The litigation on derivative transactions involving Italian counterparties: an extreme stress test for the derivative contractual documentation

The litigation on derivative transactions involving Italian counterparties: an extreme stress... Key points This article will focus on the origin of the derivative litigation in Italy and particularly on the reasons which brought Italian local authorities and corporate entities to enter into several derivative transactions in the early 2000s and on the effects of the financial crisis. The article will consider the main arguments raised by the Italian counterparties in order to challenge the validity and enforceability of the derivative contracts, particularly by differentiating the so-called ‘public law’ allegations which are typically raised by Italian local authorities and the ‘civil law’ allegations which may be raised by both local authorities and corporate entities. It will discuss the evolution followed by the Italian courts in dealing with both public and civil law allegations, particularly as a result of the decisions taken by the Italian High Courts. Finally, it will consider how the English courts approached the matter and particularly how they dealt with foreign law issues. 1. Introduction In this article, we will discuss the case law developed in connection with derivatives transactions involving Italian counterparties, focusing on the most important court pronouncements and providing certain considerations and comments on how the derivative disputes have developed in the last years and the issues on which there is currently most focus. This note is structured as follows: (i) in the first part, we will summarize the main allegations typically raised by Italian counterparties contesting the validity of derivatives contracts; (ii) in the second part, we will provide an overview of the typical litigations and relevant judicial venues (eg, civil, administrative, criminal disputes); and (iii) in the third part we will discuss the case law which has developed on these claims. As will be exposed in further detail in the following sections, several cases involving Italian counterparties are currently litigated before the English courts, as a result of the jurisdictional clause included under the ISDA Master Agreement. In this respect, a landmark case precedent is represented by the decisions taken, first by the High Court of Justice1 and then by the Court of Appeal2 on the Dexia Crediop SpA v Comune di Prato case (the Prato Case) which significantly dealt with most of the typical allegations raised by Italian counterparties; therefore, in the context of this article, we will make several references to the Prato Case which gives an interesting overview of the approach followed by an English court whilst dealing with issues related to Italian law. 2. The origins of the disputes on derivative contracts in Italy OTC derivatives transactions have become increasingly common in the Italian market starting from the end of the 1990s. Italian counterparties have generally entered into derivatives transactions for the purpose of hedging against interest rate risks or exchange rate risks. Derivatives transactions have typically involved corporate counterparties that faced such risks in the course of their entrepreneurial activities, and also local authorities,3 which historically had to deal with considerable indebtedness and had, between the years 2001–2003, ad hoc legislation enacted in order to regulate the management of such indebtedness, particularly through the recourse to bond issuances and derivatives transactions. In the case of corporates, the trades were mainly interest rate or foreign exchange swap transactions, option or forward transactions which could vary from plain vanilla to more complex deals; in the case of local authorities, these were usually plain vanilla interest rate swaps (often with a collar)4 or foreign exchange swaps. Over the last 8–10 years, we have witnessed a growing trend in the Italian litigation environment, whereby these counterparties have attempted to repudiate the validity and enforceability of derivatives contracts based on certain arguments related to mispricing and breach of conduct rules by the relevant bank acting as a swap counterparty. This on-going trend is linked to the current economic downturn and is generally related to derivative transactions in which the market has moved against the counterparty’s position, leading it to seek to avoid payments by arguing that the transactions were in violation of the applicable derivatives legislation, or is ultra vires or unenforceable based on claims including, but not limited to, mispricing, misconduct or fraud. Interestingly in this regard, these litigations—which have been subject to intense media scrutiny—started to increase slightly after the Lehman collapse. In fact, the global financial crisis and economic downturn that followed the Lehman default brought, among their consequences, a (previously unforeseeable) drop in interest rates, with the further effect that derivative instruments which were designed to protect the counterparties from a rise in interest rates became unprofitable for these counterparties. Derivative transactions in Italy are normally documented under the ISDA Master Agreement but a number of cases have also dealt with local framework agreements governed by Italian law. However, in both cases, the main allegations on the invalidity of the contracts are based on Italian legislation and concepts of Italian private law. In fact, the application of Italian law provisions can also be triggered in contracts governed by foreign law (ie English law) where they come into play (allegedly) either as overriding principles of Italian public order, or extra-contractual obligations relating to the provision of investment services, or because of the purported lack of any element of internationality (for instance when both parties are Italian and payments are taking place in Italy). Generally speaking, as will be further explained below, we have noted that the Italian high courts (such as the Supreme Court or the Council of State) seem to be more reluctant than lower courts to find derivative contracts null and void, but it should also be underlined that senior and authoritative courts, such as the Court of Appeal of Milan, have issued conflicting decisions on derivatives’ issues. 3. The typical allegations Allegations made by the Italian counterparties shall be generally distinguished, depending on such counterparties being corporate counterparties or a local authorities. Corporate counterparties typically claim that the derivative transactions entered into with the banks did not comply with mandatory provisions of Italian contractual and financial laws (the so called ‘Civil and Financial Laws Allegations’). Such claims, as will be better detailed below, may either result in the relevant derivative transactions being held null and void or in the banks being requested to compensate the damages suffered by the corporate counterparties. Local authorities, rather than relying on the same Civil and Financial Laws Allegations brought by the corporate counterparties, usually claim that the conclusion of the derivative transactions occurred in breach of certain provisions of the Italian laws which regulated, at that time, access by local authorities to the financial markets (the so called ‘Public Law Allegations’). In this respect, local authorities maintain that breach of such provision shall result in the relevant derivative transactions being null and void, notwithstanding the circumstance that the laws, to which the Public Law Allegations refer, only applied to local authorities. In this respect, in the next paragraphs, we will go through the main features of both the Civil and Financial Laws Allegations and the Public Law Allegations. The ‘mark-to-market’ value and hidden costs theory A starting point of almost all the claims raised by both corporate counterparties and local authorities, in order to challenge the validity of their derivative transactions concerns the mark-to-market (hereafter ‘MtM’) value of the same derivative transactions. In this respect, we should note, as a preliminary remark, that as has been recognized, on several occasions, by the Italian Ministry of Economics and Finance,5 the MtM, corresponds in essence to the actualization of the future payment flows that will be exchanged between the parties if the market conditions, as existing at the moment at which the MtM is established, will remain unaltered. On this basis, as it may be appreciated, the MtM value is extremely variable depending on market trends. At the same time, it should also be noted that the ‘pricing’ of a derivative transaction starts with the determination of a reference rate for a transaction at ‘par’ (that is, a transaction whose actual net value is equal to zero). This reference rate is neither a bid price not an offer price, but, rather, a so-called ‘mid-market’ rate, which is based on the average of the prices (bid–offer) listed at that given moment on the market.6 However, this rate does not present the final rate materially applicable to the transaction that could be concluded at that time. Indeed, in practice, the structuring and implementation of a derivative transaction involves costs that must be covered by the financial intermediary: costs associated with the transaction and associated with its role as a financial intermediary. It is therefore necessary to adjust the mid-market rate in order to cover the various costs and risks of the transaction and to provide, at the same time, a return for the intermediary; this is true not only with regard to derivative transactions, but also with regard to the activity associated with any other financial instrument. Reflecting such methods of determination of the pricing, the MtM value at inception (and therefore, as already indicated before the actualization of the future payment flows, based on the market conditions existing at that moment) necessarily has a negative value for the non-financial counterparty.7 However, it remains understood that the MtM is only a theoretical value and not an actual cost to be sustained by any of the parties of the derivative transaction, nor a profit for the bank. As it has been again recognized by the Italian Ministry of Economics and Finance, in the ordinary course of their contractual relationship, the parties will be, in fact, only requested to make the payments based on the respective interest rates, as specified under the derivative transaction, regardless of the MtM value of the latter.8 The MtM value will be relevant exclusively, in order to determine the termination amount to be paid if and when an early termination of the derivative transaction occurs.9 And, in any case, for the purpose of the payment of such a termination amount, it shall make reference to the value of the MtM at that historical moment, a value which, depending on the market trends, might be significantly different from the one calculated at inception.                ***** The claims of the Italian counterparties aimed at challenging the validity of the derivative transactions do not, however, take into account any of the above. Instead, Italian counterparties make, loosely, reference to a provision included under Annex 3 to the Consob Regulation no 11522/199810 which contained a sentence stating—in our view improperly and in a non-technical way—that the value of a derivative transaction is always par at the time the contract is signed.11 In this respect, prior to the submission of the claims, a financial expert12 is usually entrusted with the task of ascertaining whether or not the MtM of the relevant derivative transaction at inception was equal to zero or had a negative value for the Italian counterparty. The financial expert ordinarily concludes that the value of the MtM was negative (and, for the reasons stated above it could not be otherwise) and that such initial negative MtM represents undue and undisclosed profits gained by the bank and costs for the counterparty (so-called ‘hidden costs’). Moving from the assumption that the derivative transactions bore such ‘hidden costs’, the Italian counterparties claim that the derivative transactions breached several provisions of the Italian law (depending on whether Civil and Financial Allegation or Public Law allegations are made). In this respect, several positions may be taken: according to certain counterparties, the so-called ‘hidden costs’ shall always be considered to be unlawful, unless balanced by the payment of an ‘upfront’ for an amount equivalent to such ‘hidden costs’; other counterparties partially acknowledge that the so called ‘hidden costs’ shall not be considered unlawful, but only to the extent that they do not override a ‘fair’ amount; other counterparties agree that the MtM normally has a negative value at inception but, at the same time, maintain that such negative value shall be necessarily disclosed by the bank in order for the derivative transaction to be validly entered into. Public law allegations Most of the Italian laws to which the Public Law Allegations refer are no longer in force or have been substantially amended after 2008 when due to the turmoil affecting derivatives transactions entered into by local authorities, access by the latter to such transactions has been significantly restricted. It is, however, understood that, in the litigation context, reference must be made to the legal framework in force at the time at which the derivative transactions were entered into. Breach of Article 119 of the Italian Constitution Public Law Allegations brought by local authorities usually rely, on a first instance, on Article 119 of the Italian Constitution which regulated (and still does, even if under a slightly different content) the financial autonomy of regions and other local authorities (Municipalities, Provinces and Metropolitan Cities).13 Like all provisions of the Italian constitution, Article 119 is clearly acknowledged as a mandatory provision of Italian law. All other legislation and rules on the matters to which Article 119 relates must, as far as possible, be interpreted in accordance with Article 119 and any inconsistent laws may be struck down by an order of the Constitutional Court. This is because the Constitution is the founding law of the Italian legal system, to which all laws and other regulations are subordinate. In the version applicable until 2012, Article 119, paragraph 1, gave ‘revenue and expenditure autonomy’ to Italian administrative regions and other local authorities and it regulated the way in which that autonomy could be exercised. At paragraph 6, Article 119 it allowed local authorities to resort to ‘indebtedness’ only as a means of funding investments. Article 119 does not, however, expressly clarify what should be intended as ‘indebtedness’ for the purpose of such provisions. A typical allegation by local authorities is that derivative transactions, at least when entered into for speculative purposes, shall be actually considered as ‘indebtedness’ and, on this basis, shall be regarded as contrary to Article 119 of Italian Constitution. Breach of the ‘economic convenience’ test Another common allegation brought by local authorities in order to challenge the validity of their derivative transaction concerns the Article 41 of Law 448/2001. Pursuant to Article 41 of Law 448/2001, regions and local authorities are allowed to ‘replace’ an existing debt (deriving from certain types of loans) with a new debt (deriving from newly issued bonds or renegotiations), subject to a so called ‘economic convenience test’, ie only if the overall financial value of the relevant indebtedness post-restructuring is lower than the relevant indebtedness pre-restructuring, and therefore, there is a financial advantage for the local authority. Moreover, article 41, paragraph 2 itself, before being amended in 2008, specified that in case of issuance by the local authority of ‘bullet’ bonds, the local authority itself had to either create a sinking fund or enter into a derivative transaction for the amortization of the debt. Article 41 was issued by the Italian legislature to enable public authorities to restructure their indebtedness and to take advantage of low interest rates in circumstances where there were concerns regarding increasing local authority indebtedness in Italy. Without this provision, the public authorities would not have been able to refinance their loans and bonds because they were not incurring the new debt for a new investment, as otherwise requested by the above mentioned Article 119 of the Italian Constitution. It is also worth mentioning that the Italian legislature has never provided any instruction or guidelines aimed at clarifying how the ‘economic convenience test’ had to be carried out, therefore leaving a certain level of discretion to the local authorities concerned. Provided the above, the typical scenario to which the claims, brought by local authorities and based on Article 41, refer is one in which the local authority was originally a party to several loan agreements providing for the payment of a fixed interest rate exceeding the then current market rates. In this respect, pursuant to the mechanism envisaged under article 41, the relevant loans were terminated early and refinanced by the issuance of a bond, providing for the payment, in favour of the bondholders, of a floating rate based on the EURIBOR rate. To this end, the local authority eventually entrusted one or more banks to act as arrangers of the bond issuance (and in such a context also requested to the latter proper assistance with the ‘economic convenience test’). At the same time, also in accordance with the then existing forecasts regarding the expected future trends of the EURIBOR curve,14 the local authorities usually entered into interest rate swap agreements with the banks acting as arrangers, aimed at hedging the risk deriving from an increase in interest rates. Moreover, as anticipated, in cases of the issuance of bullet bonds, in accordance with the express provisions of Article 41, an amortizing derivative transaction was usually entered into, as an alternative to the creation of a sinking fund. Given the above scenario, notwithstanding the opposite position that has been expressed in this respect by the Italian Ministry of Economics and Finance,15 it is argued by the local authorities that such derivative transactions had to be considered as an integral part of the refinancing transactions to be perfected by the local authority and, as such, taken into account (particularly as far as ‘hidden costs’ are concerned) for the purpose of the ‘economic convenience’ test. Moreover, certain local authorities, in clear breach of the literal content of Article 41, even claim that the economic convenience test should apply to any derivative transaction under which the local authority swaps the capital or interest payments under an existing loan for different payments due from the swap counterparty (and, therefore, even if the local authority merely restructured a derivative transaction entered into before, without actually refinancing any former debt obligation). On this basis, according to the local authorities, the presence of the alleged ‘hidden costs’ within such a derivative transaction would have altered the initial evaluation about the soundness and economic convenience of the transaction. Breach of derivatives regulation applicable to local authorities Another argument brought by local authorities in the derivative disputes is that the presence of the ‘hidden costs’ resulted in a breach of the ad hoc regulation enacted by the Italian Ministry of Economy and Finance regulating derivatives transactions to be entered into by local authorities and particularly of Article 3 of Ministerial Decree 389/2003 (Decree 389). Decree 389 was the only piece of Italian legislation which specifically regulated the use of certain derivatives by local authorities.16 An explanatory circular supposedly aimed at clarifying its content was subsequently issued by the same Italian Ministry of Economy and Finance on 27 May 2004 (the Explanatory Circular). Decree 389 provided, under Article 3, paragraph 2, an list of examples of derivative transactions that the local authorities would have been allowed to enter into, including, in particular: ‘Interest rate swaps’ between two entities that give an undertaking that they will duly exchange flows of interest, associated with the main financial market parameters, in accordance with methods, timeframes and conditions laid down in the contract; The acquisition of ‘forward rate agreements’ in which two parties agree on the interest rate that the buyer of the forward undertakes to pay on the specified capital at a specific date in the future. The acquisition of an interest rate ‘cap’ whereby the buyer is guaranteed increases in the interest rate payable above the established level. The acquisition of an interest rate ‘collar’ whereby the buyer is guaranteed an interest rate level payable, varying between pre-established minimum and maximum levels. Other derivative transactions consisting of combinations of the transactions contemplated in the above points, which are able to allow switching from a fixed rate to a variable rate, and vice versa, when a pre-determined threshold is reached or when a specified period of time has elapsed. Other derivative transactions aimed at the restructuring of borrowing, but only when the maturity date does not exceed that associated with the underlying liability. These transactions are permitted when the flows received by the interested parties are equal to those paid with regard to the underlying liability and where, at the time they are entered into, they do not involve an increasing trend in terms of the current values of the individual payment flows, with the exception of a possible discount or premium to be settled when the transactions are concluded, not exceeding 1% of the notional amount of the underlying liability. Moreover, Article 3, paragraph 3 of Decree 389/2003 required the necessity of a correlation between derivative transactions entered into by the authority and the underlying debt exposure, thus precluding the possibility of purely speculative swaps. Having said the above, in the litigation context, with respect to Decree 389/2003, it is held by the claimants, among others, that: the hidden costs would be evidence that the derivative transactions did not have a hedging purpose but, rather, pursued a speculative intent, in violation of the above mentioned regulation (ie please refer to article 3, paragraph 3 of Decree 389); and/or, with particular regard to interest rate swap collars under point (d) above, the ‘hidden costs’ would reveal an imbalance in the relevant cap and floor values (ie the floor sold by the local authority was more valuable than the cap purchased by it), while Decree 389, in the light of the provisions of the Explanatory Circular17 would purportedly impose a necessary equivalence between ‘cap’ and ‘floor’ levels in an IRS collar, such that they should ‘annul’ each other; and/or since, as mentioned before, it is argued that the presence of a negative MtM should be rebalanced through the payment of an upfront and, at the same time, Decree 389 would allegedly prohibit (see, in this respect, Article 3, paragraph 2, letter f) the payment to the local authority of an upfront exceeding 1 per cent of the underlying indebtedness, any transaction bearing an initial negative MTM which exceeded such threshold would not be compliant with the provisions of Decree 389. Civil and financial law allegations With regard to the Civil and Financial Law Allegations, it is worth mentioning that most of the claims raised by the Italian counterparties refer to derivative transactions entered into prior to the implementation in Italy of the MiFID Directive (which occurred as of 1 November 2007). In this respect, while analysing the allegations relating to the alleged breach of financial conduct rules, we will make reference to the pre-MiFID legal framework. Nullity of the contract. Lack of scope (‘causa’) claim. Indeterminability/indeterminateness of the object (‘oggetto’) claim From the perspective of strict contractual law, the most often recurring argument raised by Italian counterparties in their claims relates to the alleged absence of ‘causa’ (scope) in the derivatives contracts.18 The main claim in this regard is that: the ‘causa’ of the derivative contract consists in the assumption of mutual and bilateral risks between the parties; in certain decisions derivatives are classified as a form of legal bet; all elements contributing to identify such mutual and bilateral risks (including the initial MtM) must be indicated in the contract; without this, the contract is null because one of the essential elements (the ‘causa’) is missing. This has affected the ability of the counterparty to understand the type of risks underlying the agreement and to fully appreciate the amount of risk it was undertaking. As a result, since the derivative is to be classified as a legal bet, the lack of understanding on an essential element of the bet leads to the nullity of the agreement; as an alternative argument, it is claimed that due to the imbalance caused by the initial hidden costs (or negative MtM), the mutual and bilateral assumption of risks (and therefore the contract’s function) is lacking, in the sense that the contract is held as having been structured in a way such that it is fully certain that one party will gain, and the other party will have no prospects of gaining from the contract (therefore there is actually no risk at all for one of the parties). More recently, further claims raised by corporate counterparties and local authorities concerned the so-called ‘oggetto’ (object) of the derivative contracts. In this respect, please note that, under Italian law, the object of a contract consists in the mutual obligations imposed on each of the parties;19 pursuant to the Italian Civil Code, the object is an essential element of the contract and, therefore, in order to be held valid, any contract shall have a determined or at least determinable object. In this respect, it has been claimed that the lack of specific contractual provisions dealing with the methods to determine the MtM of derivative transactions would affect the determinateness/determinability of their object and, therefore, would cause the nullity of the same transactions. Breach by the Bank of conduct and information duties in the provision of investment services Since the derivative transactions are financial instruments subject to the relevant conduct rules imposed under the Italian laws, Italian counterparties also typically claim that such conduct rules have not been complied with, especially during the phase preceding the conclusion of the relevant contracts. Such claims are, most of the times, once again, based on the hidden costs theory, and particularly on the fact that the bank did not inform the counterparty of the presence of an alleged initial negative MtM for said counterparty. It is worth mentioning that under the pre-MiFID legal framework, there were no provisions of the Italian law expressly providing for a duty to disclose the MtM value, nor any presumed ‘hidden cost’.20 On this basis, the counterparties usually claim (by a claim which is subordinated to claims concerning the alleged lack of ‘causa’ or the indeterminateness and/or indeterminability of the ‘object’ which have been analysed before) that failure to disclose the hidden costs would result in a breach of the transparency and fairness duties that financial intermediaries must observe towards customers, pursuant to the general principle set out in Article 21 of TUF that financial intermediaries must best serve the interest of the customer and for the integrity of the markets, and to operate in such a way that the client is properly informed, and able to make an informed choice. Further related allegations, in this respect, are that the bank mistakenly classified and treated the relevant local authority as a qualified/professional investor as opposed to retail investors, thus depriving it of the necessary care in the provision of an investment service to it.21 As a result of the above, it is argued that, in their dealings with the counterparties, banks failed to comply with a number of rules generally imposed only with respect to retail investors, including: Article 27 of the Consob Regulation on conflict of interests, since they supposedly acted in the capacity as both swap counterparty and advisor;22 Article 28 of the Consob Regulation on the informative duties to the investors, for the alleged failure to provide the counterparties with adequate information on the nature, risks and effects of the transaction;23 Article 29 of the Consob Regulation on the ‘adequateness’, for the alleged structuring of speculative transaction not adequate to fulfil the hedging purposes pursued by the counterparties. We have to note that, in accordance with the case precedents of the Italian Supreme Court,24 breaches by a financial intermediary of the conduct rules imposed in connection with the provision of investment services (which are different from the provisions examined under previous paragraph II.C.A) do not ordinarily affect the validity of the relevant contracts but only trigger the pre-contractual or the contractual liability of the financial intermediary concerned (depending on the breach occurring before or after the conclusion of the relevant agreement) and, eventually, the obligation to compensate the counterparty for the damages suffered thereto. However, the above principle does not apply to those provisions of TUF which expressly envisage the nullity of contracts not complying with their content. This is the case of a breach of Article 30 of TUF, called ‘offerta fuori sede’ and in English translated as an off-premises offer, and which comes into question in the case of promotion and placement with the public of certain financial instruments and investment services, in a place that is different from the headquarters of the intermediary (typically, at the client’s premises).25 In this case, a legal requirement applies according to which a right of withdrawal by the investor within seven days (so-called ‘ius poenitendi’) must be envisaged and clearly specified in the relevant contract, without which the contract is null.26 Typically, the counterparties argue that this provision applies to derivative contracts as well, regardless of the governing law of the agreement. Another example is Article 23 of TUF, according to which the contracts relating to the provision of investment services shall be entered into in writing and, in case of failure to observe such formal requirement, the relevant contracts shall be held null and void. Please note that relying on the combined reading of Article 23 TUF and Article 30 of the Consob Regulation no 11522/1998 pursuant to which contracts for the provision of investment services shall necessarily contain certain information for the investor, both local authorities and corporate counterparties have claimed the nullity of their derivative transactions on the ground that the relevant ISDA documentation did not include in writing some of the information to be mandatorily included pursuant to Article 30 of the Consob Regulation no 11522/1998. 