9.1 Introduction
This chapter addresses the vital issue of which law which should apply to substantive proceedings between parties to derivatives contracts. The discussion presumes that the jurisdiction of the English courts has been chosen or otherwise settled, as discussed in the Chapter 8. Accordingly, the impact that a contractual choice of law may have on disputes about jurisdiction is not addressed here.Footnote 1
As already established, commercial parties have great freedom in terms of forum-selection; as Bomhoff puts it, these rules emerged over time as ‘part of a well-known broader narrative of the rise of party autonomy’.Footnote 2 Unsurprisingly, this broader narrative also extends to choice of law, which is usually considered and negotiated together (if at all)Footnote 3 alongside choice of forum;Footnote 4 indeed, under the standard drafting in the ISDA MA, the choice of forum is decided without further action being required, as it follows from the choice of governing law. In the wake of the financial crisis, however, some commentators have singled out for special criticism parties’ freedom to select a governing law for their financial transactions. Most recently, this argument has been developed by Katharina Pistor as part of her call to ‘subject private coding efforts to more careful scrutiny to ensure their compliance with social goals that societies set for themselves through law’;Footnote 5 specifically, Pistor urges that ‘choosing the law that is most convenient for your own interest should be made more difficult’.Footnote 6 At present, though, we are a long way off this position. More than ten years after the crisis, English and New York law remain the default choices for many different types of international participants across the financial markets.Footnote 7 This chapter therefore begins by considering the default position, before turning to some of the consequences of, and major types of challenges to, the standard choice of law in the modern OTC derivatives markets.
The central finding of this chapter is that, as expected, the long-standing policy of upholding the party autonomy continues to shape these English cases but, at the same time, the modern derivatives markets have evolved in such a way as to generate a stream of novel and complex legal problems around choice of law. In particular, the diversification of both users and uses of OTC derivatives over the thirty years since Hazell has significantly intensified the complexity of the choice of law questions before the English courts. Several cases involving these markets, including those around the applicability of mandatory foreign law and the applicable law in capacity cases, have raised novel questions of considerable importance and become landmark authorities in private international law. Tellingly, this chapter also includes rare examples (for this study) of inconsistent first instance decisions and also a split appellate court. Nonetheless, while navigating these novel and complex legal questions, the English courts have tended to uphold a certain characterisation of these markets, portraying them as seamlessly international networks of standardised transactions.
9.2 Default Position
Under English law, the proper law of the contract is that which the parties intended to apply, whether this is choice is expressly stated, as in the case of an ISDA MA following the standardised drafting,Footnote 8 or implied.Footnote 9 This principle was described by the Privy Council as ‘well settled’ as long ago as 1939.Footnote 10 Taking a historical perspective, Mills has shown that the process whereby party autonomy came to provide the basis for choice of law analysis can be partly explained by ‘a blurring between contractual party autonomy and private international law autonomy’; in other words, choice of law clauses have, over time, become treated as ordinary contract terms.Footnote 11
This approach is evident in the English authorities. In the leading case of Vita Food Products Inc, the choice of English law in a bill of lading was challenged on the basis that it related to the carriage of goods on a Nova Scotian ship of goods from Newfoundland to New York, and there was nothing else to connect the transaction in any way with English law. The challenge was held to be wrong ‘both on grounds of principle and on the facts. Connection with English law is not as a matter of principle essential.’Footnote 12 Where the choice is expressly made, as the Privy Council stated in Vita Food Products, ‘it is difficult to see what qualifications are possible, provided that the intention expressed is bona fide and legal, and provided that there is no reason for avoiding the choice on the grounds of public policy’.Footnote 13 To this day, this principle allows English law to serve as one of the most convenient and popular choices for international commercial contracts. As the 1939 judgment presciently added, ‘those familiar with international business are aware how frequent such a provision [for English law] is even where the parties are not English and the transactions are carried on completely outside England’.Footnote 14 Once again, in law, where ships went, swaps followed.
Today, the freedom to choose the governing law of a contract is expressly recognised in the EU’s Rome I Regulation,Footnote 15 which governs conflict of laws questions in relation to ‘contractual obligations in civil and commercial matters’.Footnote 16 This Regulation applies to contracts concluded ‘as from’ 17 December 2009, replacing the Rome Convention of 1980.Footnote 17 The Rome I Regulation expressly upholds parties’ freedom to select an applicable law: Recital 11 states that ‘[t]he parties’ freedom to choose the applicable law should be one of the cornerstones of the system of conflict-of-law rules in matters of contractual obligations’, while Article 3 (‘Freedom of choice’) opens with the words ‘[a] contract shall be governed by the law chosen by the parties’, though there are some limited qualifications, which are explored further below. This is the legislative background against which some international parties have sought to test the choice of law provisions in their ISDA MA, using a variety of strategies to do so.
9.3 Mandatory Rules
Where provisions of a particular local law differ from those under the law of the contract, there can be a strong incentive for a litigant to argue that the former should apply. There are, however, only exceptional grounds where the parties’ contractual choice of law may be dislodged by mandatory rules of foreign law. Following disagreement between various first instance decisions, the English Court of Appeal has narrowly interpreted those exceptions that have proven relevant to the modern derivatives markets. While practitioners describe this outcome as a ‘relief to banks’,Footnote 18 there are important implications both for foreign counterparties using standard terms and more broadly.
