Capacity of foreign public authorities: traps and tips

Introduction

A party cannot enter into a contract if they do not have the legal capacity to do so. The harsh consequences of this straightforward proposition have been successively mitigated by statutes and by the courts for different types of legal person.

In this article, we describe some traps waiting for innocent counterparties and how they might avoid them. In particular, recent cases have shown not only that corporates must take special care when dealing with foreign public authorities, but also suggest novel ways of minimising risk.

Companies

When dealing with UK companies, the innocent counterparty is essentially protected from a lack of capacity. Although the ultra vires doctrine (that a body created by statute only had the capacity to do what was granted to it by that statute) was created largely in relation to companies, a succession of statutory provisions have limited the effect of it on innocent counterparties.

The powers of a company are set out in its objects, although now the need for an objects clause has been removed altogether (Companies Act 2006, s31). And the validity of acts done by a company cannot be called into question by virtue of anything contained in its constitutional documents (Companies Act 2006, s39). There are also provisions protecting the innocent counterparty from a lack of authority of the person acting on behalf of the company, as opposed to a lack of capacity of the company itself (Companies Act 2006, s40).

The role of the ultra vires doctrine was also further circumscribed by the courts in Rolled Steel Products (Holdings) Ltd v British Steel Corp [1986] Ch 246. In that case, under its constitutional documents, a company had the power to enter into a guarantee, but only for certain purposes. The Court of Appeal held that an act within the powers of a company but entered into for an improper purpose could be distinguished from an act which was entirely outside the powers of a company. Only the latter was properly categorised as "ultra vires" – the former did not fall within that doctrine and therefore could create rights in favour of innocent third parties. We shall see below that this distinction is less clear in the case of public authorities.

English public authorities

In the 1980s, a number of English local authorities entered into interest rate swaps and similar arrangements. When these investments unexpectedly proved to be very costly, they refused to honour their obligations on the basis that they lacked capacity to enter into the transactions. In a series of cases in the 1990s, the courts held that the local authorities did lack capacity and that the investment banks who dealt with them in good faith could not enforce what they had thought of as purely commercial arrangements.

Since these cases occurred, the statutory provisions governing the capacity of English local authorities have changed and there are now, for instance, methods by which counterparties can obtain a statutory certification of the capacity of a local authority for a particular transaction (see the Local Government (Contracts) Act 1997).

The courts have also addressed the distinction between narrow ultra vires – actions wholly outside the capacity of an authority – and wide ultra vires – acts that would have been inside the authority’s capacity but for an improper or inadequate purpose: the analogous situation to Rolled Steel for private companies. The Court of Appeal has not spoken with one voice on this issue (see Credit Suisse v Allerdale BC [1996] QB 306 and Charles Terence v Cornwall Council [2012] EWCA 1439), but there appears to be some room for allowing actions that are ultra vires only in the wide sense to be enforceable in certain circumstances.

Foreign public authorities

A recent spate of cases featuring foreign public authorities is curiously redolent of the previous cases involving English local authorities. The products involved are mainly structured credit derivatives rather than interest rate swaps, but the defence of lack of capacity is the same.

The introduction of a foreign element introduces added layers of complexity. Firstly, there is the question of jurisdiction. Matters of capacity fall within the jurisdiction of the country where the authority is incorporated or constituted, even where the parties have agreed a different exclusive jurisdiction (see Article 22 of the Brussels Regulation – now Article 24 of the Brussels Regulation Recast). This is a trap for an unwary counterparty who would have assumed it could rely on an exclusive jurisdiction clause. However, both English and European courts have rejected attempts to move proceedings from the jurisdiction named in the exclusive jurisdiction clause to the authority’s home jurisdiction, on the grounds that the action was not ‘principally concerned’ with the question of capacity.

The second trap for an innocent counterparty raised by the foreign element is caused by the substantive conflicts of law rules on capacity. Essentially, the rule is that the local law of the foreign authority will decide the question as to whether that authority has capacity but the law applicable to the purported contract will determine the consequences of any lack of capacity (see Haugesund v DEPFA [2010] EWCA Civ 579). So, in Haugesund, where a Norwegian local authority entered into an English law governed derivative, it was Norwegian law that determined whether the local authority had capacity but English law which determined the consequences of lack of capacity.