4. The litigation contexts Before outlining how the above claims and the relevant counterclaims have been addressed in the relevant case law, it is useful to briefly discuss the different types of dispute and judicial venues where such cases have been, and are, discussed. This, once again, depends on the relevant counterparties involved. Administrative litigation With respect to local authorities, the majority of the cases are discussed before the Italian administrative courts. These disputes commence with the exercise, by the relevant local authority, of certain powers of revocation granted to them with respect to administrative acts. In order to properly understand this aspect, it may be useful to clarify that contracts entered into by the public administration are stipulated on the basis of a specific administrative act adopted by the competent body which authorizes the execution of the contract. The power of revocation (also known as a power of ‘self-redress’ or ‘autotutela’) recognized to the public administration refers to administrative acts and not to contracts.27 In particular, the public administration has the general power to annul an administrative act which is illegitimate (in the presence of public interest reasons, within a reasonable time and taking into account the interests of the affected subjects). In the event that this power is exercised, there has been debate as to whether or not the effects of the revocation can extend to a contract entered into in reliance on the revocation act (and local authorities claim that the revocation does extend its effects to the contract). There has been a significant number of local authorities (varying from great Regions to small Municipalities) which relied on the presence of ‘hidden costs’ as a reason for exercising their power of self-redress, annulling the original resolutions through which they had approved entering into swap contracts, and purporting to annul the contracts themselves. In order to repudiate the self-redress measures, the banks have to commence proper proceedings before the Italian administrative courts. Italian civil litigation The most common hypothesis is that the disputes involve corporate counterparties. Less often local authorities bring their claims before the civil courts. They may do so when they do not exercise self-redress powers; however, they generally make recourse to self-redress for various reasons, such as a general belief according to which the administrative courts may take a more favourable approach towards public entities other than civil courts. UK civil litigation Various important cases have been brought (and are pending) before the civil English courts. These relate to ISDA-documented derivatives transactions which usually provide for a jurisdictional clause in favour of the English courts and where the banks have filed a pre-emptive claim in the presence of serious allegations made by the counterparty as to the invalidity of the contract (often accompanied by non-payment), therefore seeking declaratory relief as to the validity of the contract. In these cases, as noted, Italian law issues usually come into question. In fact—notwithstanding the parties’ choice of the governing law (English law)—Italian law may nevertheless be applicable in terms of overriding principles of Italian public order, or extra-contractual obligations relating to the provision of investment services, or because of the purported lack of any element of internationality (for instance, when both parties are Italian and payments are taking place in Italy). Criminal proceedings In a few cases, the allegations above discussed have been put forward by public prosecutors in the context of certain criminal investigations and proceedings, where mispricing or misconduct have been contested as criminal offences of fraud and deceitful behaviour on the part of the banks to the detriment of the local authorities (one of these cases is the City of Milan Case). These criminal proceedings may concern both single individuals within a bank, identified as being responsible for the supposed offence, and the bank itself, which: is normally held liable, under a civil perspective (responsabile civile) for crimes committed by its own employees; may be charged under Legislative Decree 231/2001, providing for an administrative liability of entities (including banks) for certain crimes (listed under the Legislative Decree 231/2001 and including fraud) committed by their employees in the interest or for the advantage of the entities themselves.28 5. Derivatives’ case law Jurisdictional matters The judicial proceedings involving derivative transactions often require the preliminary solution of exception of lack of jurisdiction filed by the parties. These exceptions may particularly concern: whether the jurisdiction to know the dispute shall be declared in favour of the administrative courts or of the civil courts; whether the jurisdiction to know the dispute shall be declared in favour of Italian courts or of English courts. It is also worth mentioning that, in accordance with the Italian Civil Procedure Code, jurisdictional matters (either relating to the competence of the administrative courts as opposed to the civil courts (and vice versa) or to the competence of a foreign court as opposed to Italian courts) may be deferred to the Joint Section of the Italian Supreme Court through the filing of a jurisdictional challenge. In such a case, the existing proceedings in Italy are usually suspended pending the decision of the Italian Supreme Court. Administrative courts versus civil courts This kind of jurisdictional matter usually arises, as a result of the commencement by the local authority of a self-redress procedure which affects the derivative transactions entered into by the same authority. In this respect, jurisdictional challenges are usually raised by the banks in order to claim that local authorities cannot use the self-redress procedure to unilaterally invalidate contracts entered into with them and that any final evaluation relating to the validity and enforceability of such contracts pertains to the civil courts. We note that the Italian Supreme Court has recently maintained that the jurisdiction of administrative courts, in the context of disputes involving a self-redress procedure, shall only concern possible irregularities in the methods by which an administrative act, preceding the conclusion by the authority of a certain agreement, has been taken, since the self-redress procedure cannot be a mere instrument to invalidate the same agreement. In fact, once that the agreement has been entered into, any claim concerning its alleged invalidity (and not irregularities of the administrative procedure preceding the conclusion of such agreement) shall be exclusively deferred to the civil courts.29 Italian courts versus English courts Several Italian local authorities have tried to circumvent the application of the jurisdictional clause in favour of the English courts, included under the ISDA Master Agreement, by filing their claims with the Italian courts. Similar attempts often move from the circumstance that, especially in the context of the issuance by the local authorities of bonds aimed at refinancing their financial indebtedness, as already indicated above (see the section ‘Breach of the “economic convenience” test’), the entering into of derivative transactions was frequently preceded by mandate agreements, providing for the appointment of the bank as arranger of the bond issuance and entrusting the latter with a number of tasks (including, in some cases, an obligation to assist the local authority with the calculation of the economic convenience, under Article 41 of Law 448/2001). Since some of such mandate agreements contained jurisdictional clauses in favour of the Italian courts, certain local authorities have sued the financial counterparties in Italy, invoking their contractual liability for the failure to comply with the obligations under the mandate agreement. In such cases, the local authorities affirm that they do not intend to challenge the validity of the derivative transactions (nor to interrupt any payment due under the latter) but only to claim compensation for the damages suffered as a result of the financial counterparties’ defaults under the mandate agreements. However, looking at their substance,30 most of the claims raised against the financial intermediaries concern the structuring by the latter of derivative transactions allegedly not compliant with the provisions of the Italian law referred to in Section 2 above. Moreover, the amount of damages to be allegedly refunded by the financial counterparties is calculated on the basis of the payments made (or expected to be made in future) by the legal authorities pursuant to the derivative transactions. Similar proceedings of the Italian local authorities may be either preceded or followed by other proceedings initiated in the UK by the financial counterparties and expressly aimed at ascertaining that the derivative transactions are fully valid and effective and did not breach any law (including the Italian ones) applicable to the latter. The contextual pending in different countries of several proceedings between the same parties and concerning related matters usually gives rise to jurisdictional challenges to be solved in accordance with the provisions of the EU Regulation no. 1215/2012 (so-called Bruxelles Recast Regulation).31 Such jurisdictional issues have recently been dealt with by the High Court of Justice in the Brescia Case.32 In this respect, a proceeding had been initiated in Italy by the Province of Brescia against Dexia Crediop SpA, in order to claim damages which allegedly derived from the failure by Dexia to comply with the obligations set out under a mandate agreement which had preceded the entering into by Dexia and the Province of two derivative transactions. After the commencement of the Italian Proceedings, Dexia initiated separate proceedings in the UK expressly aimed at ascertaining the validity and enforceability of the relevant derivative transactions and of their compliance with the applicable laws. In its acknowledgement of service, the Province of Brescia objected that the English judge lacked jurisdiction on certain declarations sought by Dexia through its claim and which regarded the compliance of the derivative transactions with Italian law. By a decision dated 21 December 2016, the High Court of Justice rejected the exception of lack of jurisdiction filed by Brescia on the grounds that the declarations sought by Dexia tracked the wording of certain representations made by Brescia under the ISDA Master Agreement which governed the relevant derivative transactions and, therefore, fell, also for the purpose of article 31 of the Brussels Recast Regulation, under the jurisdictional clause of the same ISDA Master Agreement. Specifically, to reach this conclusion the High Court of London stated the following, among other things: the argument put forward by the Province whereby some of the claims raised by Dexia should have been judged by the English court and others by the Italian would have had paradoxical consequences, causing a ‘fragmentation’ in the judicial assessments concerning the ‘representations’ provided pursuant to the ISDA Master Agreement; such a fragmentation was considered to be incompatible with the will expressed by the parties upon the execution of the ISDA Master Agreement, by providing for the exclusive jurisdiction clause in favour of the English court; the fact that the declarations sought by Dexia (and challenged by the Province) included Italian law assessments did not limit in any way the application of the jurisdictional clause referred to in the ISDA Master Agreement; in any case, pursuant to Article 31, paragraph 2, of Regulation no 1215/2012 the High Court of London had to be considered as being the jurisdictional authority designated by the parties, pursuant to the jurisdictional clause to settle any dispute arising in relation to the relevant derivative transaction (including, therefore, the challenged declarations); in this respect, the fact that the Italian court was the first one before which proceedings were brought had to be regarded as completely irrelevant. Case law on MtM and hidden costs theory The case law on this topic is quite diversified. There are a number of decisions that move from the assumption that the MtM value of a derivative transaction at inception should be par and build their decisions on this basis. The most relevant is the decision of the Court of Appeal of Milan in its judgment dated 18 September 2013, No 3459 (‘Sentenza Raineri’) which has positively based on this concept a decision leading to the nullity of the derivative contracts. There are a number of cases following this approach. There have been, however, key decisions of the Italian high courts, followed by a number of consistent lower court pronouncements that have clearly recognized over the last years that: (i) the initial ‘par’ value of MtM of a derivative transaction is a theoretical concept, based on mid-market prices; (ii) the mid-market price is merely a benchmark against which the actual price is set; (iii) the actual price agreed with the counterparty is in fact a bid or offer price that uses the mid-market price as a benchmark before adjusting for costs and risk, and the actual net present value to the dealer is not zero but a positive amount.33 The Supreme Court (Corte di Cassazione), Criminal Section, in case no. 47421/201134 judging upon derivatives contracts entered into by an Italian bank (BNL) and the Municipality of Messina held that the MtM of a derivative contract ‘does not express an actual and concrete value, but only a financial projection based on the theoretical market value in the event of early termination. The mark-to-market value is in fact influenced by a series of factors and it is therefore systematically adjusted on the basis of the market movements … . Therefore, in order to establish whether it represents an advantage or a disadvantage for the counterparty, an ex post assessment is necessary, once the contract will have reached its termination … .’ These concepts have been restated by the Council of State (the High Administrative Court) in the landmark Pisa Case.35 The Council of State held that ‘the fair value of a derivative always shows a positive value [for the Bank] and it is equal to zero only in theoretical circumstances where there is a complete financial equivalence between the estimated flows at mid-market conditions, between banking counterparties having the same rating, whereas, with respect to the retail market, considering that the scope of the contract in such market lies in the specific needs of the client, each transaction is different from the others; it follows from this that the relevant risks are not standardised and the prices are different for each transaction as they reflect the overall effective features of the contract’. The court also held that it is ‘even impossible to talk about “implicit costs” … as they represent the value of the swap and not a cost effectively borne by the administration’. It is not relevant here that the Province did not have the instruments to verify the market data and carry out the evaluations [of the MtM] and did not own software licenses for the pricing of derivative products—given that specific professional knowledge is, in any case, necessary in order to use such tools, but it is rather of relevance that the contract did contain all elements necessary for an adequate evaluation of the transaction and the Province could have certainly requested additional information from the Banks (about their internal evaluations, credit risks and other variables) in order to negotiate on such parameters. In the Milan Case,36 the court has repeatedly held that derivatives transactions of the type in question cannot have a zero initial MtM, and it is obvious that the banks would make profits from the investment service they have provided to the client. The court also noted that the initial MtM is always negative for the counterparty and positive for the bank due to the fact that the costs of the transaction are not kept separate from the price but, for constant market practice, they are included in the price. For this reason, such a price diverges from the ‘par’ or theoretical price as it also includes the costs incurred by the intermediary as well as a mark-up, ie, a margin representing the expected profit for the bank. According to the court, a public authority is aware, or should be aware, that ‘hidden costs’ have very little to do with anything ‘hidden’; a public authority is aware that ‘par’ swap agreements are considered, by the standard practice of international markets, inexistent in reality; it is well aware of the fact that, after determining the level of the theoretical price (on whose basis the actual value of the obligations falling on one party is equivalent to the value of the obligations falling on the other), such value is modified in order to take into account costs sustained by the Bank and the profit component required by the financial intermediation activity. According to the Court of Appeal of Milan, any claim based on the hidden costs is based, therefore, on a fundamental conceptual misunderstanding: ‘The Banks are for-profit organisations and must therefore earn profits. If they offered their services for free their activity would be inconsistent with their business purpose, and they would be in trouble if the regulation authorities came to know it’. It follows that the aforementioned price components cannot be considered as ‘hidden costs’ and, conversely, must be considered expenses legitimately taken into account by the Banks in determining the price of the product, since they are entirely irrelevant for the purpose of assessing the economic convenience in adherence with Article 41. The court also recalled the provisions of Annex 3 to the Consob Regulation and noted, in this respect, that a local authority must know that the relevant provisions relating to the presumed ‘par’ value of the MtM at the inception of a derivative transaction have to be correctly intended. In this respect, the court acknowledged that Annex 3 to the Consob Regulation contained misleading provisions which, however, could not in any case result in the local authority actually believing that a derivative transaction having a ‘par’ MtM value at inception might really exist. A number of other judgments followed the same line of reasoning and reached the same conclusions.37 More importantly, this principle has been restated by the High Court in London in the Prato Case, under the Prato Main Claim Judgment. In this respect, the High Court in London made reference to the Pisa Case and to the Milan Case, specifying that according to the relevant decision of the Council of State, the so-called ‘implicit costs’ of a derivative ‘do not by any means constitute an effective cost … but merely stand for the value that the swap could have had in an abstract and hypothetical (but utterly unrealistic and untrue) negotiation’. The High Court of London also argued that ‘it is the commercial terms [i.e. the interest rates specified under the derivative transaction] which have a continuing effect. It does not matter for this purpose whether the impact of those terms is computed by calculating an MTM, whether the MTM is described in accounting terms as a “cost”, or whether the MTM expresses market expectation as to the likely outcome of a swap.’ The High Court of Justice focused again on the MtM under the Prato Judgment on the Remaining Issues. In this respect, in particular, the High Court of Justice: rejected Prato’s allegation that the initial MtM should be regarded as an expression of the then expected cash flow outcome, on the ground that the actual outcome of a derivative transaction is only dependent on market rates over time and that, therefore, the initial MtM gives no information at all about its expected outcome; rejected Prato’s allegation that if the initial MtM had been disclosed to it, Prato would have refrained from entering into the derivative transaction or would have sought competitive quotes from different financial intermediaries; affirmed that a situation where the initial MtM is zero is entirely theoretical as ‘[b]y definition, no such swap occurs … it is commercially absurd to think that a retail customer could obtain a swap at mid-market rates in the absence of some particular reason on the part of the bank to trade in a way which gave it no profit element’. The above arguments have been fully recalled by the Court of Appeal for the purpose of the Prato Appeal Judgment. In this respect, the Court of Appeal particularly referred to the decision of the Council of State under the Pisa Code and maintained that: the Council of State refers to the fact that it is not possible to speak of ‘implicit costs’ … which were correctly and reasonably estimated by the consultant at €320,000, which represent the value of the swap, not a cost effectively sustained by the authority as ‘the decisive consideration’. … The judge recognized that the Messina and Arosio decisions needed to be viewed with caution given their different, criminal law context. Nevertheless they were entirely consistent with the view that initial MTM was not a real or effective cost and not one which was relevant to the calculation of financial advantage. Public Law Allegations The alleged breach of Article 119 of the Italian Constitution For the purposes of the Prato Case, the High Court of Justice has extensively examined Article 119 of the Italian Constitution concluding that the derivative transactions under its examination could not be considered to be ‘indebtedness’ for the purpose of Article 119 of the Italian Constitution with the consequence that no breach of such provision had occurred. In order to come to such conclusions, the High Court of Justice made preliminarily reference to the decision of the Italian Constitutional Court no. 425/2004, which stated that: the meaning of the word ‘indebtedness’ is not defined by Article 119, paragraph 6 and cannot be determined a priori by the judges; what is meant by ‘indebtedness’ (ie the types of transaction that can be considered ‘indebtedness’ for the purposes of Article 119) must be the same for all public authorities and it is not acceptable that each of them gives a different definition at that concept. Only the State—and in particular, only the Italian legislature—can define what is meant by ‘indebtedness’ pursuant to Article 119 and this had been done by Article 3 of the Law 350/2003 which specified general rules for classifying permitted transactions and investments for local authorities and which contained an exhaustive list of the transactions that could be classified as ‘indebtedness’ and as ‘investments’ for the purposes of Article 119. The list did not include derivative transactions. The position above partially changed only in 2008 (ie after the period that was relevant for the proceedings and for most of the litigation regarding the local authorities in general), when the list of transactions constituting ‘indebtedness’ was amended (with effect from 1 January 2009) in order to specifically include any transactions which involved any ‘premiums received at the conclusion [ie inception] of derivative transactions’ (Article 62(9) of Law Decree DLN 112 of 25 June 2008). According to the court, this change seemed particularly significant because it confirmed that the listing of the operations of indebtedness contained in the law of 2003 was comprehensive and exhaustive and did not merely contain examples. This was further confirmed by the subsequent legislative history of the provision in question which was amended so as to add transactions which involved premiums received upon entering into derivatives. According to the court this implied that the amendment was made because the Italian legislature wished derivatives to be included, but only if they were entered into on or after 1 January 2009 and only if, upon entering into the derivative in question, the local authority received a premium. On this basis, the court did not agree with the position taken by the local authority and, according to which, the modification made by means of Law Decree DLN 112 of 25 June 2008 to Article 3(17) of Law 350 was not addressed at changing or expanding the meaning of Article 119 but simply at clarifying it. The above