It's complicated - capacity, contracts and conflict of laws
Many complicated conflicts of laws issues arise in a structured finance practice, which is, of course, one of the things that makes this practice area so much fun. Unfortunately it is also one of the things that make assessing legal risk so challenging. One of the legal issues you always want to be sure of is that the counterparty has the capacity to enter into the proposed transactions. Combine capacity and conflict of laws issues and you’ve got the complicated situation faced by the English Court of Appeal in Haugesund Kommune & Anor v. Depfa ACS Bank, [2010] EWCA Civ 579 (May 27). The appellants were two Norwegian municipal governments (called Kommunes) that had entered into what were called zero coupon swaps. (Before you get too excited and think this case is actually about swaps, it isn’t. The swap was in substance a loan by an Irish bank to the Kommunes. Nevertheless, the issues addressed are highly relevant to derivatives and other structured finance transactions.) Having invested the borrowed money (in CLNs and CDOs) and lost most of it, the Kommunes were arguing that they did not have the capacity to enter into the borrowing transaction and, consequently, it was void. They were hoping that meant that they didn’t have to pay the bank back. They were wrong.
Capacity Issue
The complicated issue considered in depth on the appeal to the Court of Appeal was the relationship between English law (as the law of the forum and the governing law of the agreement) and Norwegian law (as the law governing the capacity of the Kommunes). The first step in analyzing any conflict of laws problem is to characterize the issue and the rule is that characterization is a matter for the law of the forum. So under English law the conflict of laws issue is that capacity of a corporation (and the Kommunes were corporations – as are Canadian municipalities) to contract is determined under the law of the jurisdiction of incorporation. Norwegian law though didn’t really have a similar concept of capacity, but the English court said that didn’t matter; conflict of laws rules can be modified as the circumstances require and what was important in this case was to determine whether the Kommunes had the substantive right to contract.
Now, here’s where things get a bit weird. Under Norwegian law the Kommunes had the powers of a natural person and the ability to contract in respect of anything not prohibited by law. They had the power to borrow, but it was only for specific purposes. Under Norwegian law a counterparty acting in good faith could enforce a contract in breach of the prohibition. So at this point I was thinking things were looking pretty good for the bank. But, two of the three Court of Appeal judges thought otherwise. They interpreted the Norwegian law as meaning that the entities did not have the substantive capacity to enter into this transaction. They then held that this loan transaction was void because in order to have a valid contract under English law the party must have the capacity to enter into it.
The two majority judges described the result as “both logical and reasonable”. Really? While the result is no doubt logical to conflicts of laws scholars, it is counter-intuitive (if not downright bizarre) that the transaction would have been enforceable had it been governed by Norwegian law but is void under English law because of the application of part of that same Norwegian law. As the dissenting judge pointed out, if there are circumstances in which an unauthorized or unlawful transaction is capable of being enforced or is otherwise not a nullity, it cannot be said that it is beyond the legal capacity of the corporation. There is no such thing as partial incapacity.
The court was largely dealing with English common law so unfortunately it is a relevant precedent in Canada. Hopefully if the issue arose here our courts would find the wisdom in the dissenting judgment.
In the meantime though, you may have to think more carefully about which governing law to choose if your counterparty is a limited powers entity like a municipality or a corporation created by statute. If the entity is from a jurisdiction that does not employ quite the same concepts of capacity as Canadian law does, you’ll have to be extra careful in trying to understand what is a capacity issue versus what is a power or authority issue. If capacity to contract is one of the requirements of a valid contract under the governing law (which is certainly the case under Canadian law), then you want to ensure that you have the benefit of any law that ameliorates the effect of that incapacity. If this decision is correct, you may want to choose the same law as governs capacity.
Restitution Issue
The Court of Appeal did agree however that the bank could advance a claim in restitution for the money advanced. It considered whether there was any public policy reason against allowing restitution and whether a change of position defence applied.
The public policy defence is that if recovery would defeat the purpose of the statute imposing the legal impediment it can be denied on grounds of public policy. Here it was argued that it would defeat the effect of the borrowing prohibition if recovery of the sums advanced was permitted. The court held that the restitutionary claim was governed by English law and it would not be contrary to English law or English public policy to allow the claim. The court could, however, also look to the Norwegian law to determine if the statute that gave rise to the incapacity barred the restitutionary claim. In this case it did not.
The change of position defence didn’t fare much better. The Kommunes argued that they had changed their positions by investing in the losing investments and the bank was therefore entitled to only what they managed to recover on the investments. A change of position defence depends on weighing the injustice of requiring the money to be repaid against the injustice to the party with the restitutionary claim. In this case the justice lay in favour of the bank that loaned the money and had nothing to do with the bad investments, not the Kommunes that, while they acted in good faith, had always understood that they had to repay the money regardless of the success of their investments.
