A UK vote to leave the EU has far-reaching political implications. Many commentators also foresee economic consequences, and such volatility would have commercial ramifications for participants in the debt markets.
In this briefing we focus on the possible legal and documentary impact of a vote to leave the EU and an actual withdrawal from the EU by the UK following such a vote (a Brexit). This briefing considers the impact on key debt products and finance transactions; the commercial effects of a Brexit are beyond the scope of this note. For a discussion of key issues for business generally, please see our briefing “Now Britain has voted to leave”.
- A vote to leave will not bring immediate legal change. Notwithstanding any political turbulence and market volatility which may subsequently arise, a vote to leave will not of itself trigger any sudden change to the status of EU-derived law in the UK. The UK will remain a member state until it reaches an agreement in relation to withdrawal from the EU, or the two-year Article 50 notification period expires (whichever occurs first).
- It is unlikely that a vote to leave (or, in isolation, a Brexit) will trigger defaults or other contractual triggers. We do not expect events of default, termination events, force majeure or mandatory prepayment clauses drafted on customary market terms to be triggered under loans, bonds and ISDA contracts as a result of a vote to leave, including events of default for material adverse change (MAC).
- Watch this space. For now, we can only talk to possible impact. The exact consequences of a leave vote for our products and transactions will only be capable of being analysed once the specific terms of a UK exit are known and decisions are taken as to the future shape of UK regulation and replacements for existing EU laws. While potentially relevant to all contractual arrangements, this will be particularly acute for those products affected to a large extent by EU regulation – debt capital markets, securitisation and structured products.
Implications of Brexit under loan agreements
Mandatory prepayment events or events of default for Brexit are not standard
A standard LMA-style loan agreement will not list a Brexit as an event triggering mandatory prepayment or as a specific event of default which would entitle the lenders to accelerate the loan. Though we have not seen any such clauses being introduced into the market, any bespoke provisions would need to be analysed.
A vote to leave is unlikely to entitle lenders to call a MAC
A “business MAC” clause is defined in an LMA-style facility agreement by reference to a material adverse effect on the business, operations, property, condition (financial or otherwise) or prospects of the borrower group taken as a whole.
It is difficult to envisage circumstances in which a vote to leave of itself would immediately trigger such a MAC, though economic repercussions in the medium-term may give grounds to argue for a material adverse effect on a borrower’s business, financial condition or prospects on a case by case basis - for example, if the group is predominantly a UK group and its assets are significantly devalued following a leave vote, or it is heavily reliant on trade with Europe; such circumstances would need to affect the whole group. Each MAC clause must be interpreted on its own terms; although we have not seen any Brexit-specific MACs, any bespoke clauses should be checked.
MAC clauses are generally interpreted as requiring a high threshold to be met before they can be invoked. A determination of MAC is highly subjective and, as such, we would expect calling a MAC event of default to be a last resort. It is also unlikely that a lender will be able to rely on a MAC clause if it was aware of the possibility of Brexit when entering into that contract, unless it could not have anticipated the extent of the adverse impact. For further analysis of this and other issues relating to MAC clauses, please click here.
There have been some recent reports of “flexit” clauses being introduced into loan agreements to allow lenders to increase the margin on loans in the event of a Brexit. If included in a loan agreement, the exact trigger (a vote to leave or an actual exit from the EU) for the operation of the clause would have to be considered.
Likelihood of a lender triggering illegality provisions is remote
We view it as unlikely that the illegality provisions in LMA-style loan agreements would be triggered by a Brexit. The loss of the EU single ‘passport’ may pose issues for UK financial institutions providing funding to EU borrowers without separate authorisation (if required). In practice, in this circumstance we would expect UK lenders to lend through an affiliated lending office in the EU rather than invoke illegality provisions to require repayment of their loans. However, the technical risk of potential illegality would need to be considered on a case by case basis.
Other issues for loan agreements
For more detailed discussion of these issues, and also implications of Brexit for:
- Recovery of Basel III/CRD IV costs under the increased costs provisions
- Ability of lenders to restrict the borrower’s choice of auditor
- Specific references to the EU, EEA and EU law in loan agreements
- Availability of EIB funding to UK entities, now and in the future
please click here.
Implications of Brexit for debt capital markets and structured finance transactions
Documentation: force majeure clauses, MACs and unlawfulness event of default
It is unlikely that the market disruption following a vote to leave would be severe enough to trigger market standard force majeure clauses in bond documentation (i.e. the ICMA standard form force majeure clause). For bespoke force majeure clauses (which are often found in private placements, equity linked and other "non-vanilla" deals), this will of course depend on the drafting of the clause.
For the reasons described above in relation to loans, we also view it as unlikely that a vote to leave would trigger a breach of market standard MAC representations and warranties or MAC termination rights in bond documentation, though bespoke clauses would need to be analysed.
