The Validity of Derivatives Contracts. Legal Doctrine as a Vehicle of Dialogues Over ‘Speculation’

Derivatives contracts elicit strong reactions. At first glance, this should be surprising. They are unquestionably essential for financial markets. They are amply supported by academic thinking, policy, and market documentation. They can be complex, ‘boring’, and not a topic to stir passions. And yet, cases where bank counterparties allege that derivatives contracts are void, or have something seriously wrong about them, are a feature before courts across European countries. Cases are sufficiently widespread, recurring, and important to ask a basic question: why? Or what inspires them?

In a recent paper I suggest that, despite their variations, the cases illustrate a broader theme: the ongoing social and legal dialogue about ‘speculation’. To some, this should be a thing of the past. Throughout the late XIXth and early XXth century academic analysis took pains to explain why derivatives and ‘speculation’ are socially useful. Yet, support for derivatives, rather than a simple idea, is a concatenation of related ideas: that speculators are not ‘gamblers’, that speculation is key to transition from ‘uncertainty’ to ‘risk’, and that speaking about ‘the speculator’, or discussing its role in terms of individual morality, rather than of its aggregate effects, is misleading, fruitless, or both. Each of these ideas is widely accepted academically, but less so at a social level, and crises or scandals can easily shift the consensus, threatening derivatives’ role in the financial and legal system. Restoring that role, while listening to legitimate concerns requires societal, and not just technical, dialogue.

The second message is that courts can play a meaningful ‘rebalancing’ role in this dialogue. Although the academic and policy consensus prioritises the ‘centralising’ role of market infrastructures, such as central counterparties (CCPs) and financial supervisors, courts have unique, often underappreciated, features. On one hand, their role in applying the law is not mechanistic or uncritical. It often requires applying principles which inevitably require reflecting about law’s mores in light of individual circumstances. On the other hand, court decisions have to be consistent with past practice, and follow acceptable canons of legal construction (‘rule of recognition’). Thus, courts can listen to societal concerns, but also discriminate between those that can be accommodated in the law, and those that cannot. If they get it right, courts can use this ‘reflective equilibrium’ to make the debate more mature, anchor derivatives more firmly in the law, and shed light on legitimate concerns that arise in individual cases, but may get lost in discussions over derivatives’ aggregate effects.

Of course, and this is the third message, courts do not ‘always get it right’. The doctrinal basis chosen to decide cases is crucial. If the doctrinal choice is too rigid, courts may ‘take the leap’, resulting in drastic changes that increase uncertainty (‘non-linearities’) threatening the validity of vast swathes of the market, or they may refuse to take it, which avoids an outcome that is too radical or uncertain, but also fails to defuse the tension. However, if the doctrinal basis is both elastic enough to accommodate new concerns without drastic changes, and structured enough to result in predictable results, courts can pilot a doctrinal shift, which may help the market adjust (willingly or grudgingly), while keeping legal support for derivatives strong overall.

The longer part of the paper illustrates how courts of different jurisdictions have coped with this role, with lights and shadows. An example of a ‘non-linearity’, or drastic change was the English courts’ use of doctrines of ‘capacity’ in Hazell and other municipalities cases, sending shockwaves through the system. Confronted with similarly radical claims, German courts rejected using doctrines of ‘capacity’, ‘illegality’ or ‘immorality’ to invalidate derivatives with ‘speculative’ elements, notably in cases with municipalities. Portuguese courts, for their part, toyed with the doctrine of ‘causa’ as a mechanism to control the contract’s ‘social function’ in certain types of speculative derivatives, although, being unable to fashion a predictable test, did not eventually make the doctrinal shift.

The emerging alternative to the more drastic options is illustrated by German, Spanish or Italian courts’ development of ‘advisory’ duties to find that, in certain transactions, the lack of disclosure of key ‘speculative’ aspects of the transaction (mostly in cases involving retail clients) could justify their unenforceability. The logic of insider-outsider, the focus on retail client protection, sometimes under regulatory rules, even in dialogue with the Court of Justice seems a more auspicious basis to balance overall support for derivatives with societal concerns. However, doctrines of ‘mistake’, which lead to voidness, are still too rigid and unpredictable, and the switch towards damages for contract or tort liability seems a more promising path.  As a ‘coda’ of courts’ experience, the article discusses some doctrine by the Italian Supreme Court, which, by combining the ideas of ‘disclosure duties’ with ‘causa’ and ‘object’ in cases of swaps with municipalities may have taken ‘one doctrinal turn too far’.

Finally, as an alternative, the article shows that courts need not be the only channel of societal dialogue. The episode of Interest-Rate-Hedging-Products (IRHPs) in the UK shows how the FSA/FCA used its resources and expertise to centralise the process, and obtain agreed solutions for (mostly) retail clients. And yet, despite all these advantages, financial authorities’ intervention was controversial, and criticised for lack of transparency and tardiness, leading to a subsequent independent review, with an FCA response. Part of the criticism is excessive; after all, the FSA/FCA obtained an effective settlement for thousands of clients. Yet, it illustrates how financial authorities, even when working well, can provide expediency and efficiency, but struggle to deliver clarity, accountability and ‘closure’, in the form of solutions with precedential value.

Thus, even under the best conditions, financial supervisors have a hard time channelling socio-legal dialogue over derivatives and speculation all by themselves. And, even if courts show flaws, they have a relevant role to play in what is, after all, an ongoing dialogical process. Indeed, given the complementarity of supervisors and courts, what is truly surprising is how little thought is put in making them work better together.

David Ramos Muñoz is an Associate Professor at the University Carlos III Madrid.