Choice of law A fair exchange

Chris Webber and Michael Davar weigh up the impact of the Rome Convention in financial derivatives claims

n the sphere of financial derivatives, into on 29 June 2006, cancelling the claims in the English courts by foreign pre-existing swaps. I municipalities and other public It was this Swap 6 that instigated the bodies subject to special legislation have, litigation as, from 31 December 2010, since 2008, been numerous. In particular, Prato stopped making payments due there have been a number of disputes under it. claimed for sums due. over whether foreign ‘mandatory’ In its defence, Prato contended laws apply to derivative contracts that it had not had capacity to enter by operation of Art 3(3) of the Rome into the swaps as Italian law restricted Convention despite the parties’ municipalities from entering into express choice of English law. ‘speculative’ transactions. Prato also The recent Court of Appeal alleged that the sale of the swaps had judgment in Dexia Crediop SPA v contravened Italian financial services Comune Di Prato [2017] has provided regulations, said to be mandatory some much-needed clarification and rules of Italian law pursuant to certainty as to the operation of Art 3(3) Art 3(3) of the Rome Convention. of the Rome Convention in interest rate swaps and other derivatives First instance judgment with an international element. The The Commercial Court held that the case also provides useful guidance as swaps were not ultra vires Prato’s to how foreign law issues are to be capacity under Italian local government dealt with in the English courts and legislation. The Commercial Court did, whether the mark-to-market (MTM) of however, find that Prato was entitled a swap can be considered an initial cost. to rely on rules of Italian financial Chris Webber (pictured services regulation that were treated top) is a partner and Background facts as mandatory pursuant to Art 3(3) Michael Davar an associate By December 2001, the finances of the of the Rome Convention. As Dexia with Squire Patton Boggs Comune Di Prato (Prato), an Italian failed to comply with those mandatory LLP local authority, had come under regulations, the swaps were void at pressure. Prato’s borrowing amounted Prato’s election. to approximately €111m, 88% of It followed that both parties had which was at a fixed interest rate. restitutionary claims against each other To help manage its liabilities, flowing from the voiding of the swaps. Prato appointed Dexia Crediop SPA The net result was that Dexia owed ‘The English Court of Appeal (Dexia) as a financial adviser. Dexia Prato €327,680.95. has restored the vital recommended the use of derivatives certainty engendered by to hedge against interest rate risk. On The appeal – its significance in the derivatives having a clear, 23 November 2002, Dexia and Prato financial derivatives market and single choice of law and not signed an ISDA Master Agreement, its importance for practitioners which included an English law and The Court of Appeal handed down a potentially being subject jurisdiction clause. The terms of judgment on 15 June 2017 overturning to “mandatory” rules of the ISDA Master Agreement were a number of the Commercial Court’s other jurisdictions that have incorporated in six subsequent findings and ordering Prato to pay not been anticipated and swap contracts between them, with Dexia over €12m. In doing so, the addressed by the draftsman.’ Dexia entering into six corresponding Court of Appeal dealt with a number back-to-back transactions. The of areas of law important to the last of these, ‘Swap 6’, was entered financial derivatives market, including:

