The potential impact of Brexit on securitization transactions
Impact of the referendum
Following the vote in the UK referendum on 23 June 2016 to leave the EU, there is some uncertainty as to how this will impact transactions.
We do know that the UK will not leave the EU immediately. This will only happen at the end of the two year process during which the UK may negotiate its withdrawal from the EU, and the arrangements which will apply between the UK and the EU following that. Until then all EU laws continue to apply within the UK. The two year time period for withdrawal from the EU begins when the UK Government formally provides notification of its withdrawal from the EU in accordance with Article 50 of the Treaty on the European Union (TEU).
The regulatory impact of Brexit will very much depend on the new relationship that the UK has with the EU, and much remains uncertain at this time, in particular in respect of banks, insurers and funds passporting outward from the UK. Of course, market participants may start to take steps earlier to mitigate the regulatory impact of Brexit.
EU legislation in the UK
EU legislation has been implemented into UK law in a number of different ways. EU legislation which took the form of an EU directive will have been implemented into UK law by UK Acts of Parliament or UK Statutory Instruments. EU regulations (and level 2 measures such as regulatory and implementing technical standards), on the other hand, are directly applicable in UK law without domestic implementing legislation and will cease to have effect when the UK leaves the EU, unless laws are transposed into UK law to continue the effect of those EU regulations.
The UK may use continuity legislation to avoid a legal vacuum so that EU rules relating to financial services continue to apply in the UK for the time being postBrexit. Using this continuity approach would assist in establishing that the UK satisfies "equivalence" standards applicable to some potential post-Brexit arrangements with the EU. Whether by adopting continuity legislation or replacement regulations, the UK, as a G20 participant, is obliged to meet the global standards which set the overall framework for capital markets regulation, through the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (the BCBS) and the International Organisation of Securities Commissions (IOSCO), even after leaving the EU.
In addition, many EU regulations (such as the Market Abuse Regulation (MAR), elements of the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Regulation (MIFIR, which together, with the directive is known as, MiFID II)) have wide extra-territorial effect and will continue to apply to UK firms irrespective of whether the UK leaves the EU.
The new relationship between the UK and the EU could take one of the forms set out below:
EEA / Single market access (e.g. Norway)
Bilateral agreements (e.g. Swiss model)
Free Trade Agreement (e.g. Canada)
Customs Union (covering goods not services) (e.g. Turkey)
Full exit from EU and reliance on WTO rules (default option).
Looking at the first three options these will all involve to a greater or lesser degree retaining or mirroring EU laws that apply to regulated businesses that want to be able to use passporting or equivalent arrangements to access EU markets which we would expect the UK Government will seek to preserve as much as possible. For example, EEA members must enact EU laws into their own laws.
Third country regimes allow the EU to approve regulated entities to do business in the EU on the basis that their local rules are "equivalent" to EU rules. The easiest way to achieve equivalence is to enact applicable EU laws into the country's local law.
Bilateral agreements may give some more scope for flexibility in local law but again one would expect a degree of similarity between the local law and EU law in respect of the relevant regulated industry.
Full exit would mean that the UK would be free to set local rules in respect of relevant regulated industry without concerns over equivalence, although the UK would still be obliged to satisfy its G20 commitments referred to above. It would also, obviously, mean that access to EU markets for those UK regulated entities would be unlikely to be available.
Impact on specific regulations and directives
See below some initial thoughts on the main areas of EU law which are relevant to securitizations:
Solvency II/CRR/AIFMD/AIFMR These regulations currently contain due diligence and retention requirements for insurers, banks and funds investing in securitizations. Following Brexit these rules may change for UK insurers, banks and funds but this will depend on the form of the new relationship between the UK and the EU, although liquidity considerations may dictate that EU diligence and retention rules are still complied with. Certain notes may be structured to achieve "matching adjustment" treatment for insurers for Solvency II capital requirements. These rules could well still be relevant due to attempts to allow for equivalence between the UK and EU regimes and because insurers may have operations within remaining EU countries.
Credit Rating Agency Regulations These regulate, among other matters, the use of credit ratings by financial institutions in the EU and the operation of credit rating agencies. The UK's exit from the EU would in all likelihood have a limited
impact and the regulations already include provision for the endorsement or certification of non-EU rating agencies.
Prospectus Directive (PD) UKLA approved prospectuses may no longer be PD compliant and, potentially, PD approved prospectuses may not be passported into the UK. However, this is likely to have limited impact on securitizations given investors will generally be qualified professional investors, and should therefore be exempt from the requirement for a PD prospectus (albeit as qualified investors rather than under the 100k exemption which may be removed by PD3).
STS / Securitization Regulation (draft) These contain rules which will consolidate existing rules applying to any securitizations and new rules for treatment of transactions as Simple, Transparent and Standardized (STS) securitizations. To the extent that notes are to be offered outside the UK these rules may still be relevant, although implementation is not expected until 2018. Certain provisions in the current draft mean non-EU originators and SPVs will not satisfy the requirements of STS although acceptance of third country regimes may be considered at a later date.
Depending on the form of relationship between the UK and the EU following Brexit, the effect of other EU legislation such as EMIR, MiFID II and the Bank Recovery and Resolution Directive (the BRRD) may also be impacted in the UK.
Eurosystem collateral eligibility is unlikely to be available to UK originated ABS (unless the UK becomes part of the EEA). ABS which include residual value risk have been excluded as Eurosystem collateral since earlier this year. This means that in some cases UK ABS have not qualified as Eurosystem collateral since earlier in the year (for example, UK automotive ABS often include residual value risk).