reasoning was fully confirmed by the Court of Appeal, under the Appeal Prato Judgment which maintained that: ‘[t]he task for the judge was to predict how the highest court would determine the matter if it came before it. In our judgment, the judge was plainly entitled … to conclude that the highest court would not follow the reasoning in Municipality of C. [ie a decision of the Court of Appeal of Bologna which, according to Prato, supposedly supported its conclusions] … Moreover the 2009 amendment, to include premiums on derivatives, is striking. If swap transactions were a form of indebtedness already covered by paragraph 17, it is impossible to see why the amendment was a rational one to make’. The alleged breach of Article 41 Notwithstanding the fact that authoritative and consistent court decisions, as indicated under the section ‘Case law on MtM and hidden costs theory' above, now consider that the hidden costs theory is ungrounded, this has not completely cleared the consequential argument often claimed by local authorities that, because of the presence of the hidden costs in the derivatives transaction, the ‘economic convenience’ test of Article 41 was violated. However, in the Prato Case, Article 41 was assessed and the English court excluded that the swaps in question were entered into in violation of Article 41. The court specified that the economic convenience test38 was applicable to derivatives only under if four conditions are met: the first: that the derivative is implemented in the conversion of an existing debt, by means of its extinction and the subsequent contraction of a new debt. In this respect, according to the court, the economic convenience test would not be required in case of restructuring of precedent derivative transactions; the second, third and fourth conditions according to the English court provide, on the assumption that the derivative is structurally connected to the restructuring of a debt: that the overall cost of debt refinancing is analysed, considering the derivative as an integral and substantial part of the refinancing itself; that the derivative cannot be considered in isolation, but only in the context of the refinancing operation as a whole; that, for the purposes of the analysis of financial advantage, neither the initial MtM nor the ‘hidden costs’ of the derivative, being only theoretical, should be taken into account. On the other hand, it shall be made a ‘projection as to the effect of the derivative on its cost of debit [ie the cost of the debt of the local authority concerned] using forward rates as at the date of the transaction’. In summary, the ruling confirmed: on one side, that Article 41, paragraph 2 of Law 448/2001 only concerns the transactions carried out by local authorities in order to refinance their own indebtedness; on the other side, that the initial MtM of derivatives transactions is not an actual cost incurred by the public authority, but only a theoretical value and, therefore, as such, irrelevant to the economic evaluation test pursuant to Article 41. Both the above conclusions were subsequently confirmed by the Prato Appeal Judgment. Similar principles were followed, as mentioned before, in the Milan Case and in the Pisa Case. Notably, under the Milan Case, it has also been highlighted that the provisions of Article 41 are exclusively referred to the local authorities. The above judgment starts from a harsh criticism of the conduct of the Municipality of Milan that, similar to what was done by several other local authorities, after having completed its debt refinancing under Article 41 of Law No 448/2001, employing to that end some financial intermediaries, had later challenged its legitimacy, sustaining that financial intermediaries were supposed to verify the economic convenience of the transaction. The court noted, in this regard, that ‘[i]t should not have happened that the City of Milan—appointed by the law to first evaluate and certify the underlying economic convenience and only then perform it—… omitted virtually every independent assessment on the economic convenience and the compliance with the criteria set out in Article 41 of Law No. 448/2001 of the transaction that it was about to undertake; relying (in a non-technical way)—in a contingency of “innocent rush”—on the competence and professionalism of individuals to perform their own unavoidable tasks; accepting its results (at this point it would be better without having really verified the intrinsic quality) and then, later, ambiguously and instrumentally opt out’. According to the court, therefore, local authorities are the only parties to assess and certify the economic convenience of the refinancing transaction. They are unquestionably bound, by express provision of law, to perform such duty, without being able in any way to delegate that assignment to third parties. The local authority’s alleged inexperience certainly cannot be an excuse for discharging its responsibilities on the financial intermediary, being surprised ‘when the banks pursue their corporate purpose by making profits’. The court observed that ‘there is no requirement for the directors of a public authority to access the capital market at all costs; there is a clear obligation not to gamble with the money of the citizens/taxpayers by having them assume harmful and unnecessary risks. Above all, there is the legal and ethical duty to be prepared, equipped and informed for the fulfilment of every administrative act, which requires developments in complex and uncommon matters’. The alleged breaches of Decree 389 With respect to the claims regarding the alleged breaches of the Decree 389, the arguments brought in this respect by the local authorities have been rejected by the Italian higher courts and also by the High Court of Justice in the context of the Prato Case. On the ‘collar’ point, in the Pisa Case, the Council of State argued that the provisions of Decree 389 (or the relevant explanatory note) do not require, or even suggest, an equivalence between the economic value of the cap and the floor value of an interest rate collar. Likewise, the court in the Milan Case—when dealing with the implicit costs—stated that the values of the cap and the floor of a collar swap cannot be ‘financially equivalent’, and concluded that the collar structure was in conformity with the provisions of Decree 389. As far as the High Court of London is concerned, it was particularly held that: nothing in the Decree 389 (nor in the Explanatory Circular) requires, or even suggests that, in case of collar transactions, there should be equivalence between the economic value of the cap and the floor value. In this respect, the court also clarified that the rationale of Decree 389 is that the sale of a floor by a local authority shall only be addressed at financing the protection against an increase in interest rates, protection which is furnished by the purchase of a cap. In other words, local authorities shall be refrained from selling a floor merely for speculative purpose but this does not in any way imply that the purchased cap shall have a value equivalent to the purchased floor; regarding the alleged obligation, in case of a derivative transaction bearing a negative MtM at inception, to envisage the payment of an upfront equivalent to such negative value, which, at the same time, shall not exceed 1 per cent of the notional value of the underlying indebtedness, the court stated that Decree 389 does not in any way suggest that the MtM may be regarded as an upfront payment for the purpose of its provisions, since ‘what is contemplated [by the Decree 389] is something which is paid’ and, as already explained above, the court took the view that the MtM is not an effective cost; on the ‘speculation’ allegation, the court held that the swaps concluded were not speculative in nature. In particular, according to the court, while it is true that derivatives have an inherent risk, this feature does not make them speculative tout court whenever they are intended to provide hedging (as was the case of the derivatives subject to its examination) with respect to the underlying liability of the local authority.39 It should be noted, however, that other decisions from lower courts do not entirely follow this approach and, for example, identified a violation of Decree 389 whenever the economic value of the floor and the cap do not match.40 Civil and financial laws allegation Nullity of the contract as a consequence of an alleged lack of proper information As anticipated before, the so called Sentenza Raineri held that the disclosure of the initial MtM is an essential element of the contract and, in fact, it is ‘the same object of the contract’. More specifically, according to the Court of Appeal, the ‘causa’ of derivative transactions should consist in a ‘bet’ which both parties assume. On this basis, since, for the purpose of legally authorized bets, the risk must be rational for both parties, failure to disclose the MtM at inception can only lead to the nullity of the entire contract, pursuant to Article 1418 of the Civil Code, because the non-disclosure puts the counterparty in a position where it is unable to understand the risk that it is underwriting under the contract. This concept has been repeated in various decisions of the lower courts. There have been in fact pronouncements concluding for the nullity of the contract for lack of scope (‘causa’) due to the presence of the hidden costs, as these had resulted (i) in the counterparty not understanding the structure,41 (ii) in the relevant transaction having a speculative (as opposed to hedging) intent contrary to the party’s intention;42 (iii) in the contract lacking of an essential element to determine its (alleged) scope, ie, the type and amount of risks undertaken with the contract;43 (iv) in the absence of balance of risks among the parties, so that one party has actually no prospects of benefiting from favourable payment flows under the transaction.44 On the contrary, in the Pisa Case, the Council of State held that, regardless of the professional or retail nature of the local authority, there is an obligation, first moral and then legal, by the officers who manage public money, to obtain sufficient information on the structure of the contract about to be signed, the risks related to it and the potential impact thereof on future finances. The Council of State categorically excluded that the banks had breached any disclosure duty on the swaps’ MtM value. According to the decision, at the time when the derivatives contracts were entered into by Pisa with the banks, there was no legal requirement imposing such disclosure. The court noted that such obligations were introduced in Italy only after the implementation of the MiFID Directive (in terms of a recommendation to provide—to retail customers only—the unbundling of the initial derivative market value in OTC derivatives transactions entered into with retail investors). The court found no evidence whatsoever of presumed incorrect, not transparent, unfair behaviour by the banks pursuant to the provisions of the Italian financial services law, nor it could be held that the Banks acted without acquiring the necessary information about the client. Equally, in the Milan Case, the court confirmed that there was no obligation upon the bank towards the counterparty to provide the margin, or hidden costs, or initial MtM of the derivative, since the applicable laws only required the indication of the final price of the derivative to be given.45 This was certainly the case at the time when the Milan swap transactions were entered into, on the basis of the then applicable legislation. In this respect, the court recalled the conclusions reached by the Council of State in the Pisa Case, discussed above. The Milan Court firmly concluded on the point that ‘transparency cannot have its source in the parties’ individual wishes but only in the law’. More recently the Italian Supreme Court held that the MtM consists in ‘a method of valuation of financial assets … . It consists in determining the value that such assets would have in case of renegotation of the contract or of its early termination, before the set deadline … . The value of the mark to market is infact affected by a number of factors and is therefore systematically updated based on the financial markets’ trends.’ And again: ‘mark to market is also defined as replacement cost, because it corresponds to the price, established, at a certain time, by the market, that third parties would be willing to pay in order to assume the rights and the obligations envisaged under the contract’. Provided the above, the Italian Supreme Court went on to maintain that the MtM is not a concept unknown to the Italian legal framework, being rather reflected by ‘article 203 of TUF, that for the purpose of article 76 of the Italian bankruptcy law, describes the mark to market as the replacement consist of the derivative financial instruments’.46 Based on the above, the Italian Supreme Court appears to be of the view that: the MtM is a mere theoretical value whose amount is dependent on the unpredictable market trends; the criteria to determine the MtM value and particularly their connection with the replacement costs are expressly established under the Italian laws. The above conclusions appear to be inconsistent with the claims by the local authorities that information relating to the value of the MtM at inception and to the methods to be followed for calculating the MtM shall be necessarily included under the derivative transactions in order for the latter to be held valid. As far as the Prato Case is concerned, we have to note that, under the Prato Judgment on the Remaining Issues, the High Court of Justice extensively focused on the alleged nullity of the derivative transactions for the failure to disclose the MtM and, particularly, on the so called Sentenza Raineri, fully rejecting the allegations brought by Prato in this respect. In this respect, the High Court of Justice argued that, as expressly recognized under the decisions of the Joint Sections of the Italian Supreme Courts,47 breaches of the conduct rules (unless expressly provided to the contrary) do not determine the nullity of the contract but may merely raise claims for compensation of damages. The High Court of Justice also held that the conclusions reached under the Sentenza Raineri on the configuration of derivative transactions as bets had been clearly rejected from previous case precedents of the Italian Supreme Courts. The court also expressed the view that the same criteria upon which the Sentenza Raineri rely in order to configure derivative transactions as bets, would equally apply to insurance contracts, but no one categorized insurance contracts as bets. The court, therefore concluded that ‘if the matter were to come before the Court of Cassation, then that court would not adopt the approach’ taken under the Sentenza Raineri. Conduct rules Qualified operator In the derivative disputes, the counterparties commonly ‘repudiate’ the declaration executed at the time of the transaction and certifying their conditions as qualified operators, asserting that they actually have no knowledge and experience in derivatives and the relevant bank counterparty has mistakenly classified and treated them as qualified/professional investors, thus depriving them of the required care in the provision of an investment service to them. The Supreme Court has clarified how the ‘qualified investor’ provisions and declaration must be interpreted and applied in the renowned case no 12138 of 26 May 2009. Here, the court has stated that the nature of a qualified investor comes from the simultaneous presence of two requisites: (i) a substantial one, ie, the specific expertise and competence; and (ii) a formal one, ie, the express declaration. According to the court, there is no onus on the financial intermediary that has received the declaration to actually ascertain the truthfulness of its content, as the effects of it fall within the responsibility of the subject having made the declaration in such capacity as the legal representative of the company. The court has, therefore, stated that in the absence of contrary elements emerging from the documentation acquired by the financial intermediary, the mere declaration exempts the financial intermediary from a verification of its content. Furthermore, absent any contrary evidence offered as a proof by the counterparty, the declaration constitutes an element of proof upon which the Judge can base his or her decision (on the professional nature of a party). The alleged existence of a duty to communicate the existence of the so-called hidden costs With regard to the alleged breach of the conduct rules imposed by TUF and Consob Regulation that would derive from the failed disclosure of the so-called ‘hidden costs’, opposite indications have been provided by the Council of State for the purpose of the Pisa Case. According to the Council of State, when the swaps submitted to it for review were entered into no legal obligation fell on the financial intermediaries to communicate to the counterparties the various components of the MtM value at the inception of the derivative transactions. On the other hand, the Council of State expressly maintained that it was only from 2007, after implementation of the MiFID Directive, that the Italian legal system introduced more stringent rules (referred only to non-professional clients); these rules recommend the intermediaries to provide a breakdown of the various components included in the client’s total financial expense. The Council of State, therefore, did not find ‘any evidence, not even indicative evidence, of an alleged incorrect, inattentive and non-transparent conduct, aimed at providing a disservice to the client (under Article 21 of Legislative Decree of 24 February 1998, No. 58, claimed by the Administration’s defence lawyer), nor can it be assumed that the banks acted without acquiring the necessary information from the clients and without ensuring that clients were always suitably informed; a claim that is refuted by the very specific features of the … swaps entered into, clearly tailored on the specific needs of the Provincial Administration’. Similar views were expressed by the Court of Appeal of Milan, for the purpose of the Milan Case. Significantly both the Pisa Case and the Milan Case were extensively relied upon by the High Court of Justice, for the purpose of the Prato Case in order to dismiss Prato’s allegation that failure to disclose the MtM value of derivative transactions at inception would have resulted in a breach of the provisions of Article 21 TUF and of Article 28 of the Consob Regulation. In this respect, the court held that: ‘[m]y analysis is that in the absence of special circumstances, no good reason has been identified for going beyond the no need to know legal proposition. In particular, as regards “costs”, factors said to constitute “costs” fall within article 28.2 only to the extent that the investor needs to know about them in order to understand about the nature, risks and implications of the transaction.’ Notably, in order to reach the above conclusion, the court rejected the arguments sustained under several decisions by lower courts referred by Prato, on the ground that such decisions ‘were based upon misconceptions’ since they moved from the assumption ‘that the initial MTM was an actual cost, or reflected actual costs, which would be incurred by the City if it entered into the swaps in question’. In this respect, the High Court of Justice also rejected the complaints from Prato that the decisions rendered by the Council of State and by the Court of Appeal of Milan having being rendered by an administrative and a criminal court should have lesser weight than the decisions of the civil courts upon which it relied. In particular, the High Court of Justice replied as follows: ‘in the present context I am concerned with a decision of the highest court, of comparable standing with the Court of Cassation itself, in the field of administrative law. In the field of criminal law, I am concerned with a decision of the criminal section of the same court, the Court of Appeal of Milan, as is relied upon [in] Prato. Moreover, and to my mind particularly importantly Pisa II and Arosio [ie respectively the decisions rendered by the Council of State and by the Court of Appeal of Milan for the purpose of the Pisa Case and of the Milan Case] are decisions which involve a detailed and careful examination both of the law and of the facts. These matters, to my mind, more than compensate for the fact that the decisions are not decisions of civil tribunals.’ Conflict of interest It is often claimed by the counterparties that the banks were in a conflict of interest when they entered into relevant swaps, as they were at the same time advisors of the counterparty, either by virtue of a specific advisory agreement, or because the advisory service is implicit in the offering of the derivative product. On that basis it has been claimed that failure to properly disclose such conflict amounts to a violation of the conduct rules and leads either to the nullity of the agreement or liability for damages. This theme was extensively analysed in the Milan Case where the court stated that what the law requires is essentially that any conflict of interests which is not manifest should be reported under the rule known as ‘disclose or abstain’. According to the judgment, conflict, is thus not prohibited in itself but the relevant counterparty has to be put in a position to know the existence of conflict to be able to freely decide whether it is still worthwhile to undertake the transaction or not. If on the other hand, the conflict is obvious and the Bank’s counterparty is already aware, then there is no need for the bank to give further information. The same is in fact also provided for by Article 32 of the Consob Regulation no 11522/1998, paragraph 5 and 6 (as interpreted in the light of the Consob communication 99014081/1999). In the Prato Case, the High Court of Justice went on to maintain that the disclosure obligations imposed in connection with the provisions on conflict of interest do not arise from the commercial role of the bank in the ordinary course of its business—of which the non-financial counterparty shall be considered to be well aware—but from any ulterior motive that it may have for entering into a transaction. It follows from the above that not all cases in which a bank trades as the direct counterparty of its client will involve a conflict of interest: ‘what gave rise to a conflict of interest was an ulterior and different ground for the transaction’.48 The right of withdrawal pursuant to Article 30, paragraphs 6 and 7 of the TUF The application of Article 30, paragraph 6 and 7, of the TUF to contracts not governed by the Italian Laws In the Prato Case the High Court of London stated that failure to include the provision regarding the cooling-off period in the derivative documentation leads to the nullity of the contract if (i) the counterparty is not a qualified operator; (ii) the contract has been concluded outside of the bank’s premises; and (iii) Italian law applies as a result of the application of Article 3.3 of the Rome Convention. The court went on to say that the fact that the agreement was extensively negotiated does not affect this conclusion. The application of Article 3.3 of the Rome Convention49 was triggered according to the High Court by the fact that both parties of the transaction in question were Italian, payments were supposed to be made in Italy and there was no element of the situation which could be linked to a place other than Italy itself.50 Interestingly, in the subsequent Santander Case51 the High Court reached in similar circumstances the opposite conclusion with respect to Article 3.3 of the Rome Convention and the Justice ‘respectfully disagreed’ with the previous decision on Prato. The court in that case identified various elements of a derivative contract entered into under the ISDA framework, which points to its international nature even though both parties of the transaction belong to the same country. This decision has been confirmed by the Court of Appeal (Civil Division) by a ruling dated 13 December 2016. In particular, the Court of Appeal held that: the expression of Article 3.3 of the Rome Convention ‘elements relevant to the situation’ has to be construed in a broad sense and shall not be confined (as it was done by the High Court of London, for the purpose of the Prato Case) to elements having a connection to a particular country in a conflict of laws sense; therefore any element (even if not strictly connected to the contract) that points directly from a purely domestic to an international situation could be considered to be ‘relevant to the situation’; in the specific case under the attention of the Court of Appeal, the international nature of the swaps market, the use of the ISDA documentation, the circumstance that the bank was entitled to assign its rights and obligation under any transaction entered into in accordance with the ISDA Master Agreement to any of its subsidiaries and the entering into of back-to-back transactions with foreign counterparties were all ‘elements relevant to the situation’ that underlined the ‘international’ nature of the transactions and therefore excluded the necessity to apply any law other than the one chosen by the parties. The same approach has been followed by the Court of Appeal for the purpose of the Prato Appeal Decision which, therefore, overturned the decision taken in this respect by the High Court of Justice. In particular, the Court of Appeal recognized that, with specific reference to the contractual relationship at stake, at least three ‘elements relevant to the situation’ supported the international nature of the transaction and namely: the use of the standard form of master agreement of the International Swap Dealers Association Inc. In this respect, it was argued that ‘[t]he use of the ISDA Master Agreement is self-evidently not connected with any particular country and is used precisely because it is not intended to be associated exclusively with any such country’; the fact that with respect to each of the swaps concluded between the parties, a back-to-back hedging swap with banks outside Italy had been entered into, using the same international standard documentation. In this respect, the court maintained that the entering into of similar back-to-back hedging swaps is ‘routine’ for this kind of transaction and, as such, was objectively foreseeable by Prato; the fact that non-Italian banks had taken part in the tender procedure at the end of which Dexia had been selected as advisor of Prato. According to the Court of Appeal this ‘also shows the international nature of the market in which the swaps contracts were in due course concluded’. On this basis, the Court of Appeal concluded that mandatory rules of Italian law, including Article 30, paragraphs 6 and 7, TUF could not have application to the case at hand, due to (i) the choice of English law as the governing law which had been made by the parties and, at the same time, (ii) the irrelevance of Article 3.3 of the Rome Convention, as a result of the ‘international’ nature of the transaction. It is also interesting to note that, for the purpose of the Prato Appeal Judgment, the Court of Appeal also took into account the scenario in which its conclusions on Article 3.3 of the Rome Convention were wrong and, therefore, Article 30 TUF had to be deemed applicable. On this basis, the Court of Appeal maintained that, even if the relevant derivative contracts had to be held null and void, as a result of breach of Article 30 TUF, ‘[t]he question of whether a contract is a nullity or is void (and may be declared so) is a matter concerning the validity and enforceability of contractual obligations; and is therefore governed by the choice of law rules in the Rome Convention. As we have already noted, by Article 3(1) of the Rome Convention, that law is English law. It follows that an English Court will not consider the validity of the swaps other than as a matter of English law; and will not give effect to an argument that the contracts are invalid or unenforceable as a matter of Italian law. There can be no issue that, as a matter of English law, the contracts were valid and Prato are not entitled to a declaration of nullity of the contracts on the basis of the tort claim advanced as a matter of Italian law.’ At the same time, the Court of Appeal rejected Prato’s pleadings that the court should have fashioned a remedy in damages, for the benefit of the municipality which could be harmonized with its rights under the Italian law. The Court of Appeal noted that such solution could not be followed on the ground that Prato had not been able to demonstrate that if it had been informed of its right of withdrawal under Article 30 TUF, it would have actually enforced such right. On this basis, since the alleged breach of Article 30 TUF had not caused any actual loss to the Municipality (as it had not been able to prove otherwise), it was not entitled to any claim in damages. The rationale of Article 30, paragraphs 6 and 7 of TUF Assuming that, differently from what occurred for the purpose of the Prato Case, Article 30 paragraphs 6 and 7 of TUF applies to the relevant contractual relationship, we have to note that the position of the courts is quite varied. Certain recent judgments of the Italian courts held that derivative contracts concluded at the registered office of the corporate counterparty52 or of the local authority53 shall be held null and void if not containing the required provision on the ‘ius poenitendi’, according to Article 30.6 of TUF. In this respect, the relevant courts took a very formal approach, basically relying on the mere factual element that the derivative contract had not been entered into at the premises of the financial intermediary. A similar position had been expressed by the High Court of Justice for the purpose of the Prato Case; however, as we have seen in the previous paragraph, such a position has been overturned by the Court of Appeal, on the ground that Article 30 of TUF could not apply to the transactions under its examination. However, we have to note that a different approach was followed by the decisions issued by an Italian arbitration panel which, among others criticized the conclusions reached by the Italian Supreme Court on the scope of application of Article 30.6 TUF (see note 8 above), stating, among others, that, as a result of Law Decree 69, failure to provide information on the ‘ius poenitendi’ could not affect the validity of derivative transactions entered into before 1 September 2013.54 6. Conclusion The derivative litigation cases involving Italian counterparties discussed above shows how the combination of the on-going financial crisis and the apparent complexity of derivative transactions had the unexpected result of opening discussions about the stability of fully agreed contractual relationships and, ultimately, of the rule of law itself. It is true that the financial crisis which followed the Lehman collapse seriously affected the Italian economy. However, the Italian local authorities and corporates which entered into derivative transactions before the Lehman collapse were (or in any case had to be) fully aware of the risks that such instruments might trigger. Whilst the perception of such risks might not be so clear to non-professional individual investors, public officers managing the money of the taxpayer, but also the directors of large corporates managing the capital contributed by their shareholders, had, at the same time, a legal and moral obligation to fully understand the transactions which they wished to enter into on behalf of the legal entity or the corporate body concerned. If the effects of the financial crisis actually revealed that such risks had been perhaps underestimated or totally ignored especially by public officers, that should have been a good occasion for a serious reflection of the criteria of selection of the Italian establishment. On the contrary, a number of judicial proceedings have been initiated moving from the questionable assumption that local authorities had entered into certain financial transactions without having a proper idea of their functioning, and even of the meaning of the contractual clauses On this basis, many defensive arguments have been dealt by transposing economic concepts in to the legal framework in an attempt to bend the latter through the former. The debate surrounding the legal significance of the MtM is a good example of this. Various legal theories have been developed to suggest that a derivative contract having at inception an MtM different from zero would have been a contract fundamentally biased in favour of one of the parties. However, while there may or may not be an economic basis for this assumption, it seems that the lawyers supporting this theory have failed to identify a rule of law which would sustain this conclusion. In this respect, in a significant passage of the judgment of the Court of Appeal of Milan on the Milan case, the court said ‘perhaps, a little bit disoriented by the unusual concepts of “mark to market” and “fair value” which may be calculated only through mathematical formulas not understandable by everyone, the legal experts gave up their role, forgetting that we are still talking about contracts and that the definitions of “price” and value”, which are relevant here, should be looked for in the civil law handbooks (and not in the economics ones), where the price is, very simply, the consideration that a contracting party pays to the other one, in order to receive the relevant good/service and shall not be confused with the “value”, which is something entirely different’.55 Footnotes 1 Dexia Crediop SpA v Comune di Prato [2015] EXHC 1746 (Comm). The decision of the High Court of Justice has been rendered through two separate judgments and particularly: (i) the so-called ‘main claim judgment’ which was issued on 25 June 2015 (the Prato Main Claim Judgment); and (ii) the so-called ‘judgment on the remaining issues’ which was issued on 2 November 2016 and concerned the issues not dealt under the Prato Main Claim Judgment (the Prato Judgment on the Remaining Issues). 2 Dexia Crediop SpA v Comune di Prato [2017] EXCA Civ 428 (the Prato Appeal Judgment). 3 With the general expression ‘local authorities’ we refer, herein, to various types of Italian territorial public entities, namely, regions, provinces and municipalities. 4 It was also very common, for local authorities which had issued bullet bonds (ie, bonds providing for a single principal repayment at maturity) to enter into swap transactions which also encompassed an ‘amortizing’ leg, where the local authority ‘secured’ its obligation to pay the bond’s principal at maturity by paying periodic principal instalments to the swap counterparty over the life of the transaction, with the counterparty having an obligation to pay the aggregate amount of these instalments at maturity. 5 See, in this respect, the Communication of the Italian Ministry of Finance dated 2 March 2015, ‘The Derivative Contracts in the management of public debt’. The Communication indicates inter alia that: ‘the valuation of a derivative instrument is defined as “mark to market” and in technical terms, it consists in the actualisation of future financial flows estimated on the basis of the current market conditions’. 6 On this point, see David Mengle, ISDA Research Note, ‘The Value of a New Swap’, Issue 3, 2010. 7 In this respect, see again MENGLE, The Value of a New Swap, which specifies among other aspects: ‘[t]he pricing of a derivatives transaction begins with determination of a benchmark mid-market price at which net present value is zero at the inception of a transaction. But if the dealer were actually to transact at the mid-market price, it would incur transaction costs but would not cover them, nor would it earn a return to compensate it for acting as market maker. The actual price transacted with the client is therefore not the mid-market price but a bid or offer price at which the dealer realizes a positive estimated net present value. The mid-market price is instead a starting point for setting the actual price at which the transaction will be executed’. And again: ‘[i]f the actual price of a transaction were set so net present value was zero, the dealer would not cover its costs of transacting and of serving more generally as a market maker, nor would it be compensated for the credit risk it takes in a bilateral transaction. It is therefore necessary to adjust the mid-market price to cover various costs and risks of transacting as well as provide a return to the dealer that makes a market; this is true not only of derivatives but of market making for all financial instruments …. And because the actual price is the bid or offer price, the net present value to the dealer will be a positive amount and not zero’. We must add that, as we will see in detail in the paragraphs below, the conclusion according to which the MtM of a derivative contract shall necessarily have a negative value at inception is widely supported by the decisions rendered by the Italian higher courts, such as the Milan Case, the Pisa Case and the Messina Case. 8 In this respect, the already mentioned Communication of the Italian Ministry of Finance dated 2 March 2015 specifies that the MtM ‘only represents the actual value, based on the market rates, of the derivative instrument. It becomes a “risk” only if it may be claimed as a result of the application of early termination clauses’. 9 The early termination of a derivative transaction is in any case normally triggered by the occurrence of events which are beyond the control of the parties. 10 Consob Regulation no. 11522/1998 implemented the provisions of Legislative Decree no 58/1998 (ie the Italian consolidated law on financial intermediation activities, TUF) in the period preceding the entering into force of the MiFID Directive. It was repealed with effect as of 1 November 2007. In this respect, it was applicable to most of the derivative transactions entered into by Italian counterparties in the period preceding the collapse of Lehman Brothers. 11 Annex 3, however, further specified that the derivative transaction can rapidly assume a negative (or positive) value depending on the behaviour of the parameter to which the contract is linked. 12 In our experience, the choice of such technical experts is usually limited to a number of recurring companies. 13 Art 119 was worded this way between 18 October 2001 and 20 April 2012 (and, therefore, also in the period during which derivative transactions were entered into by Italian local authorities): ‘[I] Municipalities, provinces, metropolitan cities and regions shall have revenue and expenditure autonomy. [II] Municipalities, provinces, metropolitan cities and regions shall have independent financial resources. They set and levy taxes and collect revenues of their own, in compliance with the Constitution and according to the principles of co-ordination of State finances and of the tax system. They share in the tax revenue from state taxes related to their respective territories. [III] State legislation shall provide for an equalisation fund—with no allocation constraints—for the territories having lower per-capita tax raising capacity. [IV] Revenues raised from the above-mentioned sources shall enable municipalities, provinces, metropolitan cities and regions to fully finance the public functions attributed to them. [V] The State shall allocate supplementary resources and adopt special measures in favour of specific municipalities, provinces, metropolitan cities and regions to promote economic development along with social cohesion and solidarity, to reduce economic and social imbalances, to foster the exercise of the rights of the person or to achieve goals other than those pursued in the ordinary implementation of their functions. [VI] Municipalities, provinces, metropolitan cities and regions have their own property, which are allocated to them pursuant to general principles laid down in State legislation. They may resort to indebtedness only as a means of funding investments. State guarantees on loans contracted by such authorities are not admissible.’ 14 And according to which an increase of the interest rates was expected. 15 Please refer to the opinion of the Ministry of the Economy and Finance to the Municipality of Ferrara in 2011, which expressly states that ‘according to a literal interpretation of the provision, the provision would be applicable exclusively to a debt, strictly speaking, (namely, to loans and obligations) but not to swap agreements which are qualified by national laws and Eurostat regulations not as debt but as instruments of debt management, aimed at changing the currency of the original debt (in the case of exchange rate swaps) or the type of rate under which the interest flows are indexed (in the case of interest rate swaps). […] Therefore, the assessment concerning the economic convenience conducted pursuant to Article 41, paragraph 2, of Law No. 448/2001 is not applicable to the case of execution of a swap, but, rather, only to the renegotiation of debts through new debts, in which case the provision requires to ascertain whether, due to the renegotiation, the cost of the loan has decreased.’ 16 Note that, in June 2008, due to the turmoil affecting derivatives transactions entered into by local authorities—the Government banned these entities from entering into derivatives, and Decree 389 was subsequently abrogated with the idea of enacting an updated and perhaps more detailed legislation (given that various claims were raised on the basis of the then current legislation). However, further to an initial consultation draft, no final piece of legislation has ever been enacted, essentially due to political reasons and the difficulties of reaching an agreement among the various parties involved in the drafting (the MEF, but also the Bank of Italy and the Italian financial services authority, ie, Consob). 17 This argument is loosely based on the circumstance that the Explanatory Circular states that ‘[t]he purchase of a collar implies the purchase of a cap and the contextual sale of a floor, permitted solely to finance the protection against an increase in interest rates furnished by the purchase of the cap.’ 18 The ‘causa’ is one of the four essential elements of a contract (together with: (i) the agreement between the parties, (ii) the object, and (iii) the form (in cases where a specific form is required by the law for the relevant contract)). The notion of ‘causa’ (which, in English, could be literally translated with scope, reason, function) is one of the most controversial in the Italian legal system. The traditional concept refers to the abstract and general social-economic function that the contract performs (see, in this respect, BETTI, Teoria Generale del Negozio Giuridico, in VASSALLI, Trattatato di diritto civile italiano, 172 and FF; SANTORO-PASSARELLI, Dottrine generali del diritto civile, 127 and ff.). However, the Italian scholars more recently specified that ‘causa’ is also the concrete function of the contract, ie, the practical interest that such contract is aimed at realizing (see, in this respect, FERRI, Causa e tipo nella teoria del negozio giuridico, 355 and ff.; MAZZAMUTO, Il Contratto di diritto europeo, 88 and ff.). For instance, the ‘causa’ of a contract for fire insurance consists in the exchange of a payment obligation (the premium) by the insured party versus the undertaking of a risk by the insurer. This is the ‘causa’ of the general contractual scheme for fire insurance, ie, the abstract social economic function of the contract. However, if the insured party enters into the contract after the house is burnt, and seeks insurance pretending that the damage has occurred before the execution of the contract, the concrete ‘causa’ in this case is missing and therefore the contract is null. 19 In this sense, see MIRABELLI, Dei Contratti in generale, in Commentario del Codice Civile, 127 and ff.; ROPPO, Il Contratto, in IUDICA, ZATTI, Trattato di diritto privato, 337 and ff. Please, however, note also that the concept of ‘oggetto’ is disputed under the Italian laws; in particular, other authors have maintained, that the ‘oggetto’ shall be identified with the content of the relevant contractual regulations (see, in this respect, RESCIGNO, Trattato di diritto privato, X, 371 and ff; SCOGNAMIGLIO, Dei Contratti in Generale, in Commentario del Codice Civile Scialoja Branca, 352 and ff.; IRTI, Oggetto del negozio giuridico, in Novissimo Digesto Italiano, 805 and ff. 20 Only by means of the Consob Communication of 2 March 2009 (therefore, adopted after the implementation of the MiFID Directive in Italy), a general recommendation to ‘unbundle’ the different components of the costs of derivative transactions has been envisaged and, in any case, exclusively with respect to transactions dealing with ‘retail clients’. This further confirms that no similar duty existed before. 21 Article 31 of the Consob Regulation identified two main categories of ‘professional’ investors to whom certain rules of conduct to be abided by financial intermediaries when dealing with other customers did not apply: (1) parties expressly identified by law under Article 31, and (2) parties that, although not explicitly included in the first category, were in possession of specific expertise in the field of financial transactions, certified by a special statements issued by the legal representatives. 22 It must be noted that this last point is often claimed irrespective of a formal role of advisor concretely undertaken and played by the bank, on the basis that in any derivative transaction the bank is also implicitly acting as advisor regardless of the specific reps under the ISDA documentation. 23 According to Italian legal scholars, the client had to be informed in a complete, objective and intelligible way upon the elements which were relevant for the relationship, the services and financial instruments concerned. At the same time, it was clarified that the accurateness of such information had to be calibrated on the basis of the ‘expertise’ of the client—in this respect, the classification of the client and particularly its quality of qualified/professional operator was declared void in order to verify compliance with this requirement. 24 See the decisions of the Italian Supreme Court no 26724 and 26725 of 19 December 2007. 25 It is worth mentioning that, in its original version, the provisions of art 30 TUF were expressly referred to the investment services consisting in the so called ‘placement of financial instruments’ and ‘management of individual portfolios’ only. In this respect, several commentators believed that the ‘ius poenitendi’ mechanism did not concern the investment service consisting in the negotiation of financial instruments (including, therefore, OTC derivative transactions) on its own account. As a result of the above, and considering that the provision of a cooling off period appeared hardly consistent with the structure of derivative transactions, the contracts entered into with local authorities and corporate counterparties did not usually include information on the right of withdrawal under art 30 TUF. However, a (criticized) decision of the Joint Sections of the Italian Supreme Court (see Italian Supreme Court, no 13905 of 3 June 2013) maintained that art 30 has to be construed broadly and, therefore, shall apply with respect to the provision of any investment service. Next to such decision, art 30 has been amended by the Law Decree no 69 of 21 June 2013 (Law Decree 69). In a clear attempt to prevent the risk of several agreements entered into before the mentioned decision of the Italian Supreme Court being declared void, the new version of art 30 specified that the ‘ius poenitendi’ mechanism would have been applicable to investment services consisting in the negotiation of financial instruments on its own account, only as of 1 September 2013. The ‘interpretative’ nature of such provision was supported by the majority of the Italian scholars (see in this respect, CIVALE, Dir Bancario 08/2013; DE MARI, Giur Comm 5/2014, 876; DELLA VECCHIA, Le Società 1/2014; NATOLI, Contr 1/2014; CAPOCCETTI, Giur IT 2014; GUFFANTI, Le Società 2/2014; NIGRO, NGCC 1/2014; Rivera, Società 2/2015). Notwithstanding the above, a new decision of the Joint Sections of the Italian Supreme Court (see Italian Supreme Court no 7776 of 3 April 2014) stated that Law Decree 69 could not be regarded as an ‘interpretative provision’ and that, on this basis, art 30 TUF shall be considered also applicable to investment services consisting in the negotiation on its own account of financial instruments, made before 1 September 2013. 26 The rationale underlying this provision is that when the customer has not itself sought the relevant financial service by going to the financial intermediary, and indeed the financial intermediary has gone to the client proposing the investment service, it may well have caught the customer by ‘surprise’. In this context, the legal requirement according to which the investment service contract must contain an express right of withdrawal by the customer, is a protection tool for the customer which is taken ‘by surprise’ by the financial intermediary and may have not, therefore, independently evaluated the relevant investment service. 27 These are essentially set out in art 21-nonies of Law 241 of 7 August 1990. 28 Legislative Decree 231/2001 provides a discipline quite similar to the UK Bribery Act. In this respect, entities may be exposed to an ‘administrative liability’ (which may result in the payment of a monetary fines or also in the imposition of administrative sanctions, such as the revocation of the authorization required to carry out a specific business) for certain crimes committed by their employees in their interest or advantage, unless the entity concerned is able to demonstrate that it adopted adequate procedures/ protocols aimed at preventing the commission of such crimes, which have been wilfully circumvented by the offender in order to commit the crime. 29 Judgment of the Italian Supreme Court no 22554 of 7 October 2014. More recently, see the Judgment of the Italian Supreme Court no 23600 of 10 January 2017 which followed the same line of reasoning. 30 In this respect, it is worth mentioning that, according to art 5 of the Italian Civil Procedure Code, in order to establish the court having jurisdiction over a specific dispute, it is necessary to look at the content of the claims that the claimant pleads. As clarified by steadfast and undisputed case law, however, this rule cannot be given a purely formal meaning, since that could be easily misused by someone wishing to avoid the jurisdiction of what is in fact the competent court. In particular, whilst the court is required to look at the claims made by the claimant in order to establish whether it has jurisdiction to hear a certain dispute, it has to go further than simply blindly acknowledging the case put by the claimant and examine what is referred to as the ‘petitum sostanziale’: ie, ‘[at] the specific purpose and [at] the actual nature of the dispute, which is to be identified on the basis of the cause of action, which comprises the content of the subjective position pleaded in the proceedings and can be pinpointed in relation to the substantive protection afforded in theory to that position by the provisions that apply to the individual set of circumstances’ (see Council of State, Section V, 20 July 2016, No 3288; on the same lines, among the more recent decisions, Italian Supreme Court of Cassation, Civil Division, Joint Divisions, 4 April 2017, No 8687; Italian Supreme Court of Cassation, Division VI, 4 April 2017, No 8738). 31 One of the key changes introduced by the Brussels Recast Regulation concerns the enactment of provisions expressly aimed at addressing the problem of the so-called ‘Italian torpedo’. In particular, under art 31, para 2 of the Brussels Recast Regulation, a member state court specified in an exclusive jurisdiction clause may proceed to determine a dispute, even if proceedings have been commenced first (in breach of contract) before another member state court. This amendment effectively disapplies the ‘first-in-time’ rule which was contained in the Brussels Regulation. 32 Dexia Crediop SpA v Provincia di Brescia [2016] EWHC 2361 (Comm). 33 The already quoted paper by Mengle (n 6) is often mentioned in these litigations. 34 Court of Cassation, judgment no 47421/2011 of 21 December 2011 City of Messina v BNL. 35 Consiglio di Stato judgment no 5962 of 27 November 2012. 36 Judgment of the Criminal Court of Appeal of Milan, no 1937/2014. 37 Supreme Court Judgment, no 25516 of 14 June 2012; Tribunal of Verona 27 March 2012 and 15 November 2012; Court of Lecco of 15 January 2014; Tribunal of Turin 24 April 2014; Judgment of the Court of Milan, Sec. Civ. VI 23 June 2014; and Tribunal of Palermo 25 September 2014. 38 It is curious to note how the English court pointed out that the words ‘convenienza economica’ was to be translated into English as ‘financial advantage’ rather than ‘economic convenience’, to point out that the principle at issue is focused on the financial advantage that the contemplated transaction seeks, rather than ‘convenience’ which, translated into Italian, is equivalent to something ‘useful’ or ‘appropriate’. 39 The same conclusion has been reached in the case of corporate counterparties as it was held by the Court of Bergamo 4 May 2006 X Company v bankruptcy proceeding. 40 Judgment of the Court of Milan, 24 October 2016; Judgment of the Court of Chieti, 29 December 2016. 41 Judgment of the Court of Salerno, 2 May 2013. 42 Judgment of the Court of Rome, 18 July 2016. 43 Judgment of the Court of Turin, 17 January 2014. 44 Judgment of the Court of Ravenna, 8 July 2013. 45 A similar approach was followed under the Italian Supreme Court Judgment, Sec. II criminal, No 47421 of21 December 2011. 46 Judgment of the Italian Supreme Court no 9644 of 11 May 2016. 47 See the already mentioned decisions of the Italian Supreme Court no 26724 and 26725 of 19 December 2007. 48 The High Court of Justice recalled to that effect a communication of Consob and explained that a conflict of interest may arise in case a bank, after having purchased from a municipality an entire issue of municipal bonds, includes the bonds in a ‘basket’ of securities offered to its clientele, in light of the presumed need for the bank to quickly remove from its portfolio securities of which there is an overabundance following the full subscription of the issue. 49 Art 3.3. of the Rome Convention reads as following: ‘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”’. 50 Relying basically on the same principles, the High Court of Justice held that, pursuant to art 3.3 of the Rome Convention, art 32 TUF, as well as art 23 TUF and the related art 30 of the Consob Regulation no 11522/1998 also applied to certain derivative transactions entered into between the parties which, therefore, also had to be declared null and void under such grounds. 51 Banco Santander Totta SA and Companhia De Carris De Ferro De Lisboa SA; Sociedade Transportes Colectivos Do Porto SA; Metropolitano De Lisboa E.P.E.; Metro Do Porto SA [2016] EWHC 465 (Comm). 52 Court of Rome, 13 April 2016. 53 Court of Appeal of Perugia, 24 October 2016. 54 Arbitration Panel (Iudica (Chaiman)–Carbonetti-Guzzetti), Milan 23 September 2015. 55 Court of Milan, 7 March 2014, 367. © The Author(s) (2017). 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The litigation on derivative transactions involving Italian counterparties: an extreme stress test for the derivative contractual documentation

