Local authority had capacity to enter swaps, but "jurisprudential jeopardy" remains
This decision overturns the high profile ruling from the Commercial Court in autumn 2022 which we discussed previously.
The Commercial Court concluded that Venice did not, as a matter of Italian law, have capacity to enter into the swaps at the heart of the case. The CoA has overturned that decision, concluding that Venice did in fact have such capacity.
However, the CoA declined permission to appeal on the question whether application of the Italian Supreme Court’s 2020 Cattolica ruling1 to events in 2007 was wrong on the basis that it constituted a retrospective change of law. This leaves in place the rather unpalatable risk of future changes in foreign law undermining past English law obligations. It is therefore welcome that the CoA agreed that the Banks would have had a "change of position" defence had they required it in response to a claim in restitution.
In December 2002, Venice issued a 20-year floating rate bond (the Bond). It also entered into an interest rate swap with Bear Sterns for the same notional amount so as to hedge its interest rate exposure on the Bond.
In 2007, the Bond was restructured. This had the consequence that the swap with Bear Sterns no longer aligned with the interest rate risk to which Venice was exposed. Bear Sterns was not willing to amend the swap to address this. Venice therefore agreed a novation and restructuring of the swap with the Banks instead.
The swaps were subsequently the subject of disputes. In June 2019 Venice commenced litigation against the Banks in Italy claiming damages for breach of contractual and non-contractual duties. In August 2019, the Banks commenced proceedings in England for declarations that the transactions were valid and binding, and for alternative relief in contract and tort.
The English proceedings led to the judgment of Foxton J on 14 October 2022 finding that Venice lacked capacity to enter into the swaps in 2007 and that as such they were void.
As discussed in our blog post, this was because the 2020 Cattolica decision of the Italian Supreme Court meant that Italian local authorities do not have the substantive legal power to enter into swaps if they are speculative and contravene certain Italian statutory provisions such as to constitute “indebtedness” other than for the purpose of financing investment expenditures. Applying the Cattolica decision, Foxton J found that the swaps were speculative, constituted indebtedness, and so were void for lack of capacity on Venice’s part to enter into them.
That was a striking judgment, and one at which Foxton J himself appeared to feel some discomfort, raising the question whether English law obligations “should be capable of being subject to a continuing jurisprudential jeopardy of this kind.”
Further, because the swaps were void, Venice was said to have a claim in restitution to recover the sums it had paid out under the swaps. However, the Banks were free to argue a change of position defence in response to any such claim.
The Banks pursued five grounds of appeal.
1. The judge was wrong to hold that the transactions were speculative under Italian law because the pricing reflected the negative mark-to-market (MTM) of the original Bear Stearns swap.
2. The judge was wrong to hold that the transactions involved payment of an “upfront” and thus “recourse to indebtedness”.
3. If grounds one and two were to fail, the judge was wrong to hold that the Italian law rules on speculation and indebtedness explored in Cattolica were to be characterised under English law as limits on Venice’s capacity.
4. If grounds one to three fail, the judge was wrong to apply the law as stated in Cattolica in 2020 to transactions entered into in 2007 because the development of Italian law in Cattolica was not reasonably foreseeable as at the date of the transactions, and thus constituted a retrospective change of law. (Note that at the time of the hearing, the Banks had not received permission to appeal on this ground.)
5. Only if the CoA were to uphold the conclusion that the transactions were void, the judge was wrong to hold that s.32(1)(c) of the Limitation Act 19802 applied so as to mean that Venice’s claims in restitution were not time barred.
Venice pursued two grounds of appeal of its own.
1. The judge was wrong to find that Venice’s counterclaim for restitution was governed by English law rather than Italian law.
2. The judge was wrong to find that there is a principled case for recognising a defence of change of position to the extent of any swap payments made by the Banks under their back-to-back swaps with other banks.
The CoA allowed the Banks’ appeal on grounds one and two. It would further have allowed the appeal on ground five. It would have dismissed the appeal on ground three. Permission to appeal on ground four was refused. Venice’s appeal was dismissed on both grounds.
The Banks’ grounds one and two
The Banks successfully argued that Foxton J had been wrong to conclude that the swaps were speculative. Central to this finding was the fact that the original Bear Stearns swap was a valid hedging transaction. The CoA accepted the Banks’ point that Venice had not sought to argue that the original Bear Stearns swap was speculative. Venice’s only argument for the invalidity of the Bear Stearns swap, namely that it was invalid because it had not been approved by the City Council, had been rejected by Foxton J. As such the validity of the Bear Sterns swap as a hedge was res judicata and the CoA proceeded on that basis.