18 The Commercial Litigation Journal July/August 2017 Choice of law

• the operation of Art 3(3) of the The Court of Appeal, in overturning Court of Appeal found that the swaps, Rome Convention; this decision, emphasised that, in by their very nature, had an international line with Totta SA v element. It was therefore impossible to • the manner in which foreign law Companhia Carris De Ferro De Lisboa say that ‘all other elements’ except the issues are to be dealt with on SA [2017], the Commercial Court was choice of law and jurisdiction clause appeal; and wrong to view the phrase ‘elements were located in Italy. This is as: in the situation’ as requiring elements • whether the MTM of a swap is connected to a particular country other • the ISDA Master Agreement is to be considered an ‘initial cost’. than Italy, and as such was wrong the standard form of master to hold that Art 3(3) of the Rome agreement of the International These are addressed below. Convention was engaged. The relevant Swap Dealers Association Inc question was whether the swaps were and is therefore not associated Article 3 of the Rome Convention international or domestic in nature, not with any particular country; The Contracts (Applicable Law) Act 1990 (the 1990 Act) incorporated the Rome Convention (and its successor from 17 December 2009, the Rome I The critical question in Dexia was whether ‘all other Regulation) into the law of the UK. elements relevant to the situation… are connected Article 3(1) of the Rome Convention entitles parties to choose the law which with one country only’. governs their contract. Article 3(3) of the Rome Convention provides an exception in that, where ‘all other elements’ relevant to the situation at whether they were connected to one • the form is the Multi-Currency the time when the parties chose the country more than another. Cross-Border form – as there is the governing law ‘are connected with one The Court of Appeal re-affirmed, option to use a ‘Local Currency – country only’, mandatory rules of the and added to, the relevant factors single jurisdiction form’, the court law of that country will apply to the stated in Banco Santander, namely: said this means that the parties contract regardless of the parties’ choice must have contemplated more than of governing law. In other words, • whether there is a right to assign one currency and the involvement parties to a purely domestic contract the contract to a party outside of more than one country; and cannot avoid important local laws by the country where the original choosing a foreign governing law. contracting parties are based; • the form is signed by the parties in The swaps in this case were subject English, despite both parties’ first to an English governing law clause. • whether standard international language being Italian. Prato therefore sought to rely on documentation had been used Art 3(3) to apply Italian financial in the transaction; As the court held that Art 3(3) services regulations that it said of the Rome Convention was not Dexia had breached. The critical • the practical necessity for a therefore applicable, the rules of question was whether ‘all other relationship with an institution Italian law relied on by Prato had no elements relevant to the situation… outside the country where the application to the swaps. are connected with one country only’. original contracting parties are This is a significant decision for In the first instance judgment, it based; the financial derivatives markets. The was identified that Italy was: English Court of Appeal has restored • the international nature of the the vital certainty engendered by • where both parties were financial derivatives market in derivatives having a clear, single incorporated; which the contracts were concluded; choice of law and not potentially being subject to ‘mandatory’ rules of • where both parties communicated • whether back-to-back contracts other jurisdictions that have not been with each other; are routinely concluded with anticipated and addressed by the institutions outside the country draftsman. • where the swap contracts were where the original contracting Practitioners can now advise with entered into; and parties are based; and confidence that Art 3(3) of the Rome Convention will rarely, if ever, come • the place of performance of the • whether international organisations into play in relation to derivative obligations. participated in a tendering process contracts based on the common before the derivative contract was ISDA Multi-Currency Cross-Border The Commercial Court therefore agreed. document suite. held that all the other elements of the swaps at the time of the choice The Court of Appeal went even Foreign experts on appeal of English law were connected with further. By incorporating the ISDA Financial derivative cases often involve one country only, namely Italy. Master Agreement into the swaps, the foreign law expert evidence. Examples

July/August 2017 The Commercial Litigation Journal 19 Choice of law include cases where a party alleges a an appeal is limited to a review of the • similar rules of construction to lack of capacity to enter a derivative decision of the trial judge. When the the English rules govern the contract based on foreign and legal Court of Appeal is faced with a finding interpretation of the foreign statute; regulatory requirements, as well by a trial judge on disputed issues of as disputes arising under Art 3(3) foreign law, the appeal would be one • none of the words of the statute of the Rome Convention, both of against findings of fact – something have any special meaning different which arose in this litigation. with which appellate courts have been from their ordinary meaning in the English law treats foreign law repeatedly warned not to take lightly foreign context; or issues as questions of fact to be proved when deciding to interfere. • the English judge’s common law experience and training can be applied. The Court of Appeal took the firm view in Dexia This general reluctance arises that the mark-to-market value is just a calculation because the trial judge has the of possible future payment flows, and therefore advantage of taking in the whole not really a ‘cost’ at all. ‘sea’ of the expert evidence rather than just ‘island hopping’, as the appellate court must necessarily do. In taking this approach, the Court of Appeal held that it was in no position to by evidence of suitably qualified The Court of Appeal in Dexia recreate the trial judge’s experience from experts. The task for the trial judge is reiterated the key considerations in a reading of the transcript and rejected to determine what the highest relevant reviewing findings of foreign law, Prato’s appeals of its Italian-law-based court in the foreign legal system would stating that appellate courts will show capacity defences. decide if the point had come before it. a general reluctance to intervene in Dexia is a useful reminder of, and Except in the matters identified by cases involving findings of foreign potential expansion on, the limits on CPR 52.21, such as where it is in the law. Exceptions might arise where appellate courts’ interference with interests of justice to hold a rehearing, it appears that: first instance decisions on foreign law issues. Practitioners will need to think twice when advising whether to appeal findings on foreign law expert evidence. The Court of Appeal warned PROCUREMENT & that it should not be assumed all such points are fully reviewable on appeal, OUTSOURCING JOURNAL reiterating that the first instance trial is ‘not a dress rehearsal. It is the first and The bi-monthly journal designed to last night of the show’. meet the needs of procurement professionals MTM of a swap Prato argued that the MTM of Swap 6 was an implicit cost of the derivative, and that Swap 6 breached the so-called ‘financial advantage’ test under Italian financial regulation, Each issue provides you rendering the swap void. The Court of Appeal dismissed with concise, useful Prato’s case in this area for other reasons, information that saves but nonetheless considered whether the MTM of a swap was an ‘initial cost’. you time and money A swap necessarily involves two-way flows of payment obligations. The MTM of a swap involves estimating and valuing those future payment flows as at the present date. Hence the MTM will be zero where the present estimated value of what has to be paid on the fixed leg is the For a FREE sample copy: call us on same as what it is estimated will have 020 7396 9313 or visit www.legalease.co.uk to be paid on the floating leg. Where the estimated present values of the legs diverge, the MTM will no longer