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Abstract

Key points This article will focus on the origin of the derivative litigation in Italy and particularly on the reasons which brought Italian local authorities and corporate entities to enter into several derivative transactions in the early 2000s and on the effects of the financial crisis. The article will consider the main arguments raised by the Italian counterparties in order to challenge the validity and enforceability of the derivative contracts, particularly by differentiating the so-called ‘public law’ allegations which are typically raised by Italian local authorities and the ‘civil law’ allegations which may be raised by both local authorities and corporate entities. It will discuss the evolution followed by the Italian courts in dealing with both public and civil law allegations, particularly as a result of the decisions taken by the Italian High Courts. Finally, it will consider how the English courts approached the matter and particularly how they dealt with foreign law issues. 1. Introduction In this article, we will discuss the case law developed in connection with derivatives transactions involving Italian counterparties, focusing on the most important court pronouncements and providing certain considerations and comments on how the derivative disputes have developed in the last years and the issues on which there is currently most focus. This note is structured as follows: (i) in the first part, we will summarize the main allegations typically raised by Italian counterparties contesting the validity of derivatives contracts; (ii) in the second part, we will provide an overview of the typical litigations and relevant judicial venues (eg, civil, administrative, criminal disputes); and (iii) in the third part we will discuss the case law which has developed on these claims. As will be exposed in further detail in the following sections, several cases involving Italian counterparties are currently litigated before the English courts, as a result of the jurisdictional clause included under the ISDA Master Agreement. In this respect, a landmark case precedent is represented by the decisions taken, first by the High Court of Justice1 and then by the Court of Appeal2 on the Dexia Crediop SpA v Comune di Prato case (the Prato Case) which significantly dealt with most of the typical allegations raised by Italian counterparties; therefore, in the context of this article, we will make several references to the Prato Case which gives an interesting overview of the approach followed by an English court whilst dealing with issues related to Italian law. 2. The origins of the disputes on derivative contracts in Italy OTC derivatives transactions have become increasingly common in the Italian market starting from the end of the 1990s. Italian counterparties have generally entered into derivatives transactions for the purpose of hedging against interest rate risks or exchange rate risks. Derivatives transactions have typically involved corporate counterparties that faced such risks in the course of their entrepreneurial activities, and also local authorities,3 which historically had to deal with considerable indebtedness and had, between the years 2001–2003, ad hoc legislation enacted in order to regulate the management of such indebtedness, particularly through the recourse to bond issuances and derivatives transactions. In the case of corporates, the trades were mainly interest rate or foreign exchange swap transactions, option or forward transactions which could vary from plain vanilla to more complex deals; in the case of local authorities, these were usually plain vanilla interest rate swaps (often with a collar)4 or foreign exchange swaps. Over the last 8–10 years, we have witnessed a growing trend in the Italian litigation environment, whereby these counterparties have attempted to repudiate the validity and enforceability of derivatives contracts based on certain arguments related to mispricing and breach of conduct rules by the relevant bank acting as a swap counterparty. This on-going trend is linked to the current economic downturn and is generally related to derivative transactions in which the market has moved against the counterparty’s position, leading it to seek to avoid payments by arguing that the transactions were in violation of the applicable derivatives legislation, or is ultra vires or unenforceable based on claims including, but not limited to, mispricing, misconduct or fraud. Interestingly in this regard, these litigations—which have been subject to intense media scrutiny—started to increase slightly after the Lehman collapse. In fact, the global financial crisis and economic downturn that followed the Lehman default brought, among their consequences, a (previously unforeseeable) drop in interest rates, with the further effect that derivative instruments which were designed to protect the counterparties from a rise in interest rates became unprofitable for these counterparties. Derivative transactions in Italy are normally documented under the ISDA Master Agreement but a number of cases have also dealt with local framework agreements governed by Italian law. However, in both cases, the main allegations on the invalidity of the contracts are based on Italian legislation and concepts of Italian private law. In fact, the application of Italian law provisions can also be triggered in contracts governed by foreign law (ie English law) where they come into play (allegedly) either as overriding principles of Italian public order, or extra-contractual obligations relating to the provision of investment services, or because of the purported lack of any element of internationality (for instance when both parties are Italian and payments are taking place in Italy). Generally speaking, as will be further explained below, we have noted that the Italian high courts (such as the Supreme Court or the Council of State) seem to be more reluctant than lower courts to find derivative contracts null and void, but it should also be underlined that senior and authoritative courts, such as the Court of Appeal of Milan, have issued conflicting decisions on derivatives’ issues. 3. The typical allegations Allegations made by the Italian counterparties shall be generally distinguished, depending on such counterparties being corporate counterparties or a local authorities. Corporate counterparties typically claim that the derivative transactions entered into with the banks did not comply with mandatory provisions of Italian contractual and financial laws (the so called ‘Civil and Financial Laws Allegations’). Such claims, as will be better detailed below, may either result in the relevant derivative transactions being held null and void or in the banks being requested to compensate the damages suffered by the corporate counterparties. Local authorities, rather than relying on the same Civil and Financial Laws Allegations brought by the corporate counterparties, usually claim that the conclusion of the derivative transactions occurred in breach of certain provisions of the Italian laws which regulated, at that time, access by local authorities to the financial markets (the so called ‘Public Law Allegations’). In this respect, local authorities maintain that breach of such provision shall result in the relevant derivative transactions being null and void, notwithstanding the circumstance that the laws, to which the Public Law Allegations refer, only applied to local authorities. In this respect, in the next paragraphs, we will go through the main features of both the Civil and Financial Laws Allegations and the Public Law Allegations. The ‘mark-to-market’ value and hidden costs theory A starting point of almost all the claims raised by both corporate counterparties and local authorities, in order to challenge the validity of their derivative transactions concerns the mark-to-market (hereafter ‘MtM’) value of the same derivative transactions. In this respect, we should note, as a preliminary remark, that as has been recognized, on several occasions, by the Italian Ministry of Economics and Finance,5 the MtM, corresponds in essence to the actualization of the future payment flows that will be exchanged between the parties if the market conditions, as existing at the moment at which the MtM is established, will remain unaltered. On this basis, as it may be appreciated, the MtM value is extremely variable depending on market trends. At the same time, it should also be noted that the ‘pricing’ of a derivative transaction starts with the determination of a reference rate for a transaction at ‘par’ (that is, a transaction whose actual net value is equal to zero). This reference rate is neither a bid price not an offer price, but, rather, a so-called ‘mid-market’ rate, which is based on the average of the prices (bid–offer) listed at that given moment on the market.6 However, this rate does not present the final rate materially applicable to the transaction that could be concluded at that time. Indeed, in practice, the structuring and implementation of a derivative transaction involves costs that must be covered by the financial intermediary: costs associated with the transaction and associated with its role as a financial intermediary. It is therefore necessary to adjust the mid-market rate in order to cover the various costs and risks of the transaction and to provide, at the same time, a return for the intermediary; this is true not only with regard to derivative transactions, but also with regard to the activity associated with any other financial instrument. Reflecting such methods of determination of the pricing, the MtM value at inception (and therefore, as already indicated before the actualization of the future payment flows, based on the market conditions existing at that moment) necessarily has a negative value for the non-financial counterparty.7 However, it remains understood that the MtM is only a theoretical value and not an actual cost to be sustained by any of the parties of the derivative transaction, nor a profit for the bank. As it has been again recognized by the Italian Ministry of Economics and Finance, in the ordinary course of their contractual relationship, the parties will be, in fact, only requested to make the payments based on the respective interest rates, as specified under the derivative transaction, regardless of the MtM value of the latter.8 The MtM value will be relevant exclusively, in order to determine the termination amount to be paid if and when an early termination of the derivative transaction occurs.9 And, in any case, for the purpose of the payment of such a termination amount, it shall make reference to the value of the MtM at that historical moment, a value which, depending on the market trends, might be significantly different from the one calculated at inception.                ***** The claims of the Italian counterparties aimed at challenging the validity of the derivative transactions do not, however, take into account any of the above. Instead, Italian counterparties make, loosely, reference to a provision included under Annex 3 to the Consob Regulation no 11522/199810 which contained a sentence stating—in our view improperly and in a non-technical way—that the value of a derivative transaction is always par at the time the contract is signed.11 In this respect, prior to the submission of the claims, a financial expert12 is usually entrusted with the task of ascertaining whether or not the MtM of the relevant derivative transaction at inception was equal to zero or had a negative value for the Italian counterparty. The financial expert ordinarily concludes that the value of the MtM was negative (and, for the reasons stated above it could not be otherwise) and that such initial negative MtM represents undue and undisclosed profits gained by the bank and costs for the counterparty (so-called ‘hidden costs’). Moving from the assumption that the derivative transactions bore such ‘hidden costs’, the Italian counterparties claim that the derivative transactions breached several provisions of the Italian law (depending on whether Civil and Financial Allegation or Public Law allegations are made). In this respect, several positions may be taken: according to certain counterparties, the so-called ‘hidden costs’ shall always be considered to be unlawful, unless balanced by the payment of an ‘upfront’ for an amount equivalent to such ‘hidden costs’; other counterparties partially acknowledge that the so called ‘hidden costs’ shall not be considered unlawful, but only to the extent that they do not override a ‘fair’ amount; other counterparties agree that the MtM normally has a negative value at inception but, at the same time, maintain that such negative value shall be necessarily disclosed by the bank in order for the derivative transaction to be validly entered into. Public law allegations Most of the Italian laws to which the Public Law Allegations refer are no longer in force or have been substantially amended after 2008 when due to the turmoil affecting derivatives transactions entered into by local authorities, access by the latter to such transactions has been significantly restricted. It is, however, understood that, in the litigation context, reference must be made to the legal framework in force at the time at which the derivative transactions were entered into. Breach of Article 119 of the Italian Constitution Public Law Allegations brought by local authorities usually rely, on a first instance, on Article 119 of the Italian Constitution which regulated (and still does, even if under a slightly different content) the financial autonomy of regions and other local authorities (Municipalities, Provinces and Metropolitan Cities).13 Like all provisions of the Italian constitution, Article 119 is clearly acknowledged as a mandatory provision of Italian law. All other legislation and rules on the matters to which Article 119 relates must, as far as possible, be interpreted in accordance with Article 119 and any inconsistent laws may be struck down by an order of the Constitutional Court. This is because the Constitution is the founding law of the Italian legal system, to which all laws and other regulations are subordinate. In the version applicable until 2012, Article 119, paragraph 1, gave ‘revenue and expenditure autonomy’ to Italian administrative regions and other local authorities and it regulated the way in which that autonomy could be exercised. At paragraph 6, Article 119 it allowed local authorities to resort to ‘indebtedness’ only as a means of funding investments. Article 119 does not, however, expressly clarify what should be intended as ‘indebtedness’ for the purpose of such provisions. A typical allegation by local authorities is that derivative transactions, at least when entered into for speculative purposes, shall be actually considered as ‘indebtedness’ and, on this basis, shall be regarded as contrary to Article 119 of Italian Constitution. Breach of the ‘economic convenience’ test Another common allegation brought by local authorities in order to challenge the validity of their derivative transaction concerns the Article 41 of Law 448/2001. Pursuant to Article 41 of Law 448/2001, regions and local authorities are allowed to ‘replace’ an existing debt (deriving from certain types of loans) with a new debt (deriving from newly issued bonds or renegotiations), subject to a so called ‘economic convenience test’, ie only if the overall financial value of the relevant indebtedness post-restructuring is lower than the relevant indebtedness pre-restructuring, and therefore, there is a financial advantage for the local authority. Moreover, article 41, paragraph 2 itself, before being amended in 2008, specified that in case of issuance by the local authority of ‘bullet’ bonds, the local authority itself had to either create a sinking fund or enter into a derivative transaction for the amortization of the debt. Article 41 was issued by the Italian legislature to enable public authorities to restructure their indebtedness and to take advantage of low interest rates in circumstances where there were concerns regarding increasing local authority indebtedness in Italy. Without this provision, the public authorities would not have been able to refinance their loans and bonds because they were not incurring the new debt for a new investment, as otherwise requested by the above mentioned Article 119 of the Italian Constitution. It is also worth mentioning that the Italian legislature has never provided any instruction or guidelines aimed at clarifying how the ‘economic convenience test’ had to be carried out, therefore leaving a certain level of discretion to the local authorities concerned. Provided the above, the typical scenario to which the claims, brought by local authorities and based on Article 41, refer is one in which the local authority was originally a party to several loan agreements providing for the payment of a fixed interest rate exceeding the then current market rates. In this respect, pursuant to the mechanism envisaged under article 41, the relevant loans were terminated early and refinanced by the issuance of a bond, providing for the payment, in favour of the bondholders, of a floating rate based on the EURIBOR rate. To this end, the local authority eventually entrusted one or more banks to act as arrangers of the bond issuance (and in such a context also requested to the latter proper assistance with the ‘economic convenience test’). At the same time, also in accordance with the then existing forecasts regarding the expected future trends of the EURIBOR curve,14 the local authorities usually entered into interest rate swap agreements with the banks acting as arrangers, aimed at hedging the risk deriving from an increase in interest rates. Moreover, as anticipated, in cases of the issuance of bullet bonds, in accordance with the express provisions of Article 41, an amortizing derivative transaction was usually entered into, as an alternative to the creation of a sinking fund. Given the above scenario, notwithstanding the opposite position that has been expressed in this respect by the Italian Ministry of Economics and Finance,15 it is argued by the local authorities that such derivative transactions had to be considered as an integral part of the refinancing transactions to be perfected by the local authority and, as such, taken into account (particularly as far as ‘hidden costs’ are concerned) for the purpose of the ‘economic convenience’ test. Moreover, certain local authorities, in clear breach of the literal content of Article 41, even claim that the economic convenience test should apply to any derivative transaction under which the local authority swaps the capital or interest payments under an existing loan for different payments due from the swap counterparty (and, therefore, even if the local authority merely restructured a derivative transaction entered into before, without actually refinancing any former debt obligation). On this basis, according to the local authorities, the presence of the alleged ‘hidden costs’ within such a derivative transaction would have altered the initial evaluation about the soundness and economic convenience of the transaction. Breach of derivatives regulation applicable to local authorities Another argument brought by local authorities in the derivative disputes is that the presence of the ‘hidden costs’ resulted in a breach of the ad hoc regulation enacted by the Italian Ministry of Economy and Finance regulating derivatives transactions to be entered into by local authorities and particularly of Article 3 of Ministerial Decree 389/2003 (Decree 389). Decree 389 was the only piece of Italian legislation which specifically regulated the use of certain derivatives by local authorities.16 An explanatory circular supposedly aimed at clarifying its content was subsequently issued by the same Italian Ministry of Economy and Finance on 27 May 2004 (the Explanatory Circular). Decree 389 provided, under Article 3, paragraph 2, an list of examples of derivative transactions that the local authorities would have been allowed to enter into, including, in particular: ‘Interest rate swaps’ between two entities that give an undertaking that they will duly exchange flows of interest, associated with the main financial market parameters, in accordance with methods, timeframes and conditions laid down in the contract; The acquisition of ‘forward rate agreements’ in which two parties agree on the interest rate that the buyer of the forward undertakes to pay on the specified capital at a specific date in the future. The acquisition of an interest rate ‘cap’ whereby the buyer is guaranteed increases in the interest rate payable above the established level. The acquisition of an interest rate ‘collar’ whereby the buyer is guaranteed an interest rate level payable, varying between pre-established minimum and maximum levels. Other derivative transactions consisting of combinations of the transactions contemplated in the above points, which are able to allow switching from a fixed rate to a variable rate, and vice versa, when a pre-determined threshold is reached or when a specified period of time has elapsed. Other derivative transactions aimed at the restructuring of borrowing, but only when the maturity date does not exceed that associated with the underlying liability. These transactions are permitted when the flows received by the interested parties are equal to those paid with regard to the underlying liability and where, at the time they are entered into, they do not involve an increasing trend in terms of the current values of the individual payment flows, with the exception of a possible discount or premium to be settled when the transactions are concluded, not exceeding 1% of the notional amount of the underlying liability. Moreover, Article 3, paragraph 3 of Decree 389/2003 required the necessity of a correlation between derivative transactions entered into by the authority and the underlying debt exposure, thus precluding the possibility of purely speculative swaps. Having said the above, in the litigation context, with respect to Decree 389/2003, it is held by the claimants, among others, that: the hidden costs would be evidence that the derivative transactions did not have a hedging purpose but, rather, pursued a speculative intent, in violation of the above mentioned regulation (ie please refer to article 3, paragraph 3 of Decree 389); and/or, with particular regard to interest rate swap collars under point (d) above, the ‘hidden costs’ would reveal an imbalance in the relevant cap and floor values (ie the floor sold by the local authority was more valuable than the cap purchased by it), while Decree 389, in the light of the provisions of the Explanatory Circular17 would purportedly impose a necessary equivalence between ‘cap’ and ‘floor’ levels in an IRS collar, such that they should ‘annul’ each other; and/or since, as mentioned before, it is argued that the presence of a negative MtM should be rebalanced through the payment of an upfront and, at the same time, Decree 389 would allegedly prohibit (see, in this respect, Article 3, paragraph 2, letter f) the payment to the local authority of an upfront exceeding 1 per cent of the underlying indebtedness, any transaction bearing an initial negative MTM which exceeded such threshold would not be compliant with the provisions of Decree 389. Civil and financial law allegations With regard to the Civil and Financial Law Allegations, it is worth mentioning that most of the claims raised by the Italian counterparties refer to derivative transactions entered into prior to the implementation in Italy of the MiFID Directive (which occurred as of 1 November 2007). In this respect, while analysing the allegations relating to the alleged breach of financial conduct rules, we will make reference to the pre-MiFID legal framework. Nullity of the contract. Lack of scope (‘causa’) claim. Indeterminability/indeterminateness of the object (‘oggetto’) claim From the perspective of strict contractual law, the most often recurring argument raised by Italian counterparties in their claims relates to the alleged absence of ‘causa’ (scope) in the derivatives contracts.18 The main claim in this regard is that: the ‘causa’ of the derivative contract consists in the assumption of mutual and bilateral risks between the parties; in certain decisions derivatives are classified as a form of legal bet; all elements contributing to identify such mutual and bilateral risks (including the initial MtM) must be indicated in the contract; without this, the contract is null because one of the essential elements (the ‘causa’) is missing. This has affected the ability of the counterparty to understand the type of risks underlying the agreement and to fully appreciate the amount of risk it was undertaking. As a result, since the derivative is to be classified as a legal bet, the lack of understanding on an essential element of the bet leads to the nullity of the agreement; as an alternative argument, it is claimed that due to the imbalance caused by the initial hidden costs (or negative MtM), the mutual and bilateral assumption of risks (and therefore the contract’s function) is lacking, in the sense that the contract is held as having been structured in a way such that it is fully certain that one party will gain, and the other party will have no prospects of gaining from the contract (therefore there is actually no risk at all for one of the parties). More recently, further claims raised by corporate counterparties and local authorities concerned the so-called ‘oggetto’ (object) of the derivative contracts. In this respect, please note that, under Italian law, the object of a contract consists in the mutual obligations imposed on each of the parties;19 pursuant to the Italian Civil Code, the object is an essential element of the contract and, therefore, in order to be held valid, any contract shall have a determined or at least determinable object. In this respect, it has been claimed that the lack of specific contractual provisions dealing with the methods to determine the MtM of derivative transactions would affect the determinateness/determinability of their object and, therefore, would cause the nullity of the same transactions. Breach by the Bank of conduct and information duties in the provision of investment services Since the derivative transactions are financial instruments subject to the relevant conduct rules imposed under the Italian laws, Italian counterparties also typically claim that such conduct rules have not been complied with, especially during the phase preceding the conclusion of the relevant contracts. Such claims are, most of the times, once again, based on the hidden costs theory, and particularly on the fact that the bank did not inform the counterparty of the presence of an alleged initial negative MtM for said counterparty. It is worth mentioning that under the pre-MiFID legal framework, there were no provisions of the Italian law expressly providing for a duty to disclose the MtM value, nor any presumed ‘hidden cost’.20 On this basis, the counterparties usually claim (by a claim which is subordinated to claims concerning the alleged lack of ‘causa’ or the indeterminateness and/or indeterminability of the ‘object’ which have been analysed before) that failure to disclose the hidden costs would result in a breach of the transparency and fairness duties that financial intermediaries must observe towards customers, pursuant to the general principle set out in Article 21 of TUF that financial intermediaries must best serve the interest of the customer and for the integrity of the markets, and to operate in such a way that the client is properly informed, and able to make an informed choice. Further related allegations, in this respect, are that the bank mistakenly classified and treated the relevant local authority as a qualified/professional investor as opposed to retail investors, thus depriving it of the necessary care in the provision of an investment service to it.21 As a result of the above, it is argued that, in their dealings with the counterparties, banks failed to comply with a number of rules generally imposed only with respect to retail investors, including: Article 27 of the Consob Regulation on conflict of interests, since they supposedly acted in the capacity as both swap counterparty and advisor;22 Article 28 of the Consob Regulation on the informative duties to the investors, for the alleged failure to provide the counterparties with adequate information on the nature, risks and effects of the transaction;23 Article 29 of the Consob Regulation on the ‘adequateness’, for the alleged structuring of speculative transaction not adequate to fulfil the hedging purposes pursued by the counterparties. We have to note that, in accordance with the case precedents of the Italian Supreme Court,24 breaches by a financial intermediary of the conduct rules imposed in connection with the provision of investment services (which are different from the provisions examined under previous paragraph II.C.A) do not ordinarily affect the validity of the relevant contracts but only trigger the pre-contractual or the contractual liability of the financial intermediary concerned (depending on the breach occurring before or after the conclusion of the relevant agreement) and, eventually, the obligation to compensate the counterparty for the damages suffered thereto. However, the above principle does not apply to those provisions of TUF which expressly envisage the nullity of contracts not complying with their content. This is the case of a breach of Article 30 of TUF, called ‘offerta fuori sede’ and in English translated as an off-premises offer, and which comes into question in the case of promotion and placement with the public of certain financial instruments and investment services, in a place that is different from the headquarters of the intermediary (typically, at the client’s premises).25 In this case, a legal requirement applies according to which a right of withdrawal by the investor within seven days (so-called ‘ius poenitendi’) must be envisaged and clearly specified in the relevant contract, without which the contract is null.26 Typically, the counterparties argue that this provision applies to derivative contracts as well, regardless of the governing law of the agreement. Another example is Article 23 of TUF, according to which the contracts relating to the provision of investment services shall be entered into in writing and, in case of failure to observe such formal requirement, the relevant contracts shall be held null and void. Please note that relying on the combined reading of Article 23 TUF and Article 30 of the Consob Regulation no 11522/1998 pursuant to which contracts for the provision of investment services shall necessarily contain certain information for the investor, both local authorities and corporate counterparties have claimed the nullity of their derivative transactions on the ground that the relevant ISDA documentation did not include in writing some of the information to be mandatorily included pursuant to Article 30 of the Consob Regulation no 11522/1998. 