In 2015 and 2016, two English Commercial Court decisions involving interest rate swaps addressed the question of whether local law should apply to the parties’ claims, rather than English law as selected in the parties’ contracts. This was one of the rare examples where English judges, faced with the same derivatives contracts and the same legal issues, reached inconsistent decisions.Footnote 19
The first of the two cases arose from swaps entered into by the Commune di Prato, the local authority responsible for the municipality of Prato in Italy, and an Italian bank, Dexia Crediop SpA.Footnote 20 From 2002, Dexia advised Prato on restructuring its high levels of debt, and on using interest rate swaps to do so. The parties entered into an ISDA MA in the 1992 form in November 2002, which provided for English law and the jurisdiction of the English courts, following which the parties entered into six swaps. The first five of these interest rate swaps were performed when due, ‘almost always’ involving payments from Dexia to Prato.Footnote 21 Swap six, entered into in June 2006, performed in the same way until June 2009, at which point Prato become the ‘out of the money’ party, and failed to pay. Dexia sued in the English courts for 6.5 million euros. Prato’s defences included the argument the swaps were ultra vires (i.e., beyond its legal capacity), and that it had various defences under Italian financial regulation. Prato also counterclaimed, seeking relief on the basis of restitution of sums paid under swap six, and damages in relation to all of the swaps.
The second case was between Banco Santander Totta (‘BST’), a Portuguese bank, part of the global Banco Santander group which is based in Spain, and Companhia de Carris de Ferro de Lisboa and three other Portuguese public sector transport companies. This litigation was also commenced by the bank in relation to interest rate swaps documented using the 1992 version of the ISDA MA.Footnote 22 BST sought a declaration that nine disputed swaps were legal, valid and binding, as well as payment of sums due under the swaps of over 272 million euros (the sum itself was not disputed).Footnote 23 As the first instance judgment expressly pointed out, this was not a ‘derivatives mis-selling’ case; rather the transport companies’ defences included lack of capacity and breach of several Portuguese laws and regulations which they claimed were mandatory in this context. The swaps were, like those in Prato’s case, expressed to be subject to English law and jurisdiction, but here, the products were far more complex in economic terms. These were long-term, exotic interest rate products with ‘snowball’ features, meaning that once the reference interest rate (EURIBOR or LIBOR) moved above or below pre-defined limits, a spread was applied to the sum owing by the transport companies, which was both cumulative and (in all but one swap) leveraged. When, following the global financial crisis, the reference interest rate entered a prolonged periods at near-zero, this formula had the effect of magnifying the losses facing the transport companies.Footnote 24
While the Prato and BST cases raised several overlapping legal issues, the most important shared feature for this purpose was the argument made by each of the public bodies that mandatory rules of local law applied to their contractual relationships because of Article 3(3) of the Rome Convention.Footnote 25 Article 3(3) is a carve-out from the main principle set out in Article 3, providing for ‘Freedom of choice’, and in particular Article 3(1) which states that ‘A contact shall be governed by the law chosen by the parties’. In full, Article 3(3) provides that
The fact that the parties have chosen a foreign law, whether or not accompanied by the choice of a foreign tribunal, shall not, where all the other elements relevant to the situation at the time of the choice are connected with one country only, prejudice the application of rules of the law of that country which cannot be derogated from by contract, hereafter called ‘mandatory rules’
On this basis, Prato and, later on, the Portuguese transport companies, argued that the exception in Article 3(3) should apply, and, further, that these mandatory rules rendered their swaps void. Prato sought to argue that the swaps contravened mandatory rules both in the Italian civil code and in Italian financial services law, as found in legislative decree and in regulations made by the Italian securities regulator, CONSOB. This would have rendered the swaps null and void.Footnote 26 Similarly, the Portuguese transport companies argued that two articles of the Portuguese Civil Code rendered their swaps void, namely Article 437 (whereby an abnormal change of circumstances entitles the injured party to terminate the contract) and Article 1245 (invalidating gaming and betting contracts).Footnote 27
While a great deal of time and expert evidence was deployed by the parties on the substance of these foreign law issues, the gateway issue was whether Article 3(3) applied at all. In the contracts, the parties had chosen English law, so the point turned on the requirement in the Article that ‘all the other elements relevant to the situation at the time of the choice are connected with one country only’. The public authorities had an uphill struggle as their arguments challenged the principle of party autonomy around contractual choice of law which underpins the Convention. Nonetheless, the first of the four decisions, that of Walker J in the Prato case, held that the contracts in question did so qualify as they were ‘connected with one country [Italy] only’ for the purpose of Article 3(3). The point is dealt briefly in the judgment,Footnote 28 where the judge noted that all the parties in the matter were incorporated and based in Italy; the swaps were entered into there and that is where the obligations were to be performed. The two counter-arguments raised by Dexia were that the ISDA MA ‘was designed to promote certainty, and that the significance and global nature of ISDA had been recognised by English courts’ and that Dexia had entered into back-to-back contracts in the international markets in relation to each of the disputed swaps, also using the ISDA documents.Footnote 29 Both of these arguments were swiftly rejected. The hedging was held to be a matter for the bank alone, and it was held that nothing about the ISDA documentation, nor the ‘significance and global nature of ISDA’ itself, counted as an ‘element relevant to the situation’ connecting it to a country other than Italy.Footnote 30
Applying mandatory rules of Italian financial law would have had dramatic implications for the parties’ dispute, however, Dexia’s case on Article 3(3) proved successful in a decisive and unanimous appeal.Footnote 31 Indeed, before that appeal, a similar analysis to that put forward by Dexia had proved successful in the first instance BST case. In BST, the applicability of Article 3(3) was examined in far more detail than it had been in Dexia: the BST first instance judgment takes fifty-six paragraphs (compared to three in Dexia) to analyse the parties’ submissions on fact, law and policy around Article 3(3)’s applicability, and to determine the point in favour of the banks.Footnote 32
