Governing law in financial transactions

What should lawyers take from the recent judgment in Dexia Crediop SpA v Comune Di Prato? Matteo Acciari and Luca Zamagni, of Axiis Legal Network and experts in financial derivatives, provide their view on the case and its impact on derivative transactions.

Original news

Dexia Crediop S.p.A. v Comune di Prato [2015] EWHC 1746 (Comm)

The main claim, made by the Italian bank Dexia Crediop S.p.A. against the Italian municipality of Prato, was to ascertain the validity and enforceability of six interest rate swap transactions executed by the parties between 2002 and 2006. These transactions were governed by a master agreement drafted by the International Swaps Dealers Association (ISDA) and were to be paid by the municipality in instalments, the latter suspended since 2010. The judgment accepted the defendant’s arguments that none of the six swaps was valid and enforceable, as they did not comply with mandatory provisions of Italian law. As such, Dexia’s main claim failed.

What key issues did this case raise?

This case raised a large number of issues of Italian public and financial law and the issue for the English judge was to rule in a case where the ISDA Master Agreement agreed by the parties selected English law as the sole governing law of the transactions and of any relevant claim.

The key issues of the case concerned the validity of the swap transactions and the liability of the financial intermediary for an alleged contravention of Italian law. These issues were introduced by the defendant to resist the main claim of Dexia. It was common ground that, irrespective of the English governing law clause of the master agreement, Prato could rely both on the Italian regulation limiting access of Italian local authorities to the financial markets (Italian Budget Law no 44/2001 and Decree no 389/2003 enacted by the Italian Ministry of Economics), and on the domestic regulation on the provision of financial services and related transactions set forth at the Italian consolidated law on finance (TUF) and connected regulations enacted by the Italian financial markets’ authority (Consob). Prato claimed:

  • the Italian regulation was in fact infringed by Dexia
  • the Italian regulation was mandatory for the purposes of the Rome Convention on Contractual Obligations of 1980, art 3.3, incorporated into the law of the UK by the Contracts Act 1990, and
  • the Italian regulation had to be applied to the case as the relevant circumstances of facts showed the case had ‘no connecting element’ with countries other than Italy

Prato succeeded in its defence and this opened the door to the Commercial Court to adjudicate the case applying Italian law. This was an extremely tough task for the English judge, as it required the latter to go through judgments provided by foreign courts in Italy, a jurisdiction where there is no formal system of precedent and where it is common for first instance and appellate courts to reach conflicting decisions on the same issues.

What are the common issues in this area of law?

The issues that most commonly arise in Italian litigation involving dealings on interest rate swaps and other derivatives and financial instruments are all well summarised in the Prato case. With regard to the supply of investment services—ie the legal matter that eventually decided the Prato case in favour of the defendant—the most significant issues were whether or not the intermediaries complied with the rules of validity, diligence, correctness and transparency, which Italy’s TUF and Consob impose upon the intermediary in order to protect the interests of the contracting parties and the integrity of the financial markets.

The prevailing position is that Italian case law requires strict compliance with such rules, and the law places the burden of proof of due compliance with the rules during the transactions on the intermediaries and affirms that the customer bears the prejudicial effects of the transactions executed only in cases where the intermediary has so complied with such rules, because only in such cases will the customer be deemed to have given his full and knowledgeable consent to the transactions. As mentioned above, a specific set of rules are expressly established by the TUF as rules governing the validity of the financial transactions and it was, in particular, the evidence of Dexia’s failure to comply with one of them—claiming a non-sophisticated customer has the right to be informed in writing of a suspension period of seven days during which he has the option to revoke the dealings (TUF, art 30)—that decided Prato in favour of the defendant.

Did the decision clarify the law in this area? What are the remaining grey areas?

The first issue clarified by the judgment is that in cases where two foreign parties agree their financial transactions are to be construed and governed by English law, the mere fact that the choice of law is agreed through an international standard form, such as an ISDA Master agreement (drafted by international working groups for routine use in cross borders derivatives transactions to promote certainty) it is not, as such, an ‘element in the situation’ which raises connections to venues other than their natural venue under the Rome Convention, art 3.3. Nor may these ‘elements’ be found in circumstances where, in respect of any of these swap transactions, the financial intermediary had entered into back-to-back hedging swaps with a bank outside the natural venue using the same industry standard contracts, as this is a matter for the financial intermediary alone that is completely ‘external to the situation’ existing at the time the choice of law was agreed. In such cases, the judgment affirms that English courts shall uphold the finding that mandatory provisions of the foreign country still apply.

