Lessons of the Swaps Litigation

Peter Birks, Francis Rose, Peter Birks, Francis Rose

• Publisher: Informa Law from Routledge
• Year: 2020
• ISBN:
  9781000285864
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

This is the first comprehensive review of the extent of remedies and impact of contractual agreements on restitution claims for void, unenforceable, and discharged contracts.

1

Private Law

PETER BIRKS*

Interests swaps are contracts. The money market has developed many varieties. The core concept is not difficult to understand. Indeed every house-buyer these days is familiar with the underlying idea, since few will not have had to choose between a fixed and a floating rate of interest. When two parties engage in an interest swap, one promises to pay the other a fixed rate of interest on a notional capital sum, say 5% on $5 million, for a fixed period, say five years. The counter-party promises to pay a floating rate on the same sum for the same period, the rate being determined by an agreed formula. If interest rates rise, the fixed rate payer will win. For the floating payer will have to match those rising rates. If they fall, the fixed rate payer will lay out more than comes in.

I. BACKGROUND

It is more than a decade now since litigation began to probe the consequences of the fact that during the 1980s the local authorities of the United Kingdom became very heavily involved in interest swaps. There were no doubt mixed motives for this incursion into novel financial waters. In different city halls there will have been different emphases on money management and sheer speculation. The element of money management was never wholly absent. It had a political slant, and one which may have helped to precipitate the ultimate disaster. This aspect of the story is most evident in cases in which the bank which was the local authority’s counter-party agreed to pay £2 million or more up front. Multiple front-loaded swaps of this kind, sometimes called deeply discounted swaps, could greatly improve a local authority’s immediate liquidity. They thus tended to subvert the central government’s policy of getting control of public expenditure, a policy to which the capping of public authority funding was essential. This subversion, a cause in itself for anxiety on the part of those promoting the central government’s policy, was aggravated and inflamed by the grave danger of its being achieved at a high cost to the local authority, and indirectly to the central government itself, in later years. For if interest rates moved against the local councils their liabilities could ultimately be enormous, and the pressure on the central government to bail them out would then be considerable.

* QC, DCL, LLD, FBA, Regius Professor of Civil Law, University of Oxford and Fellow of All Souls College, Oxford.

Local authorities have well-resourced legal departments, and some must have taken counsel’s opinion as to their powers. The general view evidently was that the power to enter into interest swaps could be inferred from the authorities’ powers to borrow, invest, and in other ways to manage their money. In 1988 the Audit Commission took opinions from learned counsel which, though not all of one accord in regard to money-managing swaps, were unanimous in advising that speculative swap contracts were ultra vires and void. In subsequent litigation by the District Auditor against Hammersmith and Fulham LBC the Court of Appeal took the view that money-management swaps were not ultra vires, though speculative swaps were. However, the time-bomb of universal nullity finally blew up when Hazell v Hammersmith and Fulham LBO proceeded to the Lords. The House of Lords took the extreme view. It held that all interest swaps were beyond the powers of all local authorities. These contracts were all ultra vires, without distinction between those which had been entered with serious money-managing intent and those which were purely speculative.

The leading cases which have explored the consequence of nullity have come up with a starkly simple conclusion. The money has to be given back. More accurately, the party which had won or was winning has to make restitution of the amount by which its receipts exceeded its payments out, with simple interest. It makes no difference whether the swap was already closed or had to be interrupted. The ingenuity of the legal profession was not slow in proposing defences which might limit or reduce the amount of restitution. These ideas have all proved failures. With the exception of a few payments caught by the period of limitation,² the losing party’s right to restitution has proved to be invulnerable. Up and down the country, in Scotland as well as in England, Wales and Northern Ireland, this has entailed huge financial disruption.

There are many angles on this story. Mr Bamforth in the next chapter considers its implications for public law, and Mr Hudson in the one after explores the structures within which the trade in derivatives, and interest swaps in particular, ought to be understood. But this book could not but be primarily concerned with the implications of the swaps litigation for private law. What has it told us about void contracts? What precisely are the grounds for the restitutution which has been ordered in every single case? What have we learned from their impotence in all these cases about the defences to restitutionary claims? The swaps saga has been a test-bed for the rapidly maturing law relating to the restitution of unjust enrichment. But the chapters of this book show, unsurprisingly, that they have not eliminated all controversy.

¹ [1992] 2 ac 1 (hl).

² Even these were cut off before it was appreciated that all this restitution could be characterised as relief from mistake, with the consequence that time did not begin to run until the mistake could reasonably be discovered: see infra, text from n 99.