In BST, while the factual basis of the arguments differed only marginally to that in Dexia, the bank successfully established the important preliminary point that for a situation to be ‘international’ in nature rather than domestic, it was not necessary to show a connection with specific country other than Portugal. Indeed, the judge in BST defined ‘international’ factors in this context as ‘factors with no connection to a particular legal system’Footnote 33 and the Court of Appeal agreed, holding that Article 3(3) should not apply if there were elements to the parties’ situation that were ‘non-domestic’ in character.Footnote 34 In technical terms, this outcome was the result of a narrow reading of Article 3(3), held to be appropriate for what the Court of Appeal emphasised was an exception to the ‘primary rule, or fundamental principle, [which] is the parties’ autonomy to choose the applicable law’.Footnote 35 A narrow reading was also held to reflect the general wording of Article 3(3) itself (‘situation’ in the Article being wider than ‘contract’, for example). More broadly, this outcome is also consistent with the characterisation of the modern markets as inherently international that has helped to justify the long-standing promotion of party autonomy in relation to choice of law and choice of forum. Accordingly, it is the international reach of these markets which helps to explain ‘why the parties’ choice of law and dispute resolution mechanism is so important’ in the first place;Footnote 36 as Blair J put it in BST, ‘[d]ocumentation is of the essence of such transactions in the capital markets’.Footnote 37
From this starting point, and coupled with the English courts’ more general concern to uphold these standardised terms in a certain and predictable way, it is unsurprising that in each of these three decisions (in BST at first instance and on appeal, and in Dexia on appeal) the English courts applied these rules and found that the parties’ situations in fact had elements that pointed away from the ‘purely domestic’, so that the exception in Article 3(3) did not apply. What, then, were the actual features of the parties’ derivatives contracts that courts found created a ‘non-domestic’ situation?Footnote 38
Two features were held to be particularly important in both cases. The first was that, having agreed swaps with a domestic entity, the banks routinely entered into back-to-back hedging contracts with international counterparties. In BST, the bank showed that such contracts were a practical necessity, in that that the bank could only undertake the original transactions with the transport companies because of back-to-back deals entered into for each swap with Santander Spain. This was held to be relevant, on the basis that such hedges were routine, despite the transport companies’ submissions that they did not know about these matters at the time. In Dexia, the back-to-back contracts made with parties outside Italy were regarded by the Court of Appeal as ‘equally routine’, and they were an important factor despite Prato’s submission that they were not foreseeable.Footnote 39 Hedging therefore introduces an international element, while also deterring the courts from a broad reading of Article 3(3) on the basis that applying mandatory local laws to one contract but not its equal and opposite, was said to represent a ‘real risk’ of legal certainty.Footnote 40
The second factual feature which was important to both cases was the use of the ISDA documentation itself and specifically the ‘Multicurrency-Cross border’ version of the 1992 ISDA ‘standard international documentation’ rather than the much less popular alternative which was available for single jurisdiction transactions.Footnote 41 In BST, it was found to be ‘of some relevance’ that the parties conducted business in Portuguese but documented the swaps in English language documentation,Footnote 42 though providing an English address for service was not held to be important in this context. The judge observed how international banks competed with each other in the Portuguese market, while the transport authorities transacted with banks from all over the world, almost always using on the same ISDA terms.Footnote 43 The use of the English language contract was also identified as a relevant factor in the Prato appeal. In fact, the Court of Appeal in Dexia attaches particular weight to the use of the ISDA MA in this part of its analysis, with the unanimous Court writing of the parties’ ISDA MA that ‘the following factors are important (1) it is it is the standard form of master agreement of the International Swap Dealers Association Inc. There is thus at once an international element rather than a domestic element associated with any particular country; … ’.Footnote 44
Even within the set of English cases involving the derivatives markets, this analysis stands out. It is hard to overstate the importance of this line of decisions for the parties concerned, but also for the markets and even for what one observer has called ‘the international character of contracts’ in private international law.Footnote 45 As regards these litigants, the Court of Appeal made it clear that had ‘mandatory’ Italian law applied in Prato, the effect would have been that the swaps would be null and void at Prato’s option;Footnote 46 while in the BST matter, had Portuguese law applied, the Court of Appeal stated that the transport companies would have succeeded in their case that there had been a ‘serious breach of the principles of good faith’.Footnote 47 These decisions therefore vividly illustrate what is at stake when applying Article 3(3) as a gateway provision.
The broader significance of these cases is that it is now almost impossible to imagine a swap that is entered into on the basis of the ISDA ‘Multicurrency-Cross border’ version of the MA between an end-user and a bank that manages its OTC business in a routine way by accessing the international markets, being categorised as ‘purely domestic’ for the purposes of Article 3(3). The essence of these decisions is that no such swap on these standardised terms should be considered in isolation, but rather as part of the markets in the main, reflecting the marketing, deal-making and hedging practices in the ‘international market for OTC interest rate derivatives’Footnote 48 as they were established by the banks in these landmark cases. These legal developments can therefore be seen as the latest judicial recognition of the ‘denationalisation’ of the financial markets, in this case by minimising the exceptions to the fundamental principle of party autonomy as to choice of law.Footnote 49
This line of decisions is also significant because of the meaning attributed to the ISDA documents themselves. This approach suggests that the standard market documents not only offer local end-users a default selection between pre-approved national legal systems, as has long been permissible under private international law, but also that the use of the contract itself may be taken as a factor contributing to the internationalisation of its users’ ‘situation’. This important line of decisions should therefore highlight to market participants the extremely limited capacity of Article 3(3) to qualify their contractual choice of English law; looking ahead, it may prove to be a factor which encourages some end-users to at least consider using new, standard form documents offering market participants greater choice as to governing law.Footnote 50
9.4 Applying Foreign Law
Notwithstanding the BST and Prato decisions, there have been many cases requiring the English courts to apply foreign law in the course of adjudicating claims involving OTC derivatives. Where required, the English courts will treat foreign law as a matter of fact,Footnote 51 meaning that a party must bring evidence of the point of foreign law they wish to rely upon. The parties’ evidence usually takes the form of expert reports (from one or both sides, or a joint report, though the last is rare in commercial litigation), and the experts concerned may go on to provide oral evidence and be questioned in the course of a hearing.Footnote 52 There are specific procedural rules which must be followed by a party intending to put in evidence an English court’s finding on a question of foreign law, for example if it wishes to argue that a finding in an earlier English decision should be treated as evidence in its own case.Footnote 53 On the basis of this evidence, it will then be for the English court to decide the point of foreign law.
