March 1, 2019
With the exit date of 29 March 2019 fast approaching and the UK government currently looking to renegotiate certain terms of its EU withdrawal agreement, there is no certainty that the UK and the EU will reach an agreement, and as a result, the UK could leave the EU without a deal (a “no-deal Brexit”).
Regardless of whether the UK leaves with a deal or without a deal, what is clear is that (a) businesses and financial institutions have or are starting to implement contingency plans and (b) other than as set out below, the legal and practical analysis remains the same for financial institutional clients, as the withdrawal agreement does not deal with what happens after the end of the implementation period.
This client briefing sets out the current state of play for financial institutions and lending entities regarding (A) passporting rights and lending to European entities; (B) current contractual arrangements; (C) new contractual arrangements; and (D) derivatives transactions.
Access to the Market: Passporting Rights
As widely reported, Brexit gives rise to a host of issues for non-EU lenders lending into Europe, particularly where the lender’s only European office is based in London. Currently, a lender licenced in the UK may use its UK licence as a passport” to conduct business in other EU Member States. Often, financial institutions are only licenced in the UK and use their UK licences to conduct such business.
Passporting rights will cease immediately with effect from the exit date in a no-deal Brexit. However, if the withdrawal agreement passes the House of Commons, the UK and the EU will enter into an implementation period continuing until 31 December 2020. Financial institutions will continue to benefit from passporting between the UK and the EU during the implementation period. It is, however, unclear what passporting rights financial institutions would have after the implementation period.
To address this issue as a result of Brexit (whether in a no-deal Brexit or if the implementation period kicks in), financial institutions in the UK who lend into Europe have or have started to either (a) set up a licenced operation through a separate group company within an EU Member State or (b) transfer employees/business lines to another subsidiary already established in the EU. This EU entity can then continue to make use of the passporting rights afforded to it or its subsidiary by that EU Member State. Where an entity is set up for these purposes, the European Central Bank has warned against the use of companies acting as an “empty shell.” Such an EU entity would therefore need to have adequate local risk management, employees and operational independence.
Effect on Existing Contractual Arrangements
Among other uncertainties of a No-Deal Brexit is the effect it will have on existing contractual arrangements and transactions that mature after the exit date. Brexit should not have an effect on the rights and obligations of parties to such existing contractual arrangements and transactions which are governed by English law. However, specific provisions may be affected by a no-deal Brexit, but this will largely depend on the specific circumstances and drafting.
It is unlikely that a no-deal Brexit would trigger the standard mandatory prepayment or event of default provisions under existing loan documents or bond documents. However, such transactions may be vulnerable to mandatory prepayment if, due to the loss of passporting rights, it becomes illegal for lenders licenced in the UK to lend to EU borrowers. However, as discussed above, many financial institutions have prepared or are now starting to prepare for this by transferring transactions to newly incorporated EU operations or subsidiary entities.
There is the potential for a no-deal Brexit to trigger a material adverse change (“MAC”) clause; in particular if the business of the borrower depends on the free movement of goods, capital and people which will be lost in a no-deal Brexit. Such clauses would need to be considered on a transaction-by-transaction basis, as it will depend on the drafting of the relevant MAC clause and the borrower’s specific circumstances.
The business of borrowers could also be adversely affected, which could lead to higher levels of defaults.
Effect on Contractual Arrangements
The effect on new contractual arrangements and transactions will not become entirely clear until the terms of the exit arrangements are decided. The discussion above in respect of existing transactions applies to new transactions as well. However, some parties may defer transactions as a result of the uncertainty, while some banks have started inserting clauses into new contracts to guard against a no-deal Brexit. These provisions require careful drafting to minimise potential disputes, especially as there will be no “standard” Brexit provisions to incorporate.
For derivatives transactions, many financial institutions have started to enter into two identical agreements with a counterparty under which derivatives transactions can be entered into: one with a UK entity and the other with a newly incorporated EU entity or EU subsidiary. Their intention is to continue entering into derivatives under the agreement with the UK entity, and after the exit date, to enter into derivatives under the agreement with the EU entity/subsidiary.
Many EU countries are also looking to implement national legislation to protect against a major disruption in securities, bonds and derivatives markets as a result of a no-deal Brexit. Countries like Germany, France and Sweden are working on national legislation that would protect existing derivatives transactions and allow such contracts to continue after Brexit. The preparations other EU countries are taking have helped calm participants in the financial markets.
In addition, the European Securities and Markets Authority (ESMA) confirmed on 18 February 2019 that it would give immediate formal recognition to the UK clearing houses (LCH, ICE Clear Europe and LME Clear) in a no-deal Brexit. EU banks and investment managers welcomed ESMA’s decision, as UK clearing houses play an important role in financial markets, with LCH clearing over 90 percent of Europe’s interest rate swaps (over $350 trillion in notional amount).
Whether the UK leaves the EU with or without a deal, what is clear is that the current impasse and a risk of a “cliff edge” have prompted financial institutions and businesses to no longer “wait and see.” Instead, they have or they are starting to implement contingency plans to address the risks imposed by the Brexit process.