It is also highly unlikely that a vote to leave will, in isolation, trigger an unlawfulness event of default, i.e. it is or will become unlawful for an issuer or guarantor to perform its obligations under or in respect of the bonds. This is because, from a legal perspective, nothing will immediately change following a vote to leave. The UK will remain a member of the EU and EU laws will continue to apply until it exits the EU.
Prospectus disclosure and market announcements
There has been a marked increase in the inclusion of Brexit-related risk factors in prospectuses in the run up to the EU referendum. Issuers and originators will need to consider whether it is necessary to include Brexit-related disclosure in prospectuses. Any Brexit-related risk factor should be tailored to reflect the specific circumstances of the transaction, the issuer and its business.
Though the specific circumstances of the relevant transaction and issuer will need to be considered on a case by case basis, the outcome of the vote in itself is unlikely to trigger the need for:
- an immediate prospectus supplement, as a vote to leave is of itself unlikely to constitute a "significant new factor" for Prospectus Directive purposes, particularly if the prospectus already includes Brexit-related risk factors; or
- an immediate market announcement, as the general lack of certainty in the immediate aftermath of the vote will likely make it difficult to identify the specific effects on an issuer or on any guarantor straight away.
EU legislation: no immediate change to current rules but considerable uncertainty as to eventual regulatory position
From a legal perspective, nothing will immediately change following a vote to leave. The UK will remain a member of the EU and EU laws will continue to apply until such time as the UK exits the EU. For the time being, the Prospectus Directive will continue to apply to prospectuses that relate to public offers in the EU and/or admission to trading on an EU regulated market; and the Market Abuse Regulation will still apply, from 3 July 2016, to issuers of debt securities admitted to trading on a regulated market or multilateral trading facility in the EU.
Following a vote to leave, various issues relating to the future landscape for prospectus recognition and equivalence will need to be addressed. For more details, please click here.
Securitisation is currently specifically affected by a large amount of EU regulation. Though there would be no immediate disapplication of this on a vote to leave, there will be considerable uncertainty as to the eventual regulatory position. Many securitisation transactions are medium- to long-dated, and such uncertainty, as well as to what extent any “grandfathering” might be applied, will affect structuring and marketability. Regulatory issues to consider will include risk retention requirements, the requirements for issuers of covered bonds under the UCITS IV Directive, as well as the Securitisation Regulation which is discussed further below. For more detail on these issues, please click here.
What does a vote to leave mean for Capital Markets Union (CMU)?
Whilst the proposals relating to the Prospectus Regulation and the Securitisation Regulation will continue moving forward, on a leave vote it is highly likely that the UK will step back from negotiations relating to CMU.
It is not clear whether or how the proposed Securitisation Regulation and the introduction of the "simple, transparent and standardised" (STS) securitisation criteria would impact on UK securitisations and investors upon a Brexit. Whether a non-EU originated and/or issued securitisation transaction could be capable of complying with the Securitisation Regulation and the STS criteria remains to be seen. For further discussion of these issues, please click here.
Eligibility of collateral for Eurosystem monetary policy initiatives and liquidity coverage ratio purposes
In relation to the position of securitisation debt post-issuance, in order for an asset-backed security to be eligible for use as collateral for Eurosystem monetary policy initiatives, the issuer, underlying assets, underlying obligors and the originator of the assets must be located or established in the EEA, and there are similar requirements in order for asset-backed securities to qualify for liquidity coverage ratio purposes. This eligibility is clearly a crucial feature for some EU investors, and, without further EU legislation, would be lost if the UK left the EU and ceased to be part of the EEA.
Requirements for any future UK securitisation regime
Policy trends in the UK in relation to securitisation over recent years have generally been consistent with, and to some extent a driver of, EU policy. Accordingly, a vote to leave should not, in and of itself, be suggestive of a policy reversal in the UK in relation to securitisation. In any event, in our view the UK would need to have a regime that is largely harmonised with the EU regime in order for UK securitisation debt to continue to be attractive to, and eligible for, EU investors, who have traditionally been a significant source of liquidity for UK covered bonds, RMBS and other UK ABS.
Implications of Brexit for derivatives
Swap documentation: impact on events of default, termination events and mandatory clearing
Looking at standard 1992 and 2002 ISDA Master Agreements, generally we view it as unlikely that a vote to leave or a Brexit would trigger an event of default or a termination event, including for illegality or force majeure. As in any transaction, bespoke events of default or additional termination events would need to be analysed for any potential difficulties, although we are not aware of Brexit-specific provisions being included in ISDA documentation so far.
Following Brexit and depending on the result of the exit negotiations, UK established entities may have a different status under the European Market Infrastructure Regulation (EMIR). While the standard ISDA representation on EMIR status should not be problematic, many counterparties have given simpler representations that may turn out, depending on how they are drafted, to be incorrect. An ensuing misrepresentation may give rise to a default.
