THE DELTA REPORT
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The UK referendum vote for the UK to exit the European Union ("EU") ("Brexit") raises significant potential issues for the derivatives market.
Prior to the referendum held in the UK on 23 June 2016, the International Monetary Fund and the Bank of England had warned that Brexit could have a material impact on the UK economy. Certainly, the immediate result of the Brexit vote was a period of economic volatility, coupled with a significant devaluation of sterling.12 In addition, the UK's sovereign rating post Brexit was downgraded by Standard & Poor's and Fitch.13
It is unclear when the UK will officially commence the "departure process" by invoking Article 50 of the Treaty of the EU which would activate the 2 years negotiation process between the UK and the EU.
We set out some initial observations on the immediate impact of Brexit on derivative transactions, particularly in relation to derivative transactions involving sterling, sterling collateral or UK counterparties.
Immediate Impact of Brexit
(a) Counterparty Creditworthiness
One possible impact of Brexit is that a derivative counterparties' creditworthiness may be adversely affected by Brexit. This could result in more expensive financing costs (for new or existing transactions) or new or additional collateral posting obligations. In an extreme scenario, termination rights could be triggered (if ratings related or if the counterparty becomes credit impaired).
(b) Sovereign Downgrade
If the UK’s credit rating is downgraded, the creditworthiness of counterparties with UK exposures may be adversely affected, which could result in additional financing costs (for new or existing transactions) or new or additional collateral posting obligations. In an extreme scenario, termination rights could be triggered (if ratings related or if the counterparty becomes credit impaired).
(c) Exposure Fluctuations
Economic volatility may lead to new (or increased) mark to market exposures under derivative transactions resulting in new (or increased) collateral posting requirements. In an extreme scenario, termination rights could be triggered.
(d) Collateral Valuation Fluctuations
Economic volatility, rating downgrades or currency fluctuations could lead to increased collateral posting requirements (especially if the value of UK collateral declines or if exposures in other currencies increase relative to sterling).
(e) Derivatives Documentation
It is currently difficult to assess the full impact of Brexit on derivatives documentation as the precise impact can only be assessed once the form and/or content of the post-Brexit legal arrangements are known and in particular, the final status of the UK and its relationship with the EU. At this stage, there seems to be little utility in carrying out a detailed review of one's derivatives documentation to gauge the effect of Brexit and/or amending standard derivatives documentation to cater for Brexit; although there could be some benefit in conducting a due diligence exercise to identify non-standard events of default and/or termination events which could be triggered by Brexit and/or some analysis as to which counterparties/contracts are likely to be the most affected by Brexit.
Impact on Derivatives Documentation
We set out below some initial observations on the effect of Brexit on derivatives documentation.
(a) Standard ISDA Representations and Covenants
We consider it unlikely that the standard 1992 ISDA Master Agreement (Multicurrency – Cross Border) (the "1992 ISDA Master Agreement") and/or the 2002 ISDA Master Agreement (the "2002 ISDA Master Agreement" and together with the 1992 Master Agreement, the "ISDA Master Agreement") in each case published by the International Swaps and Derivatives Associations, Inc. ("ISDA") representations and covenants would be adversely affected by Brexit. Specific references to EU/UK laws and regulations may need to be updated. Specific attention will need to be given to non-standard representations and covenants relating to creditworthiness, ratings and/or market conditions.
(b) Standard ISDA Events of Default
We consider it unlikely that the standard ISDA Master Agreement events of default would be adversely affected by Brexit. Specific references to EU/UK laws and regulations may need to be updated. Specific attention will need to be given to non-standard events of default relating to creditworthiness, ratings and/or market conditions.
(c) Standard ISDA Termination Events
We consider it unlikely that the standard ISDA Master Agreement termination events would be adversely affected by Brexit. Specific references to EU/UK laws and regulations may need to be updated. Specific attention will need to be given to non-standard termination events relating to creditworthiness, ratings and/or market conditions.