Two particular issues requiring reference to foreign law recur with some frequency in recent derivatives litigation. These two examples provide an interesting contrast in terms of the levels of engagement required of the English courts. First, in the multi-contract settings discussed in Chapter 8, rival jurisdiction clauses may have to be interpreted under foreign law in in order to determine which covers the dispute in hand.Footnote 54 For example, in BNP Paribas SA v. Trattamento Rifiuti Metropolitani SpA (‘TRM’)Footnote 55 the parties had entered into an ISDA MA providing for English law and jurisdiction of the English courts, and a financing agreement providing for Italian law and the jurisdiction of the courts of Turin. BNP issued a claim in England in relation to an interest rate hedging transaction between the parties, and TRM applied for an order dismissing the claim for want of jurisdiction. The matter turned on the construction of the jurisdiction clauses, at which point the English court set out to adopt ‘a broad, purposive and commercially-minded approach’,Footnote 56 as examined above.
Because Italian rules of construction applied to the Italian contract, the parties to the English litigation provided detailed and extensive expert evidence from Italian lawyers to assist the English court to interpret the jurisdiction clause in the financing agreement. In practice, however, this extensive expert evidence proved to have a limited impact. The central reason goes to the role of the English court in this context. As the Court of Appeal emphasised in this case, it is ‘well-established’ that the ‘role of foreign law experts in relation to issues of contractual interpretation is a limited one. It is confined to identifying what the rules of interpretation are.’Footnote 57 It is therefore for experts to set out the rules of interpretation, but not to opine on the outcome for the term in question; this remains the task of the English courts. This function is carefully guarded so that, for example, the Court of Appeal in this case expressly disregarded as ‘inadmissible and irrelevant’ TRM’s expert’s evidence once it strayed into discussion of what this particular clause meant.Footnote 58
Another, more practical reason that evidence of foreign law had a limited impact in this case was that the Italian rules of construction presented to the Court were found to have ‘no material difference on the principles of contractual interpretation’ to those in English law. This finding was consistent with the decision in Savona, where the Court of Appeal was considering Italian law in a very similar context.Footnote 59 Therefore, while the Court in TRM was technically applying English law to one jurisdiction clause and Italian to its rival, this was ultimately ‘a distinction without a difference’.Footnote 60 Effectively, therefore, English law could be applied to interpret both clauses, leading the Court on this occasion to conclude that the parties intended this claim to be covered by the jurisdiction clause in the ISDA MA, linking back to the earlier analysis in Chapter 8.
It is quite a different story in those numerous cases where the English courts have been required to apply foreign law in order to determine the capacity of foreign public bodies to enter into derivatives transactions. Determining questions of legal capacity requires far more intensive engagement with foreign law, as is borne out by judges’ detailed reviews of academic articles and even doctoral theses on controversial points of the applicable foreign law,Footnote 61 resulting in far longer sections of judgments evaluating evidence of foreign experts on matters of capacity than those found in TRM or Savona, for example. Because the consequences of a lack of capacity (if any) then fall to be determined under the law of the contract, as discussed further below, the result in these cases is that the parties’ overall position is determined by a complicated hybrid of foreign and English law.
Given their potential significance for a case, it is important to note that questions of foreign law raise special issues in terms of the potential to appeal a first instance decision. Because the judge’s finding on an issue of foreign law is a finding of fact, the starting point for the Court of Appeal is that it should not interfere ‘unless compelled to do so’.Footnote 62 The authorities are clear, however, that findings of foreign law are factual findings of a so-called ‘peculiar kind’.Footnote 63 This is because, depending on the familiarity of the language and concepts of the foreign law in question, there may have been scope for the trial judge to make a contribution of a legal nature when deciding the disputed points at first instance. The relevant authorities were reviewed in some detail by the Court of Appeal in the 2017 Dexia decision, where a contrast was drawn between how a judge might approach a disputed point of New York law (where legal input could be expected) compared to Italian law, where there would be much less scope to do so.Footnote 64 This analysis suggests that an appeal court may be less likely to overrule the judge’s findings on foreign law when it is a civil law system being considered.
9.5 The New Capacity Claims
The Localism Act 2011 is one of several examples of legislation which have now rendered the doctrine of ultra vires near obsolete in English law.Footnote 65 As the derivatives markets have rapidly grown and diversified over the last thirty years, however, one side-effect is that the issue of legal capacity has been revived in the English courts, often argued in parallel with claims of breach of contract, misrepresentation and on various other grounds identified earlier in this book and always with a novel, foreign law dimension.
