The UK government has committed to holding a referendum on the United Kingdom's membership of the European Union on June 23 2016 and has agreed the terms of its renegotiation of EU membership in readiness for that referendum.
If the United Kingdom votes for a British exit from the European Union ('Brexit'), the date on which Brexit is completed would depend on the implementation of the Brexit arrangements; but there would be a long-stop date of the second anniversary of the United Kingdom's notification to the European Council that it wishes to leave the European Union (unless the United Kingdom and the European Council both agreed to an extension).
Although the exact impact of Brexit is uncertain and much would depend on the precise terms of the outcome of the exit negotiations, there are potential issues that may affect derivative transactions in the event of Brexit.
Impact on collateral
The International Monetary Fund and the Bank of England recently warned that Brexit could have a material impact on the UK economy. If they are right, and Brexit leads to financial and economic volatility in the United Kingdom, this may have implications for the derivatives markets.
Credit rating agencies have stated that they would review their UK sovereign ratings in the event of a 'leave' vote. If there are downward changes to the UK credit rating, this would affect the creditworthiness of counterparties with exposure to the United Kingdom, which would make the cost of credit more expensive and could lead to increased collateral requirements.
Fluctuations or volatility may also increase mark-to-market exposures under existing derivatives contracts, which could trigger obligations to post additional margin. If there is a decrease in the value of UK-posted collateral such as sterling cash or gilts, counterparties would be required to post additional margin to cover the exposures.
Although it is difficult to assess the precise impact that Brexit might have on derivatives documentation, given that much will depend on the terms of the Brexit arrangements, parties might want to give initial thought as to how their derivatives documentation could be affected by undertaking an initial review to highlight any potentially difficult clauses. Such clauses will then need to be looked at more closely once the details of any Brexit agreement are available. Consideration should be given to:
- bespoke termination events;
- standard termination events;
- standard events of default;
- bespoke events of default;
- references to specific EU regulations or EU territory;
- tax provisions, which could be affected if there is a change in the withholding tax treatment, for example; and
- governing law.
Technical amendments to documentation are also likely to be required, as well as a review of the standard International Swaps and Derivatives Association (ISDA) representations and agreements.
If Brexit triggered a deterioration in creditworthiness, there might be defaults or similar credit-related events. It seems unlikely that Brexit in and of itself would trigger an event of default or termination event under the 1992 or 2002 ISDA Master Agreements. It is also difficult to see how the illegality or force majeure termination events might be triggered by Brexit.
Many over-the-counter derivatives contracts are governed by English law and include a submission to the jurisdiction of the English courts, even if there are no UK counterparties. At present, all EU countries apply the EU rules on governing law embodied in the Rome I and Rome II Regulations, which determine the law applicable to contractual and non-contractual obligations respectively.(1) In the event of Brexit, Rome I and Rome II may no longer apply; for the sake of continuity, however, a means might be found by which the United Kingdom could still be subject to these main rules on governing law.
Relevant EU regulation
Many laws governing how the derivatives markets operate in the European Union come from EU directives and regulations. Going forward, the United Kingdom will need to decide how much (if any) EU law it wishes to retain in UK law post-Brexit, with a range of possibilities from a clean break to mirroring EU law in UK law.
Where EU law has been made by way of directive, implementing legislation in the United Kingdom could continue to apply, subject to any amendments necessary to acknowledge that the United Kingdom is no longer part of a wider EU legal or regulatory structure.
Alternatively, the United Kingdom could diverge from the requirements of the relevant directive by amending that legislation. However, much recent legislation relating to derivatives has been made by way of EU regulation, which does not require implementing measures in order to be effective domestically (eg, the recent Capital Requirements Regulation, European Market Infrastructure Regulation (EMIR) and Markets in Financial Instruments Regulation). Consideration will need to be given to how EU regulations that were directly applicable – such as EMIR – would operate going forward.
In light of the global nature of the derivatives market, much of EMIR has cross-border reach and equivalency measures and consideration will need to be given to ensure that the United Kingdom can still benefit from those measures. For example, unless some form of grandfathering arrangements are established, UK central counterparties (CCPs) are likely to be treated as 'third-country CCPs' and will need to apply for 'recognition' under EMIR in order to continue to be able to offer their services to financial institutions based in the European Union. Similarly, UK trade repositories may need to be recognised as third-country trade repositories under EMIR in order for market participants to continue to report their trades to them in accordance with EMIR.
If English law becomes non-EU law, consideration will need to be given to those requirements under EU regulations that stipulate compliance by non-EU law entities. For example, in respect of bank resolution issues, it is possible that English-law governed contracts would need to include a contractual recognition of bail-in clause, given that under Article 55 of the EU Bank Recovery and Resolution Directive, these need to be included in every in-scope contract that is governed by a law of a non-European Economic Area (EEA) country.
However, if, upon Brexit, the United Kingdom were to become a European Free Trade Association member state and part of the EEA, certain EU directives would still apply, such as:
- EU directives on financial collateral arrangements;
- the EU Credit Institutions Winding-Up Directive;
- the EU Bank Recovery and Resolution Directive; and
- the Rome I and Rome II Regulations (which are relevant for the insolvency and choice of law analysis on deals).
Until the details of the post-Brexit arrangements are made available, it will be difficult to assess the potential impact on derivative transactions. Given the importance of the derivatives market to the United Kingdom, it is expected that the UK government will be keen to ensure that many of the protections for derivative transactions remain in place, and that the United Kingdom can continue to benefit from any cross-border arrangements. Care may be needed to ensure that key definitions still work in existing transaction documentation, while an initial review of documentation may throw up potentially problematic clauses. Market participants will also need to keep abreast of any applicable changes to taxation laws.
For further information on this topic please contact James Doyle or Isobel Wright at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (firstname.lastname@example.org or email@example.com). The Hogan Lovells International LLP website can be accessed at www.hoganlovells.com.
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