The local authorities swaps litigation (sometimes called simply the swaps cases) refers to a series of cases during the 1990s under English law relating to interest rate swap transactions entered into between banks and local authorities. The House of Lords ruled that such transactions were unlawful. As a result of the decision over 200 separate actions were filed as hundreds of interest rate swap contracts had to be unwound by the courts at great expense.
The law relating to recovery of payments made under contracts subsequently held to be legally void was relatively undeveloped at the time, and the numerous cases led to a rapid evolution in terms of the development and understanding of the English law of restitution and unjust enrichment. Many of the subsequent cases were appealed to the Court of Appeal and three were appealed all the way to the House of Lords. In the course of those proceedings, in addition to the development of English law of unjust enrichment, numerous long established legal precedents of general application were overturned.
The situation was described as a "debacle", and the final costs were enormous. There is no accurate record of the total legal costs over the totality of the legal actions, but the banks were estimated to have written off £600 million as either unrecoverable or compromised as part of the litigation. No one has tried to produce estimates for any corresponding losses to the local authorities.
Background.
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authorities raise money through local taxation (at the time of the swaps litigation this was rates; it has subsequently been replaced by council tax).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.
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. 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.
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. 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. 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." 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'" 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".
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. 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. In his review of the crisis, Duncan Campbell Smith remarked that the ineptitude of Hammersmith Council as a whole seemed staggering:
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. However, it appeared that for the most part their swaps transaction was measured and commensurate with respect to their borrowing.
"Hazell v Hammersmith LBC".
The Audit Commission sought legal advice in relation to the legality of the swaps. Two opinions were received from barristers. One junior counsel opined that all swaps were unlawful and void. The second, from Roger Henderson QC, expressed the opinion that use of swaps to hedge their own borrowing by a local authority was lawful, but not swaps for speculative trading. Separately Hammersmith also obtained an opinion from a barrister, Anthony Scrivener QC, who also opined that swaps to hedge an exposure would be lawful, but for any other purpose would not be. However, the solicitor to the Audit Commission, Tony Child, advised the Commission that, contrary to the opinions of the two barristers, the district auditors should take the position that "all" derivatives contracts with local authorities were unlawful.
The banks did not react well to this decision, and legal proceedings were issued. In a quirk of legal procedure, the case was commenced as Tony Hazell (as district auditor) against Hammersmith and Fulham LBC, alleging that they had engaged in unlawful practices. However, because of their financial interest in the ruling, five lead banks were named as third party respondents. Hammersmith itself barely participated in the trial and did not actively oppose the district auditor. In reality, the case was fought between the Audit Commission and the banks.
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. It was noted that "the decision had the bizarre effect of 'benefiting the chief culprit' (Hammersmith), while hurting the more prudent local authorities."
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. The Court of Appeal broadly divided up the transactions entered into by the local authorities into three different types:
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."
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, but no similar steps had been taken in relation to local authorities. He finally concluded:
Reaction.
The banks were reported to be "furious" and referred to the decision as "incomprehensible". 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." 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