The Venezia Appeal
On 8 November 2022, we reported on the first instance decision of Foxton J in Banca Intesa SanPaolo v Comune di Venezia. The Court of Appeal has now reversed that decision ([2023] EWCA Civ 1482). This article will respectfully suggest that the Court of Appeal reached the wrong decision because it misunderstood the Transactions.
The relevant background is:
- On 20 December 2002, Venice entered into an interest rate swap with Bear Stearns in connection with its obligations to pay interest under the so-called Rialto Bond.
- 5 years later, Venice was seriously out of the money under the Bear Stearns IRS; its negative MTM was E7.5M. Bear Stearns was also entitled to charge early termination fees.
- On 21 December 2007, Venice entered into the Transactions with different Banks (Banca Intesa and Dexia).
- Under the Transactions:
- in return for the Banks paying roughly E8m (the negative MTM plus fees) to Bear Stearns, the notional amount of the Bear Stearns IRS was reduced to zero; and
- under new IRSs, Venice agreed to pay new interest rates.
- Foxton J based his decision on one key commercial premise (“the heart of the matter” [224]): the terms of the Transactions had been structured so as to cover amounts which the Banks had to pay to Bear Stearns to close out the Bear Stearns IRS.
The Banks made 6 points on the Transactions [71]. The Court of Appeal was, it is submitted, wrong to accept any of them:
- “In legal and commercial terms, Venice did not borrow any money under the [Transactions] but the Banks paid the novation fees to Bear Stearns as the price of stepping into its shoes.” The Banks therefore accepted that they paid E8m to Bear Stearns to step into its shoes. Why pay that price or make that investment? So that they had the chance to recover the novation fees and more from Venice. Commercially, that is akin to lending. It does not matter that legally there was no loan, what matters is that commercially the Transactions were structured not to manage Venice’s risk under the Rialto Bond, but instead to manage its risk arising from the negative MTM of the Bear Stearns IRS.
- “The pricing of the Transactions by reference to the negative MTM under the Bear Stearns Swap did not bring into being any new risk for Venice but matched the risk it was already exposed to.” This is just flat out wrong. The Bank’s point 4 below acknowledges that.
- “Whilst it was true that if rates moved in the future, Venice’s contingent liability might go up or down, that did not make the Transactions speculative, since that is true of every swap.” Of course every IRS counterparty has a contingent liability depending on interest rate movements, but what made the Transactions speculative was the very strong likelihood that Venice would pay out under the Transactions. The Banks did not challenge the evidence of Venice’s expert that the probability of a negative payoff for Venice under the Transactions was between 77.1 and 78.7% [226(iii)].
- “The negative MTM under the Bear Stearns Swap meant that the Transactions were less advantageous than if Venice had started with a clean slate, but it did not start with a clean slate because it was already exposed to paying the floor rate under the Back Stearns Swap and could not wish away that risk.” It is right that Venice was not starting with a clean slate. The Transactions were structured to deal with its exposure to Bear Stearns (its dirty slate), but the commercial result was that Venice was almost certain to significantly increase that exposure. Venice speculated that interest movements would produce a miracle rescue.
- “It is instructive to consider what would have happened if Bear Stearns had agreed to restructure its swap. It would have said we will restructure the swap and match the Rialto Bond maturity date of 2037 and rollover the MTM, so precisely what happened would have happened, but that would not make it speculative or borrowing.” It is commercially inconceivable that Bear Stearns would have ignored the negative MTM in any re-negotiation (as recognised in point 6). If Bear Stearns had been prepared to re-structure, it would have been on similar terms to the Banks and the re-structure would therefore have shared the speculative characteristics of the Transactions.
- “Any change to the swap would require the negative MTM to be addressed in some way, because no sensible commercial counterparty is simply going to give up that which is in its favour.” This point recognises the commercial reality that Venice was seriously out of the money on the Bear Stearns IRS and that Venice could not magic that away. Neither Bear Stearns nor any other bank would let that happen. Because Venice would or could not pay its debt to Bear Stearns in the short term, it speculated on a highly unlikely long term solution. By doing so, it assumed a new risk to which it was not previously exposed.
The springboard for the Banks’ arguments on appeal was the proposition that the Bear Stearns IRS was not speculative. At first instance, Venice challenged the validity of the Bear Stearns IRS (for want of proper approval) and Foxton J rejected that challenge. However, the fact that the Bear Stearns IRS was validly authorised does not mean that it was automatically a hedging transaction. As there was no determination on whether the Bear Stearns IRS was hedging or speculation, it is surprising that the Court of Appeal found that issue to be res judicata [8]. Nevertheless, even if the Bear Stearns IRS was a hedge, the Transactions were not for the reasons set out above.
Gibson & Co.
19 January 2024