Derivatives mis-selling claims by Public Authorities in Italy

Banking and finance disputes review

Publication November 2015


Introduction

Following the financial crisis of 2008, Italian public authorities filed thousands of legal actions against banks and financial institutions seeking redress for the negative consequences they suffered as a result of entering into complex derivatives transactions.

In this article, we examine the course of this litigation and discuss the ramifications for the interpretation of the ISDA Master Agreement and the risks undertaken by banks and financial institutions in dealing with Italian counterparties and facing litigation in Italy.

Use of derivatives by the Italian Public Sector

The Italian Ministry of Economy and Finance has estimated that, at the end of 2014, 216 Italian public authorities had entered into 433 over the counter (OTC) derivatives contracts with a notional value of approximately EUR 24.8 billion (61% with foreign counterparties and the remaining 39% with Italian banks). The Italian regions were the most active, accounting for about EUR 15 billion (60% of the total), followed by 30 municipalities with EUR 6 billion (24%), 32 provinces with EUR 2.4 billion (10%) and 137 smaller cities with EUR 1.5 billion (6%).

Their use of derivatives had been more extensive in the past (reaching its peak in 2007 with 1,333 contracts involving 798 public entities), decreasing only in the last few years, after the Italian Central Bank in 2008 banned public authorities from entering into swap contracts. Public authorities are now subject to strict limitations when entering into derivatives transactions. The damage, however, has already been done, as shown by the raft of legal proceedings in the recent past.

Claims by Italian Public Authorities

Derivatives mis-selling claims by Italian public authorities are based on both contractual and tortious liability. They have commonly included the following allegations:

  • the public authority’s lack of capacity to enter into the swap;
  • the public authority’s lack of expertise in respect of financial instruments, notwithstanding that it signed a declaration that it was a sophisticated investor before executing the derivatives transaction;
  • the presence of costs associated with the transaction that were not disclosed by banks at the time the derivatives transaction was executed (so-called ‘implicit costs’); and
  • the violation of the principle of good faith and the breach of a number of provisions of Italian financial services regulation.

These claims may also include allegations of misconduct by financial institutions, such as that:

  • the transaction was vitiated for reasons such as misrepresentation or fraud;
  • the ISDA Master Agreement was not signed by the bank (although duly performed by both sides) and/or did not contain certain required information;
  • the bank failed to inform them of the ‘cooling off period’ under Italian law during which they could have cancelled the contracts;
  • the bank failed to comply with the duties of care, fairness and transparency and failed to operate so as to obtain the best possible result for the local authority from the investment service provided;
  • the bank did not communicate the conflict of interest to which it was subject by being both arranger and swap dealer, nor did it obtain the public entity’s consent in writing to this conflict;
  • the transaction, represented by banks as being for the purpose of hedging, was actually speculative and consequently inappropriate for the public authority’s risk profile;
  • the bank did not clearly explain the nature of the derivative products and the related risks; and
  • the banks failed to assess the public authority’s investment experience and appetite for risk or provide them with general information on the risks of financial investments.

Focus on jurisdiction

Jurisdiction has been a central, substantive issue arising in almost all the proceedings between Italian public authorities and banks. Public authorities have routinely tried to have derivatives disputes heard in Italy rather than in the UK, perhaps due to a perception of higher litigation costs in England or a belief that English courts would be more favourable to international banks than Italian municipalities. Conversely, banks have turned first to the English courts and, when sued in Italy, have argued that the ISDA Master Agreement confers exclusive jurisdiction on the English courts.

This has resulted in pre-emptive proceedings brought by public authorities before Italian courts, on the grounds that under the Brussels I Regulation (Regulation 44/2001, now replaced by Regulation 1215/2012), the first court to be chosen has the right to determine its jurisdiction, thereby staying any subsequent proceedings in a Member State until that determination is reached. Note that this tactic may not now be effective as under Article 31(2) of the Brussels I Regulation, since the beginning of 2015, the English courts would not be obliged to stay proceedings where exclusive jurisdiction has been conferred on them by the terms of the ISDA Master Agreement.

Italian interpretation of the ISDA Master Agreement Jurisdiction Clause

Following a number of contradictory Italian local court decisions, the Italian Supreme Court has recently ruled on jurisdiction and forum-shopping issues in two cases involving ISDA Master Agreements entered into by two Italian municipalities (Milan and Venice).

The municipalities claimed damages for tortious liability arising from conduct before the conclusion of the contract (i.e. in the pre-contractual phase). Then both municipalities filed a concurrent claim for damages for contractual liability for breach of collateral consultancy agreements. The defendants disputed the local courts’ jurisdiction on the basis of Article 13 of the ISDA Master Agreement, which provided that English courts have jurisdiction for disputes “relating to this Agreement”.