The second issue clarified by the judgment is that when English courts are asked to apply the law of a country where there is no formal system of precedent, so that there may be more than one stream of previous decisions on the same issue, the English courts will need to determine which stream is correct, referring to the reasoning of the highest foreign courts on similar cases, if available, or decide with the assistance of foreign law experts which of the different approaches would be most likely to be eventually adopted by the highest courts.

The judgment clarifies that both the Italian regulations on swaps of Italian local governments and on the provisions of investment services are mandatory in nature according to the Rome Convention, and therefore shall be observed by market operators while dealing in Italy with an Italian counterparty that is not a sophisticated customer according to the Italian law and case law. The latter has particular significance for transactions agreed prior to November 2007, when the Markets in Financial Instruments Directive 2004/39/EC entered into force, as under the previous Italian regulation, sophisticated investors were extremely narrowly defined by the Consob regulation, art 31—also excluded from the category were municipalities, provinces and even regions (not only private customers comparable to consumers).

Finally, the judgment clarified that, according to what was found by the joint civil sections of the Italian Court of Cassation (Judgment 13905/2013), the right of suspension and withdrawal established by TUF, art 30 shall be determined as the right of any non-sophisticated customer dealing on a financial transaction outside the offices of the financial intermediary to receive information in writing of the option he has to revoke his investment decision for the period of seven days (throughout which the financial intermediary is banned from performing on the customer’s account the same transaction under penalty of its nullity).

Are there any grey areas?

Grey areas still surround some of the alleged contraventions of the Italian sector regulation on local entities swaps. In particular, a key point raised by Prato was whether or not swaps with an initial negative mark to market value may burden the amount of indebtedness of the public entity and, as such, render void again the transaction as contravening the prohibition to Italian entities to enter into swaps other than hedging swaps with no negative impact of their indebtedness existing at the time of the stipulation. On this issue Mr Justice Walker recognised a decision of the Civil Court of Appeal of Bologna (no 734/2014) which accepted the initial negative market value of swaps, where it is not compensated by the upfront payment of an equal amount by the financial intermediary, burdens the entities’ debts. However, Mr Justice Walker affirmed he believes Bologna’s decision does not accurately state Italian law, relying on assertions of an Italian law expert. The Bologna judgment has been now brought before the Italian Court of Cassation, so that this key issue will be eventually clarified by the highest Italian court. That decision will have a great impact on this question.

What are the trends in this area?

In regards to Italian financial law, the Prato judgment appears consistent with Italian civil case law which over the past few years has examined alleged contraventions of financial transactions with the mandatory regulations of the TUF. Regarding the litigation specifically involving local authorities, the Italian Court of Cassation has not yet decided the merit of a case concerning swaps. Lower civil courts, however, appear to be oriented principally in favour of the local authorities and these local decisions are potentially relevant also for the cases on ISDA derivatives, in relation to which it is thus possible to predict victory for the local governments who have not effectively received a complete informative note on the risks of mark to market values prior to the conclusion of the transaction—a feature of the litigation that is becoming more and more crucial after the leading decision given by the Civil Court of Appeal of Milan on 18 September 2013.

What should lawyers advising in this area of law take note of? What should they advise their clients?

Colleagues who have to deal with a derivatives transaction that involves Italian local authorities and which is governed by an ISDA Master Agreement, should first of all evaluate whether the connecting elements of the case suggest that mandatory provision of Italian law shall apply to it and, if so, whether or not the local authority should be classified as a non-sophisticated customer according to the Consob regulations.

It is crucial to select the appropriate strategy for the litigation, as the financial intermediaries tend to not observe the rules imposed upon them by this set of mandatory regulations on the false assumption that they may be set aside by the ISDA Master Agreement. Furthermore, and before filing any claim, it is worth clarifying whether the financial intermediary acted only as counterparty of the local entity or also which possible incriminating conduct may have occurred on the part of the financial intermediary, and on what basis it may be deemed to be unlawful—this is necessary in order to evaluate whether or not a claim for tortious liability or contractual liability on the part of the intermediary can be raised in the case as this may have an impact in selecting the competent forum for the case. Indeed, where certain requirements are met, the Italian Court of Cassation has accepted that both claims brought for contractual liability of the intermediary as advisor of the local entity on swaps, rather as a counterparty of the same, and claims brought for an alleged tortious liability of the intermediary, are outside the scope of the jurisdiction clause of the ISDA Master Agreement and may be adjudicated by the Italian courts.

Matteo Acciari is admitted as Avvocato in Italy and earned an LLM in the US. Luca Zamagni is admitted as Avvocato cassazionista in Italy. They are both founding members of Axiis Legal Network with a deep knowledge of the Italian regulation on financial matters and assist private and public entities in domestic and international disputes on derivatives. Matteo and Luca are also authors of several publications concerning the Italian law in financial intermediation.

Interviewed by Barbara Bergin.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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