In addition to our comments under "Standard ISDA Termination Events" above, we consider it unlikely that Brexit will result in performance under a standard ISDA Master Agreement becoming illegal, impossible or impracticable (including force majeure). Specific references to EU/UK laws and regulations may need to be updated. Specific attention will need to be given to non-standard termination events relating to performance (including force majeure) and any withdrawal of passporting rights (which may adversely affect the legality of the performance of cross-border transactions).
(e) Withholding Tax
It is possible that tax events could be triggered if there is a change in the cross-border withholding tax regime post Brexit (although this seems quite unlikely).
(f) Material Adverse Change
We consider it unlikely that a MAC clause would be adversely affected by Brexit. Specific references to EU/UK laws and regulations may need to be updated. Specific attention will need to be given to those contracts in which a counterparty’s business is dependent on EU legislation and/or free access to the UK/EU markets.
(g) Choice of English Law
It seems unlikely that Brexit will adversely affect the enforceability of derivative contracts governed by English law. This aspect is considered in more detail below under the heading "Choice of English law".
(h) Choice of English Jurisdiction
It seems unlikely that Brexit will adversely affect derivative contracts containing an express submission to the English courts as the chosen disputes resolution forum. This aspect is considered in more detail below under the heading "Choice of English jurisdiction". Special attention will need to be paid to jurisdiction clauses drafted by reference to EU laws and regulations, such as Section 13(b)(i)(1) of the 2002 ISDA Master Agreement. One would expect that some of the required amendments to market standard documentation to implement Brexit will be dealt with by way of industry protocols.
(i) EU Laws and Regulations
The derivatives market is cross border in nature and a multitude of UK and EU laws and regulations govern the derivatives market and its operation. Market infrastructure also relies on EU and local recognition agreements. There are a number of key EU directives and regulations that will need to be dealt with as part of the Brexit transition. Whilst there is the possibility that there may be a gap in applicable law (i.e. the existing law ceases to apply before new laws are introduced or there are omissions in the new law), we would expect the legal framework for the derivatives market to be substantially settled by the time Brexit occurs. The key areas to be aware of include:
(i) the continuation of the MiFID passport for cross border financial services;
(ii) the continuation of safeguards for collateral netting, set-off and financial collateral arrangements (as currently envisaged in the Financial Collateral Directive (2002/47/EC), the Bank Recovery and Resolution Directive (2014/59/EU) and the Credit Institutions Winding Up Directive (2001/24/EC));
(iii) the continuation of the cross-border recognition of EMIR (see further below under the heading "Trade reporting, clearing and risk mitigation"); and
(iv) the continuation of cross-border access to market infrastructure under the Markets in Financial Instruments Directive II (2014/65/EU), the Markets in Financial Instruments Regulation (Regulation (EU) No 600/2014) and the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories ("EMIR").
(j) Contractual Bail-in
Under current law, derivative contracts governed by the law of a non-EEA14 country relating to the liability of an in-scope entity must include a bail-in provision (the "Article 55 requirement").
It seems unlikely that the UK would repeal applicable legislation which transposes the Bank Recovery and Resolution Directive into UK law15 and more likely that UK banks would still need to include bail-in provisions in their derivative contracts post Brexit to satisfy the Article 55 requirement. However, if the UK did not retain EEA membership post Brexit, EU banks would need to include bail-in provisions in their derivative contracts which are governed by English law. This would be a substantial documentation requirement unless dealt with by way of an industry protocol.
(k) Trade Reporting, Clearing and Risk Mitigation
Pursuant to EMIR, specified entities are subject to detailed rules concerning trade reporting, clearing and risk mitigation requirements. EMIR binds in its entirety16 and is directly applicable in all EU Member States17 since it was enacted in the form of an EU regulation.18 EMIR would no directly apply to the UK post Brexit since the UK would become a "third country entity". The term "third country entity" is not defined in EMIR. However, in the context of the application of certain obligations, EMIR distinguishes between entities that are established in the EU (financial counterparties and non-financial counterparties) and entities that are not established in the EU.
