Swap stop

A recent ruling on an Italian local authority’s ability to escape from a swaps contract could set the scene for a heavy fightback by lenders, say Lucio Bonavitacola and Riccardo Coassin

In a landmark case Italy’s top ­administrative court recently ­handed down an important ­judgment affecting the way local authorities enter into derivatives contracts – and how they can escape from them.

The Council of State ruled that Italian administrative courts have jurisdiction over the legitimacy of the administrative ­annulment by a local authority of its ­decision to enter into derivative contracts.

Courts also have jurisdiction over the consequences of the annulment on the validity of the relevant contracts, ­notwithstanding the jurisdiction clauses in the ­contracts and prior legal proceedings pending before non-Italian courts. 

Splice of Pisa

The court further ruled that a local ­authority may, subject to certain conditions, revoke ­unilaterally its decision to enter into a ­derivative transaction, in which case the transaction must be deemed retroactively unenforceable.

The case revolved around a bond issued in 2007 by the province of Pisa to refinance its pre-existing bank debt. At the same time the province entered into a swap ­transaction with the arranging banks for hedging purposes.

Subsequently in 2009 the province used its statutory power of self-protection to annul its decision to enter into the hedging transactions with the arrangers, claiming that it had since become aware that the swaps involved carried undisclosed “implicit costs” in the form of negative mark-to-market for the province at inception.

This had made the bond issue more expensive for the province than its pre-­existing indebtedness, which constituted a breach of the Italian law requirement that local authorities might only refinance their indebtedness if there is “economic convenience” in doing so.

The province also argued that, because the swaps had been entered into on the basis of the annulled decision, the swaps were unenforceable from the beginning. On these grounds the province suspended its payments under the swaps.

The arrangers challenged the legitimacy of the annulment before the Regional Administrative Court of Tuscany, whose first-instance decision was then appealed before the Council of State.

Court appointed

The Council of State’s ruling dealt first with the question of whether Italian courts had jurisdiction over the case.

In this regard the Council of State held that Italian courts – and specifically ­administrative rather than civil courts – do have jurisdiction not only with regard to the annulment in self-protection by a local authority of its own decision, but also the consequences of the annulment on the ­contracts entered into on the basis of the annulled decision, regardless of the ­governing law of the contracts.

This is because, in the Council of State’s view, the subject of the dispute is one that the parties are not free to dispose of contractually, as it is concerned primarily with the appropriate exercise of administrative power, in the pursuit of a public interest, that ultimately led to the execution of the contract rather than the performance or interpretation of the contract itself.

Moving to the merits, the Council of State further ruled that, if a local authority acts within a reasonable timeframe and in ­pursuit of an appreciable public interest, it cannot be deemed to have waived its self-protection powers to annul unilaterally its decision to enter into a contract.

Moreover, if such an annulment is made lawfully, the contract executed on the basis of the annulled decision would in turn be deemed unenforceable retroactively.

Cost analysis

In this context it is worth noting that, in the court’s view, the mere absence of economic convenience due to the existence of ­implicit costs appears to provide sufficient grounds for the annulment of the province’s decision to enter into the swaps. This is regardless of whether or not the implicit costs should have been disclosed to the province in ­accordance with applicable business ­conduct rules, or whether or not implicit costs were excessive.

The decision of the Council of State is expected to turn up the heat in the already lively debate over the use of derivatives by Italian local authorities in the past few years.
Local authorities may feel encouraged to follow Pisa’s example and opt for the ­unilateral annulment of their decisions to stipulate the derivative contracts by way
of self-protection rather than being ­compelled to commence litigation before the civil courts, thus placing on the banks the onus of starting proceedings before the administrative courts in order to challenge the annulment.

The start of something big?

This may not be the end of it, however. Because it rules on matters of jurisdiction, the Council of State decision can still be appealed before the Supreme Court of ­Cassation. Besides, foreign courts ­stipulated to have jurisdiction in accordance with the jurisdiction clauses in the International Swaps and Derivatives Association (ISDA) Master Agreement may take a stance against the position of the Council of State, leveraging on Council Regulation (EC) 44/2001 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters.

Lucio Bonavitacola is a partner and ­Riccardo Coassin is an associate in Clifford Chance’s debt capital markets group