Under Italian contract law, a contract must be directed to the realisation of interests deserving protection according to the law; that is, a contract must have a social and economic function which is worthy of legal protection. This is known as “causa”.

Under an Interest Rate Swap (I.R.S.), each counterparty undertakes to exchange their own stream of future interest payments for another based on a specified principal amount. Normally the counterparties exchange a fixed payment for a floating payment.

A recently published judgement of the Court of Appeal of Milan (sentence n. 2244/15 of 25 may 2015), , ruled that an I.R.S. derivative entered into by counterparties for hedging purposes to limit or manage their exposure to fluctuations in interest rates is void for lack of “causa”, when the uncertainty or the risk (referred to as “alea”) – an essential element of I.R.S. derivatives – has been borne by one counterparty (the customer) unilaterally, since the inception of the contract, rather than being borne mutually by the customer and the bank.

The judgement of the Court of Appeal of Milan is interesting, because it appears to identify the economic function of I.R.S. derivatives not with hedging, but with dealing with the mutual uncertainty that must be borne by counterparties.

For further information please contact Nicolo Juvara.