The meaning of "established" has also not been defined in this context; existing commentary from European authorities suggests that it refers to the jurisdiction in which an entity is incorporated or otherwise constituted (rather than any physical presence from which it does business, to the extent that this differs from its jurisdiction of incorporation or constitution); for example, an entity which is incorporated outside the EU but has a physical presence in the EU by way of a branch would still be a "third country entity".
The European Commission (the "Commission") has the power under EMIR to declare that the supervisory arrangements relating to trade reporting, clearing and risk mitigation of a non-EU jurisdiction are "equivalent" to the EU legislative framework under EMIR so that if an equivalence decision is made, such applicable non-EU counterparties will be deemed to have satisfied their applicable EMIR obligations.
The UK will need to determine whether to negotiate to continue under EMIR in a similar way to Iceland, Liechtenstein and Norway (which are in the EEA but not in the EU) or to seek bilateral "equivalence" arrangements with other jurisdictions or the EU as a whole (pursuant to Article 13.2 of EMIR). Regardless of such negotiations, UK counterparties will need to comply with at least some of the existing EMIR obligations when trading with EU counterparties post Brexit. For example, EU branches of UK banks would need to comply with certain obligations under EMIR.
Similarly, UK branches of EU banks may need to comply with UK comparable laws in relation to trade reporting, clearing and risk mitigation. However, this will depend whether the UK wants to create a different regime from EMIR. With the enormous amount of legislation that will need to be reviewed, it is plausible to assume that the UK will try to maintain existing EMIR legislation which UK counterparties are already familiar with.
In the absence of an "equivalent" decision, UK counterparties may have to comply with UK enacted laws and EMIR (as amended from time to time) in relation to trade reporting, clearing and risk mitigation when contracting with EU counterparties. Conversely, EU counterparties may have to comply with UK enacted laws and EMIR (as amended from time to time) in relation to trade reporting, clearing and risk mitigation when contracting with UK counterparties.
Currently, the mandatory clearing obligation can only be satisfied if applicable derivative contracts are cleared through either an authorised (in the case of an EU CCP) or recognised (in the case of a non-EU CCP) central counterparty ("CCP"). Non-EU CCPs are recognised if the Commission has determined that the non-EU supervisory arrangements relating to such CCPs are "equivalent" to those under EMIR.
Similarly, the trade reporting requirement under EMIR can only be satisfied if the relevant derivative contracts are reported to an authorised trade repository ("TR") (in the case of an EU Trade Repository) or recognised TR (in the case of a non-EU TR). Non-EU TRs are recognised if pursuant to Article 77 of EMIR the Commission has determined that the non-EU legal and supervisory arrangements relating to such TRs are "equivalent" to those under EMIR.
One possible scenario is that UK based CCPs and UK based TRs may need to apply for recognition under EMIR pursuant to Article 25 or 77 (respectively) of EMIR in order to provide clearing and reporting services in the EU. Similarly, EU based CCPs and EU based TRs will need to apply for recognition in the UK in order to carry on their clearing and reporting services in the UK.
An open question is the extent to which the UK will be able to benefit from the existing EU negotiated arrangements with non-EU countries, i.e. whether the UK would still benefit from the current implementing acts with third countries (Australia, Canada, Hong Kong, Japan, the USA, etc.) In principle, those third countries with existing equivalence arrangements with the EU should have no issues replicating similar arrangements with the UK (which is fully EMIR compliant). Failing this, the UK may end up in the unenviable position of having to start from scratch equivalence negotiations with non-EU countries. However, it is difficult to predict the effect of exogenous factors (politics, lack of resourcing etc.) on the timing and outcome of recognition or equivalence decisions.
