On 14 October 2022, the High Court of Justice of England and Wales declared that the derivative contracts entered into by an Italian local authority with some banks in December 2007 are void and unenforceable (Case FL-2019-000012, ref. [2022] EWHC 2586 (Comm)). The High Court held that the municipality in question lacked capacity to enter into such derivatives as they were predominantly speculative and created additional debt for the local authority, which was not aimed at financing investment expenditure, in violation of Article 119(6) of the Italian Constitution.

This ruling is a significant turning point in English case law. In the vast litigation involving banks and Italian local authorities before Italian courts, some banks have turned to English courts both to resolve jurisdictional issues and to have the validity of swap contracts ascertained in advance to avoid the uncertainties of litigation threatened or pending in Italy. In contrast to the well-established approach of English courts which recognizes the validity of derivative contracts, by this decision, for the first time, the English judge declared the invalidity of swap contracts governed by English law and entered into by an Italian local authority based on the principles set forth by the Joint Divisions of the Italian Supreme Court in the decision no. 8770/2020.

In this case, the banks sought declarations before the English court that certain interest rate swap transactions they entered into with an Italian municipality on 21 December 2007 are valid and binding, and alternative relief in contract and tort if it was found that they are not. The municipality, for various reasons, sought declarations that the same transactions are not valid and binding (and relief in unjust enrichment), and alternatively relief in contract and tort if it was found that they are.

A crucial circumstance in this case was that the swap transactions restructured – inter alia – a previous derivative transaction entered into with a US bank. This position was early terminated against a payment made by the banks. The cost of the early termination, borne by the banks, was subsequently “absorbed” into the contractual terms of the transactions to the detriment of the municipality, significantly altering the contractual balances.

In particular, the invalidity of the contracts was argued on the basis of two main arguments: (i) the English court held that the contracts were speculative and as such the municipality lacked capacity to enter into such contracts, and (ii) it considered them as indebtedness for the municipality, indebtedness that was not used to finance investment expenditures, in compliance with Article 119(6) of the Constitution, but to finance the early termination of the previous derivative transaction.

i) As to the speculative nature of the contracts, based on an analytical and in-depth analysis of the abovementioned decision no. 8770/2020 as well as the Italian regulatory and case law framework and the English case law, the judge held that “an Italian court would clearly find that the Transactions were speculative“.

The judge found that the costs of winding up the previous derivative had had a significant negative impact on the contractual terms for the municipality. This would confirm the speculative nature of the transactions, which had a considerable negative MtM for the municipality (10.5 million) from the outset due to such costs that were subsequently ‘absorbed' in the components of the new derivative.

Indeed, the collar component had a considerable imbalance in favour of the Banks: the value of the floor was five times the value of the cap; the floor was between 80 and 100 basis points higher than it would otherwise have been. The minimum interest rate that the municipality paid pursuant to the transactions was not aligned with the forward rate curve at inception, so the probability of the municipality losing money on the transactions was higher than the risks it would have assumed if only the underlying liability had been considered.

This led the English court to find that the transactions were “predominantly speculative”.

ii) The contracts had a further unlawful aspect. The transactions created additional indebtedness which was not used to finance investment expenditures as required by Article 119(6) of the Constitution.

According to the judge, it is not sufficient, as the Banks contend, to argue that the previous derivative transaction was issued to finance expenditures, and that the costs of termination of the previous swap were paid as part of a transaction undertaken to restructure that debt, but he considers such costs as an upfront payment, embedded in the transactions, which, according to the principles of the decision no. 8770/2020, were the loan element. The upfront rendered the transactions a recourse to indebtedness, that was not entered into for the purpose of financing investment expenditures, as required by Article 119(6) of the Constitution, but in order to meet the winding-up costs of the previous derivative transaction. For this reason, the court held that the transactions contravened Article 119(6) of the Constitution.

The predominantly speculative nature together with the unlawfulness of the additional indebtedness created by the derivatives led judge Foxton to declare the invalidity of the swap contracts. The municipality lacked capacity to enter into the transactions since Italian local authorities are not allowed to enter into speculative transactions or to have recourse to indebtedness otherwise that for the purpose of financing investment expenditures.

It is interesting to note that although the municipality is entitled to restitution of the amounts paid to the banks under the transactions, the judge allowed the banks to rely on a defence of change of position in respect of payments made under the “back-to-back” hedging swaps.

According to this defence, which in principle is not available as a matter of Italian law, it would be inequitable to make full restitution of the undue amounts since, after the derivative contracts were entered into, the banks' position changed due to the hedging transactions.

According to the judge, this defence will temper some of the consequences which would otherwise flow from the decision issued by the Joint Divisions no. 8770/2020, “a legal development in 2020 leading to a transaction which both parties had treated as binding for nearly 13 years being held to be void from the outset”.

We will see if and how such a defense will make the recourse to English courts more favorable for banks in claims for nullity of the swap contracts entered into with Italian local authorities.

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