This new wave of capacity claims has involved numerous foreign public bodies (so far, Italian, German, Norwegian, Sri Lankan, Dutch and Portuguese),Footnote 66 and there are both similarities and differences with the cases of the Hazell era. In both waves of litigation, the stakes involved are the highest possible because the parties’ contracts risked being declared void ab initio, regardless of any contractual promises as to capacity. On this basis, both sets of cases fundamentally challenge those core objectives of legal certainty and predictability in the markets. The Hazell saga had a conflicts of law dimension and raised unprecedented questions in both English and Scottish law,Footnote 67 but as this section shows, the later capacity cases have raised new and complex issues of, and about, jurisdiction,Footnote 68 applicable law and the availability of restitutionary remedies.
9.5.1 Applicable Law
Deciding which law should apply to a dispute about capacity is a matter of applying English common law rules, because this issue falls outside the scope of the Rome Convention. The leading authority is Haugesund Kommune v. Depfa ACS Bank,Footnote 69 a majority decision by the Court of Appeal which was part of the complex dispute between two Norwegian municipalities and an Irish bank over ‘disastrous’ ‘zero coupon swaps’ entered into on ISDA terms.Footnote 70 As the parties agreed in this case,Footnote 71 the relevant common law rule is that stated in Dicey, Morris & Collins, rule 162:
(1) The capacity of a corporation to enter into any legal transaction is governed both by the constitution of the corporation and by the law of the country which governs the transaction in question;
(2) All matters concerning the constitution of a corporation are governed by the law of the place of incorporation.Footnote 72
On its face, it appears that applying this rule should be straightforward. The ‘capacity’ of, say, a German public authority to enter a particular contract should accordingly be decided under German law with the consequences of any lack of capacity being determined by reference to the law of the contract, which in these derivatives cases is English law. In the course of the English litigation between Berlin Verkehrsbetriebe (BVG) and JP Morgan it was therefore common ground that the questions of the validity of the decisions of BVG’s management and supervisory boards about the credit swap agreement were a matter of the ‘German corporate law of ultra vires’ though, as we have already seen, the parties went on to disagree about what this meant in terms of jurisdiction.Footnote 73
Applying this rule, however, requires knowing what ‘capacity’ in sub-section (1) means. Certainty on this point may be lacking if English law and the foreign law in question are found to take different approaches to this issue, especially where the latter ‘is not … interested in the question of whether a resolution [of the entities] is valid or invalid, but rather in the question whether the resolution can have an effect on third parties’.Footnote 74 Should ‘capacity’ here mean that the English concept is transposed to a foreign legal system in order to determine an equivalent, which is then applied to the facts, or should the English courts seek to establish how foreign law regulates organisations’ entry into legal transactions more generally, and then take what may be a bundle of various rules as amounting to ‘capacity’ for these purposes? This question arose in the Haugesund litigation, where the question was described by Etherton LJ as coming down to ‘a matter of policy’Footnote 75 and proceeded to split the Court of Appeal.
Having heard extensive expert evidence, and over the course of a detailed judgment, the first instance judge in Haugesund established that Norwegian law approached these matters very differently to English law.Footnote 76 The fundamental differences included that Norwegian law did not directly address the extent of the capacity of local authorities, nor did it focus on the validity or invalidity of their transactions per se, but was primarily concerned with the binding nature of the transactions for third parties.Footnote 77 Furthermore, if a municipality exceeded its powers to enter a contract such as the loan agreements in question,Footnote 78 under Norwegian law, the act would be reviewable (in English, the technical term used was ‘assailable’) rather than automatically invalid, with the expert evidence stating that it would remain in existence until a declaration that it was invalid.Footnote 79 This, of course, contrasts sharply with the outcome in English law where a body exceeds its statutory powers and the contract is void ab initio. For all these reasons, it was ‘not easy to transpose Norwegian legal theory into English terminology and in particular not into the language of capacity’.Footnote 80
Tomlinson J went on to find that, on the facts, the Norwegian kommunes lacked substantive powers under Norwegian law to enter the loans and that this amounted to an ‘underlying lack of competence’ which he concluded equated to a lack of ‘capacity’ under English law.Footnote 81 It was common ground that the consequences of a lack of capacity were to be determined under the law of the transaction, that is, English law. The contracts were therefore held to be void, leaving Depfa, just like those banks facing UK local authorities in the 1990s, to pursue its claim in restitution.Footnote 82 This outcome contrasts with that under Norwegian law, which would have treated the swaps in the same circumstances as valid and enforceable. Following the judge’s rejection of their defences to a claim in restitution, however, the decision on capacity represented a ‘Pyrrhic victory’ for the municipalities.Footnote 83
On appeal, it was arguedFootnote 84 that the swaps were valid because the local authorities had the capacity to conclude the swap agreements under Norwegian law. Though Norwegian statute curtailed their powers to do so, the appellant asserted that this did not affect their status as English law contracts. In this view, ‘capacity’ in the Dicey rule should be read narrowly and in accordance with the English approach. To take a broader set of legal issues into account for this purpose, it was suggested, was to conflate the concepts of capacity with the limits on an entity’s powers. This version of the rule therefore required the court to ask whether under local law, a factor was absent which, if so, would automatically lead to the nullity of the contract regardless of whether a third party had notice.Footnote 85 As this was not the case under Norwegian law, the swaps should be treated as valid.
