Local authority borrowing and hedging

Local government in the United Kingdom is devolved to various different types of political subdivisions, but these were generally collectively referred to as "local authorities" in the litigation. These local authorities raise money through local taxation (at the time of the swaps litigation this was rates; it has subsequently been replaced by council tax). Local authorities also have limited powers to borrow money in order to fund capital projects and defray the cost over future years. These powers to borrow are carefully circumscribed in the Local Government Act 1972.

In the early 1980s a number of local authorities began to use interest rate swaps in order to hedge their exposure to interest rate fluctuations in relation to their borrowing. Interest rate swaps were still a relatively new commercial innovation at the time. Following the volatility of global interest rates in the 1970s, interest rate swaps became an increasingly popular way for borrowers to manage the risk of future volatility affecting their payment obligations. Although most of the subsequent reporting focused upon a few local authorities who were less circumspect, it appears that in the majority of cases local authorities used interest rate swaps in a prudent and measured manner as part of their financial management function.^[8]

The position of Hammersmith and Fulham LBC

The position of Hammersmith and Fulham London Borough Council was quite different from most of the other local authorities. From about 1985 onwards Hammersmith had entered into interest rate swap transactions on an extremely large scale. At one stage it was calculated that Hammersmith was a counterparty to 0.5% of the global trade in swaps, and 10% of the sterling denominated trade.^[9] Moreover, quite exceptionally, all of Hammersmith's positions in the swap market were betting on a fall in interest rates. Most large participants in the swap market have their exposure balanced by taking positions on both sides and across multiple currencies, but Hammersmith was essentially repeatedly entering into one-way bets that sterling interest rates would fall; a bet that they would end up losing spectacularly when interest rates climbed from around 8 per cent to 15 per cent in the space of ten months.^[10]

From subsequent reports of events, it is not at all clear that Hammersmith had any real idea what they were doing. Each time they entered into an interest rate swap they would receive a premium. They would then treat this as additional funding which they could spend on providing services. Any liabilities payable under the swaps (including the eventual repayment of the premium) would only arise at a later date.

The problem coming to light

Responsibility for monitoring the finances of the local authorities comes under the various district auditors, who are appointed by, but do not actually report to, the Audit Commission (and the Audit Commission in turn worked in partnership with, but operated independently of, a number of central government departments). Although during the 1980s the Audit Commission had become increasingly concerned about the use of financial derivatives, it had never taken any steps to prevent this other than simply advocating that local authorities use caution.^[11] But in June 1988 they would discover not all local authorities had heeded that advice. At that time a new team member had recently relocated to London swaps desk of Goldman Sachs, and almost immediately she noticed that (a) Hammersmith Council had entered into an absolutely massive number of swaps with the bank, and (b) that all of them were entered on the same side, i.e. betting that interest rates would fall.^[12] She telephoned the Audit Commission's office and explained her concerns. The Audit Commission then telephoned the council's district auditor, Mr Tony Hazell at Deloitte, who asserted that he had no idea about any significant swaps exposure on the part of the local authority. The Audit Commission then telephoned the council's chief executive, who confirmed that the council had been entering into swaps, but did not think that it had any significant exposure. The chief executive reportedly then stated: "I really wouldn't worry about this ... everybody knows that interest rates are going to fall."^[13] Upon hearing this, which the Audit Commission took for confirmation that Hammersmith's exposure was in fact entirely unhedged, teams from both the Audit Commission and the district auditor were sent in to investigate.

