Capacity of Portuguese public sector companies to enter into 'snowball' swaps

Capacity of Portuguese public sector companies to enter into 'snowball' swaps

Discussion of the recent case transferred into the Financial List of Banco Santander Tutto S.A. v Companhia de Carris de Ferro de Lisboa S.A. and others concerning the validity of nine derivative transactions entered into between Banco Santander and four Portuguese public transport companies.

Background to the Financial List

Banco Santander Tutto S.A. v Companhia de Carris de Ferro de Lisboa S.A. and others [2016] EWHC 465 (Comm), [2016] All ER (D) 61 (Mar) was the first case to be transferred into the Financial List and was transferred in with the consent of both parties only 12 days after the Financial List came into operation in October 2015.

What were the issues in the case?

The claimant in the company was Banco Santander Totta SA (the bank) and the defendants were four public sector Portuguese transport companies (the transport companies). Between 2005 and 2007 the bank and the transport companies entered into nine different long-term interest rate swaps. All of them were under the International Swaps and Derivatives Association Inc 1992 Multi-Currency Master Agreement (ISDA Master Agreement) governed by English law and subject to the jurisdiction of the courts of England and Wales.

The bank paid a floating rate and the transport companies paid a fixed rate under the swaps but they were not vanilla interest rate swaps. The swaps in question had a 'memory' feature. This meant that once referenced interest rates moved outside upper or lower 'barriers', the fixed rate that was payable by the transport companies had a spread added to it. Spread means that an additional interest rate is added. The spread was cumulative at each payment date and subject to leverage (in all but one of the nine swaps). Leverage operates as a multiplying factor on the spread in an amount which varies from swap to swap. Therefore, this meant the payments due by the transport companies 'snowballed' if the interest rates were outside of these barriers. Five of the swaps contained mitigating features (such as a 'digi-coupon' which was designed to reduce the interest rate each time the referenced interest rate fell within the barriers again).

The financial crisis of 2008 meant that interest hit a near zero rate and stayed that way, meaning that the interest rate moved below the lower barrier. The memory feature and leverage meant that the aggregate mark-to-market value of the swaps hit an amount exceeding €1.3bn in the bank's favour.

In 2013, the transport companies stopped making payments to the bank under the swaps.

The bank said that the transactions entered into were legal, valid and binding, enforceable in accordance with their terms.

The transport companies did not allege that the swaps had been mis-sold to them but asserted that:

  • each of the companies lacked capacity to enter into the swaps under Portuguese law
  • the swaps were speculative and therefore void under Portuguese law
  • although English law governed the swaps, article 3(3) of Convention 80/934/ECC on the law applicable to contractual obligations (Rome Convention) provided that the choice of law did not prejudice 'mandatory rules' under Portuguese law. This meant that:
    • the swaps were void as they were unlawful 'games of chance', and
    • seven of the nine swaps should be terminated under rules on 'abnormal change of circumstances' because since 2009 (and still at the time of judgment) interest rates remained close to zero

On these grounds, the transport companies declared that the swaps were invalid and therefore unenforceable.

What did the court decide?

The court discussed in significant detail the background to the parties entering into the swaps. It considered, among other things, the way the bank marketed the swaps, the alleged financial sophistication of the transport companies and whether the transport companies understood the risks involved in entering the swaps.

The court also discussed the wider background in that not very many snowball swaps were sold by banks to the Portuguese public sector and that this type of swap was not very common in the market generally.

Speculation or hedging?

One of the main arguments that the transport companies ran was that the swaps were speculative and therefore each of the companies lacked the necessary capacity to enter into the swaps with the bank. The bank said that the swaps were proper instruments of financial management. The reason that the transport companies linked speculation with their capacity to enter the swaps was because they said that if the swaps were speculative, the bank should not have ever presented the swaps to them, under the Portuguese Securities Code.

The transport companies claimed that entering the swaps was like a bet—if the interest rates stayed within the barriers, the bet was good as the rates were lower than they would have been if the transport companies had entered into vanilla interest rate swaps, but if the interest rates went outside the barriers, the bet was bad. If the swaps were characterised as speculative, then the bank should not have offered the swaps to them under Portuguese law. Their argument was that in considering the potential benefits of entering into the swaps, the potential downsides also had to be considered. The swaps exposed them to increased interest rates even if interest rates were low. The risk could only be managed by exiting the swaps and paying termination costs to do so.

The bank contended that the swaps were financial management instruments as well as hedging instruments.

The court agreed that the potential benefits had to be considered along with the potential downsides. It also agreed that the instruments were risky, but that the risk at the time the swaps were entered into was seen as reasonable as the financial crisis could not have been foreseen at that stage. The court also believed that the transport companies understood the risk that they were undertaking and it was for the transport companies to decide if the risk was acceptable to them. The swaps were not just hedging instruments—but hedging is only one element of why a party may enter into a swap. The court noted that the swaps did reduce the transport companies' interest rate payments until 2009 when adverse conditions took over in the form of the global financial crisis.