The Court of Appeal was split on the point, but the majority dismissed this argument favouring the broader reading of the word ‘capacity’ for the purposes of Dicey’s rule. Adopting what the majority notably described as a ‘broader, internationalist meaning’ of the term,Footnote 86 it took ‘capacity’ in this context to describe the bundle of issues relating to a company’s legal ability to enter into a valid contract under local law.Footnote 87 On this basis, the majority agreed with the judge that ‘for the purposes of English conflicts of laws, a lack of substantive power to conclude a contract of a particular type is equivalent to a lack of “capacity”, to use English terminology’ so the judge’s finding of that the municipalities lacked capacity to enter the swaps was upheld. In justifying favouring this approach over the alternative outlined by the appellant, the majority held that it was relevant that the conflicts rule in question was inevitably intended to apply to non-English corporations. In this context, it must be right to assume, as the majority did, that the term has ‘a commonly understood content and significance so far as concerns non-English corporations’.Footnote 88 The majority underlined the point by expressing concern that it would be risking ‘legal parochialism’ to assume that the term in Dicey’s rule should be read narrowly in line with English common law concepts.Footnote 89
While the majority decision on the meaning of ‘capacity’ follows a pragmatic and ‘internationalist’ reading of this pivotal term in the conflicts rule, it is, unfortunately, difficult to justify the overall outcome in this case on similar grounds. Indeed, in his dissent, Etherton LJ expressly disagreed with what he called a ‘wholly artificial’ approach to the meaning of capacity that he found led to a ‘bizarre result’.Footnote 90 As he pointed out, if Norwegian law had applied to the contract, or even English domestic law, the contracts would be treated as valid and enforceable. Instead, the hybrid analysis produced by a ‘broad’ reading of capacity applied to Norwegian law, and the English law of the ultra vires, resulted in treating the contracts as void. In subsequent cases, litigants have unsurprisingly indicated their intention to challenge this part of Haugesund.Footnote 91 The problem with any such challenge, however, is that the majority’s approach to the narrow question around the meaning of ‘capacity’ is, in itself, persuasive for the reasons set out and because, as Edelman and Briggs have commented, Dicey’s rule was intended to be pragmatic rather than restrictive.Footnote 92 More broadly, the majority’s approach to capacity here can also be seen as consistent with the pragmatic, internationalist approach to other questions that have proved ‘difficult to resolve’Footnote 93 elsewhere in modern derivatives litigation. While the overall effect may be problematic depending on the provisions of foreign law in question, and it remains a likely target for a future appeal, the underlying decision on the meaning of capacity in this rule would therefore seem a difficult one to persuade the courts to reverse.
9.5.2 Determining Capacity
Once questions of jurisdiction and applicable law have been settled, it is for the court to evaluate whether the disputed transactions fall within the capacity of the local authority. This exercise turns on the details of the foreign law, which, as discussed, the English courts will apply in order to reach a decision.Footnote 94 As this section shows, this exercise has always been a complicated one, but recent developments in the global derivatives markets have made it more so.
As a preliminary point, it is worth noting that the questions of foreign law before the English courts on these occasions are often novel as regards that legal system itself. On the question of the capacity of Portuguese transport companies to enter into ‘snowball swaps’, the English judge noted that ‘[t]here is no Portuguese jurisprudence, or indeed doctrine, which settles the matter’, yet against this background, a stark choice between different accounts of the Portuguese law of capacity fell to be resolved. The legal aspects of determining capacity of foreign public bodies are therefore likely to be unfamiliar to the English courts, but may also be uncharted as a matter of foreign law.Footnote 95 Against this background, the recent cases show that the complexity of the legal questions involved increases further in line with three factors that are ultimately linked to broader trends in the derivatives market.
The first factor is the system of law which the English courts are seeking to apply, and specifically, the relatability of the relative concepts of capacity. There is wide variation here, depending primarily on whether the foreign law in question is a civil or common law system. In the important case around the capacity of the Ceylon Petroleum Company (‘CPC’) to enter into certain oil-referencing derivatives contracts, the Court of Appeal observed that
It was common ground before the judge and before us that the scope of CPC’s capacity is to be determined by reference to the law of Sri Lanka, but it was also accepted that there is no material difference for these purposes between the law of Sri Lanka and English common law. As a statutory corporation CPC’s capacity is determined by the legislation under which it is established …Footnote 96
On this basis, the Court of Appeal was on familiar territory as, in a unanimous judgment, it proceeded to analyse the position of the CPC by reference to both the relevant provisions of the Ceylon Petroleum Corporation Act 1961 and the English authorities. In contrast, we have already seen the English Court of Appeal split when confronted by the profoundly different approach to municipalities’ decision-making under Norwegian law, a civil law system, which said nothing about capacity in the English sense. Similarly, in the course of an appeal brought by Regione Piedmonte in relation to its claim that it lacked capacity to entered into certain derivatives, the Court of Appeal held that it was wrong to fall back on English law on those points where evidence was lacking to show that Italian law was different, and ‘This is particularly so in respect of a doctrine such as the ultra vires doctrine or concepts of voidness/voidability which civil law countries may not necessarily adopt or use in the same way.’Footnote 97 As there was no expert evidence or other indication in Italian case law that the decisions by Piedmont would be regarded as void ab initio under Italian law, the Court of Appeal held that there was no real prospect of the local authority establishing that it lacked capacity.
