In the July 2017 edition of the Delta Report, we provided a snapshot update on Brexit and set out some of the key issues that were beginning to emerge as relating to the regulatory framework for the derivatives market once the UK has formally exited the European Union ("EU")². Since July 2017, a number of significant developments have occurred that have provided some further colour on the respective negotiating positions of the EU and the British government and a degree of insight into what the next steps are for the regulatory and legal framework impacting derivatives users. In this article, we consider these developments, their potential impact on the derivatives market in the coming year and highlight some of the issues that counterparties are already seeking to address when negotiating core documentation such as the ISDA Master Agreement.
Key Developments: Summer 2017
Following the formation of a new coalition government in June, three rounds of negotiations between the British government and the EU's representatives have been held, the final round of which concluded at the beginning of October 2017. The British government's strong desire, following the conclusion of such talks, was to move to discussing the future relationship between the UK and the EU, providing much needed clarity for, among others, the financial sector. In order to address some of the concerns raised by the EU that might have prevented negotiators approving a move to this next step, British PM Theresa May gave a speech in Florence on 22 September 2017 (the "Florence Speech"), which outlined some of the key positions of the British government including (i) the desire for an 'implementation period' of around two years from the exit date, (ii) payments into the EU budget and the ability of the UK courts to take into account judgments of the European Court of Justice (the "ECJ") during such period and (iii) offering certain guarantees around the rights of EU citizens. While generally welcomed for its constructive tone, on 3 October 2017, the European Parliament voted to approve the lead negotiators' view that there had not been 'sufficient progress' on key issues such as the UK's existing and contingent liabilities to the EU, the rights of EU citizens and resolution of the border issue in Northern Ireland to move to the next phase of talks regarding future relations. However, the draft text for a recent summit of EU Member States (which took place in late October 2017) indicates some scope for consideration of transitional arrangements3, agreement of which would greatly assist, among others, financial institutions concerned about the impact on their operations based in the UK should the UK exit the EU without an agreement in approximately 18 months' time.
Over the course of the recent rounds of talks, the British government has also issued a series of 'Position Papers' and 'Future Partnership Papers'. Key papers of note include those on 'Ongoing Union Judicial and administrative proceedings' 4, 'Privileges and Immunities' 5, 'Providing a cross-border civil judicial cooperation framework' 6 and 'Enforcement and dispute resolution' 7. A summary of the key points for consideration for derivative market participants currently negotiating and with existing English law governed documentation is set out below. However, it remains difficult to predict with any certainty the likely route that will be taken in ensuring the continuity of current arrangements as relating to cross-border enforcement of English law judgments, the future role of the ECJ (on a short term and long term basis) and the impact on ongoing judicial proceedings as the shape of an agreement between the EU and UK is yet to emerge. Such uncertainty looks set to continue, given the EU's principle that "nothing is agreed until everything is agreed".
Choice of law, jurisdiction and enforcement of judgments
As noted above, one of the key papers published by the British government over the summer of 2017 was 'Providing a cross-border civil judicial cooperation framework'. The paper published in response to a corresponding position paper published by the EU Commission entitled 'Judicial Cooperation in Civil and Commercial Matters' 8.
In comparing the two papers, we note that the British government paper is broadly in alignment with the Commission's proposals in terms of separation issues where assuming no agreement on future relations between the EU and the UK is reached. However, it is also wider in scope than the Commission's in that it posits what a future relations arrangement should include as well as noting certain key points that could be covered in a withdrawal agreement with EU. The comparison does offer some level of insight into what such a withdrawal agreement may contain (and therefore some indicative preliminary guidance for parties using (or seeking to negotiate) English law governed contracts. We would caveat this, however, by noting that the British government paper remains aspirational and generalist in nature as opposed to providing a set framework that it wishes to see adopted. A number of the posited future arrangements are also, in large part, dependent upon the consent of third parties (including the EU and individual Member States in the EU and EEA).
