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Pro-bank decision in local authorities' swap disputes

Dec 2012

The Italian Administrative Supreme Court has handed down a landmark decision (Decision No 5962 Judgment of the Consiglio di Stato, 27 November 2012) regarding the enforceability of interest rate swap agreements entered into with Italian local authorities.

The court held that certain interest rate swaps could not be executed at mid-market prices and price components such as credit charges, hedging charges and profits could be legitimately charged by banks in their role as investment services providers.

The banks were under no obligation to disclose such price components to Pisa. The decision will affect numerous long-standing disputes currently pending in Italy (and England) on the validity of swap transactions.

The dispute relates to two interest rate swap transactions (the Swaps) entered into in July 2007 between DEPFA Bank plc, Dexia Crediop SpA (the Banks), both represented by the Italian and London offices of Allen & Overy LLP, and the Province of Pisa, an Italian local authority (Pisa). The Swaps are ISDA documented contracts governed by English law and subject to the jurisdiction of the English courts.

In June 2009, Pisa alleged that the Swaps were unenforceable and requested an immediate write-off of the amounts owed by it under the Swaps. The Banks commenced proceedings before the English Commercial Court seeking declaratory relief as to the validity of the Swaps. On 25 May 2010, the English court affirmed its jurisdiction over the case at hand and dismissed Pisa’s jurisdictional challenge.

Pisa subsequently issued executive decisions whereby it annulled, by self-redress, the resolutions adopted in 2007 which authorised the execution of the Swaps (the Selfredress Decisions). Consequently, the Banks commenced separate proceedings before the Italian administrative courts in October 2009 challenging the validity of the Selfredress Decisions.

In September 2011, the Italian court issued a preliminary judgment affirming jurisdiction on the validity of the Self-redress Decisions and their effects on the Swaps.

However, since the issues to be dealt with were too complex and technical to be decided by the court, the court appointed a technical expert (the Expert) to provide further analysis on these points. Meanwhile, the English proceedings have been stayed since 9 May 2012 pending the Italian court’s judgment.

Pisa’s arguments

It has been Pisa’s main allegation in both the English and Italian proceedings that: (i) the Swaps should have a zero (or neutral) market value at inception, with the consequence that the actual initial negative mark-to-market value for Pisa represented profits gained by the Banks and costs borne by Pisa which were undisclosed and unknown to Pisa; (ii) the presence of these “hidden costs” would have altered the initial analysis of the suitability and economic convenience of the transaction for a public body (as Italian legislation imposes a test of “economic convenience” for debt restructuring transactions entered into by public bodies); and (iii) the presumed mispricing meant that the Banks were in violation of rules of conduct set out in the financial services laws concerning transparency and disclosure duties in the provision of investment services to customers.

These arguments were also adopted by other local authorities in respect of their swap transactions.

Italian court decision

Agreeing with the Expert, the Italian court recognised that, in practice, the initial market value of the Swaps could not be equal to zero, as the relevant mid-market (theoretical) value is used as a benchmark to determine the pricing of the derivative and is adjusted to cover various necessary transaction costs and risks incurred by the intermediary as well as to provide a return for its services. As a consequence, the price components of the Swaps such as credit charges, hedging charges and even profits cannot be regarded as “implicit costs” but rather as legitimate charges by the banks as part of their services.

If there is any excess margin after such components have been calculated, this may be deemed to be “implicit costs”, however these are not costs actually borne by the counterparty or profits gained by the bank, as they are not actually paid by one party to the other. Moreover, in the Pisa case, the relevant costs (assessed at EUR 320,000 by the Expert, as opposed to the approximately EUR 1,356,000 claimed by Pisa) would not affect the economic convenience of the debt restructuring transaction put in place by Pisa in the context of which the Swaps were executed. As a consequence, the Self-redress Decisions were deemed to be illegitimate.

From a regulatory standpoint, there was no obligation on the part of the Banks to disclose the various components of the final price of the Swaps to Pisa at the time the Swaps were executed (ie before 1 November 2007, the date on which the MiFID Directive was implemented in Italy). On this basis, the court concluded that the Banks acted at all times in good faith and that Pisa had a duty of due diligence to seek the information that it deemed necessary to properly evaluate and undertake its decision to enter into the Swaps. Finally, as Pisa had already executed swap transactions in the past, the court stated that the Banks could reasonably have assumed a certain degree of understanding by Pisa.


The current economic downturn and resultant fiscal pressures on local governments has resulted in many local authorities challenging the validity and enforceability of derivative contracts based on allegations of mispricing, misconduct and, in some cases, fraud. In this context, the Pisa judgment is important as it shows the Italian court robustly rejecting some of these types of arguments.

Helpful for banks is the court’s recognition that a correct pricing methodology of swap transactions necessarily reflects the costs and risks (eg credit and hedging charges) that are part of a financial intermediary’s role of providing investment services to customers. The idea of a purported obligation to execute swap transactions at mid-market value, which was pleaded by the local authorities in several of the current cases, was shown to be groundless.

This is likely to have a sizeable impact from a legal standpoint as it means that the “implicit costs” allegation will be extremely unlikely to be used to justify repudiation of a swap contract based on an alleged imbalance of information available to each party.

Likewise, the court’s endorsement of the banks’ transparent and fair behaviour is also encouraging, particularly given recent case law and media articles, which have often blamed banks for presumed misconduct resulting in increased scrutiny of the banks’ behaviour in executing transactions with local authorities.

Such entities were often portrayed as a “weak” counterparty who has been deprived of any due care and transparency in information provision. Perhaps this judgment will signify a reversal in such views as the court here stressed an increased responsibility on the part of the local authorities and demonstrated a deeper understanding of the financial aspects of these types of transactions.

Southern Europe