The court discussed other cases relating to the issue of whether the swaps were speculative, in particular,Standard Chartered Bank v Ceylon Petroleum Corporation [2011] EWHC 1785, [2011] All ER (D) 113 (Jul). In this case, the judge had emphasised the blurred line between management and speculation. All swaps have an element of speculation about them, but in this case the judge held that the transport companies' intention was to manage their debts, not to speculate.

Capacity of the transport companies to enter the swaps

The transport companies' argument was that it was for the bank to assess whether they had capacity to enter the swaps. Their capacity was limited by their purposes as public enterprises. Although they had capacity to enter into swaps, they did not have capacity to enter into speculative swaps, which increased their exposure to financial risk.

The bank argued that the transport companies' had the same capacity to enter into swaps as private companies did and that this argument had not been raised by public enterprises in Portugal before, despite similar swaps (not snowball swaps) being closed out at considerable cost.

The court agreed with the bank. Whether companies are profitable is irrelevant to their capacity. A third party having to assess whether a company can achieve financial balance for itself is not workable and it is for the company to do that. Publicly =-owned corporate entities are not a distinct class of legal person subject to separate capacity rules. While they may have public interest missions, these are to do with how they conduct their business and not to do with their capacity to enter into contracts.

Rome Convention, art 3(3)

The transport companies sought to rely on the Rome Convention to argue that Portuguese law should apply. The Rome Convention applied rather than the later Regulation (EC) 593/2008 (Rome I Regulation) because of when the swaps were entered into. Rome Convention, art 3(3) sets out that:

'The fact that the parties have chosen a foreign law, whether or not accompanied by the choice of a foreign tribunal, shall not, where all the other elements relevant to the situation at the time of the choice are connected with one country only, prejudice the application of rules of the law of that country which cannot be derogated from by contract, hereinafter called 'mandatory rules'.

The transport companies contended that all elements of the contract were connected with Portugal and that therefore 'mandatory rules' of Portuguese law should be applied, notwithstanding that the swap confirmations were governed by English law (and that they were governed by English law was not contested).

The case of Dexia Crediop S.p.A. v Comune di Prato [2015] EWHC 1746 (Comm), [2015] All ER (D) 20 (Jul) was considered. In that case, the applicability of Rome Convetion, art 3(3) to interest rate swaps under an ISDA Master Agreement governed by English law was discussed. In that case, the parties were incorporated in Italy, the swaps were entered in Italy and were to be performed in Italy. The court in that case decided that the use of an international master agreement and back to back swaps outside of Italy were not relevant for the purposes of Rome Convention, art 3(3).

In this case, Mr Justice Blair took a commercial view of when Rome Convention, art 3(3) should be applied and did not follow the decision of Dexia Crediop. He said the contracts were not purely domestic and any other conclusion would undermine the principle of legal certainty. His conclusions were based on the fact that:

  • the ISDA Master Agreement was designed to provide legal certainty in the market—indeed, the parties elected to change from a Portuguese framework agreement to the 1992 Multicurrency-Cross Border form of the ISDA Master Agreement—and legal certainty would be jeopardised if Rome Convention, art 3(3) could be relied upon
  • the bank relied upon its parent company, Santander Spain, to enter into the swaps and hedged its exposure with back-to-back contracts with Banco Santander de Négocios Portugal SA which in turn had entered into back-to-back contracts with Santander Spain. Santander Spain also priced the swaps and even approved the swaps through its product and risk committees
  • the swaps were concluded in the international capital markets. The transport companies had entered numerous swaps with international banks on ISDA terms, and
  • the ISDA Master Agreement gave the bank the right to assign its position to a bank outside Portugal

Portuguese law

A number of arguments were put forward by the transport companies about the validity of the swaps under Portuguese law. As the court had already held that Rome Convention, art 3(3) was inapplicable, these arguments did not hold weight but the court still gave its opinion on them as if Rome Convention, art 3(3) did apply.

The game of chance

The transport companies argued that the swaps were unlawful 'games of chance' by virtue of their speculative nature and were therefore void under the Portuguese Civil Code. The court's opinion was that even if the swaps were purely speculative, that in itself is not an illegitimate activity.

Abnormal change in circumstances

The transport companies extensively argued that because of the financial crisis, there had been a fundamental change in circumstances since the swaps were entered into and therefore they could not be enforced by the bank in good faith. This is based on article 437 in the Portuguese Civil Code (the Civil Code) which refers to 'an abnormal change of circumstances'. If Rome Convention, art 3(3) did apply, it would need to be considered whether the Civil Code, art 437 was a 'mandatory rule'—in which case it could not be derogated from—but the court found that the Civil Code, art 437 was not.