Rating downgrades of UK banks may mean that they do not hold the applicable ratings to act as account banks, liquidity facility providers or swap counterparties. On existing transactions where the most senior notes are rated higher than such counterparties this may mean that the relevant bank has to be replaced.
The sovereign ceiling is the rating level above which local securitizations cannot be rated. It is linked to (but can be higher than) the rating of the sovereign. In the worst case and depending on further downgrades of the UK's sovereign rating, it may be that UK ABS cannot achieve AAA ratings in the future.
Impact on UK fundamentals
It is possible that Brexit could adversely affect UK (and European or worldwide) economic conditions. This could trigger an increase in defaults and voluntary terminations in respect of the underlying assets backing transactions, and transactions where there is a high proportion of multi-let office and retail commercial property or buy-to-let residential properties may be particularly exposed. The market uncertainty may favor vanilla deals involving short dated assets such as auto loans structured with UK issuers, and deals backed by longer dated assets looking to the private rather than publicly placed transactions in the short term.
Risk factors will need to be updated to reflect the outcome of the Brexit referendum and the economic, political and regulatory uncertainty that will now ensue for the UK. Consideration should be given to mentioning this in non-UK deals as well.
Contractual choice of law and jurisdiction
If the UK is no longer party to Rome I, English courts are still likely to continue to recognize the choice of other laws in commercial contracts. The position on choice of law to govern non-contractual claims (which is governed by Rome II) may be less clear. Courts in the remaining EU jurisdictions will continue to recognize the choice of English law in commercial contracts. This is because the Rome Regulations make no basic distinction between the laws of states inside and outside the EU: parties are free to choose either.
Choice of jurisdiction clauses would also continue to be recognized if post-Brexit the UK acceded to the 2005 Hague Convention on Choice of Court Agreements as an independent contracting state. (It is already subject to the Convention following the EU's accession in 2015.) This would result in reciprocal recognition between UK and EU Member States (except Denmark). Accession of countries to the Convention is not subject to the approval or agreement of existing signatories, but it is also not retrospective in effect. This means that the Convention
applies only to choice of jurisdiction agreements concluded after the Convention comes into force in the country whose courts are identified in the clause. The clause must also be exclusive and, with limited exceptions, not one-sided.
The EU Insolvency Regulations may cease to apply. These regulations deal with establishing the primacy of insolvency processes in relation to companies throughout the EU.
The UK has implemented into UK law the Model Law of the United Nations Commission on International Trade Law (UNCITRAL) on cross-border insolvency. The Model Law aims to provide a common international framework in which to deal more effectively with crossborder insolvencies, by enabling recognition of foreign insolvency proceedings and allowing for co-operation between foreign courts and foreign representatives. Only a limited number of EU Member States have implemented UNICITRAL, and there is at present little case law to indicate how the English courts will apply the provisions of UNCITRAL as implemented in UK law.
Accordingly, even in a worse case, we consider straightforward securitizations could still be structured with nonUK SPVs, although this would need to be considered on a transaction-by-transaction basis and it may not be the case for securitizations of some asset classes.
The EU Credit Institution Winding-Up Directive may cease to apply. This would be relevant to transactions for which the winding-up under UK law of an originator which is a credit institution is important for legal structuring.
Security financial collateral arrangements which were implemented under the Financial Collateral Arrangements (No. 2) Regulations 2003 will cease to apply, but are likely to be re-enacted by UK domestic law.
If data is to be passed from EU countries to the UK as part of the securitization, consideration will have to be given to whether EU citizens receive adequate protection under UK law in relation to the storage and processing of their personal data, once the UK is no longer part of the EU. If data is to be passed from the UK to EU countries as part of the securitization, similar considerations are likely to be relevant depending on the requirements of UK law at that time. Such transfers could take place because of the location of SPVs, servicers or data trustees depending on the identity of the data controller and data processor.
The position is complicated further by the current process of implementing the EU General Data Protection Regulations which will apply in EU Member States from 25 May 2018. This will impose higher requirements on companies which process personal data, and it would in theory apply to UK companies if the UK had not yet left the EU.
Withholding on the receivables Payments on the underlying receivables from the UK to another jurisdiction (including within the EU) may be subject to withholding for UK tax. On transactions where there are such payments we would expect the position to have been considered already as part of the initial advice, and for these to be made gross due to the payments not constituting interest, other exemptions, treaty clearances or HMRC guidance. We do not expect the position to change following Brexit.
Withholding on the notes Many transactions will rely on the notes being listed on a recognized stock exchange. This allows the notes to benefit from the "quoted eurobond" exemption so interest can be paid gross. There is no indication that this will change and it is a feature of UK law rather than EU law.
Double tax treaties Subject to eligibility and, in some cases, clearance by HMRC, double tax treaties allow payments to be made out of the UK, gross of withholding for UK tax. These treaties are bilateral agreements between UK and the counterparty country. Accordingly, we do not expect the position to change following Brexit.
VAT There is uncertainty on VAT generally but the most likely outcome is that the current VAT system will be retained and changes will be gradual. Depending on the outcome of discussions there may be a change in VAT treatment and charges for the
services provided under the servicing agreements. For example, the UK may apply an exemption to servicing fees, which is an approach currently adopted in some EU jurisdictions.
Stamp tax The 1.5% stamp charge on issue of notes into a clearance service has been declared incompatible with EU law and accordingly HMRC do not collect the tax. Without a change in law, Brexit would resurrect this charge, although in most cases exemptions would be available.
For more resources on readying your business for Brexit, and our latest thinking, visit our Brexit Hub at: www.hoganlovells.com/brexit
This briefing note is a summary for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. If you have any questions, please contact your usual contact at Hogan Lovells or any of the contacts listed on the left hand side of this briefing note.
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