Background

Depfa ACS Bank, an Irish bank, (the “Bank”) entered into two “zero coupon swap agreements” (the “Swaps”) (so called because the Bank paid no interest on the agreements) with two Norwegian local authorities, Haugesund and Narvik (the “Kommunes”). The agreements were entered into in June 2004 and September 2005 respectively. Both agreements contained English law and jurisdiction clauses.

Under the Swaps, the Bank agreed to advance a capital sum to each of the Kommunes who were then each obliged to make fixed quarterly payments over the period of the Swaps, together with a “bullet” repayment of the outstanding interest and principal at the end of the fixed period.

Prior to entering into the Swaps the Bank took legal advice from Wikborg Rein & Co (“WR”) as to whether the Kommunes had the legal power and capacity to enter into the Swaps in light of the terms of section 50 of the Norwegian Local Government Act 1992 (the “Act”), which deals with the purposes for which Norwegian local authorities can raise loans. WR advised the Bank that the Swaps were not “loans” for the purposes of the Act and that the Kommunes therefore had the power and authority to enter into the agreements, which would create valid and binding obligations on them.

The Kommunes, on the advice of their financial adviser invested the sums advanced by the Bank in financial instruments with disastrous consequences, incurring losses totalling approximately £26.7 million. Shortly afterwards, the Norwegian Ministry of Justice published its opinion that agreements such as the Swaps did in fact constitute loans within section 50 of the 1992 Act.

The commercial court hearing

The Kommunes invoked the jurisdiction clause in the Swaps and brought proceedings in the Commercial Court for declarations of non-liability to the Bank, alleging that they had been concluded ultra vires the powers of the Kommunes by virtue of section 50 of the Act and were therefore void.

The Bank counterclaimed, alleging that the Swaps were valid and enforceable, but, in the event that they were not, the Bank claimed in restitution for the return of the sums advanced to the Kommunes.

In addition, the Bank joined WR to the proceedings and claimed damages against WR for alleged negligence in relation to the advice it had given the Bank concerning the capacity of the Kommunes to enter into the Swaps.

Decision of the commercial court

Tomlinson J in the Commercial Court held that the Swaps were “loans” for the purposes of the Act and therefore the Kommunes lacked the “substantive power” under Norwegian law to enter into them. Tomlinson J held that the lack of “substantive power” was characterised in English legal terminology as a lack of capacity and therefore the Swaps were void. However, the Bank was entitled in restitution to the capital sums advanced together with interest and the Kommunes were not entitled to rely on the defence of “change of position”. In addition, it was held that WR’s advice was negligent and they were liable to the Bank for damages.

Issues arising on appeal

The Kommunes appealed against the decision of Tomlinson J that they were liable to make restitution of sums advanced by the Bank under the Swaps. The Bank challenged the decision that the Kommunes had lacked capacity to enter into the Swaps by cross-appeal.

The following issues were considered by the Court of Appeal (Aikens, Etherton and Pill LJs):

  1. Was Tomlinson J correct to conclude that the Kommunes lacked the “capacity” to enter into the Swaps with the consequence that they were void?
  2. In the event that Tomlinson J was correct to hold that the Swaps were void, was the Bank entitled to recover by restitution the sums advanced?
  3. What is the scope of the following defences in a claim for restitution:
    1. public policy; and
    2. change of position?

Issue 1 – Capacity

In the Commercial Court, Tomlinson J held that English common law conflict of law rules govern the issues concerning the legal capacity of companies with regard to contracts. Tomlinson J considered this issue by reference to the English conflict of law rules as stated by Dicey, Morris and Collins, at Rule 162(1) and (2):

“(1) The capacity of a corporation to enter into any legal transaction is governed both by the constitution of the corporation and by the law of the country which governs the transaction in question.

(2) All matters concerning the constitution of a corporation are governed by the law of the place of incorporation”.

Therefore, the issue of the Kommunes’ capacity was governed by Norwegian Law. Having regard to the evidence given by Norwegian law experts, Tomlinson J concluded that the Kommunes lacked the “substantive power” to enter into the Swaps and held that this could “only properly be characterised as going to capacity” and that, therefore, “in English terminology [the Kommunes] lacked capacity” to enter into the Swaps. It was then necessary to consider the effect of the lack of “capacity” as a matter of English law (being the applicable law of the Swaps). Tomlinson J found that the lack of capacity had the consequence in English law that the contracts were invalid.