4. The litigation contexts Before outlining how the above claims and the relevant counterclaims have been addressed in the relevant case law, it is useful to briefly discuss the different types of dispute and judicial venues where such cases have been, and are, discussed. This, once again, depends on the relevant counterparties involved. Administrative litigation With respect to local authorities, the majority of the cases are discussed before the Italian administrative courts. These disputes commence with the exercise, by the relevant local authority, of certain powers of revocation granted to them with respect to administrative acts. In order to properly understand this aspect, it may be useful to clarify that contracts entered into by the public administration are stipulated on the basis of a specific administrative act adopted by the competent body which authorizes the execution of the contract. The power of revocation (also known as a power of ‘self-redress’ or ‘autotutela’) recognized to the public administration refers to administrative acts and not to contracts.27 In particular, the public administration has the general power to annul an administrative act which is illegitimate (in the presence of public interest reasons, within a reasonable time and taking into account the interests of the affected subjects). In the event that this power is exercised, there has been debate as to whether or not the effects of the revocation can extend to a contract entered into in reliance on the revocation act (and local authorities claim that the revocation does extend its effects to the contract). There has been a significant number of local authorities (varying from great Regions to small Municipalities) which relied on the presence of ‘hidden costs’ as a reason for exercising their power of self-redress, annulling the original resolutions through which they had approved entering into swap contracts, and purporting to annul the contracts themselves. In order to repudiate the self-redress measures, the banks have to commence proper proceedings before the Italian administrative courts. Italian civil litigation The most common hypothesis is that the disputes involve corporate counterparties. Less often local authorities bring their claims before the civil courts. They may do so when they do not exercise self-redress powers; however, they generally make recourse to self-redress for various reasons, such as a general belief according to which the administrative courts may take a more favourable approach towards public entities other than civil courts. UK civil litigation Various important cases have been brought (and are pending) before the civil English courts. These relate to ISDA-documented derivatives transactions which usually provide for a jurisdictional clause in favour of the English courts and where the banks have filed a pre-emptive claim in the presence of serious allegations made by the counterparty as to the invalidity of the contract (often accompanied by non-payment), therefore seeking declaratory relief as to the validity of the contract. In these cases, as noted, Italian law issues usually come into question. In fact—notwithstanding the parties’ choice of the governing law (English law)—Italian law may nevertheless be applicable in terms of overriding principles of Italian public order, or extra-contractual obligations relating to the provision of investment services, or because of the purported lack of any element of internationality (for instance, when both parties are Italian and payments are taking place in Italy). Criminal proceedings In a few cases, the allegations above discussed have been put forward by public prosecutors in the context of certain criminal investigations and proceedings, where mispricing or misconduct have been contested as criminal offences of fraud and deceitful behaviour on the part of the banks to the detriment of the local authorities (one of these cases is the City of Milan Case). These criminal proceedings may concern both single individuals within a bank, identified as being responsible for the supposed offence, and the bank itself, which: is normally held liable, under a civil perspective (responsabile civile) for crimes committed by its own employees; may be charged under Legislative Decree 231/2001, providing for an administrative liability of entities (including banks) for certain crimes (listed under the Legislative Decree 231/2001 and including fraud) committed by their employees in the interest or for the advantage of the entities themselves.28 5. Derivatives’ case law Jurisdictional matters The judicial proceedings involving derivative transactions often require the preliminary solution of exception of lack of jurisdiction filed by the parties. These exceptions may particularly concern: whether the jurisdiction to know the dispute shall be declared in favour of the administrative courts or of the civil courts; whether the jurisdiction to know the dispute shall be declared in favour of Italian courts or of English courts. It is also worth mentioning that, in accordance with the Italian Civil Procedure Code, jurisdictional matters (either relating to the competence of the administrative courts as opposed to the civil courts (and vice versa) or to the competence of a foreign court as opposed to Italian courts) may be deferred to the Joint Section of the Italian Supreme Court through the filing of a jurisdictional challenge. In such a case, the existing proceedings in Italy are usually suspended pending the decision of the Italian Supreme Court. Administrative courts versus civil courts This kind of jurisdictional matter usually arises, as a result of the commencement by the local authority of a self-redress procedure which affects the derivative transactions entered into by the same authority. In this respect, jurisdictional challenges are usually raised by the banks in order to claim that local authorities cannot use the self-redress procedure to unilaterally invalidate contracts entered into with them and that any final evaluation relating to the validity and enforceability of such contracts pertains to the civil courts. We note that the Italian Supreme Court has recently maintained that the jurisdiction of administrative courts, in the context of disputes involving a self-redress procedure, shall only concern possible irregularities in the methods by which an administrative act, preceding the conclusion by the authority of a certain agreement, has been taken, since the self-redress procedure cannot be a mere instrument to invalidate the same agreement. In fact, once that the agreement has been entered into, any claim concerning its alleged invalidity (and not irregularities of the administrative procedure preceding the conclusion of such agreement) shall be exclusively deferred to the civil courts.29 Italian courts versus English courts Several Italian local authorities have tried to circumvent the application of the jurisdictional clause in favour of the English courts, included under the ISDA Master Agreement, by filing their claims with the Italian courts. Similar attempts often move from the circumstance that, especially in the context of the issuance by the local authorities of bonds aimed at refinancing their financial indebtedness, as already indicated above (see the section ‘Breach of the “economic convenience” test’), the entering into of derivative transactions was frequently preceded by mandate agreements, providing for the appointment of the bank as arranger of the bond issuance and entrusting the latter with a number of tasks (including, in some cases, an obligation to assist the local authority with the calculation of the economic convenience, under Article 41 of Law 448/2001). Since some of such mandate agreements contained jurisdictional clauses in favour of the Italian courts, certain local authorities have sued the financial counterparties in Italy, invoking their contractual liability for the failure to comply with the obligations under the mandate agreement. In such cases, the local authorities affirm that they do not intend to challenge the validity of the derivative transactions (nor to interrupt any payment due under the latter) but only to claim compensation for the damages suffered as a result of the financial counterparties’ defaults under the mandate agreements. However, looking at their substance,30 most of the claims raised against the financial intermediaries concern the structuring by the latter of derivative transactions allegedly not compliant with the provisions of the Italian law referred to in Section 2 above. Moreover, the amount of damages to be allegedly refunded by the financial counterparties is calculated on the basis of the payments made (or expected to be made in future) by the legal authorities pursuant to the derivative transactions. Similar proceedings of the Italian local authorities may be either preceded or followed by other proceedings initiated in the UK by the financial counterparties and expressly aimed at ascertaining that the derivative transactions are fully valid and effective and did not breach any law (including the Italian ones) applicable to the latter. The contextual pending in different countries of several proceedings between the same parties and concerning related matters usually gives rise to jurisdictional challenges to be solved in accordance with the provisions of the EU Regulation no. 1215/2012 (so-called Bruxelles Recast Regulation).31 Such jurisdictional issues have recently been dealt with by the High Court of Justice in the Brescia Case.32 In this respect, a proceeding had been initiated in Italy by the Province of Brescia against Dexia Crediop SpA, in order to claim damages which allegedly derived from the failure by Dexia to comply with the obligations set out under a mandate agreement which had preceded the entering into by Dexia and the Province of two derivative transactions. After the commencement of the Italian Proceedings, Dexia initiated separate proceedings in the UK expressly aimed at ascertaining the validity and enforceability of the relevant derivative transactions and of their compliance with the applicable laws. In its acknowledgement of service, the Province of Brescia objected that the English judge lacked jurisdiction on certain declarations sought by Dexia through its claim and which regarded the compliance of the derivative transactions with Italian law. By a decision dated 21 December 2016, the High Court of Justice rejected the exception of lack of jurisdiction filed by Brescia on the grounds that the declarations sought by Dexia tracked the wording of certain representations made by Brescia under the ISDA Master Agreement which governed the relevant derivative transactions and, therefore, fell, also for the purpose of article 31 of the Brussels Recast Regulation, under the jurisdictional clause of the same ISDA Master Agreement. Specifically, to reach this conclusion the High Court of London stated the following, among other things: the argument put forward by the Province whereby some of the claims raised by Dexia should have been judged by the English court and others by the Italian would have had paradoxical consequences, causing a ‘fragmentation’ in the judicial assessments concerning the ‘representations’ provided pursuant to the ISDA Master Agreement; such a fragmentation was considered to be incompatible with the will expressed by the parties upon the execution of the ISDA Master Agreement, by providing for the exclusive jurisdiction clause in favour of the English court; the fact that the declarations sought by Dexia (and challenged by the Province) included Italian law assessments did not limit in any way the application of the jurisdictional clause referred to in the ISDA Master Agreement; in any case, pursuant to Article 31, paragraph 2, of Regulation no 1215/2012 the High Court of London had to be considered as being the jurisdictional authority designated by the parties, pursuant to the jurisdictional clause to settle any dispute arising in relation to the relevant derivative transaction (including, therefore, the challenged declarations); in this respect, the fact that the Italian court was the first one before which proceedings were brought had to be regarded as completely irrelevant. Case law on MtM and hidden costs theory The case law on this topic is quite diversified. There are a number of decisions that move from the assumption that the MtM value of a derivative transaction at inception should be par and build their decisions on this basis. The most relevant is the decision of the Court of Appeal of Milan in its judgment dated 18 September 2013, No 3459 (‘Sentenza Raineri’) which has positively based on this concept a decision leading to the nullity of the derivative contracts. There are a number of cases following this approach. There have been, however, key decisions of the Italian high courts, followed by a number of consistent lower court pronouncements that have clearly recognized over the last years that: (i) the initial ‘par’ value of MtM of a derivative transaction is a theoretical concept, based on mid-market prices; (ii) the mid-market price is merely a benchmark against which the actual price is set; (iii) the actual price agreed with the counterparty is in fact a bid or offer price that uses the mid-market price as a benchmark before adjusting for costs and risk, and the actual net present value to the dealer is not zero but a positive amount.33 The Supreme Court (Corte di Cassazione), Criminal Section, in case no. 47421/201134 judging upon derivatives contracts entered into by an Italian bank (BNL) and the Municipality of Messina held that the MtM of a derivative contract ‘does not express an actual and concrete value, but only a financial projection based on the theoretical market value in the event of early termination. The mark-to-market value is in fact influenced by a series of factors and it is therefore systematically adjusted on the basis of the market movements … . Therefore, in order to establish whether it represents an advantage or a disadvantage for the counterparty, an ex post assessment is necessary, once the contract will have reached its termination … .’ These concepts have been restated by the Council of State (the High Administrative Court) in the landmark Pisa Case.35 The Council of State held that ‘the fair value of a derivative always shows a positive value [for the Bank] and it is equal to zero only in theoretical circumstances where there is a complete financial equivalence between the estimated flows at mid-market conditions, between banking counterparties having the same rating, whereas, with respect to the retail market, considering that the scope of the contract in such market lies in the specific needs of the client, each transaction is different from the others; it follows from this that the relevant risks are not standardised and the prices are different for each transaction as they reflect the overall effective features of the contract’. The court also held that it is ‘even impossible to talk about “implicit costs” … as they represent the value of the swap and not a cost effectively borne by the administration’. It is not relevant here that the Province did not have the instruments to verify the market data and carry out the evaluations [of the MtM] and did not own software licenses for the pricing of derivative products—given that specific professional knowledge is, in any case, necessary in order to use such tools, but it is rather of relevance that the contract did contain all elements necessary for an adequate evaluation of the transaction and the Province could have certainly requested additional information from the Banks (about their internal evaluations, credit risks and other variables) in order to negotiate on such parameters. In the Milan Case,36 the court has repeatedly held that derivatives transactions of the type in question cannot have a zero initial MtM, and it is obvious that the banks would make profits from the investment service they have provided to the client. The court also noted that the initial MtM is always negative for the counterparty and positive for the bank due to the fact that the costs of the transaction are not kept separate from the price but, for constant market practice, they are included in the price. For this reason, such a price diverges from the ‘par’ or theoretical price as it also includes the costs incurred by the intermediary as well as a mark-up, ie, a margin representing the expected profit for the bank. According to the court, a public authority is aware, or should be aware, that ‘hidden costs’ have very little to do with anything ‘hidden’; a public authority is aware that ‘par’ swap agreements are considered, by the standard practice of international markets, inexistent in reality; it is well aware of the fact that, after determining the level of the theoretical price (on whose basis the actual value of the obligations falling on one party is equivalent to the value of the obligations falling on the other), such value is modified in order to take into account costs sustained by the Bank and the profit component required by the financial intermediation activity. According to the Court of Appeal of Milan, any claim based on the hidden costs is based, therefore, on a fundamental conceptual misunderstanding: ‘The Banks are for-profit organisations and must therefore earn profits. If they offered their services for free their activity would be inconsistent with their business purpose, and they would be in trouble if the regulation authorities came to know it’. It follows that the aforementioned price components cannot be considered as ‘hidden costs’ and, conversely, must be considered expenses legitimately taken into account by the Banks in determining the price of the product, since they are entirely irrelevant for the purpose of assessing the economic convenience in adherence with Article 41. The court also recalled the provisions of Annex 3 to the Consob Regulation and noted, in this respect, that a local authority must know that the relevant provisions relating to the presumed ‘par’ value of the MtM at the inception of a derivative transaction have to be correctly intended. In this respect, the court acknowledged that Annex 3 to the Consob Regulation contained misleading provisions which, however, could not in any case result in the local authority actually believing that a derivative transaction having a ‘par’ MtM value at inception might really exist. A number of other judgments followed the same line of reasoning and reached the same conclusions.37 More importantly, this principle has been restated by the High Court in London in the Prato Case, under the Prato Main Claim Judgment. In this respect, the High Court in London made reference to the Pisa Case and to the Milan Case, specifying that according to the relevant decision of the Council of State, the so-called ‘implicit costs’ of a derivative ‘do not by any means constitute an effective cost … but merely stand for the value that the swap could have had in an abstract and hypothetical (but utterly unrealistic and untrue) negotiation’. The High Court of London also argued that ‘it is the commercial terms [i.e. the interest rates specified under the derivative transaction] which have a continuing effect. It does not matter for this purpose whether the impact of those terms is computed by calculating an MTM, whether the MTM is described in accounting terms as a “cost”, or whether the MTM expresses market expectation as to the likely outcome of a swap.’ The High Court of Justice focused again on the MtM under the Prato Judgment on the Remaining Issues. In this respect, in particular, the High Court of Justice: rejected Prato’s allegation that the initial MtM should be regarded as an expression of the then expected cash flow outcome, on the ground that the actual outcome of a derivative transaction is only dependent on market rates over time and that, therefore, the initial MtM gives no information at all about its expected outcome; rejected Prato’s allegation that if the initial MtM had been disclosed to it, Prato would have refrained from entering into the derivative transaction or would have sought competitive quotes from different financial intermediaries; affirmed that a situation where the initial MtM is zero is entirely theoretical as ‘[b]y definition, no such swap occurs … it is commercially absurd to think that a retail customer could obtain a swap at mid-market rates in the absence of some particular reason on the part of the bank to trade in a way which gave it no profit element’. The above arguments have been fully recalled by the Court of Appeal for the purpose of the Prato Appeal Judgment. In this respect, the Court of Appeal particularly referred to the decision of the Council of State under the Pisa Code and maintained that: the Council of State refers to the fact that it is not possible to speak of ‘implicit costs’ … which were correctly and reasonably estimated by the consultant at €320,000, which represent the value of the swap, not a cost effectively sustained by the authority as ‘the decisive consideration’. … The judge recognized that the Messina and Arosio decisions needed to be viewed with caution given their different, criminal law context. Nevertheless they were entirely consistent with the view that initial MTM was not a real or effective cost and not one which was relevant to the calculation of financial advantage. Public Law Allegations The alleged breach of Article 119 of the Italian Constitution For the purposes of the Prato Case, the High Court of Justice has extensively examined Article 119 of the Italian Constitution concluding that the derivative transactions under its examination could not be considered to be ‘indebtedness’ for the purpose of Article 119 of the Italian Constitution with the consequence that no breach of such provision had occurred. In order to come to such conclusions, the High Court of Justice made preliminarily reference to the decision of the Italian Constitutional Court no. 425/2004, which stated that: the meaning of the word ‘indebtedness’ is not defined by Article 119, paragraph 6 and cannot be determined a priori by the judges; what is meant by ‘indebtedness’ (ie the types of transaction that can be considered ‘indebtedness’ for the purposes of Article 119) must be the same for all public authorities and it is not acceptable that each of them gives a different definition at that concept. Only the State—and in particular, only the Italian legislature—can define what is meant by ‘indebtedness’ pursuant to Article 119 and this had been done by Article 3 of the Law 350/2003 which specified general rules for classifying permitted transactions and investments for local authorities and which contained an exhaustive list of the transactions that could be classified as ‘indebtedness’ and as ‘investments’ for the purposes of Article 119. The list did not include derivative transactions. The position above partially changed only in 2008 (ie after the period that was relevant for the proceedings and for most of the litigation regarding the local authorities in general), when the list of transactions constituting ‘indebtedness’ was amended (with effect from 1 January 2009) in order to specifically include any transactions which involved any ‘premiums received at the conclusion [ie inception] of derivative transactions’ (Article 62(9) of Law Decree DLN 112 of 25 June 2008). According to the court, this change seemed particularly significant because it confirmed that the listing of the operations of indebtedness contained in the law of 2003 was comprehensive and exhaustive and did not merely contain examples. This was further confirmed by the subsequent legislative history of the provision in question which was amended so as to add transactions which involved premiums received upon entering into derivatives. According to the court this implied that the amendment was made because the Italian legislature wished derivatives to be included, but only if they were entered into on or after 1 January 2009 and only if, upon entering into the derivative in question, the local authority received a premium. On this basis, the court did not agree with the position taken by the local authority and, according to which, the modification made by means of Law Decree DLN 112 of 25 June 2008 to Article 3(17) of Law 350 was not addressed at changing or expanding the meaning of Article 119 but simply at clarifying it. The above reasoning was fully confirmed by the Court of Appeal, under the Appeal Prato Judgment which maintained that: ‘[t]he