derivative contracts absent the provision of this information or, instead, was solely concerned with the elements of a valid contract under Italian law. Following a detailed analysis, the Commercial Court concluded that the Cattolica judgment was discussing the Italian law requirements for a contract, rather than making a broader finding regarding local authorities' capacity to enter into derivative contracts. The significance of this finding was that, where the swaps between DB and Busto Arsizio were governed by English law, any Italian law requirements that a financial institution provide mark-to-market valuations and probabilistic scenarios were inapplicable and could be disregarded by the Commercial Court.
In light of these findings, the Commercial Court found in DB's favour and concluded that the swaps were valid and binding on Busto Arsizio and that Busto Arsizio could not avoid its liabilities thereunder.
Commentary
As the first occasion on which the English Court has analysed the Cattolica judgment, this judgment represents interesting reading for anyone who has been involved in the now long list of Italian swap cases. It will be welcomed by London-based financial institutions which have entered into derivative contracts with Italian local authorities, although not by their counterparties.
While Cattolica was a judgment of the highest court in Italy, there was some uncertainty regarding whether Cattolica was authority for the proposition that Italian local authorities lacked capacity to enter into certain derivative contracts or, alternatively, had made narrower findings that a derivative contract would be invalid under Italian law if the derivative fell to be characterised as 'speculative' and/or if the financial institution providing the swap did not disclose details of the mark to market valuations and probabilistic scenarios at the time the contract was entered into. This prompted a number of Italian authorities to try and rely upon Cattolica and argue that derivative contracts which they had previously entered into were void and/or unenforceable.
The Commercial Court's finding that the Cattolica judgment was primarily concerned with the elements of a valid contract under Italian law, rather than broader questions of the capacity of local authorities to enter into derivative contracts removes a well-trodden avenue for trying to avoid obligations under English law governed swaps entered into by Italian local authorities.
A significant number of similar claims by other Italian local authorities remain in progress (both in the English and Italian Courts) and the arguments raised by the Italian local authorities may now need to evolve as they attempt to find novel ways of relying upon Cattolica in order to raise arguments regarding their capacity to enter into derivative contracts.