In Deutsche Bank v Busto [2021] EWHC 2706, the English High Court recently considered the validity of certain swap contracts entered into between an Italian public authority (“Busto”) and Deutsche Bank AG, London Branch (“DB”). The capacity of public bodies to enter into derivative contracts has been fertile ground for litigation in recent years.

To manage its principal repayment and interest obligations on its indebtedness, in 2007 Busto entered into several swap contracts with DB including a collar transaction involving (i) an exchange of principal, which allowed Busto to reduce its near term repayment obligations, but increasing them towards the end of the term and (ii) DB making fixed and floating payments to Busto corresponding to its interest obligations, with Busto making floating rate payments to DB linked to Euribor, subject to a cap and floor. Following dramatic reductions in Euribor stemming from the global financial crisis, the swaps were heavily out of the money for Busto.

Busto challenged the validity of the swaps on a number of grounds, including that: (i) Article 119 of the Italian Constitution prohibits Italian local authorities from entering into derivative contracts of a “speculative nature”, (ii) Busto’s City Council was required to approve the transactions, but had failed to do so, (iii) DB was required, but had failed, to provide information to Busto on mark-to-market values, probabilistic scenarios and hidden costs of the swaps for inclusion in its approval and (iv) the swaps were speculative contracts rather than for hedging, which was not permitted for public authorities. These three final grounds were based on the Italian Court of Cassation/Supreme Court decision 8770/20 Banca Nazionale Del Lavoro S.p.A v Municipality of Cattolica (“Cattolica”).

In general, under conflict of laws rules, the capacity of an entity to enter into a contract is governed by the law where it is located, i.e. for a company, where it is incorporated, whilst the effect of a contract (whether it is valid) is a matter for its governing law – in this case English law. Hence, the court considered whether the various Italian requirements listed above are properly characterised, as a matter of English private international law, as limits on Busto’s capacity to contract. The court concluded that (i) Article 119 of the Italian Constitution did place a limit on the capacity of Italian public authorities, but on its plan reading did not prohibit the relevant swap transactions and (ii) the three Cattolica grounds of challenge related to elements of a valid contract under Italian law, rather than the capacity of Italian public bodies to enter into derivatives, and therefore were not relevant to the dispute – as the governing law of the contracts was English law. Accordingly, as the swaps were valid under English law (not containing rules similar to Cattolica), the swaps were valid and binding on Busto and enforceable in accordance with their terms.

The case highlights that the requirements for a valid derivative contract in different legal jurisdictions are not harmonious. It also underscores the importance of undertaking adequate due diligence in respect of counterparties and taking specialist legal advice in relation to counterparty capacity. Section 4(a)(ii) of the 2002 ISDA Master Agreement, for instance, allows parties to specify (in Part 3(b) of the schedule) documents to be delivered to the other party prior to closing (or by any other specified date). It is common to include legal opinions as to capacity of a counterparty in Part 3(b) of the schedule. Where a market participant is dealing with a relatively unusual counterparty such as a public body it should consider requiring a capacity legal opinion from a reputable law firm. Please speak to your contact at Mayer Brown if you would like more information on our derivatives or legal opinions capabilities.