Further, if in a post-Brexit scenario, a UK based CCP no longer benefits from the authorisation or recognition (as the case may be) under EMIR, this could have adverse regulatory capital implications.
Particular issues could arise for UK clearing members of EU CCPs as such entities will cease to be EU credit institutions post Brexit and therefore may no longer be eligible to be a clearing member under the relevant EU CCP's eligibility criteria. The converse could apply to EU clearing members of UK CCPs.
The European Central Bank could also renew its attempt to have CCPs having more than 5% of Euro denominated products located in the EU. In March 2015, the EU General Court ruled that the European Central Bank did not have the "competence necessary to regulate the activity of security clearing systems" and such an attempt failed.
(l) Choice of English Law
English law is the most popular choice of law for cross-border transactions and many of the reasons why commercial parties choose English law will not change as a result of Brexit.
EU Member States currently apply the same rules to determine the governing law of contractual (as a result of the Rome 1 Regulation (Regulation (EC) No 593/2008)) and non-contractual (as a result of the Rome II Regulation (Regulation (EC) No 864/2007)) obligations. Such regulations generally require EU Member State courts to respect party autonomy of choice of law, subject to limited exceptions. Such requirements also apply regardless of whether the contracting parties are located in the EU and/or whether the chosen law is a law of an EU Member State.
If post Brexit the UK decided to leave the principles enshrined in the Rome 1 and Rome II Regulations in place, with the English courts (as opposed to the European Member State courts) as the arbiter of such Regulations, there will be little short term impact as a result of Brexit; although over time, the interpretations of such Regulations could diverge between the English courts and the courts of the EU Member States.
If the Rome 1 and Rome II Regulations were no longer to apply in the UK post Brexit, one would assume that the UK would revert to the law in force prior to the introduction of the Rome I and Rome II Regulations: namely, the Rome Convention19 (in the case of contractual obligations) and the Private International Law (Miscellaneous Provisions) Act 1995 (in the case of non-contractual obligations). There is no significant difference between the provisions of the Rome Convention and the Rome 1 Regulation; in particular, in relation to party autonomy concerning choice of governing law. In relation to non-contractual obligations, there are differences between the Rome II Regulation and the Private International Law (Miscellaneous Provisions) Act 1995; in particular, the Private International Law (Miscellaneous Provisions) Act 1995 does not give the parties an express right to choose the law applicable to non-contractual obligations. So far as the other EU Member States are concerned, the Rome 1 and Rome II Regulations will continue to apply to a choice of English law irrespective of whether the UK is an EU Member State or not.
Substantive English commercial law has developed largely independently of EU law (other than in specific areas such as consumer contracts, insurance and agency contracts). The English law on key contractual issues such as contractual interpretation, estoppel, the implication of terms, penalties and forfeiture derives principally from English common law and any effect of Brexit is likely to be practically limited.
A similar position applies in English torts law apart from statutory torts that have a European law basis. Specific areas will require detailed consideration such as financial services regulation, prospectus rules and consumer protection, but general English commercial law will remain largely unaffected by Brexit.
(m) Choice of English Jurisdiction
It is critical that commercial parties have the ability to choose which court will resolve commercial disputes. The implementation of rules applied by EU Member States in relation to jurisdiction and the enforcement of judgments (now set out in the Recast Brussels Regulation EU1215/2012 (the "Recast Regulation")) has been one of the successful EU initiatives, subject to the rules relating to parallel proceedings and so-called torpedo litigation (such a strategy is now largely ineffective in the case of an exclusive jurisdiction clause, although the position where only one party to a contract is bound to a chosen court is still unclear). Pursuant to the Recast Regulation, the EU Member State courts must recognize and enforce judgments of another EU Member State and party autonomy is respected, subject to limited exceptions.
There are other reasons why, notwithstanding the Recast Regulation, commercial parties choose to litigate their disputes in the English courts and such reasons are unlikely to be significantly affected by Brexit. In general, we would expect commercial parties to continue to select the English courts in their commercial contracts, subject to limited exceptions.