Although it would take months to fully understand the position, it soon became apparent that Hammersmith had been entering into swaps and other transactions recklessly on a massive scale simply to collect the premiums (although those premiums would all be repayable over the life of – or at the end of – the swap). The situation was bad enough when the Audit Commission and the district auditor began to examine it, but it would get worse. Despite the council initially promising to suspend entering into new transactions, they would later backtrack on that, and state that they "would not preclude further selective trades as 'the most prudent response to the present uncertain position'"^[14] They then started to embark on ever more frantic trading in derivatives – at a rate of more than one per business day – trying to trade out of trouble. According to the judgment later delivered by the House of Lords, by the time the curtain came down even though the total borrowings of Hammersmith were in the order of £390 million, it had entered into swap transactions with a total aggregate notional principal of over £6 billion.^[15]

Moreover, it was not clear that the executive of the council ever knew what their finance department was doing, or that the finance department which was entering into the trades truly understood the nature of the transactions they were entering into.^[14] Hammersmith Council started entering derivatives in 1983 (although the significant exposures did not start until 1985), but it was not until several years later before they even approached their own internal legal team, and they never sought any external advice until the very end. The Audit Commission's in-house lawyer, Tony Child, expressed the view that the finance officers simply never really understood what it was that they were doing.^[14] In his review of the crisis, Duncan Campbell Smith remarked that the ineptitude of Hammersmith Council as a whole seemed staggering:

Over the following six months, Hammersmith compounded the managerial ineptitude that had already brought it to the brink of disaster. As an illustration of just how badly a local authority could be run, it might almost have been designed to accompany the first two of the Commission's Management Papers. Neither the leader of the council nor any of its elected members had any idea what was happening in their finance department.^[14]

The Audit Commission also worked to find out how many other local authorities – other than Hammersmith – had an exposure. It transpired that a total of 137 did.^[16] However, it appeared that for the most part their swaps transaction was measured and commensurate with respect to their borrowing.

Divisional court

The case was heard by two judges at first instance in the divisional court, Lord Justice Woolf and Mr Justice French. In those proceedings the banks conceded that speculative swaps were unlawful, but urged the court that swaps entered into to hedge against exposure arising from borrowing should be a lawful extension of the power of local authorities to borrow. The court delivered its judgment on 1 November 1989, and held that all of the swap transactions were ultra vires and beyond the powers of the local authorities.^[19] It was noted that "the decision had the bizarre effect of 'benefiting the chief culprit' (Hammersmith), while hurting the more prudent local authorities."^[20]

Court of Appeal

The case was appealed, and came before Sir Stephen Brown, Lord Justice Nicholls and Lord Justice Bingham who handed down their decision on 22 February 1990.^[21] The Court of Appeal broadly divided up the transactions entered into by the local authorities into three different types:

1. Purely speculative swaps, which it held were void;
2. Swaps which were part of managing the local authorities' interest rate exposure under their borrowing, which it held were valid; and
3. Swaps which were entered into by local authorities once it became apparent that earlier swaps might be void to mitigate the damage caused by those void swaps (called the "interim strategy"), which it held were also valid.^[22]

The decision of the Court of Appeal was received with relief in the City of London. A column in the Financial Times noted "overseas financial institutions can feel more confident that City deals will not be sabotaged by arcane UK laws. The integrity of the markets has been preserved, without allowing the banks to escape the consequences of their foolishness in over-trading with Hammersmith and Fulham."^[23]

House of Lords

The case was then appealed to the House of Lords. The main judgment was given by Lord Templeman, with whom all judges agreed. Having almost immediately stated that all swaps were, in his view, conceptually the same as the speculative types of swap which the banks had admitted in argument were unlawful, Lord Templeman then explored the limits of the powers of local authorities under the Local Government Act 1972. Having considered various cases, Lord Templeman noted that, despite its title, debt management is not in itself a function. He also noted that in the case of building societies Parliament has expressly conferred upon them a power to enter into swap transactions,^[24] but no similar steps had been taken in relation to local authorities. He finally concluded:

In the result, I am of the opinion that a local authority has no power to enter into a swap transaction.^[25]