As discussed above, the consequences of lack of capacity in English law are often severe. But what if the local law has an expansive law of capacity, so that many transactions are potentially affected, and prevents unfairness by limiting the consequences of incapacity? In that case, there may be an unfortunate mismatch. The local law may ascribe incapacity to a wider range of contracts than would be expected under English law, but it will still be English law that determines the consequences of incapacity. One possible response is to argue that the local law of capacity is too wide to be treated as such for conflicts of law purposes and it should be given some other classification. However, this argument was expressly rejected in Haugesund. It appears that the courts will take a wide view of what constitutes capacity and then apply the harsh consequences of English law when incapacity is found.

Credit Suisse v Stichting Vestia

This conflicts of law background perhaps lies behind some of the reasoning of the judge, Mr Justice Andrew Smith, in Credit Suisse v Stichting Vestia [2014] EWHC 3103 (Comm). Stichting Vestia (SV) was a Dutch housing association. It entered into an ISDA Master Agreement and various structured interest rate derivatives under it with the claimant bank. When the bank sought to enforce the derivatives, SV claimed that the transactions were void as it did not have capacity to enter into them.

Andrew Smith J held that, as a matter of Dutch law, SV only had power to enter into derivatives for hedging purposes and that certain of the derivatives were not entered into for this purpose. Accordingly, they were ultra vires. The consequences of this were determined by English law, the putative applicable law of the contract, which rendered the contracts void and unenforceable against SV.

The Master Agreement contained Additional Representations by SV to the effect that it had capacity to enter into the transactions and that they were made for hedging purposes. Andrew Smith J held that these Additional Representations constituted warranties as to the future capacity of SV and that they could be enforced by the bank or used to found a contractual estoppel. He considered the "bootstraps" argument: that a public body cannot widen the scope of its capacity by contract or estoppel, eg, by warranting that it has capacity. However, he dismissed it with the following reasoning:

"[the bank] are not making a claim under the ultra vires contracts and in this part of their claim are not asserting that they are valid. Their argument is that they are entitled to enforce the Master Agreement as if the ultra vires contracts were valid" (para. 319 – emphasis in the original).

The judgment is of general interest both in its interpretation of the Additional Representations in a Master Agreement as warranties and not representations (although this is a question of construction that may be of limited precedent value), and in its extension of contractual estoppel to apply to future states of affairs, which is a development that could be used in a wide variety of situations.

However, here we focus on the capacity issue.

The striking aspect of the judgment is the ability to use contractual estoppel to enforce a warranty as to capacity, seemingly contrary to the principle that a public authority cannot widen its own capacity by making a representation as to its capacity. The judge’s reasoning was that the bank was enforcing the Master Agreement rather than the void derivative. But the obligation the bank sought to enforce was the obligation to pay the sum calculated in accordance with the derivative. It is exactly this obligation that, in the circumstances found by the judge to exist, was beyond the capacity of SV.

The principle in Haugesund required the court to apply the Dutch laws as to capacity and the English laws as to the consequences of incapacity. Also, the restitution claim available in Haugesund was not sufficient for the bank: they were asking for enforcement of the underlying obligation, not simply the return of monies already paid. It is understood that the decision is subject to an appeal and will be watched with interest.

Traps and practical tips

Any party entering into a transaction with a foreign public authority under English law should be aware that foreign capacity rules will apply even though English law has been chosen. Not only that, but these rules may be more nuanced and complex than the equivalent English rules on capacity, requiring a sensitive appraisal of questions of mixed fact and law.

The fact-dependent nature of some foreign capacity rules means that reliance on transaction legal opinions may not be sufficient – the risks are outside those covered by such legal opinions as the facts are likely to be assumed for the purposes of the opinion. Only a detailed examination of the facts, including in particular any factual assumptions in legal opinions, can provide practical comfort.

The argument that the English law consequences of ultra vires in the "wide" sense are not necessarily enough to render the contract void may be worth making in these circumstances. Available case law gives this only faint support but the issue has not been addressed in detail in the recent cases. The argument may provide a more principled solution that does justice on the merits where foreign laws state that contracts entered into for improper purposes lack capacity, but do not necessarily render them void.

Another option is to seek restitution in respect of any potentially void contract. Haugesund and the English local authority cases confirm that this remedy is available. However, there may be cases, such as Stichting Vestia, where a restitutionary remedy would not provide adequate recompense. It only worked in Haugesund because the bank had made all payments up front under a zero coupon swap.

Finally, companies should consider obtaining warranties as to capacity as in Stichting Vestia. These could be structured as part of a separate "umbrella agreement" that pre-dates any substantive transactions. Although, prior to Stichting Vestia, these would have been thought unlikely to have any effect, they must now be considered a significant part of any protection for companies dealing with foreign public authorities.