We now know the result of the referendum on the UK's continued membership of the EU and it is a vote to leave, marking the start of a period of uncertainty for businesses. The shape that Brexit will take is not certain: we don't know how this will develop politically and we don't know the terms of any deal the UK will strike with the EU. As of yet there is no agreed proposal from the leave campaigners on how they want our future trading relationships to look. We do know there is only one established way to leave the EU, contained in Article 50 of the Treaty on European Union, and once this is triggered, there is no turning back. But this isn't the only option for leaving, we are in unchartered waters and who knows how it will play out?
This leaves all of us in business with some interesting contingency planning to do, because we don't know whether in the future we will be guaranteed seamless and tariff-free access to EU markets and, if so, on what terms. Into this mix we then add the effect of EU regulation. Currently, it is pervasive and is not going to disappear overnight and possibly at all in many areas, particularly where the UK has "gold-plated" underlying EU directives, where politically it is too contentious to repeal or where regulation is a result of global initiatives.
This briefing gives some general pointers for contingency planning for general commercial contracts. It does not look at particular sectors or regulations, nor the impact of a reduction in migration of labour but is a starting point for a review of the leave vote's general implications for trading arrangements. This is planning for short term uncertainty until the point is reached when the UK's future relationship with the EU becomes clearer. Irrespective of how we all plan for this uncertainty, it is in all of our interests to work out what our particular businesses need and to lobby for that outcome.
A starting point for contract review
Although there are various possible trading models the UK and the EU could agree to adopt, one approach for contingency planning is to adopt certain assumptions from worst case and best case scenarios. There is no shortage of viewpoints here but this briefing is going to use the CBI's March 2016 report commissioned from PwC and that report's adoption of 2 scenarios on which to base their view of the economic implications of Brexit on the UK economy.
That report's best case scenario is that the UK negotiates a free trade agreement with the EU, based on tarifffree trade in goods (but not services). This still means that the UK would have to implement EU standards on goods supplied to the EU, would be in a position to negotiate separate free trade agreements with the US and other non-EU countries and would gain greater control over regulatory policy which could result in the cutting of some red tape and cost savings. However, there would be regulatory divergence between the UK and the EU over time which would have to be managed by businesses, leading to potential other costs.
On the other hand, the report's worst case scenario is that the UK, having failed to agree a free trade deal, trades with the EU on World Trade Organisation rules, so that tariff-free trade in goods with the EU stops. The UK government would gain greater control over regulatory policy but again there would be regulatory divergence between the UK and the EU over time. This scenario also means that current free trade agreements between the EU and third party countries will no longer apply to the UK so that tariffs and other barriers should be assumed across the board.
Whichever scenario applies, there are certain constants: some regulatory divergence and in the short term uncertainty over the UK's future relationship with the EU which in turn is likely to lead to financial market and exchange rate volatility, higher risk premia in credit and equity markets and consequential impact on investor confidence. Statements by Germany's finance minister earlier this month making clear that there would be no single market access for the UK after Brexit suggests contract review should lean towards the worst case scenario.
Identifying contracts at risk
A starting point for contingency planning is an initial high level assessment of trading relationships to identify priorities, for example by focusing on strategic contracts or those relationships where:
- there is dependence on EU trade or on EU funding or grants
- EU authorisation or passporting is assumed
- pricing mechanisms assume no tariffs, quotas or other barriers (and those other barriers could be regulatory requirements, legal barriers or transaction costs) or are tailored to take account of particular savings or levels based on EU free movement of goods and people
- currency fluctuations will cause significant increased burden
- performance assumes compliance with particular EU law that the UK government in the future might repeal as "red tape" or where regulatory divergence is likely in the future.
Determining the risk criteria
Once contracts and relationships have been prioritised, they can be assessed by reference to the extent to which they could be affected by uncertainty (both market turmoil and adverse currency movements) and by the risks identified in the CBI's scenarios: the potential application of tariffs, quotas or non-tariff barriers and by regulatory divergence. Categorisation by location of production or service, industry sector or value of the contract can be used to score arrangements to establish a further priority of review. This process should also be embedded into any tender or evaluation processes for new arrangements.
Contracts also need to be reviewed to check whether any particular clauses could be triggered either against you or in your favour by a particular consequence of Brexit. For example clauses dealing with illegality, market disruption or material adverse change. And what if conduct requires EU registration or authorisation? What happens if this is lost?
A range of contractual tools
The next stage would be to assess the risks you have identified against the possible contractual mechanisms you can use in mitigation. These include:
- compliance with law obligations should they apply to Brexit imposed changes?
- providing that changes in particular laws or new barriers give rise to rights to renegotiate or price adjust but with significant changes or those which result in significant adverse consequences allowing for exit or suspension rights
- agreeing renegotiation rights or costs allocation if Brexit or any associated market volatility or credit risk results in increased or reduced costs or reduced rate of return
- considering transitional arrangements if exit rights are triggered
- ensuring territorial restrictions or definitions continue to work in a post Brexit world.
Each of these tools need to be assessed against the desirability of triggering them. Are they the best way to deal with Brexit uncertainty? Do they cut both ways for example, Brexit might mean your obligations become less onerous but equally the standards of performance of your suppliers could be reduced. Considering when they come into play and when they trigger additional rights is going to be as important as their effect you could for example provide that they are triggered if a particular event occurs (such as the introduction of new tariffs or other barriers to a supply) or only if costs of performance exceed a predefined ceiling.