Similarly, if the derivative is subject to mandatory clearing then post-Brexit an EU established entity will not meet the requirement by clearing through a UK central clearing counterparty, absent an equivalence determination under EMIR. However, it seems unlikely that these issues would not be addressed in exit negotiations.
Implications of Brexit for restructurings
Future recognition of insolvency proceedings; possible shift to more limited use of pan-European restructuring tools
A vote to leave the EU would create uncertainty about the future recognition of insolvency proceedings of individuals, companies (and to a certain extent) credit institutions and insurance undertakings between Britain and the EU. From a corporate restructuring perspective, attention will be focused on whether and how corporate insolvency proceedings will be recognised as between Britain and member states in the future.
On the one hand, both Britain and the EU might agree to maintain the current pan-European approach to insolvency proceedings in view of the certainty with which corporate rescue and insolvency procedures can be implemented today. On the other hand a return to the territorialist approach of days past might be preferred. This would be likely to give rise to a less co-ordinated approach where there is a pan-European group of companies in insolvency proceedings and would perhaps limit the future use of some or all British mechanisms as pan-European restructuring tools.
Impact on UK schemes of arrangement
The impact on the widely used UK scheme of arrangement is difficult to predict. Following a Brexit, certain aspects of EU law may cease to apply, which may make it harder for English law schemes to gain recognition across the EU, requiring petitioners to fall back on international private law to fill the gap. This is causing real concern that the current widespread use of schemes to restructure the debt of EU-based companies would become more difficult, with a potential shift in the centre of gravity away from the UK to other EU states, many of which are adopting “scheme” type mechanisms in any event.
Implications of Brexit for debt contracts generally
Brexit will pose implications for contracts generally, including debt documentation. For a detailed discussion of these issues, please click here. As an executive summary of the key points:
- On a Brexit, a choice of English law to govern contractual obligations should still be recognised by courts in the UK and will still be recognised by EU member states. A choice of English law to govern non-contractual obligations would continue to be upheld by the courts of EU member states, though the position under English law would be less clear.
- On a Brexit, English courts would still be likely to respect provisions in contracts that confer jurisdiction by agreement on the English courts. However, in the absence of any supranational arrangement with the EU, recognition of English jurisdiction clauses and enforcement of English court judgments by the courts of EU member states is likely to be significantly more complex than at present.
- It is unlikely that a Brexit would have an impact on the reciprocal recognition of arbitral awards where the parties have agreed on arbitration as the only dispute resolution method under a contract.
- If the UK leaves the EU and ceases to be a member of the EEA, going forward certain English law-governed contracts will need to include a “contractual recognition of bail-in clause” for the purposes of the EU Bank Recovery and Resolution Directive, and may need to include a “contractual recognition of resolution stays clause”.
- A large proportion of the body of law currently applicable in the UK consists of law derived from the EU. It is unclear to what extent the UK government would decide to retain EU-derived law as part of UK law following a Brexit. We view it as likely that the UK government would, as part of preparations leading up to a Brexit, enact legislation to maintain the effect of most EU-derived law, at least for a transitional period. The UK government could also decide to “grandfather” pre-existing contractual arrangements so they are unaffected by any repeal or modification of the relevant legislation. Both mechanisms would decrease the scope for uncertainty in this area.
- Contracts may refer to pieces of UK legislation that implement EU law or to pieces of EU law itself. Certain construction clauses (if included) may help but will need to be analysed, particularly in view of EU-derived law that is repealed but not replaced following a Brexit. The transitional arrangements to provide continuity of EU-derived law following a Brexit and the “grandfathering” of contractual arrangements discussed above may assist in mitigating this uncertainty.
What next - documenting for Brexit?
Given the uncertainty that will ensue following a vote to leave, together with the expected time period between the vote and the UK’s exit from the EU, it is difficult to anticipate what, if any, particular contractual or structural features may be introduced into the debt markets or into finance transactions in the immediate term.
That said, following a vote to leave, industry bodies such as the LMA, ICMA and ISDA may well begin reviewing their standard documentation for technical changes which could help to mitigate uncertainty, for example, amending references to EU legislation, or to the EU itself, or enabling future amendments to address change in law and regulation.
A distinction should be drawn between such technical changes, and any business-driven changes market participants may seek to include in debt documentation in the coming months or longer to protect themselves against the scenarios to which a Brexit could give rise. For the moment, it is likely to be too soon to start including specific clauses to deal with Brexit. The consequences for debt products in the medium- and longer-term will be shaped by the macro context of Brexit for legislators and market participants alike, and should be closely monitored as the legal and regulatory landscape becomes more certain.
This post comes to us from the finance practice of Freshfields Bruckhaus Deringer. It has also been featured in Lexology.