WR argued that Tomlinson J had impermissibly equated the Kommunes’ lack of “substantive power” with “capacity” when considering Dicey’s rule. WR submitted that the Kommunes were in an analogous position to an English corporation created by Royal Charter or an English common law corporation. The court accepted such a corporation has the full “capacity” of a natural person to contract, even if there were limiting terms in its charter of corporation. WR contended that there was a clear distinction between the “capacity” and “powers” of such a corporation. Where such a corporation acted outside its capacity the resulting contract would be void, whereas if it has acted outside its powers that result would not always be the outcome. WR contended that for the purposes of the English conflict of laws rules, the Kommunes had capacity to conclude the Swaps, but on the proper analysis of the Act their powers to do so had been either limited or prohibited. Therefore, under the English conflict of laws rules the Act did not affect their validity as English law contracts. The Kommunes had not argued that Norway was the place of performance of the contract and therefore any prohibition under Norwegian law was irrelevant.

The Kommunes relied on Tomlinson J’s conclusion in the Commercial Court that, even if they had capacity to conclude the contracts, the individuals who purported to enter into them did not have authority to do so and that the Swaps were, therefore, void for want of authority.

Aikens LJ rejected WR’s narrow approach to the issue of “capacity” and held that, for the purposes of the English conflict of laws rules, the concept of “capacity” had to be given a broad “internationalist” meaning. This analysis was in line with the purpose of the conflict of laws rules. Whilst Norwegian law’s concept of a company’s capacity was very different from that of English law, Aikens LJ considered that “capacity” should be interpreted as the legal ability of a corporation to exercise specific rights, in particular the legal ability to enter into contracts. Aikens LJ did not consider that the legal concepts of the relevant foreign law had to conform exactly to the English law concept and was concerned that the courts might be accused of legal parochialism if they were to follow such an approach.

Therefore, Aikens LJ found that a lack of “substantive power” under the relevant Norwegian law principles to conclude a contract was equivalent to a lack of “capacity” in English legal terminology. Once the issue of capacity had been decided according to the constitution of the corporation, the consequence of that lack of capacity was to be determined by the applicable law of the contract. As the Kommunes did not have the capacity to enter into the Swaps, it followed that as a matter of English law that the Swaps were invalid and void.

Pill LJ agreed with Aikens LJ’s analysis. However, Etherton LJ dissented on the basis that he considered that “capacity” as referred to in Dicey’s Rule 102 meant capacity in the ultra vires sense of English domestic law.

Issue 2 –Restitution in loan contracts ultra vires the borrower

The Kommunes argued, relying on the House of Lords’ authority of Sinclair v Brougham1 that it would be contrary to public policy to allow a claim in restitution in the instance of a borrowing contract which is void because ultra vires the borrower. It was argued that the later House of Lords case of Westdeutsche Landesbank Girozentrale v Islington London BC2 did not depart from the ruling in Sinclair v Brougham on this point.

Aikens LJ noted that the reasoning behind the decision in Sinclair v Brougham was two-fold. Firstly, the ultra vires doctrine was designed to protect the public and, secondly, if a claim to recover the money could be made in restitution, it would circumvent the rule that contracts made ultra vires the borrower are void.

After considering the decision in Sinclair v Brougham and a close analysis of the Lords’ speeches in Westdeutsche Landesbank Girozentrale v Islington London BC, Aikens LJ concluded that the latter case had departed from the Sinclair case on the issue of the right of a borrower to make a restitutionary claim, at law, to recover money lent under a borrowing contract which is rendered void because ultra vires the borrower. Therefore, such a claim could be advanced but would be subject to any available restitutionary defences.

Issue 3 – Scope of defences to restitution

The Kommunes challenged Tomlinson J’s conclusion that they were not entitled to a defence of change of position on two grounds. Firstly, they argued that the purpose of section 50 of the Act, namely, to protect Kommunes and its citizens from the consequences of borrowing money for prohibited purposes had been ignored. The Kommunes argued that they should not be liable to repay to the Bank any monies other than the sums which they had been able to recoup following the liquidation of the investments they had made with the capital sums lent by the Bank.