20 The Commercial Litigation Journal July/August 2017 Choice of law be zero. A swap’s MTM will therefore Appeal’s firm view that the MTM value Overall, the Court of Appeal vary throughout the life of a swap, is just a calculation of possible future judgment reflects the English courts’ depending on estimates of the present payment flows, and not really a ‘cost’ at wider emphasis on clarity and certainty value of the different legs at any given all, will undermine arguments that the in the context of the international time. MTM ‘cost’ represents a secret profit or financial derivatives markets, where The Court of Appeal agreed with the charge alleged to have been wrongfully participants need the interpretation of Commercial Court on the following: concealed from the buyer, as is often widely used standard form agreements argued in mis-selling claims. to be consistent and predictable. It is • The initial MTM does not indicate an outcome: it is the present value of the expected cash flows discounted at present market rates. Whether financial derivative products using different The outcome depends on what standard forms to the ISDA Master Agreement happens to the market rates. will exclude the operation of Art 3(3) of the Rome • Far from being a predictor of Convention is uncertain. cash flows, MTM represents an adjustment to a notional benchmark, representing the provision that the has Dexia also resolves controversy that in part for that reason that the English made for costs, risks and return. arose as a result of the conflict between courts have generally been resistant to the first instance decision and the Banco attempts by parties to undermine their • The MTM is based on the spread Santander judgment. If it can now be derivative contracts by later raising between the fixed rate and a said that all swaps based on this widely arguments such as lack of capacity, notional interbank rate, at which used ISDA Master Agreement are non-disclosure of MTM hidden costs no bank would transact with a not affected by Art 3(3) of the Rome or breach of rules of a foreign law counterparty like Prato. Convention, then can have not chosen to govern the agreement. confidence that the choice of English Decisions like Haugesund Kommune v • Given the mechanics, it is only law often embedded in ISDA-based Depfa ACS Bank [2010] and in hindsight that it is possible to swaps will govern all aspects of the International v Stichting Vestia Groep establish whether such transactions transaction, at least where the dispute [2014] can also be considered as part of represent an advantage or a is before the English courts. that pattern. disadvantage. Contracting parties may want to The English court system has set consider taking advantage of this out to continue to attract international • In these respects, therefore, the initial certainty by using this ISDA document financial services disputes in an MTM does not represent a cost, or suite rather than other forms of increasingly competitive global even an expected cost. It is really just derivative contract. In order to exclude marketplace for dispute resolution. an estimate of future costs, which Art 3(3) of the Rome Convention, Innovations like the Financial List of may or may not transpire. contracting parties may also want to the Chancery Division and Commercial ensure the existence of international Courts, specialist training in finance • The Court of Appeal was accordingly factors, such as choosing international matters for List judges and the (as yet not willing to treat the MTM as a counterparties for back-to-back swaps largely untested) test case mechanism financial advantage gained by Dexia or contracting through a group entity for financial markets issues are part at its customer’s expense. in a different jurisdiction to the swap of that push. The courts are also alive buyer, in order to exclude Art 3(3) of the to the need for the substantive rules This approach is significant. Local Rome Convention wherever possible. of English law to be attractive to laws often prohibit public bodies from Grey areas do remain. Whether the financial markets in promoting entering into transactions that increase financial derivative products using certainty, and this decision will be their borrowing or are considered different standard forms to the ISDA welcomed in that respect. n financially detrimental. The notion that Master Agreement will exclude the the initial MTM is not a ‘cost’ at all will operation of Art 3(3) of the Rome give increased certainty to financial Convention in the same way is uncertain. Banco Santander Totta SA v Companhia institutions when structuring financial Also, the Rome Convention and Rome I Carris De Ferro De Lisboa SA & ors [2017] EWCA Civ 1267 derivative products for such clients. Regulation differ subtly in wording. Although we believe a similar approach Credit Suisse International v Stichting Vestia Groep Concluding comments will likely be taken with Art 3(3) of the [2014] EWHC 3103 (Comm) The Court of Appeal judgment Rome I Regulation, it is not guaranteed. Dexia Crediop SPA v Comune Di Prato helpfully tackles the argument, made In the longer term, the answer to the [2017] EWCA Civ 428 in numerous cases in recent years, that question of how Brexit will impact on Haugesund Kommune & anor v Depfa the day-one MTM value of a swap the incorporation into English law of ACS Bank & anor represents a hidden ‘cost’ or financial the Rome I Regulation, which is an EU [2010] EWCA Civ 579 disadvantage to the buyer. The Court of legislative instrument, is unclear.

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