Reaction

The banks were reported to be "furious" and referred to the decision as "incomprehensible".^[26] The written evidence later submitted by the Bank of England to the Treasury and Civil Service Committee about the affair noted (at paragraph 3.4) that it "has caused considerable damage to the reputation of the City of London among counterparties who entered into swap transactions with local authorities in good faith during the period."^[8] Most local authorities had mixed views; although many were exculpated from potential liabilities, they also faced the prospect of long and expensive litigation unwinding the swaps. Furthermore, they were now shut out of the swaps market completely, regardless how prudent they had been. The Audit Commission mostly felt relief and vindication. The council members at Hammersmith and Fulham were unsure how to react; they wanted to take credit for striking a blow against financial capitalism, but this was at odds with the evidence that they had been oblivious to what their finance department had been doing.^[26]

The banks made a brief but concerted effort to have retrospective legislation passed validating the swaps, but were "robustly" rebuffed by the Chancellor of the Exchequer, Norman Lamont.^[27] The government was reported to have a sense of frustration that despite trying to close loopholes in relation to financing of local authorities, the banks had kept working around them and had subsequently received their comeuppance.^[27]

Westdeutsche Landesbank Girozentrale v Islington LBC

The Westdeutsche case^[39] is probably the best known, and arguably the most important, of all the swaps cases.^[40] Ironically, the matters under dispute in the case give the appearance of being somewhat trivial. By this stage of the swaps litigation, there was general acceptance that the local authorities needed to repay the sums that they had received under the swap contracts with interest. Technically, in Westdeutsche the courts had to decide whether the interest was to be calculated as compound interest or simple interest. The reason that such a small matter relating to such small sums reached the highest court in the land is that answer to that question lay in the fundamental nature of resulting trusts in English law. If the banks only had a common law right to repayment of the money, they could only claim simple interest. But if they could trace the money in equity, then they could recover compound interest. In determining whether the right to equitable tracing arose when a party received money mistakenly and unaware of the mistake, the House of Lords exhaustively reviewed and considered the existing law, before finally determining (by a bare majority) that the bank had no proprietary interest in the money and was not entitled to claim compound interest. But the importance of the case is reflected in the legal rationale rather than the sums at stake or the actual outcome.

Kleinwort Benson v Glasgow CC (No 2)

The swaps entered into between Kleinwort Benson and Glasgow City Council led to two separate case reports, of which the second was the more significant, and was appealed all the way to the House of Lords.^[41] Glasgow City Council argued that the English courts had no jurisdiction over it, and the bank's claim should be brought in the Scottish courts (because of differences in the limitation periods under English law and Scottish law, Scotland was likely to be much more favourable to the local authority). Jurisdiction between the constituent parts of the United Kingdom is regulated by the Civil Jurisdiction and Judgments Act 1982, which effectively incorporates the provisions of the Brussels Convention on Jurisdiction and Judgments of 1968 into domestic jurisdictional issues as well as international ones. That Convention provides that the defendant should normally be sued in their domicile (i.e., in the case of Glasgow City Council, in Scotland) but it created exceptions for particular types of claim related to contract and tort. Accordingly, the courts had to decide whether claims for restitution or unjust enrichment could be treated as either contractual or tortious. The House of Lords held that they were neither, and accordingly, there being no relevant exception, the bank would need to bring its claims in Scotland.^[42]

Kleinwort Benson Ltd v Lincoln CC

The decision which is reported under the name Kleinwort Benson Ltd v Lincoln CC^[35] actually represents four co-joined appeals. It originally represented five (Kleinwort Benson Ltd v Glasgow CC was also included as a fifth co-joined appeal until it was stayed on jurisdictional grounds). The House of Lords unanimously held that the old rule that a mistake of law did not give rise to a right of recovery should no longer be applied. However, the five Law Lords then disagreed as to what the effect should be where the understanding of the law is changed by judicial pronouncement. When judges express an opinion on the common law, as noted by Lord Browne-Wilkinson, "The theoretical position has been that judges do not make or change law: they discover and declare the law which is throughout the same. According to this theory, when an earlier decision is overruled the law is not changed: its true nature is disclosed, having existed in that form all along." He then added: "This theoretical position is, as Lord Reid said, a fairy tale in which no-one any longer believes. In truth, judges make and change the law."^[43] Accordingly, in the view of Lord Browne-Wilkinson "although the decision in Hazell is retrospective in its effect, retrospection cannot falsify history: if at the date of each payment it was settled law that local authorities had capacity to enter into swap contracts, Kleinworts were not labouring under any mistake of law at that date. The subsequent decision in Hazell could not create a mistake where no mistake existed at the time."