The Supreme Court found that the Italian courts had jurisdiction in both cases. The first case, involving the Municipality of Milan, was decided by the Supreme Court on 27 February 2012. The Supreme Court held that the jurisdiction clause did not extend to tort claims. First, it decided that in a complex dispute where subordinate claims are also filed, jurisdiction is determined by the main claim. Italian courts had jurisdiction over the main tort claim under the Brussels Regulation, subject to the effect of the jurisdiction clause in the ISDA Master Agreement.

The Supreme Court then set out principles of interpretation of this jurisdiction clause. It clarified, in line with European case law, that jurisdiction clauses must be strictly interpreted and assessed separately from the agreement in which they are contained and, most importantly, that the national judge, before which their interpretation is sought, decides such interpretation. Hence, based on Italian law principles of contractual interpretation, the Court held that the wording “relating to this Agreement” in the jurisdiction clause under Article 13 of the ISDA Master Agreement did not extend the jurisdiction of English courts to all disputes, whether contractual or tortious, connected to the same derivative contractual framework.

In conclusion, the Italian Supreme Court ruled that in the event of a jurisdiction clause as the one contained in the ISDA Master Agreement, referring to disputes “relating to this Agreement”, English jurisdiction does not extend also to tort claims.

Two years later, in a similar case involving the Municipality of Venice, the Italian Supreme Court reconfirmed the first ruling in full based on the same reasoning.

Administrative and criminal implications

Italian derivatives disputes may also involve administrative claims and criminal liability.

For instance, in a derivatives dispute involving the city of Pisa, one issue was the validity of a public authority’s power to exercise self-redress on the grounds that the transaction did not meet the “economic convenience test” laid down in Italian law. This enabled the public authority to make a unilateral decision to retroactively cancel the resolutions authorising the entry into the derivatives transaction. The Italian Supreme Administrative Court ruled in 2012 that Pisa’s exercise of self-redress was void as the existence of ‘implicit costs’ in a swap was not sufficient in itself to violate Italian law. Another potential violation is that the public authority has exceeded the statutory limitations on entering into derivatives contracts.

Recent cases have shown that Italian administrative courts generally accept jurisdiction over derivatives disputes involving public authorities whenever the exercise of administrative powers (or the procedure to select the swap counterparty) is disputed, irrespective of the fact that the parties agreed to the exclusive jurisdiction of the English courts. Conversely, where the only issue is the validity of the derivatives contract, Italian administrative courts will generally accept that English courts have sole jurisdiction. Where the sole cause of action is administrative, the Brussels Regulation may not apply as it covers only ‘civil and commercial’ matters.

There have also been proceedings in Italy before the criminal courts, such as one widely publicised case before the Criminal Court of Milan against four international banks, some bank employees and former city officials. Banks and their representatives could face significant risks in criminal proceedings: for instance, seizure of assets, temporary bans from doing business with municipalities, and monetary fines. Criminal actions may also trigger administrative liabilities, which also apply to international corporations doing business in Italy.

Conclusions

There are significant differences between litigation in Italy and litigation in the UK. Legal proceedings in Italy can be extremely lengthy due to the Italian judicial system’s “three instance” structure. Banks involved in legal actions pending before Italian courts have faced reputational damage, following some initial unfavourable judgments on derivatives transactions. In some cases, Italian courts have adopted a highly formalistic interpretation of Italian financial services regulations, which can be disadvantageous to banks. However, in other cases, banks have succeeded in jurisdiction challenges following years of litigation. Accordingly, the outcome of legal proceedings in Italy can be highly unpredictable. Finally, derivatives litigation in Italy often follows a two-track procedure, with claims filed in both civil and administrative courts. This leads to the risk of conflicting judgments from civil, administrative and even criminal courts in respect of the same matter.

The Italian courts have shown a propensity to accept jurisdiction in these cases. Administrative proceedings fall outside the jurisdictional limitations of the Brussels I Regulation. Even where the Brussels I Regulation does apply, the Italian Supreme Court’s restrictive interpretation of the ISDA Master Agreement exclusive jurisdiction clause has allowed it to take jurisdiction over tortious claims arising out of derivatives disputes, perhaps surprisingly from an international perspective.

In light of the above and considering the volume of trading in derivatives, its impact on Italian local finance and the uncertainty of case law on many substantial issues, derivatives litigation involving public authorities is a continuing source of risk and liability for financial institutions.



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