In his recent decision in Banca Intesa Sanpaolo v Comune di Venezia [2022] EWHC 2586, Foxton J revisited an important potential defence to any bank claim to enforce a derivative transaction. This firm acted for the Ceylon Petroleum Corporation (CPC) in a suite of claims by banks seeking to enforce their rights under derivatives that they alleged protected CPC from fluctuations in the price of crude oil. The centrepiece of the CPC defence was that it lacked the capacity to enter transactions that were in fact purely speculative.
The defence did not find favour with the English Commercial Court and Court of Appeal (Standard Chartered Bank v Ceylon Petroleum Corp [2012] EWCA 1094), but that judgment refers to an arbitral tribunal decision in which the defence succeeded.
Some context first:
- The derivative transactions themselves in the CPC and Venezia pieces of litigation were governed by English law following an election made in the standard ISDA documentation. However, as Foxton J pointed out [107] that does not mean that every legal issue which rises the determination is exclusively a matter of English law. It was common ground in both cases that issues as to the capacity of the bank customer to enter into the transactions were to be determined by reference to the legal system which brought it into being. For CPC, this was the law of Sri Lanka, albeit it was agreed that there was no material difference between English and Sri Lankan law for this purpose. For Venezia, this was Italian law.
- Whether there is a legal ability or substantive power to enter into a contract of a particular type is judged by reference to any constitutional documents, statutes and rules of the law of the country where the corporation is situated.
- The date at which the content of the foreign law be determined is by reference to the law in force when the transactions were entered into.
The principles set out above are common to Foxton J’s Venezia decision and to the Court of Appeal’s approach in CPC. However, thereafter their approaches differ.
The Court of Appeal in CPC was very reluctant to engage with the distinction between hedging and speculation: “In our view the critical question for present purposes is not whether [the relevant transactions] are properly classed as hedges or speculations, but whether by their nature they fall within the scope of the business that CPC was formed to undertake” [33]. The Court of Appeal found that the transactions did fall within that scope [40] and that it was unnecessary for the purposes of the appeal to decide whether CPC had capacity to indulge in purely speculative transactions unrelated to any immediate commercial pressures [37].
By contrast, in Venezia the Italian legal background to interest rate swaps and other derivatives is very extensive. Foxton J takes nearly 50 pages of his judgment to cover it all. Importantly however the Italian legal background also involved an assessment of whether the transactions were speculative. Whether the transactions were speculative was part and parcel of the Italian law analysis. The court had to engage in the argument.
There is another important factual difference between the two cases. In CPC, the relevant transactions were not restructuring earlier transactions. However, in Venezia, the relevant transactions did restructure an existing swap with a negative mark to market valuation. The local authority did not deal with its exposure to its original banking counterparty by making a payment to it to close out that initial transaction. Rather, in a second transaction with a different bank, the new bank made the payment necessary to close out the initial swap and recovered the cost of doing so through the terms of the new swap. This was an important factor in determining that the transactions were speculative. The desire to cover the winding up costs of the initial swap meant that the transactions were dealing with the liabilities of a past adverse event and involved the local authority taking on a significant new risk to which it had not been previously exposed.
Notwithstanding the Court of Appeal’s decision in CPC, the distinction between hedging and speculation can have a role to play in challenges to derivative transactions.
Toby Gibson