The key points in the paper are as follows:
- As consistent with the 'Repeal Bill' which is currently making its way through the UK Parliament9, the Rome I and Rome II Regulations10 (the "Regulations") will be incorporated directly into UK law following repeal of the European Communities Act 1972. Upon the UK's exit from the EU, this should therefore mean that English courts (and those in the remaining EU member states) will be applying the same body of rules to determine the governing law of the relevant parties' relationship. The British government paper does not state how courts should interpret the Regulations post exit, but presumably, as per section 6(3) of the Withdrawal Bill, English courts (other than the UK Supreme Court) should apply EU law in accordance with retained case law and retained principles of EU law pre-dating the formal date of the UK's exit. Section 6(4) of the Withdrawal Bill states that the UK Supreme Court will not be so bound but it must apply the same test as it would apply in deciding to depart from its own case law. In respect of EU case law decided post the formal date of the UK's exit, the Withdrawal Bill is clear that UK courts may ignore such jurisprudence.
- The British government paper indicates that the UK will seek to continue to participate in the Lugano Convention11, which itself contains reciprocal rules on jurisdiction and cross-border judgment enforcement between the EU and Norway, Switzerland and Iceland. The Lugano Convention is open to participation by sovereign states that are or become members of the European Free Trade Association (EFTA) and also by other sovereign states. Other states wishing to accede can, however, only do so with the unanimous agreement of the existing signatories to the convention. Even assuming that consent is provided, we would view it as likely that there will be a gap between the UK's formal date of exit and formal accession to the Lugano Convention, particularly if the formal date of exit remains March 2019. Likewise, the Lugano Convention does not provide (unlike the Regulations) that where proceedings are commenced in a EU Member State court in breach of an exclusive jurisdiction clause, the EU Member State court is required to stay its proceedings to allow the chosen court to rule on jurisdiction (which may well lead to increased delay). Adoption of this position by the British government is, however, significant given Lugano Convention members are required to 'pay due account to' ECJ rulings, something that the British government has previously indicated would not be acceptable (although during the Florence Speech, a softening of this position was also eluded to).12
- The paper also indicates that the UK intends to participate in the Hague Convention on Choice of Court Agreements 2005 (the "Convention") which sets out jurisdiction and cross-border enforcement rules where there is an exclusive choice of court agreement. The UK is currently a party to the Hague Convention by virtue of its EU membership, as are all EU Member States. Further, the UK will be free to accede to the Convention without the need for the consent of other parties. However, it will likely only apply to agreements made after the UK accedes to the Convention in its own right. Such arrangement in itself would, while welcome, also be inferior to the current enforcement regime under the Regulations. For example, the Hague Convention requires each contracting state to designate a 'Central Authority' to receive and execute requests for service originating in other contracting state; a process likely to be slower than service pursuant to the Regulations.
- With regards to enforcement of judgments between the UK and the remaining EU Member States following the UK's exit, the paper does not otherwise provide any specific proposals. The paper states only that it is the government's intention that a future framework will be agreed "which reflects closely the substantive principles of cooperation under the current EU framework". This is obviously not something that is within the complete control of the UK given it requires an actual agreement with the EU. Should the UK leave the EU with no such agreement in place (and assuming consent to the Lugano Convention was not forthcoming), the enforcement of English law judgments in EU member states could become much less streamlined than is the case at present under the Regulations.
- In the event that no agreement is reached with the EU, contract parties who have existing or soon to be concluded English law governed agreements subject to the jurisdiction of the English courts should note, for the moment, that the existing EU rules: (i) should continue to apply to judicial decisions made before the UK's formal exit date and to proceedings instituted before that date, (ii) on applicable law for contractual and – based on the UK Government's indications – non-contractual obligations should continue to apply to contractual agreements that have been concluded before the formal exit date and (iii) where a choice of court has been made prior to the formal exit date, the current rules should continue to apply to the establishment of jurisdiction and recognition and enforcement of any resulting judicial decision, albeit that there remains some uncertainty as to the precise position that will apply in respect of jurisdiction over claims and enforcement proceedings that post-date the formal exit date.
- Regarding the longer term arrangements, further clarity is still needed, although as a general principle, the UK appears to be looking to replicate its existing arrangements (albeit without the directly applicable recourse to the ECJ that is currently available along with the obligation to apply its jurisprudence). For parties negotiating English law governed agreements at present, the issue to be considered is really whether the ability to quickly and easily enforce a UK judgment across EU Member States or a judgment given in an EU Member State in the UK) is a key aspect in the decision as to which court should have jurisdiction. If enforcement without delay across EU Member States is a key factor, then the differences between the EU and the UK positions could lead to some uncertainty, requiring more detailed jurisdiction-specific consideration than jurisdiction provisions have previously been accorded.