The grand title of this chapter should not mislead. Its function is introductory. Most of the questions which arise are questions of private law. They are dealt with in detail in the chapters which follow. The purpose of this introduction is partly to fill in one or two gaps which fall between those more specialised treatments but chiefly to make the whole book more useful to readers by providing a map of the main private law issues to which to recur if the later detail threatens to fragment the whole picture. Some readers will think that the map needs adjusting and correcting. It may well do so. However, so long as one never forgets that it may be imperfect, even a map which leaves room for improvement is better than none at all.

Gaming and wagering

One distracting element in the story can conveniently be eliminated at the outset. Since these swaps have the look of being bets on the movement of interest rates, are they not void anyhow as wagering contracts? The short answer is that, even supposing that they are wagers, nevertheless when entered into by at least one party “by way of business” they are expressly validated by the Financial Services Act 1986, s 63. The massive restitution under the void swaps nonetheless stands in tantalising contrast with the rule that money lost in a wager cannot be recovered back despite the nullity of the wagering contract.³

In Morgan Grenfell v Welwyn Hatfield DC⁴ Hobhouse J found himself faced with an argument, by way of a defence, that the ultra vires swap in question had indeed been a wager and one which was outside section 63 because not entered “by way of business”. From these premises it was supposed to follow that money received under it was irrecoverable. Hobhouse J did not accept the premises. In particular he deftly denied that swaps were wagers. They would not be wagers unless in a particular case it could be shown that the swap had been entered in pursuit of no other interest than purely speculative profit. Since he regarded the conclusion that a swap had been so motivated as very unlikely to be reached in any case, he did not think it necessary to venture an opinion as to whether the irrecoverability of wagers would trump the otherwise automatic recoverability of payment made under an ultra vires contract.⁵

³ At common law wagers were not void except in cases in which they could be said to be illegal. Sir Guenter Treitel attributes the irrecoverability to either the validity or the illegality of the contract: The Law of Contract, 9th ed (London, 1995), 476. He also points out, ibid, that the words of section 1 of the Gaming Act 1845 probably do not directly account for the irrecoverability of a bet which has once been paid. In Moses v Macferlan (1760) 2 Burr 1005 Lord Mansfield seems to have thought that where money was fairly lost at play the reason why it could not be recovered was that, even where there was no civil obligation, there was still a natural obligation to pay it, as in the case of a debt paid after the period of limitation.

⁴ [1995] 1 AUER 1.

Closed and interrupted swaps

It is convenient to keep constantly in mind the difference between an interrupted and a closed swap. After the chosen period of time has expired, in our example five years, and both parties have received all that their contract entitled them to receive, the contract, having been fully executed, is a closed swap. There are ways of deliberately closing a swap before its period has run, but we shall not be concerned with that kind of closure. For our purposes, a closed swap is one which has run its full term. If the parties have simply stopped making payments in mid-term, the swap is open but interrupted. This book is preponderantly concerned with interest swaps which turned out to be nullities ab initio.⁶ When their nullity was discovered, some of these void swaps had already been completed. The period had run, and the game had been played out to the end. Both parties had received exactly what they had bargained for, albeit their bargain had all along been void. Those are the “closed swaps” of this book. Others were still in progress, with time still to run. They were still open, but no further payments were made. Hence these open swaps were, in contrast to the closed swaps, interrupted.

II. A TAXONOMY AND TEN QUESTIONS

Unless chaos is to ensue, the private law problems arising from the void swaps have to be considered within an explicit and stable taxonomy. Private rights – the rights which are the concern of private law – arise from the consent of some grantor or by operation of law, independently of such consent. Where they arise independently of consent they arise from wrongs, from unjust enrichments, or from miscellaneous other events. In this taxonomy of causative events, the issues with which we are concerned all belong in the category of unjust enrichment. The parties to an interest swap intend to make a contract. Rights arising from contract belong in the first category, because a contract is one species of manifestation of consent. But when the contract which they intend to make turns out to be void, but money has nonetheless been paid under it, such restitutionary rights as the law may recognise cannot be said to arise from contract. Those rights, whatever they are, arise by operation of law independently of consent.

⁵ Ibid, 14–15.

⁶ The notable exception, discussed by Hubert Picarda in chapter 7, is Bankers Trust International Plc v PT Dharmala Sakti Sejahtera [1996] CLC 518.

It is necessary to pause at that point to emphasise that the words “arise from” are to be taken seriously. These restitutionary rights cannot be said to “arise from” contract. In a classification by ca...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Preface
• Table of Contents
• List of Contributors
• Table of Cases
• Table of Statutes
• 1. Private Law
• 2. Public Law
• 3. The Law of Finance
• 4. The Reason for Restitution
• 5. Incapacity
• 6. Restitution after Executed Void Contracts
• 7. Contract and Tort
• 8. Tracing
• 9. Property
• 10. Change of Position
• 11. Interest
• 12. Conflict of Laws
• 13. Lapse of Time: Limitation
• Bibliography
• Index