The CoA said that Foxton J ought to have concluded that the Bear Stearns swap was a hedge and was valid, and bound Venice at the time of the restructuring. The failure to recognise or give effect to this fact was said to be the "root" of the error in his analysis.
The CoA accepted the Banks’ submission that the restructuring of the Bear Stearns swap did not create new, significant risks for Venice. The fact that the transaction rolled over the negative MTM value of the Bear Stearns swap into the new swap with the Banks did not render it speculative.
The CoA also considered that Foxton J had overemphasised the significance of the difference between the cap and floor values of the swaps. In fact, the disparity between the cap and the floor corresponded with the negative MTM on the Bear Stearns swap, so was in effect an existing exposure. The transfer of Venice’s existing exposure from Bear Stearns to the Banks could not change the swap from a hedge into speculation.
For the swaps to be found valid, the Banks also needed to succeed on their ground two. However, in the event this was not difficult, and the CoA found that similar errors of reasoning led the judge to reach the wrong conclusion on the "indebtedness" question. The CoA found that the novation fees paid by Venice were mischaracterised by the judge and were not in fact “upfront” payments that might constitute “indebtedness” under Italian law. Moreover, even if that had not been the case, the restructuring of the Bond was "for the purposes of financing investment expenditure", which rendered any indebtedness permissible under Italian law.
The CoA said that the finding to the contrary had flowed from the error in characterising the swaps as speculative. In fact, as the restructuring of the Bond was “clearly” for the purposes of financing investment expenditure, and the swaps were hedging and an “integral and necessary part of that restructuring”. They were therefore permissible under Italian law.
The success of grounds one and two together meant that the swaps were hedges, Venice had capacity to enter into them and in consequence they were and continued to be valid and binding.
The Banks’ ground five
Having found that the swaps were valid, there was strictly no requirement to consider the question whether Venice’s claim for restitution would be time barred. However, the CoA made interesting obiter comments on the application of the Supreme Court’s decision in FII.3
Section 32(1)(c) Limitation Act 1980 provides that where a case is brought for the consequences of a mistake, the six-year limitation period does not start to run until the claimant has discovered the mistake, or could with reasonable diligence have discovered it. FII establishes that this does not mean limitation is suspended until the true position has been authoritatively determined. That would mean that a claimant could wait until it was certain to win before bringing a claim. Instead, time runs from the point at which the claimant ought, through reasonable diligence, to have realised that it had a worthwhile claim.
Applying that reasoning to this case, the CoA said that Venice’s hypothetical claim for restitution (had the swaps been void) would have been time barred. Venice was wrong to think that its limitation period ran from the date of the Cattolica decision, and Foxton J had misapplied the test. Venice, exercising reasonable diligence, would have recognised from a much earlier date that it had a worthwhile claim. Other Italian local authorities were bringing claims from around 2010 and Venice could have done so too.
Change of position
Again, given that the swaps were valid and there could be no claim for restitution, the CoA’s comments on the availability to the Banks of a change of position defence to a claim for restitution are strictly obiter. However, it is helpful that the CoA commented that such defence should be available in principle.
The CoA said that it is well established that a bank that has paid a local authority under a swap contract which has turned out to be invalid or void because it was ultra vires is entitled to claim in restitution for unjust enrichment to recover the sums paid out. That is not considered to be an attempt indirectly to enforce an ultra vires contract. The CoA explained that where the position is reversed such that the local authority is the one seeking restitution, a defence of change of position is equally not an attempt to enforce indirectly an ultra vires contract. As such, there is “no reason of public policy why such a defence should not be available in principle”.
Retrospective change of law
The fact the CoA declined to consider the issue of retrospective change of law means this decision stops short of providing the level of reassurance financial institutions might have wished for.
Having allowed the appeal on the Banks’ grounds one and two, the CoA declined permission on ground four. As a difficult issue, the CoA preferred to leave this for an appeal where it was central. The CoA said merely that “the issue whether the decisions of a foreign highest court should be given retrospective effect by an English court is a difficult, albeit interesting, one on which there is no authority of direct relevance” before endorsing the suggestion that it is better not to make obiter comments on such a point that does not need to be decided.
While there is no doubt that legally that is a sensible position for the CoA to adopt, it does leave open the considerable "jurisprudential jeopardy" referred to by Foxton J. The risk that one’s English law contracts could be undermined by later decisions of foreign law has not yet been annulled.
2 For an interesting discussion of s.32(1)(b) of the Limitation Act 1980, see the recent Supreme Court decision in Canada Square v Potter  UKSC 41, which we consider in a previous article.