If the UK adopts the Norwegian model post Brexit,20 one would expect the UK to accede to the 2007 Lugano Convention,21 (which is broadly similar, but not identical, to the existing EU regime). If the UK adopts the WTO model post Brexit,22 the UK could still negotiate to accede to the 2007 Lugano Convention and/or the Hague Convention on Choice of Court Agreements (the "Hague Convention") which provides a mechanism for the allocation of jurisdiction and the enforcement and recognition of judgments between contracting states where the parties have agreed an exclusive jurisdiction clause in relation to a contracting state.23 Note that for entirely EU matters, the Recast Regulation prevails over the Hague Convention. It is a moot point as to whether the UK would need to resign the Hague Convention in its own right in order to ensure such convention is effective post Brexit in relation to the UK.
Regardless of any agreement with EU Member States as to choice of jurisdiction, the English courts are likely to continue to recognise party autonomy. Although it is an open question as to how such clauses will be interpreted by the courts of the EU Member States, it seems likely that the EU Member State courts will continue to recognise party autonomy as to choice of jurisdiction. Note that the UK had previously been a party to a number of reciprocal enforcement arrangements with a number of EU Member States - see the Foreign Judgments (Reciprocal Enforcement) Act 1933. Note that the Recast Regulation allows EU Member State courts to decline jurisdiction in favour of non-EU Member State courts in limited circumstances (see Articles 33 and 34 of the Recast Regulation). It is also possible that the Brussels Convention ((Regulation (EC) 44/2001), the predecessor to the Recast Regulation) could apply.
(n) Parallel Proceedings and Anti-suit Injunctions
One can anticipate an increase in parallel proceedings and anti-suit injunctions post Brexit. Under the current EU regime, if parallel proceedings are bought in more than one court of a EU Member State, the court first seized decides the question of jurisdiction unless the parties have conferred exclusive jurisdiction on the courts of another EU Member State in which case the chosen court can determine the question of jurisdiction (notwithstanding that such chosen court was not first seized). Such a provision dramatically reduces the risk of parallel proceedings in the EU Member States (although the position in relation to asymmetric exclusive jurisdiction clauses is still unclear). It is noteworthy that such a provision does not exist in the 2007 Lugano Convention. Further, if the courts of an EU Member State do not respect an English jurisdiction clause; post Brexit the English courts may be inclined to grant an anti-suit injunction against any party which commenced proceedings in an EU Member State court in breach of an English jurisdiction clause to restrain the continuation of such proceedings. Anti-suit injunctions could also be revived in the arbitration context (i.e. to protect UK arbitration).
There could also be a shift to arbitration (given the enforcement mechanisms for arbitral awards set out in the New York Convention) as the chosen dispute resolution forum (as many countries are a party to the New York Convention).24
(p) Service of Process
Service of process out of England could become more complex post Brexit, although current market practice typically requires an agent for service of process to be appointed for non-UK counterparties. If an agent for service of process is appointed in the UK, service of process pre Brexit and post Brexit will be straightforward. If service of process needs to be effected overseas, the claimant needed to apply to the English courts for permission to serve out of the jurisdiction. This in turn required the claimant to demonstrate that the English courts had jurisdiction. In the case of service in the EU, there was no need to apply for permission to serve out of the UK if the English courts had jurisdiction pursuant to the Recast Regulation. Further, the Service Regulation (1393/2007/EC) provides helpful assistance with the procedural aspects of effecting service. A similar position applies in relation to service in countries which are a party to the 2007 Lugano Convention. If an agent for service of process in the UK is not appointed post Brexit, it could be necessary to apply to the English courts for permission to serve out of the UK jurisdiction into an EU Member State.