However the majority, led Lord Goff disagreed. After a long and carefully reasoned judgment, Lord Goff summarised the position of the majority: "There is no principle of English law that payments made under a settled understanding of the law which is subsequently departed from by judicial decision shall not be recoverable in restitution on the ground of mistake of law. ... It is no defence to a claim in English law for restitution of money paid or property transferred under a mistake of law that the defendant honestly believed, when he learnt of the payment or transfer, that he was entitled to retain the money or property."

Kleinwort Benson Ltd v Birmingham CC

In Kleinwort Benson Ltd v Birmingham CC^[44] the Court of Appeal was required to consider whether a defence of "passing on" existed under English law. Such a defence had been suggested by academics, and the counsel for the respondent local authority argued that because the bank had entered into back-to-back swaps, any loss arising under the swaps with the local authority had been passed on under other contractual arrangements. The Court of Appeal rejected that such a defence existed.

Kleinwort Benson v South Tyneside MBC

Kleinwort Benson v South Tyneside MBC^[45] was a first instance decision of Mr Justice Hobhouse (who would hear a number of the swaps cases). The court made a number of important holdings, mostly relating to the effect of limitation periods under English law. The court held that (1) for the purposes of limitation each contract had to be looked at separately, rather than simply looking at the bank's net claim; (2) payments by the local authority under the swaps did not amount to an "acknowledgement of indebtedness" for the purposes of the Limitation Act 1980; (3) the fact that banks had entered into back-to-back swaps was irrelevant in relation to liability under these swaps (the decision in Kleinwort Benson v South Tyneside MBC was handed down prior to the Court of Appeal decision in Kleinwort Benson Ltd v Birmingham CC); and (4) as the claim was at common law only simple interest could be recovered. An appeal against the decision was stayed pending the outcome of the decision in Westdeutsche.

Morgan Grenfell & Co Ltd v Welwyn Hatfield DC

The Welwyn Hatfield DC case^[46] was a test case to determine certain preliminary issues relating to the swaps.

1. Firstly, whether the swaps should be characterised as wagering contracts within section 18 of the Gaming Act 1845 or section 1 of the Gaming Act 1892.^[47]
2. Secondly, whether section 63^[48] and paragraph 12 of schedule 1 to the Financial Services Act 1986^[49] affected that conclusion.
3. Thirdly, whether any right to restitution arose if the contracts were held to be wagering contracts.

Mr Justice Hobhouse gave the judgment of the Court. He held that, whilst an interest rate swap contract had (at least potentially) a speculative character, where the interest rate swaps entered into by parties or institutions involved in the capital markets and/or the making and receiving of loans, the normal inference was that such contracts were not wagering or gaming. That inference would only be rebutted if the purpose and interest of both parties to the transaction was to wager, in which case the contracts would be legally invalid and unenforceable.^[50] He further held that in any event the transactions would have been validated by section 63 of the Financial Services Act 1986. Having made those findings, he declined to answer the third issue as irrelevant.

There was no appeal from his decision.

Baring Bros & Co v Cunninghame DC

Baring Bros & Co v Cunninghame DC^[51] was a decision of the Scottish Court of Session, which held that where a swaps contract was void ab initio, that also voided the governing law clause within the contract. Accordingly, the principles upon which restitution was to be repaid were not dictated by the putative governing law clause in the agreement but by the law with which the matter had its closest connection.^[52] Thus, the law to determine the quantum of the remedy would be determined by Scots law, as the law of the forum.