A second factor which intensifies the complexity of new capacity cases is the legal nature of the end-users in question. The legal status of the UK local authorities emerged as a minor issue in the Hazell litigation, as the banks unsuccessfully ran an argument, described by the Court of Appeal as a ‘somewhat arcane point’,Footnote 98 based upon the fact that the corporation in this case was a ‘hybrid, created by Royal Charter issued pursuant to a statute’.Footnote 99 Though the banks persisted with this argument at each level of their appeal, it ultimately offered no assistance to their case. Such arguments have, however, become both more central and more complex over time as end-users in the OTC derivatives markets have continued to diversify. In the recent Portuguese case, for example, the legal analysis of the capacity issue, an already complex exercise, was muddied further by the fact that of the four transport companies involved, all were public enterprises, but three were incorporated under commercial law while one was a public business entity, state-owned and regulated by its own ‘decree-law’Footnote 100 meaning that there were variations in the legal regimes which applied to each of these entities. In Credit Suisse v. Stichting Vestia Groep (‘Vestia’), Vestia was a Dutch social housing association from which the bank claimed over 83 million euros, pursuant to eleven derivatives transactions entered into in 2010–11. As becomes obvious over the long judgment, the fact that the defendant was a housing association with both public and private features added an extra dimension to the already complex issues in dispute and meant that the judge was required to examine the ‘legislative and governmental background’ to this type of social housing association, its role in Dutch society and its regulation in Dutch law over the last century.Footnote 101
The final complicating factor evident in these new capacity cases relates to the nature and functions of the derivatives in question. In 1990, the Court of Appeal unanimously held that Hammersmith and Fulham council had capacity to enter or to sell swaps if they were ‘parallel contracts’ entered into for the purpose of ‘interest rate risk management’,Footnote 102 but not if the swaps were entered into ‘by way of trading’.Footnote 103 However, not only was the Court of Appeal decision overturned by the House of Lords, but even internally, this ‘parallel contract’ analysis was problematic: in the end, the Court of Appeal did not test the council’s swaps on a transaction-by-transaction basis or similar. Rather, the Court of Appeal went on to determine the issue of validity of the contested swaps by reference to a single watershed date, which was when the council was advised by the auditor that certain swaps might be invalid. Before this date, the Court of Appeal held there was ‘no attempt to match the council’s actual debts and investments, either singly or in aggregate, with any of these transactions’.Footnote 104 These swaps were therefore held to be invalid. After this date, the council’s transactions were held to have amounted to a valid ‘interim strategy’ to mitigate the council’s losses from earlier swaps. Justifying this approach, the Court of Appeal held that the contrary conclusions ‘do not seem to reflect that fundamental fairness and pragmatic good sense which are boasted to infuse the common law’.Footnote 105 This justification is, in fact, one grounded in crisis management, not the management of interest rate risk and, as we have seen already, the House of Lords went on to disagree fundamentally with the Court of Appeal.Footnote 106 Having rejected the suggestion that the council’s use of swaps was valid for any purpose, including as part of the interim strategy, the House of Lords was not required to work out what ‘interest rate risk management’ might have meant in this context.
In several of the new capacity cases, however, the English courts have been required to engage more actively with this type of analysis. This has most obviously been the case where, under the applicable foreign law, public bodies have been found to have the capacity to enter into derivatives for some but not all purposes. For example, in Vestia and CPC respectively,
There is no dispute that [social housing associations] generally and Vestia in particular could (and can) properly enter into derivative transactions in order to manage their finances, including their borrowing costs.
… Vestia have capacity to invest in financial instruments of the kind with which this case is concerned only if they are properly to be regarded as ‘hedging instruments’ …Footnote 107
and
CPC accepted that it had that capacity to enter into derivative contracts insofar as they constituted hedging …
… however, [Standard Chartered Bank] did not accept the sharp dichotomy between hedging and speculation for which CPC contended, or that CPC did not have capacity to enter into transactions of a speculative nature.Footnote 108
The inherent problem with this type of binary analysis, as the Court of Appeal was to underline in the latter of these two decisions, is that hedging and speculating are not classifications that can be applied ‘solely objectively’.Footnote 109 Moreover, this fundamental problem has been compounded as market participants’ use of derivatives, and the products themselves, have become increasingly sophisticated over time. As the judge observed in the Vestia decision, any derivative could potentially be a hedging product.Footnote 110 It may depend on external factors,Footnote 111 on the user’s broader hedging strategy,Footnote 112 on taking into account how products work in combination with each otherFootnote 113 or on factors present at the corporate group level.Footnote 114 Strategies may also shift over time, while multiple strategies may be embodied by a single product or set of products. In Titan Steel Wheels, for example, the manufacturer initially purchased ‘vanilla’ derivatives to hedge its currency risk, before then moving into more complex structured products.Footnote 115 The company’s motive for the later transactions was explored in some detail in the case, with the judge eventually finding that they were ‘not entered into solely by way of a hedge’ but to make a profit as well.Footnote 116 This case alone illustrates how it can be impossible, even in relatively simple factual scenarios, to try to separate out contracts which constitute hedges from those which do not.
It is important to remember that the questions which the English courts have to ask at this stage of a capacity dispute are dictated by the provisions of the applicable foreign law, not by a functional analysis per se. These cases indicate that whenever possible, the English courts should avoid using purpose as a shibboleth. Instead, given the realities of modern derivatives markets and the legal task in hand, a more appropriate and workable approach is to focus on the scope of an entity’s capacity and whether the specific, contested derivatives lie within it. In 2012, this ‘capacity-centric’ approach was firmly adopted by the Court of Appeal in the CPC decision, following strongly worded observations about the classification exercise it was originally being invited to undertake.
The dichotomy which CPC sought to draw between hedging and speculation is to some extent illusory, in the sense that the two shade into each other …
We are not surprised that the experts in this case (as in [a parallel] arbitration) were divided in their opinion. We consider on the whole that hedging may come in more or less speculative forms, and that speculation may come in more or less hedged or risk averse forms.Footnote 117
Rather than be tempted to ask what it regarded as ‘a false question’ about whether the disputed transactions were hedges or not, the Court of Appeal in CPC sensibly held that ‘it is better simply to ask whether [the disputed transactions] were within CPC’s capacity’.Footnote 118 On this basis, the Court focused on the relevant law of Sri Lanka and, having established the limits within which CPC was permitted to operate, concluded that at the time of entering the deals (rather than with the benefit of hindsight, when the deals clearly looked imprudent), they fell within these parameters.