(q) Pre-existing Agreements
There will likely to be an increase in disputes relating to existing derivatives documentation post Brexit. In addition to the matters flagged above concerning "Standard ISDA Events of Default" and "Standard ISDA Termination Events", contracting parties could seek to exit unprofitable contracts or renegotiate contractual terms. This could arise as a result of contractual uncertainty related to questions of contractual construction and contractual interpretation; for example (and by no means an exhaustive list), how will obligations to comply with specific provisions of EU law be interpreted post Brexit; will the UK be included in the "European Union" or not; what law applies where EU law applied at the time of entering into a contract, but not at the time of its performance; and, to what extent should principles of EU case law established prior to Brexit influence the English courts interpretation of similar UK legislation enacted as a result of Brexit.
How does Brexit currently affect you?
At this stage, there is no market consensus as to what steps to recommend to market participants to deal with Brexit. There is currently too much uncertainty to perform a meaningful assessment of the effect of Brexit on derivatives documentation and derivatives transactions. Market participants will need to monitor Brexit developments closely over the transition period. We will continue to publish Brexit related topics of interest once further details of the form, content and timing of Brexit are revealed.
12 See "Sterling falls below Friday's 31-year low amid Brexit uncertainty", CNBC, 27 June 2016.
13 See Reuters Business News, Monday 27 June 2016, "Rating agencies rip into UK's credit score after Brexit vote". See also "Moody's changes outlook on UK sovereign rating to negative from stable, affirms Aa1 rating" published on 24 June 2016 by Moody's Investors Service.
14 The European Economic Area ("EEA") unites the EU Member States and the three EEA EFTA States (Iceland, Liechtenstein, and Norway) into an internal market governed by the same basic rules. Switzerland is not part of the EEA but has a bilateral agreement with the EU.
15 See PRA policy statement (PS1/15, PS 15/2 and PS 17/16) and BoE/PRA Supervisory Statement 7/16, the Bank Recovery and Resolution (No 2) Order 2014, the Banking Act 2009 (Mandatory Compensation Arrangements Following Bail-In) Regulations 2014, the Banking Act 2009 (Restriction of Special Bail-in Provisions, etc) Order 2014, the Building Societies Order 2014, the Bank Recovery Bail-in and Resolution Order 2014 and the Banks and Building Societies (Depositor Preference and Priorities) Order 2014.
16 However, please see Article 12 of EMIR which allows EU Member States to lay down rules on penalties.
17 The EU is an economic and political union of 28 countries. It operates an internal (or single) market which allows free movement of goods, capital, services and people between member states. The current EU Member States are: Austria, Belgium, Bulgaria, Croatia, Republic of Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the UK. As a result of Brexit, the UK will cease to be an EU Member State.
18 Article 288 of the Treaty of the Functioning of the European Union.
19 The Convention on the Law Applicable to Contractual Obligations 1980.
20 See "Five models for post-Brexit UK trade", BBC News – EU Referendum, 27 June 2016.
21 Convention on jurisdiction and enforcement of judgments in civil and commercial matters signed in Lugano on 30 October 2007 which governs issues of jurisdiction and enforcement of judgments between the EU Member States and Iceland, Switzerland and Norway. Published in the Official Journal on 21 December 2007 (L339/3). Incorporated into UK Law by the Civil Jurisdiction and Judgments Regulations 2009.
22 See "Five models for post-Brexit UK trade", BBC News – EU Referendum, 27 June 2016.
23 In 2005, the Hague Conference on private international law finalized the text of the Hague Convention which became applicable in the EU Member States (other than Denmark) in October 2015. The Hague Convention is accompanied by an official explanatory report by Professors Hartley and Dogauchi (the "Hague Convention Report"). Copies of the Hague Convention, the Hague Convention Report and a status table are available at the Choice of Court section of the Hague Conference's website: http://www.hcch.net/index_en.php?act=text.display&tid=134.
24 The New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, concluded in 1958. Such Convention provides a regime for the enforcement and recognition of arbitral awards within contracting states.
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