task for the judge was to predict how the highest court would determine the matter if it came before it. In our judgment, the judge was plainly entitled … to conclude that the highest court would not follow the reasoning in Municipality of C. [ie a decision of the Court of Appeal of Bologna which, according to Prato, supposedly supported its conclusions] … Moreover the 2009 amendment, to include premiums on derivatives, is striking. If swap transactions were a form of indebtedness already covered by paragraph 17, it is impossible to see why the amendment was a rational one to make’. The alleged breach of Article 41 Notwithstanding the fact that authoritative and consistent court decisions, as indicated under the section ‘Case law on MtM and hidden costs theory' above, now consider that the hidden costs theory is ungrounded, this has not completely cleared the consequential argument often claimed by local authorities that, because of the presence of the hidden costs in the derivatives transaction, the ‘economic convenience’ test of Article 41 was violated. However, in the Prato Case, Article 41 was assessed and the English court excluded that the swaps in question were entered into in violation of Article 41. The court specified that the economic convenience test38 was applicable to derivatives only under if four conditions are met: the first: that the derivative is implemented in the conversion of an existing debt, by means of its extinction and the subsequent contraction of a new debt. In this respect, according to the court, the economic convenience test would not be required in case of restructuring of precedent derivative transactions; the second, third and fourth conditions according to the English court provide, on the assumption that the derivative is structurally connected to the restructuring of a debt: that the overall cost of debt refinancing is analysed, considering the derivative as an integral and substantial part of the refinancing itself; that the derivative cannot be considered in isolation, but only in the context of the refinancing operation as a whole; that, for the purposes of the analysis of financial advantage, neither the initial MtM nor the ‘hidden costs’ of the derivative, being only theoretical, should be taken into account. On the other hand, it shall be made a ‘projection as to the effect of the derivative on its cost of debit [ie the cost of the debt of the local authority concerned] using forward rates as at the date of the transaction’. In summary, the ruling confirmed: on one side, that Article 41, paragraph 2 of Law 448/2001 only concerns the transactions carried out by local authorities in order to refinance their own indebtedness; on the other side, that the initial MtM of derivatives transactions is not an actual cost incurred by the public authority, but only a theoretical value and, therefore, as such, irrelevant to the economic evaluation test pursuant to Article 41. Both the above conclusions were subsequently confirmed by the Prato Appeal Judgment. Similar principles were followed, as mentioned before, in the Milan Case and in the Pisa Case. Notably, under the Milan Case, it has also been highlighted that the provisions of Article 41 are exclusively referred to the local authorities. The above judgment starts from a harsh criticism of the conduct of the Municipality of Milan that, similar to what was done by several other local authorities, after having completed its debt refinancing under Article 41 of Law No 448/2001, employing to that end some financial intermediaries, had later challenged its legitimacy, sustaining that financial intermediaries were supposed to verify the economic convenience of the transaction. The court noted, in this regard, that ‘[i]t should not have happened that the City of Milan—appointed by the law to first evaluate and certify the underlying economic convenience and only then perform it—… omitted virtually every independent assessment on the economic convenience and the compliance with the criteria set out in Article 41 of Law No. 448/2001 of the transaction that it was about to undertake; relying (in a non-technical way)—in a contingency of “innocent rush”—on the competence and professionalism of individuals to perform their own unavoidable tasks; accepting its results (at this point it would be better without having really verified the intrinsic quality) and then, later, ambiguously and instrumentally opt out’. According to the court, therefore, local authorities are the only parties to assess and certify the economic convenience of the refinancing transaction. They are unquestionably bound, by express provision of law, to perform such duty, without being able in any way to delegate that assignment to third parties. The local authority’s alleged inexperience certainly cannot be an excuse for discharging its responsibilities on the financial intermediary, being surprised ‘when the banks pursue their corporate purpose by making profits’. The court observed that ‘there is no requirement for the directors of a public authority to access the capital market at all costs; there is a clear obligation not to gamble with the money of the citizens/taxpayers by having them assume harmful and unnecessary risks. Above all, there is the legal and ethical duty to be prepared, equipped and informed for the fulfilment of every administrative act, which requires developments in complex and uncommon matters’. The alleged breaches of Decree 389 With respect to the claims regarding the alleged breaches of the Decree 389, the arguments brought in this respect by the local authorities have been rejected by the Italian higher courts and also by the High Court of Justice in the context of the Prato Case. On the ‘collar’ point, in the Pisa Case, the Council of State argued that the provisions of Decree 389 (or the relevant explanatory note) do not require, or even suggest, an equivalence between the economic value of the cap and the floor value of an interest rate collar. Likewise, the court in the Milan Case—when dealing with the implicit costs—stated that the values of the cap and the floor of a collar swap cannot be ‘financially equivalent’, and concluded that the collar structure was in conformity with the provisions of Decree 389. As far as the High Court of London is concerned, it was particularly held that: nothing in the Decree 389 (nor in the Explanatory Circular) requires, or even suggests that, in case of collar transactions, there should be equivalence between the economic value of the cap and the floor value. In this respect, the court also clarified that the rationale of Decree 389 is that the sale of a floor by a local authority shall only be addressed at financing the protection against an increase in interest rates, protection which is furnished by the purchase of a cap. In other words, local authorities shall be refrained from selling a floor merely for speculative purpose but this does not in any way imply that the purchased cap shall have a value equivalent to the purchased floor; regarding the alleged obligation, in case of a derivative transaction bearing a negative MtM at inception, to envisage the payment of an upfront equivalent to such negative value, which, at the same time, shall not exceed 1 per cent of the notional value of the underlying indebtedness, the court stated that Decree 389 does not in any way suggest that the MtM may be regarded as an upfront payment for the purpose of its provisions, since ‘what is contemplated [by the Decree 389] is something which is paid’ and, as already explained above, the court took the view that the MtM is not an effective cost; on the ‘speculation’ allegation, the court held that the swaps concluded were not speculative in nature. In particular, according to the court, while it is true that derivatives have an inherent risk, this feature does not make them speculative tout court whenever they are intended to provide hedging (as was the case of the derivatives subject to its examination) with respect to the underlying liability of the local authority.39 It should be noted, however, that other decisions from lower courts do not entirely follow this approach and, for example, identified a violation of Decree 389 whenever the economic value of the floor and the cap do not match.40 Civil and financial laws allegation Nullity of the contract as a consequence of an alleged lack of proper information As anticipated before, the so called Sentenza Raineri held that the disclosure of the initial MtM is an essential element of the contract and, in fact, it is ‘the same object of the contract’. More specifically, according to the Court of Appeal, the ‘causa’ of derivative transactions should consist in a ‘bet’ which both parties assume. On this basis, since, for the purpose of legally authorized bets, the risk must be rational for both parties, failure to disclose the MtM at inception can only lead to the nullity of the entire contract, pursuant to Article 1418 of the Civil Code, because the non-disclosure puts the counterparty in a position where it is unable to understand the risk that it is underwriting under the contract. This concept has been repeated in various decisions of the lower courts. There have been in fact pronouncements concluding for the nullity of the contract for lack of scope (‘causa’) due to the presence of the hidden costs, as these had resulted (i) in the counterparty not understanding the structure,41 (ii) in the relevant transaction having a speculative (as opposed to hedging) intent contrary to the party’s intention;42 (iii) in the contract lacking of an essential element to determine its (alleged) scope, ie, the type and amount of risks undertaken with the contract;43 (iv) in the absence of balance of risks among the parties, so that one party has actually no prospects of benefiting from favourable payment flows under the transaction.44 On the contrary, in the Pisa Case, the Council of State held that, regardless of the professional or retail nature of the local authority, there is an obligation, first moral and then legal, by the officers who manage public money, to obtain sufficient information on the structure of the contract about to be signed, the risks related to it and the potential impact thereof on future finances. The Council of State categorically excluded that the banks had breached any disclosure duty on the swaps’ MtM value. According to the decision, at the time when the derivatives contracts were entered into by Pisa with the banks, there was no legal requirement imposing such disclosure. The court noted that such obligations were introduced in Italy only after the implementation of the MiFID Directive (in terms of a recommendation to provide—to retail customers only—the unbundling of the initial derivative market value in OTC derivatives transactions entered into with retail investors). The court found no evidence whatsoever of presumed incorrect, not transparent, unfair behaviour by the banks pursuant to the provisions of the Italian financial services law, nor it could be held that the Banks acted without acquiring the necessary information about the client. Equally, in the Milan Case, the court confirmed that there was no obligation upon the bank towards the counterparty to provide the margin, or hidden costs, or initial MtM of the derivative, since the applicable laws only required the indication of the final price of the derivative to be given.45 This was certainly the case at the time when the Milan swap transactions were entered into, on the basis of the then applicable legislation. In this respect, the court recalled the conclusions reached by the Council of State in the Pisa Case, discussed above. The Milan Court firmly concluded on the point that ‘transparency cannot have its source in the parties’ individual wishes but only in the law’. More recently the Italian Supreme Court held that the MtM consists in ‘a method of valuation of financial assets … . It consists in determining the value that such assets would have in case of renegotation of the contract or of its early termination, before the set deadline … . The value of the mark to market is infact affected by a number of factors and is therefore systematically updated based on the financial markets’ trends.’ And again: ‘mark to market is also defined as replacement cost, because it corresponds to the price, established, at a certain time, by the market, that third parties would be willing to pay in order to assume the rights and the obligations envisaged under the contract’. Provided the above, the Italian Supreme Court went on to maintain that the MtM is not a concept unknown to the Italian legal framework, being rather reflected by ‘article 203 of TUF, that for the purpose of article 76 of the Italian bankruptcy law, describes the mark to market as the replacement consist of the derivative financial instruments’.46 Based on the above, the Italian Supreme Court appears to be of the view that: the MtM is a mere theoretical value whose amount is dependent on the unpredictable market trends; the criteria to determine the MtM value and particularly their connection with the replacement costs are expressly established under the Italian laws. The above conclusions appear to be inconsistent with the claims by the local authorities that information relating to the value of the MtM at inception and to the methods to be followed for calculating the MtM shall be necessarily included under the derivative transactions in order for the latter to be held valid. As far as the Prato Case is concerned, we have to note that, under the Prato Judgment on the Remaining Issues, the High Court of Justice extensively focused on the alleged nullity of the derivative transactions for the failure to disclose the MtM and, particularly, on the so called Sentenza Raineri, fully rejecting the allegations brought by Prato in this respect. In this respect, the High Court of Justice argued that, as expressly recognized under the decisions of the Joint Sections of the Italian Supreme Courts,47 breaches of the conduct rules (unless expressly provided to the contrary) do not determine the nullity of the contract but may merely raise claims for compensation of damages. The High Court of Justice also held that the conclusions reached under the Sentenza Raineri on the configuration of derivative transactions as bets had been clearly rejected from previous case precedents of the Italian Supreme Courts. The court also expressed the view that the same criteria upon which the Sentenza Raineri rely in order to configure derivative transactions as bets, would equally apply to insurance contracts, but no one categorized insurance contracts as bets. The court, therefore concluded that ‘if the matter were to come before the Court of Cassation, then that court would not adopt the approach’ taken under the Sentenza Raineri. Conduct rules Qualified operator In the derivative disputes, the counterparties commonly ‘repudiate’ the declaration executed at the time of the transaction and certifying their conditions as qualified operators, asserting that they actually have no knowledge and experience in derivatives and the relevant bank counterparty has mistakenly classified and treated them as qualified/professional investors, thus depriving them of the required care in the provision of an investment service to them. The Supreme Court has clarified how the ‘qualified investor’ provisions and declaration must be interpreted and applied in the renowned case no 12138 of 26 May 2009. Here, the court has stated that the nature of a qualified investor comes from the simultaneous presence of two requisites: (i) a substantial one, ie, the specific expertise and competence; and (ii) a formal one, ie, the express declaration. According to the court, there is no onus on the financial intermediary that has received the declaration to actually ascertain the truthfulness of its content, as the effects of it fall within the responsibility of the subject having made the declaration in such capacity as the legal representative of the company. The court has, therefore, stated that in the absence of contrary elements emerging from the documentation acquired by the financial intermediary, the mere declaration exempts the financial intermediary from a verification of its content. Furthermore, absent any contrary evidence offered as a proof by the counterparty, the declaration constitutes an element of proof upon which the Judge can base his or her decision (on the professional nature of a party). The alleged existence of a duty to communicate the existence of the so-called hidden costs With regard to the alleged breach of the conduct rules imposed by TUF and Consob Regulation that would derive from the failed disclosure of the so-called ‘hidden costs’, opposite indications have been provided by the Council of State for the purpose of the Pisa Case. According to the Council of State, when the swaps submitted to it for review were entered into no legal obligation fell on the financial intermediaries to communicate to the counterparties the various components of the MtM value at the inception of the derivative transactions. On the other hand, the Council of State expressly maintained that it was only from 2007, after implementation of the MiFID Directive, that the Italian legal system introduced more stringent rules (referred only to non-professional clients); these rules recommend the intermediaries to provide a breakdown of the various components included in the client’s total financial expense. The Council of State, therefore, did not find ‘any evidence, not even indicative evidence, of an alleged incorrect, inattentive and non-transparent conduct, aimed at providing a disservice to the client (under Article 21 of Legislative Decree of 24 February 1998, No. 58, claimed by the Administration’s defence lawyer), nor can it be assumed that the banks acted without acquiring the necessary information from the clients and without ensuring that clients were always suitably informed; a claim that is refuted by the very specific features of the … swaps entered into, clearly tailored on the specific needs of the Provincial Administration’. Similar views were expressed by the Court of Appeal of Milan, for the purpose of the Milan Case. Significantly both the Pisa Case and the Milan Case were extensively relied upon by the High Court of Justice, for the purpose of the Prato Case in order to dismiss Prato’s allegation that failure to disclose the MtM value of derivative transactions at inception would have resulted in a breach of the provisions of Article 21 TUF and of Article 28 of the Consob Regulation. In this respect, the court held that: ‘[m]y analysis is that in the absence of special circumstances, no good reason has been identified for going beyond the no need to know legal proposition. In particular, as regards “costs”, factors said to constitute “costs” fall within article 28.2 only to the extent that the investor needs to know about them in order to understand about the nature, risks and implications of the transaction.’ Notably, in order to reach the above conclusion, the court rejected the arguments sustained under several decisions by lower courts referred by Prato, on the ground that such decisions ‘were based upon misconceptions’ since they moved from the assumption ‘that the initial MTM was an actual cost, or reflected actual costs, which would be incurred by the City if it entered into the swaps in question’. In this respect, the High Court of Justice also rejected the complaints from Prato that the decisions rendered by the Council of State and by the Court of Appeal of Milan having being rendered by an administrative and a criminal court should have lesser weight than the decisions of the civil courts upon which it relied. In particular, the High Court of Justice replied as follows: ‘in the present context I am concerned with a decision of the highest court, of comparable standing with the Court of Cassation itself, in the field of administrative law. In the field of criminal law, I am concerned with a decision of the criminal section of the same court, the Court of Appeal of Milan, as is relied upon [in] Prato. Moreover, and to my mind particularly importantly Pisa II and Arosio [ie respectively the decisions rendered by the Council of State and by the Court of Appeal of Milan for the purpose of the Pisa Case and of the Milan Case] are decisions which involve a detailed and careful examination both of the law and of the facts. These matters, to my mind, more than compensate for the fact that the decisions are not decisions of civil tribunals.’ Conflict of interest It is often claimed by the counterparties that the banks were in a conflict of interest when they entered into relevant swaps, as they were at the same time advisors of the counterparty, either by virtue of a specific advisory agreement, or because the advisory service is implicit in the offering of the derivative product. On that basis it has been claimed that failure to properly disclose such conflict amounts to a violation of the conduct rules and leads either to the nullity of the agreement or liability for damages. This theme was extensively analysed in the Milan Case where the court stated that what the law requires is essentially that any conflict of interests which is not manifest should be reported under the rule known as ‘disclose or abstain’. According to the judgment, conflict, is thus not prohibited in itself but the relevant counterparty has to be put in a position to know the existence of conflict to be able to freely decide whether it is still worthwhile to undertake the transaction or not. If on the other hand, the conflict is obvious and the Bank’s counterparty is already aware, then there is no need for the bank to give further information. The same is in fact also provided for by Article 32 of the Consob Regulation no 11522/1998, paragraph 5 and 6 (as interpreted in the light of the Consob communication 99014081/1999). In the Prato Case, the High Court of Justice went on to maintain that the disclosure obligations imposed in connection with the provisions on conflict of interest do not arise from the commercial role of the bank in the ordinary course of its business—of which the non-financial counterparty shall be considered to be well aware—but from any ulterior motive that it may have for entering into a transaction. It follows from the above that not all cases in which a bank trades as the direct counterparty of its client will involve a conflict of interest: ‘what gave rise to a conflict of interest was an ulterior and different ground for the transaction’.48 The right of withdrawal pursuant to Article 30, paragraphs 6 and 7 of the TUF The application of Article 30, paragraph 6 and 7, of the TUF to contracts not governed by the Italian Laws In the Prato Case the High Court of London stated that failure to include the provision regarding the cooling-off period in the derivative documentation leads to the nullity of the contract if (i) the counterparty is not a qualified operator; (ii) the contract has been concluded outside of the bank’s premises; and (iii) Italian law applies as a result of the application of Article 3.3 of the Rome Convention. The court went on to say that the fact that the agreement was extensively negotiated does not affect this conclusion. The application of Article 3.3 of the Rome Convention49 was triggered according to the High Court by the fact that both parties of the transaction in question were Italian, payments were supposed to be made in Italy and there was no element of the situation which could be linked to a place other than Italy itself.50 Interestingly, in the subsequent Santander Case51 the High Court reached in similar circumstances the opposite conclusion with respect to Article 3.3 of the Rome Convention and the Justice ‘respectfully disagreed’ with the previous decision on Prato. The court in that case identified various elements of a derivative contract entered into under the ISDA framework, which points to its international nature even though both parties of the transaction belong to the same country. This decision has been confirmed by the Court of Appeal (Civil Division) by a ruling dated 13 December 2016. In particular, the Court of Appeal held that: the expression of Article 3.3 of the Rome Convention ‘elements relevant to the situation’ has to be construed in a broad sense and shall not be confined (as it was done by the High Court of London, for the purpose of the Prato Case) to elements having a connection to a particular country in a conflict of laws sense; therefore any element (even if not strictly connected to the contract) that points directly from a purely domestic to an international situation could be considered to be ‘relevant to the situation’; in the specific case under the attention of the Court of Appeal, the international nature of the swaps market, the use of the ISDA documentation, the circumstance that the bank was entitled to assign its rights and obligation under any transaction entered into in accordance with the ISDA Master Agreement to any of its subsidiaries and the entering into of back-to-back transactions with foreign counterparties were all ‘elements relevant to the situation’ that underlined the ‘international’ nature of the transactions and therefore excluded the necessity to apply any law other than the one chosen by the parties. The same approach has been followed by the Court of Appeal for the purpose of the Prato Appeal Decision which, therefore, overturned the decision taken in this respect by the High Court of Justice. In particular, the Court of Appeal recognized that, with specific reference to the contractual relationship at stake, at least three ‘elements relevant to the situation’ supported the international nature of the transaction and namely: the use of the standard form of master agreement of the International Swap Dealers Association Inc. In this respect, it was argued that ‘[t]he use of the ISDA Master Agreement is self-evidently not connected with any particular country and is used precisely because it is not intended to be associated exclusively with any such country’; the fact that with respect to each of the swaps concluded between the parties, a back-to-back hedging swap with banks outside Italy had been entered into, using the same international standard documentation. In this respect, the court maintained that the entering into of similar back-to-back hedging swaps is ‘routine’ for this kind of transaction and, as such, was objectively foreseeable by Prato; the fact that non-Italian banks had taken part in the tender procedure at the end of which Dexia had been selected as advisor of Prato. According to the Court of Appeal this ‘also shows the international nature of the market in which the swaps contracts were in due course concluded’. On this basis, the Court of Appeal concluded that mandatory rules of Italian law, including Article 30, paragraphs 6 and 7, TUF could not have application to the case at hand, due to (i) the choice of English law as the governing law which had been made by the parties and, at the same time, (ii) the irrelevance of Article 3.3 of the Rome Convention, as a result of the ‘international’ nature of the transaction. It is also interesting to note that, for the purpose of the Prato Appeal Judgment, the Court of Appeal also took into account the scenario in which its conclusions on Article 3.3 of the Rome Convention were wrong and, therefore, Article 30 TUF had to be deemed applicable. On this basis, the Court of Appeal maintained that, even if the relevant derivative contracts had to be held null and void, as a result of breach of Article 30 TUF, ‘[t]he question of whether a contract is a nullity or is void (and may be declared so) is a matter concerning the validity and enforceability of contractual obligations; and is therefore governed by the choice of law rules in the Rome Convention. As we have already noted, by Article 3(1) of the Rome Convention, that law is English law. It follows that an English Court will not consider the validity of the swaps other than as a matter of English law; and will not give effect to an argument that the contracts are invalid or unenforceable as a matter of Italian law. There can be no issue that, as a matter of English law, the contracts were valid and Prato are not entitled to a declaration of nullity of the contracts on the basis of the tort claim advanced as a matter of Italian law.’ At the same time, the Court of Appeal rejected Prato’s pleadings that the court should have fashioned a remedy in damages, for the benefit of the municipality which could be harmonized with its rights under the Italian law. The Court of Appeal noted that such solution could not be followed on the ground that Prato had not been able to demonstrate that if it had been informed of its right of withdrawal under Article 30 TUF, it would have actually enforced such right. On this basis, since the alleged breach of Article 30 TUF had not caused any actual loss to the Municipality (as it had not been able to prove otherwise), it was not entitled to any claim in damages. The rationale of Article 30, paragraphs 6 and 7 of TUF Assuming that, differently from what occurred for the purpose of the Prato Case, Article 30 paragraphs 6 and 7 of TUF applies to the relevant contractual relationship, we have to note that the position of the courts is quite varied. Certain recent judgments of the Italian courts held that derivative contracts concluded at the registered office of the corporate counterparty52 or of the local authority53 shall be held null and void if not containing the required provision on the ‘ius poenitendi’, according to Article 30.6 of TUF. In this respect, the relevant courts took a very formal approach, basically relying on the mere factual element that the derivative contract had not been entered into at the premises of the financial intermediary. A similar position had been expressed by the High Court of Justice for the purpose of the Prato Case; however, as we have seen in the previous paragraph, such a position has been overturned by the Court of Appeal, on the ground that Article 30 of TUF could not apply to the transactions under its examination. However, we have to note that a different approach was followed by the decisions issued by an Italian arbitration panel which, among others criticized the conclusions reached by the Italian Supreme Court on the scope of application of Article 30.6 TUF (see note 8 above), stating, among others, that, as a result of Law Decree 69, failure to provide information on the ‘ius poenitendi’ could not affect the validity of derivative transactions entered into before 1 September 2013.54 6. Conclusion The derivative litigation cases involving Italian counterparties discussed above shows how the combination of the on-going financial crisis and the apparent complexity of derivative transactions had the unexpected result of opening discussions about the stability of fully agreed contractual relationships and, ultimately, of the rule of law itself. It is true that the financial crisis which followed the Lehman collapse seriously affected the Italian economy. However, the Italian local authorities and corporates which entered into derivative transactions before the Lehman collapse were (or in any case had to be) fully aware of the risks that such instruments might trigger. Whilst the perception of such risks might not be so clear to non-professional individual investors, public officers managing the money of the taxpayer, but also the directors of large corporates managing the capital contributed by their shareholders, had, at the same time, a legal and moral obligation to fully understand the transactions which they wished to enter into on behalf of the legal entity or the corporate body concerned. If the effects of the financial crisis actually revealed that such risks had been perhaps underestimated or totally ignored especially by public officers, that should have been a good occasion for a serious reflection of the criteria of selection of the Italian establishment. On the contrary, a number of judicial proceedings have been initiated moving from the questionable assumption that local authorities had entered into certain financial transactions without having a proper idea of their functioning, and even of the meaning of the contractual clauses On this basis, many defensive arguments have been dealt by transposing economic concepts in to the legal framework in an attempt to bend the latter through the former. The debate surrounding the legal significance of the MtM is a good example of this. Various legal theories have been developed to suggest that a derivative contract having at inception an MtM different from zero would have been a contract fundamentally biased in favour of one of the parties. However, while there may or may not be an economic basis for this assumption, it seems that the lawyers supporting this theory have failed to identify a rule of law which would sustain this conclusion. In this respect, in a significant passage of the judgment of the Court of Appeal of Milan on the Milan case, the court said ‘perhaps, a little bit disoriented by the unusual concepts of “mark to market” and “fair value” which may be calculated only through mathematical formulas not understandable by everyone, the legal experts gave up their role, forgetting that we are still talking about contracts and that the definitions of “price” and value”, which are relevant here, should be looked for in the civil law handbooks (and not in the economics ones), where the price is, very simply, the consideration that a contracting party pays to the other one, in order to receive the relevant good/service and shall not be confused with the “value”, which is something entirely different’.55 Footnotes 1 Dexia Crediop SpA v Comune di Prato [2015] EXHC 1746 (Comm). The decision of the High Court of Justice has been rendered through two separate judgments and particularly: (i) the so-called ‘main claim judgment’ which was issued on 25 June 2015 (the Prato Main Claim Judgment); and (ii) the so-called ‘judgment on the remaining issues’ which was issued on 2 November 2016 and concerned the issues not dealt under the Prato Main Claim Judgment (the Prato Judgment on the Remaining Issues). 2 Dexia Crediop SpA v Comune di Prato [2017] EXCA Civ 428 (the Prato Appeal Judgment). 3 With the general expression ‘local authorities’ we refer, herein, to various types of Italian territorial public entities, namely, regions, provinces and municipalities. 4 It was also very common, for local authorities which had issued bullet bonds (ie, bonds providing for a single principal repayment at maturity) to enter into swap transactions which also encompassed an ‘amortizing’ leg, where the local authority ‘secured’ its obligation to pay the bond’s principal at maturity by paying periodic principal instalments to the swap counterparty over the life of the transaction, with the counterparty having an obligation to pay the aggregate amount of these instalments at maturity. 5 See, in this respect, the Communication of the Italian Ministry of Finance dated 2 March 2015, ‘The Derivative Contracts in the management of public debt’. The Communication indicates inter alia that: ‘the valuation of a derivative instrument is defined as “mark to market” and in technical terms, it consists in the actualisation of future financial flows estimated on the basis of the current market conditions’. 6 On this point, see David Mengle, ISDA Research Note, ‘The Value of a New Swap’, Issue 3, 2010. 7 In this respect, see again MENGLE, The Value of a New Swap, which specifies among other aspects: ‘[t]he pricing of a derivatives transaction begins with determination of a benchmark mid-market price at which net present value is zero at the inception of a transaction. But if the dealer were actually to transact at the mid-market price, it would incur transaction costs but would not cover them, nor would it earn a return to compensate it for acting as market maker. The actual price transacted with the client is therefore not the mid-market price but a bid or offer price at which the dealer realizes a positive estimated net present value. The mid-market price is instead a starting point for setting the actual price at which the transaction will be executed’. And again: ‘[i]f the actual price of a transaction were set so net present value was zero, the dealer would not cover its costs of transacting and of serving more generally as a market maker, nor would it be compensated for the credit risk it takes in a bilateral transaction. It is therefore necessary to adjust the mid-market price to cover various costs and risks of transacting as well as provide a return to the dealer that makes a market; this is true not only of derivatives but of market making for all financial instruments …. And because the actual price is the bid or offer price, the net present value to the dealer will be a positive amount and not zero’. We must add that, as we will see in detail in the paragraphs below, the conclusion according to which the MtM of a derivative contract shall necessarily have a negative value at inception is widely supported by the decisions rendered by the Italian higher courts, such as the Milan Case, the Pisa Case and the Messina Case. 8 In this respect, the already mentioned Communication of the Italian Ministry of Finance dated 2 March 2015 specifies that the MtM ‘only represents the actual value, based on the market rates, of the derivative instrument. It becomes a “risk” only if it may be claimed as a result of the application of early termination clauses’. 9 The early termination of a derivative transaction is in any case normally triggered by the occurrence of events which are beyond the control of the parties. 10 Consob Regulation no. 11522/1998 implemented the provisions of Legislative Decree no 58/1998 (ie the Italian consolidated law on financial intermediation activities, TUF) in the period preceding the entering into force of the MiFID Directive. It was repealed with effect as of 1 November 2007. In this respect, it was applicable to most of the derivative transactions entered into by Italian counterparties in the period preceding the collapse of Lehman Brothers. 11 Annex 3, however, further specified that the derivative transaction can rapidly assume a negative (or positive) value depending on the behaviour of the parameter to which the contract is linked. 12 In our experience, the choice of such technical experts is usually limited to a number of recurring companies. 13 Art 119 was worded this way between 18 October 2001 and 20 April 2012 (and, therefore, also in the period during which derivative transactions were entered into by Italian local authorities): ‘[I] Municipalities, provinces, metropolitan cities and regions shall have revenue and expenditure autonomy. [II] Municipalities, provinces, metropolitan cities and regions shall have independent financial resources. They set and levy taxes and collect revenues of their own, in compliance with the Constitution and according to the principles of co-ordination of State finances and of the tax system. They share in the tax revenue from state taxes related to their respective territories. [III] State legislation shall provide for an equalisation fund—with no allocation constraints—for the territories having lower per-capita tax raising capacity. [IV] Revenues raised from the above-mentioned sources shall enable municipalities, provinces, metropolitan cities and regions to fully finance the public functions attributed to them. [V] The State shall allocate supplementary resources and adopt special measures in favour of specific municipalities, provinces, metropolitan cities and regions to promote economic development along with social cohesion and solidarity, to reduce economic and social imbalances, to foster the exercise of the rights of the person or to achieve goals other than those pursued in the ordinary implementation of their functions. [VI] Municipalities, provinces, metropolitan cities and regions have their own property, which are allocated to them pursuant to general principles laid down in State legislation. They may resort to indebtedness only as a means of funding investments. State guarantees on loans contracted by such authorities are not admissible.’ 14 And according to which an increase of the interest rates was expected. 15 Please refer to the opinion of the Ministry of the Economy and Finance to the Municipality of Ferrara in 2011, which expressly states that ‘according to a literal interpretation of the provision, the provision would be applicable exclusively to a debt, strictly speaking, (namely, to loans and obligations) but not to swap agreements which are qualified by national laws and Eurostat regulations not as debt but as instruments of debt management, aimed at changing the currency of the original debt (in the case of exchange rate swaps) or the type of rate under which the interest flows are indexed (in the case of interest rate swaps). […] Therefore, the assessment concerning the economic convenience conducted pursuant to Article 41, paragraph 2, of Law No. 448/2001 is not applicable to the case of execution of a swap, but, rather, only to the renegotiation of debts through new debts, in which case the provision requires to ascertain whether, due to the renegotiation, the cost of the loan has decreased.’ 16 Note that, in June 2008, due to the turmoil affecting derivatives transactions entered into by local authorities—the Government banned these entities from entering into derivatives, and Decree 389 was subsequently abrogated with the idea of enacting an updated and perhaps more detailed legislation (given that various claims were raised on the basis of the then current legislation). However, further to an initial consultation draft, no final piece of legislation has ever been enacted, essentially due to political reasons and the difficulties of reaching an agreement among the various parties involved in the drafting (the MEF, but also the Bank of Italy and the Italian financial services authority, ie, Consob). 17 This argument is loosely based on the circumstance that the Explanatory Circular states that ‘[t]he purchase of a collar implies the purchase of a cap and the contextual sale of a floor, permitted solely to finance the protection against an increase in interest rates furnished by the purchase of the cap.’ 18 The ‘causa’ is one of the four essential elements of a contract (together with: (i) the agreement between the parties, (ii) the object, and (iii) the form (in cases where a specific form is required by the law for the relevant contract)). The notion of ‘causa’ (which, in English, could be literally translated with scope, reason, function) is one of the most controversial in the Italian legal system. The traditional concept refers to the abstract and general social-economic function that the contract performs (see, in this respect, BETTI, Teoria Generale del Negozio Giuridico, in VASSALLI, Trattatato di diritto civile italiano, 172 and FF; SANTORO-PASSARELLI, Dottrine generali del diritto civile, 127 and ff.). However, the Italian scholars more recently specified that ‘causa’ is also the concrete function of the contract, ie, the practical interest that such contract is aimed at realizing (see, in this respect, FERRI, Causa e tipo nella teoria del negozio giuridico, 355 and ff.; MAZZAMUTO, Il Contratto di diritto europeo, 88 and ff.). For instance, the ‘causa’ of a contract for fire insurance consists in the exchange of a payment obligation (the premium) by the insured party versus the undertaking of a risk by the insurer. This is the ‘causa’ of the general contractual scheme for fire insurance, ie, the abstract social economic function of the contract. However, if the insured party enters into the contract after the house is burnt, and seeks insurance pretending that the damage has occurred before the execution of the contract, the concrete ‘causa’ in this case is missing and therefore the contract is null. 19 In this sense, see MIRABELLI, Dei Contratti in generale, in Commentario del Codice Civile, 127 and ff.; ROPPO, Il Contratto, in IUDICA, ZATTI, Trattato di diritto privato, 337 and ff. Please, however, note also that the concept of ‘oggetto’ is disputed under the Italian laws; in particular, other authors have maintained, that the ‘oggetto’ shall be identified with the content of the relevant contractual regulations (see, in this respect, RESCIGNO, Trattato di diritto privato, X, 371 and ff; SCOGNAMIGLIO, Dei Contratti in Generale, in Commentario del Codice Civile Scialoja Branca, 352 and ff.; IRTI, Oggetto del negozio giuridico, in Novissimo Digesto Italiano, 805 and ff. 20 Only by means of the Consob Communication of 2 March 2009 (therefore, adopted after the implementation of the MiFID Directive in Italy), a general recommendation to ‘unbundle’ the different components of the costs of derivative transactions has been envisaged and, in any case, exclusively with respect to transactions dealing with ‘retail clients’. This further confirms that no similar duty existed before. 21 Article 31 of the Consob Regulation identified two main categories of ‘professional’ investors to whom certain rules of conduct to be abided by financial intermediaries when dealing with other customers did not apply: (1) parties expressly identified by law under Article 31, and (2) parties that, although not explicitly included in the first category, were in possession of specific expertise in the field of financial transactions, certified by a special statements issued by the legal representatives. 22 It must be noted that this last point is often claimed irrespective of a formal role of advisor concretely undertaken and played by the bank, on the basis that in any derivative transaction the bank is also implicitly acting as advisor regardless of the specific reps under the ISDA documentation. 23 According to Italian legal scholars, the client had to be informed in a complete, objective and intelligible way upon the elements which were relevant for the relationship, the services and financial instruments concerned. At the same time, it was clarified that the accurateness of such information had to be calibrated on the basis of the ‘expertise’ of the client—in this respect, the classification of the client and particularly its quality of qualified/professional operator was declared void in order to verify compliance with this requirement. 24 See the decisions of the Italian Supreme Court no 26724 and 26725 of 19 December 2007. 25 It is worth mentioning that, in its original version, the provisions of art 30 TUF were expressly referred to the investment services consisting in the so called ‘placement of financial instruments’ and ‘management of individual portfolios’ only. In this respect, several commentators believed that the ‘ius poenitendi’ mechanism did not concern the investment service consisting in the negotiation of financial instruments (including, therefore, OTC derivative transactions) on its own account. As a result of the above, and considering that the provision of a cooling off period appeared hardly consistent with the structure of derivative transactions, the contracts entered into with local authorities and corporate counterparties did not usually include information on the right of withdrawal under art 30 TUF. However, a (criticized) decision of the Joint Sections of the Italian Supreme Court (see Italian Supreme Court, no 13905 of 3 June 2013) maintained that art 30 has to be construed broadly and, therefore, shall apply with respect to the provision of any investment service. Next to such decision, art 30 has been amended by the Law Decree no 69 of 21 June 2013 (Law Decree 69). In a clear attempt to prevent the risk of several agreements entered into before the mentioned decision of the Italian Supreme Court being declared void, the new version of art 30 specified that the ‘ius poenitendi’ mechanism would have been applicable to investment services consisting in the negotiation of financial instruments on its own account, only as of 1 September 2013. The ‘interpretative’ nature of such provision was supported by the majority of the Italian scholars (see in this respect, CIVALE, Dir Bancario 08/2013; DE MARI, Giur Comm 5/2014, 876; DELLA VECCHIA, Le Società 1/2014; NATOLI, Contr 1/2014; CAPOCCETTI, Giur IT 2014; GUFFANTI, Le Società 2/2014; NIGRO, NGCC 1/2014; Rivera, Società 2/2015). Notwithstanding the above, a new decision of the Joint Sections of the Italian Supreme Court (see Italian Supreme Court no 7776 of 3 April 2014) stated that Law Decree 69 could not be regarded as an ‘interpretative provision’ and that, on this basis, art 30 TUF shall be considered also applicable to investment services consisting in the negotiation on its own account of financial instruments, made before 1 September 2013. 26 The rationale underlying this provision is that when the customer has not itself sought the relevant financial service by going to the financial intermediary, and indeed the financial intermediary has gone to the client proposing the investment service, it may well have caught the customer by ‘surprise’. In this context, the legal requirement according to which the investment service contract must contain an express right of withdrawal by the customer, is a protection tool for the customer which is taken ‘by surprise’ by the financial intermediary and may have not, therefore, independently evaluated the relevant investment service. 27 These are essentially set out in art 21-nonies of Law 241 of 7 August 1990. 28 Legislative Decree 231/2001 provides a discipline quite similar to the UK Bribery Act. In this respect, entities may be exposed to an ‘administrative liability’ (which may result in the payment of a monetary fines or also in the imposition of administrative sanctions, such as the revocation of the authorization required to carry out a specific business) for certain crimes committed by their employees in their interest or advantage, unless the entity concerned is able to demonstrate that it adopted adequate procedures/ protocols aimed at preventing the commission of such crimes, which have been wilfully circumvented by the offender in order to commit the crime. 29 Judgment of the Italian Supreme Court no 22554 of 7 October 2014. More recently, see the Judgment of the Italian Supreme Court no 23600 of 10 January 2017 which followed the same line of reasoning. 30 In this respect, it is worth mentioning that, according to art 5 of the Italian Civil Procedure Code, in order to establish the court having jurisdiction over a specific dispute, it is necessary to look at the content of the claims that the claimant pleads. As clarified by steadfast and undisputed case law, however, this rule cannot be given a purely formal meaning, since that could be easily misused by someone wishing to avoid the jurisdiction of what is in fact the competent court. In particular, whilst the court is required to look at the claims made by the claimant in order to establish whether it has jurisdiction to hear a certain dispute, it has to go further than simply blindly acknowledging the case put by the claimant and examine what is referred to as the ‘petitum sostanziale’: ie, ‘[at] the specific purpose and [at] the actual nature of the dispute, which is to be identified on the basis of the cause of action, which comprises the content of the subjective position pleaded in the proceedings and can be pinpointed in relation to the substantive protection afforded in theory to that position by the provisions that apply to the individual set of circumstances’ (see Council of State, Section V, 20 July 2016, No 3288; on the same lines, among the more recent decisions, Italian Supreme Court of Cassation, Civil Division, Joint Divisions, 4 April 2017, No 8687; Italian Supreme Court of Cassation, Division VI, 4 April 2017, No 8738). 31 One of the key changes introduced by the Brussels Recast Regulation concerns the enactment of provisions expressly aimed at addressing the problem of the so-called ‘Italian torpedo’. In particular, under art 31, para 2 of the Brussels Recast Regulation, a member state court specified in an exclusive jurisdiction clause may proceed to determine a dispute, even if proceedings have been commenced first (in breach of contract) before another member state court. This amendment effectively disapplies the ‘first-in-time’ rule which was contained in the Brussels Regulation. 32 Dexia Crediop SpA v Provincia di Brescia [2016] EWHC 2361 (Comm). 33 The already quoted paper by Mengle (n 6) is often mentioned in these litigations. 34 Court of Cassation, judgment no 47421/2011 of 21 December 2011 City of Messina v BNL. 35 Consiglio di Stato judgment no 5962 of 27 November 2012. 36 Judgment of the Criminal Court of Appeal of Milan, no 1937/2014. 37 Supreme Court Judgment, no 25516 of 14 June 2012; Tribunal of Verona 27 March 2012 and 15 November 2012; Court of Lecco of 15 January 2014; Tribunal of Turin 24 April 2014; Judgment of the Court of Milan, Sec. Civ. VI 23 June 2014; and Tribunal of Palermo 25 September 2014. 38 It is curious to note how the English court pointed out that the words ‘convenienza economica’ was to be translated into English as ‘financial advantage’ rather than ‘economic convenience’, to point out that the principle at issue is focused on the financial advantage that the contemplated transaction seeks, rather than ‘convenience’ which, translated into Italian, is equivalent to something ‘useful’ or ‘appropriate’. 39 The same conclusion has been reached in the case of corporate counterparties as it was held by the Court of Bergamo 4 May 2006 X Company v bankruptcy proceeding. 40 Judgment of the Court of Milan, 24 October 2016; Judgment of the Court of Chieti, 29 December 2016. 41 Judgment of the Court of Salerno, 2 May 2013. 42 Judgment of the Court of Rome, 18 July 2016. 43 Judgment of the Court of Turin, 17 January 2014. 44 Judgment of the Court of Ravenna, 8 July 2013. 45 A similar approach was followed under the Italian Supreme Court Judgment, Sec. II criminal, No 47421 of21 December 2011. 46 Judgment of the Italian Supreme Court no 9644 of 11 May 2016. 47 See the already mentioned decisions of the Italian Supreme Court no 26724 and 26725 of 19 December 2007. 48 The High Court of Justice recalled to that effect a communication of Consob and explained that a conflict of interest may arise in case a bank, after having purchased from a municipality an entire issue of municipal bonds, includes the bonds in a ‘basket’ of securities offered to its clientele, in light of the presumed need for the bank to quickly remove from its portfolio securities of which there is an overabundance following the full subscription of the issue. 49 Art 3.3. of the Rome Convention reads as following: ‘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”’. 50 Relying basically on the same principles, the High Court of Justice held that, pursuant to art 3.3 of the Rome Convention, art 32 TUF, as well as art 23 TUF and the related art 30 of the Consob Regulation no 11522/1998 also applied to certain derivative transactions entered into between the parties which, therefore, also had to be declared null and void under such grounds. 51 Banco Santander Totta SA and Companhia De Carris De Ferro De Lisboa SA; Sociedade Transportes Colectivos Do Porto SA; Metropolitano De Lisboa E.P.E.; Metro Do Porto SA [2016] EWHC 465 (Comm). 52 Court of Rome, 13 April 2016. 53 Court of Appeal of Perugia, 24 October 2016. 54 Arbitration Panel (Iudica (Chaiman)–Carbonetti-Guzzetti), Milan 23 September 2015. 55 Court of Milan, 7 March 2014, 367. © The Author(s) (2017). Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com

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Capital Markets Law JournalOxford University Press

Published: Jan 1, 2018

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