Issues emerging in core derivatives documentation negotiation
Given the widespread assumption until very recently that the UK and EU would reach an agreement on a form of transitional arrangement, the need to consider further amendments in English law governed derivatives documentation has been limited. However, given the pace at which negotiations between the EU and UK have progressed, it is becoming apparent that a number of counterparties are preparing, in their documentation, for a scenario in which the UK exits the EU without an arrangement that broadly preserves the status quo in the near future. Some key examples of this are as follows:
- We have noted an increasing number of queries around the jurisdiction clause in the ISDA Master Agreement and whether parties should be looking to amend Section 13 (Governing law and Jurisdiction). Given the uncertainty around future arrangements, parties have broadly continued to opt for the status quo, however, certain counterparties have considered (i) inserting a fully exclusive jurisdiction clause that dispenses with the current references to European legislation, (ii) inserting an arbitration clause which would be unaffected by the UK's withdrawal from the EU, or (iii) inserting a fully non-exclusive jurisdiction clause which would also remove any uncertainty as to exclusivity/non-exclusivity in the EU and gives parties a full range of options as to where to bring proceedings.
- We are also starting to see requests to incorporate the ISDA 2015 Universal Resolution Stay Protocol (as published by the International Swaps and Derivatives Association, Inc. on 4 November 2015)13 which allows for the contractual recognition of cross-border application of special resolution regimes, into the ISDA Master Agreement given that the UK will upon exit become a 'third country' for the purposes of the Bank Resolution and Recovery Directive (and as is mandated by Article 55 of the same)14.
- We have seen a much deeper analysis given by counterparties in negotiations of certain representations (e.g. Section 3(a)(iii) (No violation or Conflict) or Section 3(a)(iv) (Consents)), termination events (Force Majeure and Illegality) and events of default (Breach of Agreement) in the ISDA Master Agreement.
Potential impact on the derivatives market more generally
As noted in our July 2017 article on Brexit in the Delta Report, with regards to the derivatives market, attention thus far has focused on the future role of clearing houses and the indications by the EU that it intends to mandate clearing of euro denominated derivatives to be conducted within the geographical confines of the EU. However, given a large portion of derivative contracts are still conducted over-the-counter and, in the event of the UK exiting the EU without an agreement (and therefore the loss of passporting rights that allow financial institutions to conduct business, including entry into derivative contracts, across the EU), this could present issues both for the signing of new derivative contracts and for existing contracts. While existing contracts would have been entered into prior to the UK's exit date, regularly conducted exercises such as compression (where some (or all) offsetting contracts are terminated to be replaced with a new contract), novations to another counterparty or even 're-setting' of trade terms could constitute 'regulated activities' that a UK based financial institution may no longer be authorised to conduct in the EU.
As such, if portfolios of legacy trades remain in the UK upon the date of exit, counterparties may be prevented from making the day-to-day adjustments that are common practice in the market where there is a contractual nexus with an EU based entity.
Solutions to such issues are not readily apparent. One that is oft-cited is that counterparties could look to novate legacy trades to a legal entity within the EU. However, this approach has two major shortcomings in that: (i) such legacy trades may then become subject to clearing or margining requirements pursuant to the European Market Infrastructure Regulation15 (to the extent they have not already been subjected to such requirements) and (ii) this would also require the novating counterparty to have a suitable entity based within the EU to novate the trades to. While less of an issue for end-users of derivatives, for financial institutions, the requirements around novations may prove extremely challenging in view of the timeframe left prior to the UK's exit date and the apparent resistance of EU regulators to such entity being of a 'brass plaque' nature.
On the latter point, on 12 October 2017, the European Banking Authority provided guidance on certain issues related to the UK's departure from the EU16 and emphasised that institutions lining up to be authorised who are seeking to implement 'post-Brexit' arrangements should have a proper risk management function based in the relevant EU member state and sufficient capital held in such member state to cover the entity including where it is looking to book 'back-to-back trades' with one of its other group entities based outside the EU (i.e. in the UK).
Clearly such requirements (and the other issues mentioned above) will prove extremely challenging to address in the time left prior the UK's exit date, again assuming that no transitional arrangements are agreed. We are actively working with clients to consider the potential impact of these issues on their existing portfolios and future trading arrangements.