Posted on: 13/05/22



    The Court of Turin disapply and redraw the principles set out by the Joint Divisions on the subject of derivatives.


    With ruling no. 673/2022, the Court of Turin acknowledges certain concepts known to operators in the field of derivatives and misinterpreted for so long by case law, which have allowed and still allow a sectarian use of actions for damages brought by investors who are simply unhappy with their investments.


    In the case in question, the plaintiff company entered into an interest rate swap (IRS) with effective date March 31, 2011, to hedge the interest rate risk on a ten-year loan. The company complained, among other things, of the existence of a contractual risk that originally was in favour of the credit institution, the circumstance that the debt was only partially correlated to the swap and that the most efficient solution would have been a cap option. Such option would have hedged the company against the risk of a rising interest rate against the payment of an initial premium, giving the company the right to collect the difference if positive between the benchmark and a predetermined level of the interest rate (so-called strike). Moreover, the company deduced that it should have been paid the cost of the transaction by the bank as an upfront payment in order to rebalance the contractual payments.


    The Turin Judge fully rejected the plaintiff’s requests, brilliantly separating certain concepts regarding derivatives, summarized below.


    – Hedging purpose: the Judge reiterates that this purpose is fulfilled when there is a high correlation between the technical and financial characteristics of the hedged item and the swap. Full hedging of the risk for the entire capital or for the entire duration of the underlying transaction is not necessary, according to a clear analysis of the Consob resolutions and the accounting standards on the subject.


     The swap par does not exist: the Court of Turin acknowledges that, once the possibility of accruing positive differentials for contractual parties has been assessed (in concrete terms, at inception), “it is normal that the IRS contract expresses an initial negative value, due to ‘setting of’ parameters and the hedging costs and intermediary’s margin embedded in the contractual structure”. The bank is not obliged to pay the client the initial negative MtM (mark to market, e. the market value of the derivative at a certain date, which is the result of estimates expected from future payments that the parties will exchange) generated by the presence of the implicit costs.


    – Mark to market: the Court of Turin clearly affirms (correctly, in the author’s opinion) that the Supreme Court’s rulings on MtM are “poorly controlled“. By ruling no. 8770/2020, the Supreme Court considers that the MtM expresses the “measure of risk” and that therefore it must be the subject of the agreement between the parties. In the absence of an agreement on the contractual risk, the contract would be null and void. The Court of Turin correctly observes that the extent of the risk is not external to the economic conditions of a swap contract (notional amount, rate, spread, any options and so on), but inherent in them since “there is always agreement on these economic conditions. The Court of Turin correctly pointed out that the failure to communicate the MtM represents a violation of the standards of correctness and transparency pursuant to art. 21 of the Consolidated Finance Act, but it is not a reason of nullity of the contract, as sustained by the Joint Divisions.


    – Pricing method: the most recent case law elaboration of the Supreme Court (ruling no. 21830/2021) requires that the client is about the “mathematical formula” on the basis of which the parties calculate the present value of future payments under the contracts. The Turin Judge notes that understanding the mathematical models for calculating the MtM requires advanced knowledge and that Consob regulations do not provide for the communication of the pricing model that is difficult for a non-professional operator to understand. In the case of a plain-vanilla IRS derivative (in other words, a simple derivative that provides for the exchange of one rate against another rate), the results of the calculation are convergent and similar despite the different calculation methods. The court-appointed expert in the case in question, when questioned on this point, stated that the MtM of a plain vanilla IRS can be determined using a method that is commonly and universally used (so-called discounted cash flow) and that the correctness of the calculation can be verified by any institution that has a Bloomberg or Reuters (or other minor) platform, or that in any case, has the necessary historical data for the calculation. The above-mentioned principle set out by the Supreme Court should, therefore, only be applied in the case of non-plain vanilla derivatives that have options or other exotic components, for which it is not possible to use market quotations.


    – Probabilistic scenarios: the “probability” of gain/loss, depending on the occurrence of events that are favorable or adverse to the client, may be the subject of findings and yield simulations, which the intermediary is professionally equipped to elaborate, but no intermediary is able to guarantee that the fluctuation of the parameters will remain within the represented risk range. The fluctuation dynamics of these parameters (in particular, of interest rates) are outside the sphere of the intermediaries’ control, in the absence of a crystal ball. For example, a derivative concluded to hedge the rise in interest rates in March 2011 ignores the fact that in the following winter there will be a sovereign debt crisis in Europe, including that of Italy, and that, in the summer of 2012, the European Central Bank will decide to defend the Euro “whatever it takes“, injecting liquidity on the market with massive purchases of government bonds, which will keep the Euribor close to zero, pushing it until it is in negative territory. Once again, this concerns information that is uncertain and not contractual agreements.


    The Consob regulations recommended the communication of the “analysis of yield scenarios” which should be included in the information provided to the client and not in the contractual object. In the specific case, the Judge held that such information had been provided to the client.


    Finally, the Court, on the basis of the considerations made by the court-appointed expert, in the case in question, ruled out that an interest rate cap was advisable; moreover, this choice had been presented to the client who had preferred to take out the swap.


    In conclusion, the ruling in question has the merit of highlighting some errors which the Supreme Court’s  case law has committed in the most recent decisions: in the author’s opinion, the informative elements of the derivative contracts cannot have, and it is not correct that they have, repercussions on the origin of the contract, and therefore cannot generate the annulment of the derivative contract.


    However, according to the Turin Judge, the inexact fulfilment of the informative obligations by the intermediary, gives the client the right to refuse the proposed or recommended financial instrument, and to refuse the legal consequences (pursuant to art. 1711 Civil Code, even if referred to the mandate) and therefore to bring an action aimed at ascertaining the contract ineffectiveness and the restitution of the net differentials, in addition to any compensation for damages.






    DISCLAIMER: This newsletter merely provides general information and does not constitute legal advice of any kind from Macchi di Cellere Gangemi. The newsletter does not replace individual legal consultation. Macchi di Cellere Gangemi assumes no liability whatsoever for the content and correctness of the newsletter.





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