Secondly, the Kommunes argued that Tomlinson J had misapprehended the effect of the relevant authorities on the restitutionary defence of “change of position”. In deciding whether there has been a change of position, the correct starting point was that the Kommunes would not have made any of the underlying investments if they had not been advanced sums by the Bank. The Kommunes argued that it had been wrong for Tomlinson J to have regard to the Kommunes’ acceptance at the time of entering into the Swaps that they realised they would have to make repayment, because this assumed that the Swaps were valid when they were not. The Kommunes argued that the correct approach was to recognise that they had received the monies from the Bank in good faith, had made the investments and thereby changed their position all in good faith. Therefore, the correct approach would be to entitle the Bank to recover only the net value on liquidation of the investments made by the Kommunes in good faith.

Aikens LJ considered that the public policy and change of position arguments amounted to two separate defences. He dealt first with the public policy argument.

Public policy defence

Aikens LJ was of the view that there is no longer any general public policy rule of English law that either prevents or restricts the right to claim restitution of money advanced under a borrowing contract that is void as ultra vires the borrower. However, he accepted that in English law a restitutionary claim for the return of money may be defeated on the grounds of public policy, if on the correct construction of a statute, recovery in restitution would be contrary to the objective of that statute.

In this case, the public policy defence was based on a foreign statute. In the absence of previous authority on this issue, Aikens approached the issue from first principles. In his view the English court should take account of the express or clearly implied intention of the foreign statute in deciding whether and to what extent a restitutionary remedy should be available, notwithstanding that the claim is governed by English law. In his view it should do so as a matter of comity and should only refuse to do so in the event that such an approach would be contrary to English public policy.

On the facts of the case, Aikens LJ held that there was nothing to suggest that the recovery of money under a contract held to be invalid would be contrary to the statutory intent of section 50 of the Act. It appears from the judgment that the Kommunes had not, during the trial, sought to take the point that recovery of monies under the Swaps would be contrary to the statutory intent of the Act and there was, therefore, no evidence on which the trial judge could have made such a finding. Aikens LJ therefore rejected the Kommunes argument that they were not liable to repay to the Bank the full amount of the sums advanced. If that were the case, the Kommunes would have been unjustly enriched.

Change of position defence

Following a detailed review of the principles of and relevant authorities on the defence of “change of position”, Aikens LJ found that such a defence is a general defence to all restitution claims based on unjust enrichment. Whether a party has been unjustly enriched will depend on whether it has so changed its position that the injustice of requiring repayment outweighs the injustice of denying the claimant restitution.

He drew a clear distinction between a defendant that obtained money in circumstances where he understands in good faith, that it is his to keep and a defendant who at the time of receipt of the money understands that he will have to repay that sum at a later stage. In this case, the Kommunes made their investments on the understanding that they would have to repay the Bank whatever happened to the investments. Therefore, the risk was with the Kommunes and not the Bank. The Bank was entitled to recover the full amount it had paid to the Kommunes and there was no basis on which a defence of change of position could succeed.

Conclusion

This case is particularly pertinent given the current economic climate which leads parties to scrutinise closely deals which have turned out to be bad following the financial crisis to see if there is some legal basis to escape the financial consequences.

The case is reminiscent of the previous “interest – rate swaps” cases in the 1990’s. At that time there was much litigation in the English courts arising from English local government authorities concluding such contracts with banks. The contracts proved disastrous for the local authorities and led to challenges being made to the validity of the arrangements on the basis that the local authorities did not have the capacity to enter into such arrangements. On reaching the House of Lords, it was held that they were not able to enter into such arrangements3. The present case introduces an international aspect to the issue.

However, this case will provide some comfort to lenders who find themselves in such situations. The judgment in this case confirms that even in a situation where the contracts themselves are found to be void under English Law, a lender will likely be able to recover any capital sums lent unless such a recovery would be contrary to the provision of the foreign law.

Where capital sums are lent on the basis that the borrower is under an obligation to repay, the borrower takes the risk of any investments and justice requires that full repayment is made to the lender regardless of the consequences of those investments.