Interest rate swap null and void

Case No 3459, 18 September 2013, Court of Appeal of Milan, First Civil Division

The Court of Appeal of Milan has declared certain pre MiFID, Italian law governed, OTC interest rate swaps (not based on ISDA model agreements) null and void for lack of "causa" (a concept similar, but not directly comparable, to the common law concept of consideration). The "causa" of a derivative "lies in a bet placed by both parties" and such a bet is only valid if both parties are fully informed of the risks associated with the transaction. The Court of Appeal outlined certain information that must be provided as a minimum, including the mark to market of the derivative contract (MTM) at inception, the "possible scenarios" of the value of the MTM during the contractual relationship and bank profit. In the absence of this information, the contract is null and void for lack of "causa". This case is important because the reasoning of the court could influence other Italian judges and might even be applied to contracts drafted pursuant to ISDA models, ie governed by a foreign law.

The parties involved are an Italian bank (Bank) and a small Italian law partnership (a "società in nome collettivo" – Company). These parties entered into interest rate swap transactions documented by: (i) a master agreement dated 6 February 2004; (ii) the relevant confirmation dated 18 February 2004; (iii) a master agreement dated 31 August 2005; and (iv) the relevant confirmation dated 13 September 2005. All these contracts (the Contracts) were governed by Italian law and not based on an ISDA model agreement.1 When the Company suffered huge losses under the Contracts, it commenced proceedings against the Bank. The proceedings commenced before the Court of First Instance of Pavia (the First Instance Court) whose judgment (the First Judgment) was then appealed before the Court of Appeal of Milan (the Court of Appeal). The rules applied by the judges to the case at issue are those provided, respectively, by:

(1) Article 21 of the Italian Consolidated Law on Finance (TUF), which sets forth general criteria for disclosure duties to be performed by intermediaries (applied by the First Instance Court); and (2) Article 1418 of the Italian Civil Code, which sets forth general principles of Italian contract law providing for the nullity of the contract in the case, inter alia, of lack of "causa" (applied by the Court of Appeal).

The First Judgment

The Company sued the Bank before the First Instance Court asking it:

(1) to declare null and void the Contracts and, as a result, to restore the loss suffered by the Company (ie EUR 88.911,99); or, alternatively, (2) to order the Bank to restore the damages suffered (EUR 88.911,99) for breach of the disclosure duties set out under Article 21 TUF.

With the First Judgment (No 597/2009), the First Instance Court held the Bank responsible for damages resulting from the breach of disclosure duties under Article 21 TUF and for pre-contractual liability, without however declaring the Contracts null and void.The Bank appealed

The Appeal Judgment

The Court of Appeal2 fully upheld the Company's arguments and dismissed the Bank's appeal, on the basis that the "causa"3 of a derivative contract "lies in a bet placed by both the parties" and that a bet can be considered legitimate at law only if both parties enter into the bet consciously, ie being fully aware either of the nature as well as of the scope of the risks that the agreement would entail.

According to the Court of Appeal, in order to enter into a bet consciously, both parties should be aware at least of: (i) the value of the mark to market of the derivative contract (MTM) at the moment of its inception; (ii) any potential hidden costs; (iii) the criteria for determining the penalties in case of an early termination; (iv) the "possible scenarios" of the values of the MTM of the derivative during the course of the future contractual relationship (the so called "scenari probabilistici"); and (v) the profit for the Bank or, at least, the pricing model used to calculate this.

In light of the above-mentioned assumptions, the Court of Appeal concluded that, if evidence is given that even just one of the parties (ie in the vast majority of the cases, the non-banking counterparty) was not aware of the risk factors entailed in the bet, the bet has been entered into "blindly", and therefore, the Contracts have to be deemed null and void for lack of a legitimate "causa” at law.

According to Italian law, a derivative contract which has been declared null and void by a Court has to be considered as ineffective from the date on which the parties entered into that contract.

As a consequence of the said nullity, in the case at issue the Bank has been ordered to repay to the Company the losses it suffered under the Contracts, ie EUR 88.911,99 (as indeed if the contract was never entered into by the parties).

Implications

These decisions may have a fundamental effect in Italy in relation to the long standing debate on the validity of derivatives contracts governed by Italian law.

The decision issued by the Court of Appeal has been heavily criticed by a large majority of Italian scholars. Indeed, against the legal principles applied by the First Instance Court and by the Court of Appeal it is possible to argue that: (i) there is no express duty upon the Bank to provide the Company with the information pursuant to Article 21 TUF; and (ii) it is highly debatable that the lack of communication of certain information could affect the "causa" of a derivative contract4 and thereby determine its nullity.

It is likely that the Italian Supreme Court will be asked to rule on these matters in due course. However, in the mean time, these decisions may well influence other local courts, since Milan has a prominent role in the context of Italian case law and might encourage non-banking counterparties and local authorities to challenge the validity of loss making derivative contracts.

It is worth emphasising that both the First Instance Judgment and the Appeal Judgment do not directly affect contracts based on ISDA models, since such contracts are governed by English law and, as such, they offer an additional significant protection. Nevertheless, the reasoning of the Court of Appeal might be applied even to contracts drafted pursuant to ISDA models, which are governed by a foreign law, on the basis of public policy doctrine. As a result, these cases may prove problematic for banks.