English and Italian courts on opposite sides on the validity of IRS derivative contracts
13 December 2021
The debate of the conflicting trends of Italian lower courts’ case law on the validity of Interest Rate Swap (IRS) contracts following the decision by the Joint Divisions of the Supreme Court No. 8770/202 and following decision of the Commercial Court (Financial List) of the London High Court of Justice (the Commercial Court).
With our previous publications in December 2020 and April 2021, we provided an overview of the conflicting trends of Italian lower courts’ case law on the validity of Interest Rate Swap (IRS) contracts following the decision by the Joint Divisions of the Supreme Court No. 8770/2020 (the Cattolica Decision). In this heated debate, in October 2021, an important decision of the Commercial Court (Financial List) of the London High Court of Justice (the Commercial Court) took the stage, affecting significantly financial intermediaries who trade in derivative contracts.
The latter decision established that, when derivatives are governed by English law, the IRS validity requirements set out by the Cattolica Decision are not applicable even if one of the parties to the contract is Italian. Conversely, in July 2021, the Italian Supreme Court decided in accordance the Cattolica Decision on a derivative contract governed by Italian law: the Supreme Court strongly supported the principles set out by the Cattolica Decision and confirmed the nullity of an IRS contract due to the lack of mark-to-market. During these months, Italian lower courts’ case law has continued to be divided on the validity of IRS contracts.
The case submitted to the Commercial Court
In 2007, an Italian Municipality (the Municipality) and the London-based branch of a major investment bank (the Bank) entered into: (i) a Mirror Swap derivative contract to counterbalance the effect of a previous derivative contract entered into with an Italian bank; and (ii) a Cash Flow Swap derivative contract aimed at managing the Municipality’s debts (the Swaps). The relevant ISDA contracts were governed by English law. In 2013, the Municipality started making payments under the Cash Flow Swap and, in 2018, the aggregate amounts paid by the Municipality exceeded the overall payments made by the Bank. In December 2020, the Municipality decided not to proceed with any further payments, arguing that the Swaps were not valid under Italian law and that, as a consequence, the payments of 31 December 2020 and 30 June 2021 under the Cash Flow Swap were not performed. The Bank brought a claim before the Commercial Court seeking, inter alia, confirmation of the following: (i) the Municipality had capacity to enter into the Swaps; and (ii) the contracts were perfectly valid and binding. The Municipality argued that they were not bound by the Swaps because the Cattolica Decision established that Italian local authorities lack the capacity to enter into derivative transactions when the mark-to-market, probabilistic scenarios and hidden costs are not provided by financial intermediaries. Furthermore, the Municipality argued that the Cattolica Decision required that the City Council approved the Swaps, which, in the case at issue, did not occur.
The decision of the Commercial Court
In her decision of 12 October 2021 ( EWHC 2706 (Comm)), Judge Cockerill upheld the claim brought by the Bank and entirely rejected the arguments of the Municipality. The Commercial Court, among other things, held that:
- The analysis of the relevant provisions of the Italian constitution on the indebtedness of Italian local authorities (Article 119 of the Italian Constitution) shows that no restrictions on entering into derivative contracts exist, even those of a speculative nature;
- The requirements outlined in the Cattolica Decision on derivative contracts do not concern the capacity of Italian local authorities; they rather constitute contractual validity requirements of Italian law. As a result – since the Swaps between the Bank and the Municipality are governed by English law – the Cattolica Decision requirements (i.e. mark-to-market, probabilistic scenarios and the hidden costs of the derivative) are not applicable;
- Even if such requirements were relevant, requiring a bank to disclose the mark-to-market, probabilistic scenarios and hidden costs of the derivatives would be too formalistic; under the Cattolica Decision as construed by the English Court, the evaluation of the client’s effective risk assessment on a derivative contract would require a case-by-case approach;
- The Cattolica Decision established that derivative transactions must be approved by the City Council exclusively in the event of: (i) upfront payment; (ii) termination of existing loans; or (iii) a significant change in existing loans. In the case at issue, such requirements did not occur and therefore no approval by the City Council was necessary.
The recent ruling of the Italian Supreme Court
While the Commercial Court has confirmed that the principles set out in the Cattolica Decision are not applicable to contracts governed by English law, the Italian Supreme Court has once again taken the same position on the validity of IRS contracts as the Cattolica Decision, thus adopting an opposite stance to that of the Commercial Court.
In its decision of 29 July 2021 (Court of Cassation, I Division, 29 July 2021, No. 21830), the Supreme Court rejected the appeal of an Italian bank against a decision of the Court of Appeal of Milan which had declared the nullity of a plain vanilla IRS governed by Italian law due to the fact that the mark-to-market was not communicated to the client before the contract was entered into (Court of Appeal of Milan, 25 September 2018, No. 4242).
In particular, the Supreme Court – which also added to the principles set out in the Cattolica Decision – established, among other things, that:
- The mark-to-market is a critical element to obtain the client’s consent and must be provided before entering into the contract; this element is essential to determine the investor’s consent on risk and contractual costs especially when the bank’s counterparty is not a professional investor. According to this interpretation: (i) any communication of the mark-to-market during the performance of the contract would not be sufficient to fix the initial failure to agree on this value; and (ii) both a generic formulation of the calculation method and the indication of measurement criteria based on market quotations by the financial intermediaries do not constitute a valid agreement on the mark-to-market element;
- The mark-to-market – as well as the mathematical formula to calculate it – is an essential element of IRS contracts. Its omission makes it impossible to assess the risk incurred; as a result, the contract is null because its object (e. the “oggetto”, one of the characteristic elements of a contract) cannot be determined.
In addition to the aforementioned principles, the Supreme Court also clarified the scope of the Cattolica Decision:
- Failure to provide the requirements set out by the Cattolica Decision (e. mark-to-market, probabilistic scenarios and hidden costs) does not constitute a breach of disclosure obligations but rather affects the essence of the contract and determines its nullity;
- The principles of the Cattolica Decision are generally applicable: they are therefore applicable to derivative contracts entered into by banks with both public and private entities.
Italian lower courts’ case law
From our last publication in April 2021, the Italian lower courts issued an additional 32 decisions on IRS contracts. In particular:
- 22 decisions declared the nullity of the derivative contracts; whereas
- 10 decisions declared their validity.
Such scenario shows that there is no clear trend in the Italian lower courts on the validity of IRS contracts. In some courts, such as, notably, the Court of Milan, contrasting trends within different divisions of the court are emerging.
The decision by the Commercial Court shows that, as far as English courts are concerned, derivative contracts governed by English law, even if an Italian party is involved, are immune from the contractual validity requirements set out by the Cattolica Decision.
However, as far as derivative contracts regulated by Italian law are concerned, a disputable trend is emerging, in line with the Cattolica Decision, and recently confirmed once again by the Supreme Court. This trend requires financial intermediaries to provide their clients with the mark-to-market, probabilistic scenarios and hidden costs at the moment of entering into an IRS contract, otherwise the contract is null and void. Specifically, the new decision of the Italian Supreme Court seems to confirm the severe practical consequences for financial intermediaries who trade in derivatives governed by Italian law by requiring a precise indication of the mark-to-market before entering into IRS contracts under penalty of nullity.
In any event, there is a substantial number of Italian lower courts’ decisions which do not follow the principles set out in the Cattolica Decision; it is therefore still possible – and hoped for – that this trend, together with court decisions such as the Commercial Court’s decision, may lead the Italian Supreme Court to reassess its recent stand.