On April 27, 2009, Italian financial police, acting on the order of a judge, seized the assets of four large banks, valued at approximately €476 million, in connection with a probe relating to a derivatives transaction entered into by the city of Milan. The seized assets of the banks include the banks’ stakes in Italian companies, real estate assets and bank accounts.

Prosecutors are investigating whether the banks fraudulently made over €100 million in “illicit profits” from the city of Milan under a certain derivative transaction. Although the details remain unclear, it appears that the city entered into an interest rate collar in 2005 relating to approximately €1.7 billion of debt, which the city had previously converted from a fixed rate to a floating rate through an interest rate swap. Under an interest rate collar, an investor purchases an interest rate cap and sells an interest rate floor, thereby capping the maximum interest rate it must pay at the collar’s ceiling (the counterparty pays the excess) but requiring it to make a payment to the counterparty if rates go below the collar’s floor. In light of the sharp decline in interest rates, it appears that the city’s obligation to make payments to its counterparties has come into effect, with such payments, of course, being in addition to the debt service on its bonds.

This investigation is one of a string of probes and lawsuits involving derivatives transactions entered into by local governmental entities that have been initiated during the credit crisis. The most notable case in the United States involves Jefferson County, Alabama. Several years ago, Jefferson County refinanced its fixed rate debt to variable rate debt and entered into interest rate swaps, which it now alleges exceeded the notional amount of bonds being hedged and may have been awarded in a less-than-competitive manner. In another Alabama case filed in October 2008, the Alabama Public School and College Authority is seeking to void a swaption (or an option to enter an interest rate swap) that it sold to a bank in 2002.

As with other disputes involving public entities, much will ride on the risks disclosed by the banks to the Milan city council that approved the transaction and whether the banks misled the city about, or otherwise concealed the risks involved in, the transaction. City officials may be asked to explain whether they understood these risks, including the risk that the city could be obligated to make payments under the transaction if interest rates declined. City officials also may need to explain why the transaction was entered into on a negotiated-as opposed to competitively bid-basis if this in fact proves to be the case.

The Milan transaction may very well be the tip of the iceberg of cases involving allegations of fraud and misselling of derivatives to European municipalities, as it appears that hundreds of Italian (and other European) local governmental entities may have entered into derivatives trades over the past few years. According to the Italian Treasury, Milan is one of approximately 600 Italian municipalities that entered into some 1,000 derivatives contracts having aggregate notional amounts in excess of €35.5 billion. It is not known how many of these transactions are either deeply out-of-the-money or require municipalities to make payments.