An Italian court is expected to rule on Wednesday on whether four foreign banks missold derivatives to the city of Milan in a case seen as a litmus test for hundreds of local governments facing big losses from complex financial contracts.
Deutsche Bank , JP Morgan , UBS and Depfa Bank have been charged with aggravated fraud and accused of making 100 million euros ($132 million) in illicit profits from the sale of an interest-rate swap on a bond issued by the city of Milan.
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Prosecutor Alfredo Robledo, who has requested jail terms of up to 12 months for nine bankers, also says the lenders lied about the risks linked to the swap and falsely represented the deal as a way to reduce Milan's debt. The banks deny any wrongdoing and say they were transparent in their dealings.
The case comes as banks face increased scrutiny, particularly in Britain, over alleged misselling of interest-rate hedging products to small businesses. British banks have set aside hundreds of millions of pounds for possible compensation.
Derivatives misselling is one of a number of banking scandals that authorities are investigating following the global financial crisis.
Switzerland's UBS will pay around $1.5 billion to settle charges that a group of traders at its Japanese unit rigged Libor interest rates, a source familiar with the matter said on Monday, while Deutsche Bank is the subject of a number of probes including suspected tax evasion over trade in carbon permits.
The Milan case is the first criminal trial of this kind in Italy, where about 600 local governments bought derivative products worth 36 billion euros, many of which turned sour when the financial crisis started to bite.
"A guilty verdict would set a rather dangerous precedent for the banks," said Tommaso Iaquinta, a lawyer involved in several cases pitting local authorities against banks over derivatives.
The case relates to a swap contract signed by Milan city council when it issued a 1.68 billion euro, 30-year bond in 2005, the biggest from an Italian city.
According to prosecutors, the swap contract appeared to offer the Milan city council an attractive interest rate but turned out to inflict much higher costs, paid for by taxpayers, than it had anticipated.
Prosecutors also said the banks involved were both advisers to the city of Milan and counterparts in the derivative deal. The lenders face a possible fine of 1.5 million euros each and an order to pay back 72 million euros.
"This trial could trigger a chain reaction for other local administrations thinking of suing over derivative contracts, and for the banks that sold those products," said Fabio Amatucci, an expert on local government finances at Bocconi university.
Italian cities face nearly 4 billion euros of potential losses from derivatives operations, Bank of Italy data show.
Amatucci said local authorities often lacked the expertise to fully understand the financial contracts they were signing.
"The trial has pretty much established that the derivative contract was not attractive for the city of Milan from the start. The question is whether the banks knowingly misled the local authorities or not," he said.
During testimony at the trial, the former head of the city council treasury, Elfo Butti, said he was "certainly not an expert in derivatives" and only had a basic knowledge of English - the language in which the contract was written.
The banks say authorities were fully informed about the risks linked to the contract and that the city of Milan, Italy's financial capital, had experience handling complex operations such as the 1998 listing of its municipal utility.
(Additional reporting by Giulio Piovaccari; Editing by Erica Billingham)