Italian Local Authority succeeds in swap claim before the English Court

In a significant judgment in Banca Intesa Sanpaolo SpA v Comune di Venezia [2022] EWHC 2586, the English Commercial Court has found that, as a consequence of the 2020 decision of the Italian Supreme Court in Banca Nazionale del Lavoro SpA v Comune di Cattolica (Cattolica), English law governed interest rate swaps entered into by the Municipality of Venice (Venice) were void for lack of capacity. Venice was therefore entitled to restitution for the amounts paid to the Banks under the interest rate swaps. However, the English Court also found that the Banks were in principle entitled to rely on a defence of change of position in respect of payments made under back-to-back swaps with other financial institutions which operates to reduce the sums recoverable by Venice.

Background 

Following the controversial 2020 decision of the Italian Supreme Court in Cattolica, which concluded that certain interest rate swaps entered into by local authorities were void as a matter of Italian law, the Claimants, Banca Intesa Sanpaolo SPA and Dexia Crediop SA (the Banks), issued proceedings against Venice in relation to certain interest rate swaps (IRS) that were entered into under a ISDA Master Agreement in 2007 and sought declarations that the IRS were valid and binding. Venice sought alternative declarations that the IRS are not valid and, in addition, sought restitution of the net sums it had paid to the Banks over the life of the IRS. Venice argued that, as a matter of Italian law and as a consequence of the findings in Cattolica, Venice had lacked the capacity to enter into the IRS.

A key element of the IRS was that they had been entered into in order to replace a previous swap between Venice and Bear Stearns which had a significant negative mark-to-market from Venice's perspective. Rather than Venice paying the unwind costs of closing-out the original swap, the IRS were structured in such a way that the Banks paid these unwind costs (of c.€8m), with the pricing of the IRS adjusted accordingly. 

1. The Speculation Argument 

A major finding in Cattolica had been that Italian local authorities lacked the capacity to enter into speculative derivatives. While the English Court noted that the Italian Supreme Court's reasoning "may not appear entirely satisfactory", the English Court accepted that the Italian Supreme Court had spoken on this issue. The English Court therefore assessed whether, as a matter of Italian law, the IRS were in fact speculative. As Italian law does not define what a makes a derivative speculative, the assessment in this case involved a detailed analysis of Italian case law, as well as guidance found in judgments of the English Court.

The English Court concluded that under Italian law the IRS would be regarded as speculative, or at least predominantly speculative. This was based on a number of factors, including the fact that the manner in which they had been structured to cover the costs paid by the Banks to unwind the original swap meant that the IRS provided the Banks with protection of significantly greater value than Venice was obtaining from the Banks. It also meant that the pricing of the IRS diverged significantly from the prevailing forward rate curve and Venice had also taken on a significant new risk to which it had not been previously exposed to. 

2. The Indebtedness Argument 

The second argument advanced by Venice was that it had 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.

In Cattolica it was held that some derivatives constituted "indebtedness" for the purposes of Article 119, in particular derivatives which involved an "upfront loan". In this case, the English Court concluded that the payment of €8m, which the Banks had made to Bear Stearns in order to unwind the original swap and which was priced into the terms of the IRS, was as much an "upfront loan" as if the payment had been made directly by the Banks to Venice. In addition, because the IRS had been found to be speculative, it had not been entered into for the purposes of financing investment expenditure and, consequentially, contravened Article 119 of the Italian Constitution. 

As a result of the findings above, the English Court determined that the IRS had contravened Italian law restrictions which prevent Italian local authorities from entering into speculative derivatives and having recourse to indebtedness, other than for investment. The IRS was therefore void for lack of capacity as a matter of English law and Venice was entitled to restitution of all sums which it had paid to the Banks under the IRS.

The Banks' Defences 

The Banks raised a number of defences, including those outlined below. 

3. Estoppel

The Bank argued that in light of representations by Venice in the ISDA Master Agreement (representing that it had the power to enter into the IRS and that doing do did not contravene Italian law), Venice was estopped from contending that the IRS were void. The basis of the Banks' argument was that the ISDA Master Agreement was a separate contract to the other contracts which governed the IRS such that, even if the IRS contracts themselves were void, the representations in the ISDA survived and gave rise to an estoppel.

Whilst the English Court accepted that there are circumstances where the ISDA Master Agreement and individual transaction contracts could "live separate lives", in the present case the argument was rejected. The English Court considered the ISDA Master Agreement and the IRS contracts to be a single contract as they were entered into for the same purpose and at the same time and the representations relied on by the Banks under the ISDA contracts were therefore equally unenforceable.  

4. Change of Position Defence 

The Banks also advanced the defence of change of position to Venice's claims for restitution. The Banks' argued that, in order to hedge their liability under the IRS with Venice, they had entered into the back-to-back swaps with other financial institutions under which the Banks had been obliged to make significant payments. The position of the Banks had therefore changed detrimentally.

Venice's case was that it could not be said that the Banks were relying on receipt of any payment by Venice when they entered into the back-to-back swaps because these had been entered into before they received any payments from Venice and at a time when there was no certainty that the Banks would ever receive any such payments. The Banks' decisions to enter into the hedging swaps should therefore be seen as a wholly independent decision taken for their own purposes and at their own risk, rather than in reliance on the receipt of payments by Venice.

The English Court chose not to follow findings from previous case law that the defence of change of position is ordinarily only available in respect of changes made after receipt of payment (noting this would result in an "inevitable appeal"),¹ and considered that, while the Banks' decision to enter into the back-to-back hedges may have pre-dated the actual receipt of sums from Venice, it was taken in anticipation of payment from Venice and for the purpose of hedging the Banks' liabilities under the IRS. Considering the circumstances of the case, the English Court found that the Banks did, in principle, have a defence of change of position notwithstanding the fact that the IRS was void for lack of capacity. However, quantification of the value of the claim (and the impact of the Banks' defence in reducing the sums Venice is entitled to recover) remains outstanding as quantum did not form part of the trial. 

5. Limitation 

The Banks also contended that Venice's claims were time-barred. However, the English Court found that Venice could rely upon section 32(1)(c) of the Limitation Act 1980, as in this case, Venice could not with reasonable diligence have identified its mistake prior to Cattolica's publication in 2020.

Comment

This is the first time an Italian local authority has successfully argued that an English law governed swap is void as a consequence of Italian law. While the English Court's interpretation of Cattolica means that not all English law governed interest rate swaps entered into by Italian local authorities will be void (and vanilla swaps not incorporating the break cost of an earlier swap do not appear to be impugned), the English Court's findings do provide further arguments for Italian local authorities to rely upon when seeking to set-aside swaps. 

Subject to any appeal, the decision is likely to have a significant impact on other ongoing Italian swaps cases, as well as potentially triggering fresh claims by Italian local authorities. This is particularly the case where the English Court observed that many swaps entered into by Italian authorities incorporated break costs of earlier swaps, which it now appears fall foul of Cattolica, such that these swaps appear highly vulnerable to challenge.

¹Westdeutsche Landesbank Girozentrale v Islington LBC [1994] 4 All ER 890, South Tyneside MBC v Svenska International plc [1995] 1 All ER, Dextra Bank and Trust Co Ltd v Bank of Jamaica [2002] 1 All ER 1993.