Portuguese Securities Code

The Portuguese Securities Code (Securities Code) is a central component of securities law in Portugal and has been in force since 1999. It has been amended since then, significantly so in 2007 when the Markets in Financial Instruments Directive 2004/39/EC came into force.

The transport companies contended that the bank acted in breach of its duties—while the bank could profit significantly if the relevant reference rates did not perform in accordance with market expectations, the transport companies were significantly exposed. The transport companies argued that the bank had a pre-contractual duty of good faith and loyalty to the transport companies under statutory duties imposed by the Securities Code. The bank should have assessed if the swaps were appropriate for their need.

The bank argued that it didn't have a duty to propose swaps based on an evaluation of the client's suitability and that was up to the transport companies. The transport companies were sophisticated clients who understood the risks of entering into the swaps. The bank did not need to assess the suitability of the swaps as if they did that they would be advising the transport companies which they had explicitly carved out of their duties when they entered the swaps with the transport companies.

The court agreed with the bank that the Securities Code did not apply but that in any event the bank did not breach any duty in proposing these swaps. The transport companies had been discussing swaps, including snowball swaps, with other banks before entering into the swaps which were at issue in this case, and had entered into the swaps they thought were the best at that time. The transport companies argued that although they were sufficiently sophisticated to understand the formulae of the swaps they did not understand the possible permutations and combinations of actual outcomes. However, the court found that the transport companies did understand the scale of the risks but thought they were risks worth taking.


The court concluded by commenting on the riskiness of the swaps but concluded that, at the time they were entered into, the swaps suited both parties. The transport companies paid less interest than if they had entered into vanilla swaps at the time of entering into the snowball swaps (and until 2009 were paying much less than they would have under a vanilla swap) and the bank entered into profitable transactions. The transport companies probably did not appreciate the sensitivity of the mark to market value of the swaps to interest rate volatility at the time, but they did understand the risks involved in entering the swaps. The bank did try to mitigate the problem by proposing restructuring options to the transport companies but the transport companies delayed in agreeing as they did not know whether it would be in their interests to terminate, restructure or wait and see what happened in the market. The court concluded that this was a reasonable reaction.

What should practitioners take away from the case?

It was found that the transport companies had capacity to enter into the swaps. There have been a lot of derivatives cases over the past few years where capacity of parties to enter into swaps, especially the capacity of public bodies, has been challenged. This is an interesting capacity case with a very different result to that in the recent case of Credit Suisse International v Stichting Vestia Groep [2014] EWHC 3103 (Comm), [2014] All ER (D) 58 (Oct) (see News Analysis: Determining capacity to enter derivative contracts). The judge discussed the fact that the swaps were capable, at the time of execution, of assisting the transport companies in fulfilling their purpose or object of pursuing profit and therefore they were capable. It is still prudent for banks and other financial institutions entering into swaps with different types of entity to ensure that their counterparty has capacity to enter into the swaps, but this decision indicates that the burden is on that counterparty to ensure it has capacity.

The discussion of the transport companies' sophistication and understanding of the swaps is interesting. In discussing this the court found that although the products were relatively straightforward and easy to understand, the implications were not and that no one could really have foreseen the financial crisis and how long interest rates would stay close to zero. However, Mr Justice Blair said that the transport companies did understand the risks and so could not seek to argue otherwise to avoid their liabilities due under the swaps. This seems to be an example of caveat emptor—it was for the transport companies to do their research into the snowball swaps and while they did not understand all permutations of the risks of entering the swaps (especially the volatility risks), their understanding was sufficient.

Another interesting takeaway is the discussion of the application of the Rome Convention, art 3(3) and the different conclusion the judge came to from the decision in Dexia Crediop. In this case, although the transactions were all negotiated and carried out in Portugal, the international nature of the capital markets, the ISDA Master Agreement, the bank's ability to assign the swap contracts and the nature of the bank's relationship with Santander Spain were all taken into account. Above all else, the judge valued the certainty of law. This will be a welcome decision for a lot of market participants as, when negotiating swaps and other capital market products with counterparties, it would not be practical to consider all the implications of local law when using a master agreement governed by, for example, English law. Different risk and legal assessments would otherwise need to be considered in detail on every transaction, which could have significant cost and time implications for the parties.

Emma Millington, solicitor in the Lexis®PSL Banking & Finance team.

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About the author:

Emma is head of the Banking and Finance team and the Finance Group at LexisNexis®UK.

Emma has wide-ranging experience in derivatives and capital markets with a particular emphasis on credit derivatives and structured products. Emma qualified as a solicitor with Allen & Overy LLP, working in the derivatives and structured finance teams in both their London and Paris offices before gaining experience with Deutsche Bank AG (advising the foreign exchange prime brokerage desk) and Crédit Agricole CIB (advising the fixed income and derivatives desk) before joining LexisNexis®.