The conflict between the views of the Italian case law on derivatives in 2020
23 December 2020
Serious risks of invalidity, restitution effects and possible defences.
Italian Courts issued numerous rulings on derivatives in the last decade: but the year 2020 has been particularly dense of judgments and could mark a turning point. Indeed, in a judgment of May 2020, the Joint Divisions of the Italian Supreme Court set out some general principles on Interest Rate Swap agreements, declaring them null and void in the absence of certain requirements. Even before May and then in the following months of this year, numerous other merit judgements were issued: the majority shared the opinion of the Supreme Court but some expressed also a different view.
This document analyses these two different views and indicates the risk profiles that may arise as serial litigation cannot be excluded.
The decision of the Joint Divisions of the Italian Court of Cassation
By Decision No. 8770 of 12 May 2020, the Joint Divisions of the Italian Court of Cassation – widely commented by the press and scholars – ruled on the validity of derivative contracts (in this case IRS) entered into with local public authorities (enti pubblici). The Court – in addition to dealing with some very specific issues related to local public authorities – has however stated some general principles applicable also to derivatives entered into with companies and individuals. In particular, the Joint Divisions have ruled that the bank must – at the time the contracts are signed – disclose to the client, inter alia, the mark to market and the probabilistic scenarios. If this information is not disclosed, the contract lacks causa and its object is undetermined, which causes the invalidity of the same.
The 2020 merit rulings
The principles at law expressed by the Court of Cassation were already set out by a ruling of the Court of Appeal of Milan (Court of Appeal of Milan, 18 September 2013, No. 3459). During 2020, at least six other merit rulings by Tribunals followed the same trend and declared the nullity of over the counter Interest Rate Swap (IRS) contracts governed by Italian Law and mainly concluded with companies.
Among these judgments, the following five have been published:
- Tribunal of Florence, 24 February 2020, No. 561;
- Tribunal of Pescara, 31 March 2020, No. 300;
- Tribunal of Bergamo, 18 June 2020, No. 786;
- Tribunal of Florence, 24 August 2020, No. 1865;
- Tribunal of Pavia, 2 October 2020, No. 870.
The judgments declaring the nullity of IRS contracts substantially grounded their decisions on the following legal arguments:
- IRS contracts are a “sort of differential financial bet” (Court of Cassation, Joint Divisions, judgment 12 May 2020, No. 8770) which may have a hedging or speculative function; this sort of bet is protected by the law only when the risk of the contract can be considered as “reasonable”. The investor must be able to understand, when it signs the contract, its real mechanics and therefore must know the exact perspective of economic advantage and/or disadvantage deriving from the transaction and thus the degree of risk it takes on itself;
- only a reasonable risk integrates the concrete causa of the contract (i.e. its economic purpose), which, in this way, becomes worthy of protection by the law as set forth by Art. 1322 of the Italian Civil Code (ICC); from another point of view, the data identifying the risk are necessary to determine another essential element of the contract, namely its object (oggetto) and, therefore, the obligations that arise for each party;
- therefore, for the contract to be valid, it has to present a concrete causa and its object has to be determined or (at least) determinable. It is thus necessary that, at the time of its stipulation, the bank informs the client, inter alia, the mark to market as well as the “probabilistic scenarios”, the latter being understood as the likely return of the two interest flows, taking into account the forecast curves (forward curves) and the future perspectives of the interest rate trends; and
- lacking these elements, the above-mentioned judgments have therefore declared null and void the contracts and ordered the bank to return the flows received during the contractual relationship, in addition to the legal interest.
On the contrary, as far as we are aware, always in 2020 at least three merit rulings (whose two published) declared the validity of derivative contracts:
- Court of Appeal of Milan, 28 July 2020, No. 2003;
- Tribunal of Milan, 14 October 2020, No. 6224.
The rulings declaring the validity of IRS contracts have been substantially grounded on the following legal arguments that however might have been determined by the specific factual elements of the underlying cases:
- in the above-mentioned cases, the IRS could not be declared null and void for lack of causa as they featured “an adequate causal characterization of underlying risk hedging”. These were, in fact, plain vanilla IRS contracts closely linked to underlying floating rate leasing contracts (Euribor 3 months), aimed at obtaining a conversion of the floating rate paid with the lease with a fixed rate (Tribunal of Milan, 14 October 2020, No. 6224);
- the mark to market does not constitute the object of the IRS contract and, therefore, it cannot be undetermined or undeterminable: instead “the object of the derivative contract is the exchange of differentials calculated on a certain amount, called notional, at a given maturity, while the mark to market constitutes a different element and, in particular, represents the replacement value of the derivative at a given time” (Tribunal of Milan, 14 October 2020, No. 6224);
- therefore, it is not mandatory to disclose the mark to market within the contract; moreover, and with reference to the specific cases decided in these judgments, the plain vanilla IRS contracts actually contained the elements for determining the value of the mark to market (i.e. the duration of the contract, the payment dates, the notional principal amount, the agreed fixed rate, the rule of calculation of interests); and
- likewise, it is not necessary to disclose the probabilistic scenarios within the contract; in one of the cases decided, the Court has, inter alia, found that the data used for discounting expected future cash flows and for the calculation of forward rates were in any case “publicly available” by means of applications such as Bloomberg (Court of Appeal of Milan, 28 July 2020, No. 2003).
Risk assessment profiles
This brief review of the 2020 case law commented on above leads to two risk assessment profiles.
Firstly, the Joint Divisions of the Court of Cassation and other merit rulings have expressed a trend, which, at present, seems to be majority for the nullity of the IRS contracts.
It is therefore clear that there is a risk that a material number of new litigation may arise, with subsequent decisions that may lead to the nullity of derivative contracts entered into between banks and companies, for the lack of disclosure, at the time of their stipulation, of the mark to market and probabilistic scenarios as well. As is well known, the action for nullity is not subject to statute limitation (prescrizione) although the restitution action, i.e. the one aimed at obtaining the restitution from the bank of the flows paid during the contractual relationship, is subject to a limitation of ten years.
Secondly, the aforementioned ruling of the Tribunal of Florence (Tribunal of Florence on 24 February 2020, No. 561) – which declared the nullity of some IRS contracts – has also stated that the amounts to be returned by the bank, following the nullity of the contracts, must be charged with legal interest. In this case, the Tribunal ruled not to apply the standard rate set forth by Art. 1284, section 1, of the Italian Civil Code (ICC), but the increased rate of 8% set forth by Art. 1284, section 4, ICC, despite the fact that the claimant had not made a specific request for the said increased rate.
It is therefore clear that, in the event of a negative outcome of litigation on derivatives agreements, the risks may become extremely serious – including the possible underestimations of “the provisions for risks and charges” made in respect of the relevant litigation – and so the analysis of the specific positions in derivatives is certainly worth to be closely evaluated by banks and financial intermediaries.