The most recent of the new capacity cases has followed this approach, which is to be welcomed. When faced with making a choice between two opposing accounts of how to determine whether snowball swaps were within the capacity of Portuguese transport authorities, a matter on which there was no answer in Portuguese law or doctrine, the judge rejected a test based on whether the swaps were ‘speculative’ or not. Instead, Blair J agreed with the bank’s expert, whose ‘theory of capacity’ was closely based on the provisions of the relevant legislation and whose approach ‘provides a workable capacity test based on provisions which actually state that they deal with capacity for the companies within their ambit’.Footnote 119 This judgment emphasises that the alternative approach, based on the nature of the transaction and its impact on the corporate purchaser would leave third parties unsure as to the validity of their transactionFootnote 120 and cause ‘great uncertainty’.Footnote 121 Notably, this part of the judge’s decision was not appealed,Footnote 122 unlike the equivalent part of the first instance decision in CPC, consideration of which was an important part of the 2012 appellate decision, as discussed above.
For all these powerful legal and economic reasons, which are closely tied to the nature of the modern derivatives markets, determining the capacity of certain types of end-users is a complicated task. The new capacity cases are symptomatic of wider trends in the market, so they present problems about legal capacity which have additional dimensions of difficulty linked to foreign law, the status of counterparties, and the economic features of the products involved. Furthermore, capacity is often raised alongside multi-faceted mis-selling claims, and this combination makes for lengthy hearings, extensive evidence and judgments of daunting proportions. Nonetheless, as this section has shown, patterns, practices and some precedent on questions of process have emerged. Most significantly, a detailed approach to the applicability and use of foreign law, and a more workable test for capacity have been hammered out over this series of cases. Each should help to mitigate the inherent complexity associated with these types of cases in the future.
9.5.3 Redress
The consequences of any lack of capacity depend on the law of the contract, which in the ISDA MA cases being considered here is English law. In Haugesund, this analysis was accepted by both parties, and held to be both implicit in the applicable conflicts rule (considered above, in the context of the applicable law for the question of capacity) and logically correct, as otherwise there would be ‘no scope for involvement of the putative applicable law of the contract’.Footnote 123 As seen in Haugesund, where the English court concludes that an entity lacks capacity under the law of its constitution, the contested transactions will be held to be void under English law, even if they would have been valid under the applicable local law.
Once a contract is found to be void ab initio, the principal, though not the only, route to redress for banks is a claim in restitution. At this stage in swaps litigation, banks have also advanced novel arguments that the undertakings in their ISDA Master Agreement remain valid and provide a basis for a contractual remedy, as argued successfully at first instance in Vestia,Footnote 124 and have (unsuccessfully) sought to recover losses relating to the restitutionary claim from their legal advisors.Footnote 125 Claims in restitution based on unjust enrichment, in turn, raise a series of important and detailed questions around jurisdiction. The details have been explored in depth in the specialist scholarship,Footnote 126 but for these purposes, it is worth noting that this debate continues to take place against the background of the House of Lords’ decision in Kleinwort Benson v. Glasgow City Council,Footnote 127 which was the culmination of the protracted litigation triggered by Hazell. In this controversial majority decision on the allocation of jurisdiction within the United Kingdom, the House of Lords held that the English courts had no jurisdiction to entertain the bank’s claim in restitution. The matter turned on whether this claim qualified as a claim ‘relating to a contract’ for the purpose of the applicable statutory provision, the current version of which is found in Article 7(1) of the Recast Brussels Regulation. As Lord Goff explained in one of the speeches for the majority, where a contract is found never to have existed, ‘it seems impossible to say that the claim for the recovery of the money is based upon a particular contractual obligation’.Footnote 128 This case is, however, now regarded as wrongly decided on this point and as ‘untenable in light of recent authorities’: as a result, it seems that the consequences of an ultra vires contract which was freely assumed by the parties can now be treated as falling within Article 7(1).Footnote 129
Capacity cases arising from the derivatives markets have played a central role in catalysing substantive aspects of the English law of restitution.Footnote 130 Most importantly, the wave of cases brought by banks in the aftermath of the decision in Hazell, including the landmark House of Lords decision on restitutionary remedies in Westdeutsche Landesbank,Footnote 131 has been credited with making ‘an enormous contribution’ to the development into this area of law.Footnote 132 In keeping with the legal issues considered earlier in this chapter, the new capacity cases have given rise to novel questions in this area too, once again because of their foreign law dimension. There have been various significant developments in the law of restitution as a result. For example, following on from the decision on capacity, several novel questions in the area of restitution arose in Haugesund. One such question arose as a result of the municipalities’ argument that the claim for restitution would be contrary to Norwegian public policy.Footnote 133 The English Court of Appeal regarded this argument as raising unprecedented point of law, to be analysed ‘from first principle’.Footnote 134 Ultimately, the Court held that, subject to English public policy, it would be ‘logical and consistent’ to consider foreign statute at this point, given that it had taken account of the same statute when deciding the issue of capacity in the first place.Footnote 135 However, the Court unanimously went on to uphold the judge’s finding that nothing under this Norwegian statute would bar recovery of money paid under a contract which was invalid.Footnote 136 The municipalities’ success on one unprecedented point of law (regarding capacity) was therefore overshadowed by their loss on a second (regarding the law of restitution). This is just one recent example of the wide-reaching implications that litigation over international derivatives contracts has had for the development of English law.
