HCJP's Synopsis on the Potential Impact of "Hard" Brexit
The Situation: The Legal High Committee for Financial Markets of Paris ("HCJP") recently published a synopsis of its three Brexit reports on contracts continuity.
The Result: In the event of the United Kingdom crashing out of the European Union in March without an overall deal, the three reports examine potential effects of a "hard" Brexit on (i) banks & investment firms, (ii) asset managers, and (iii) insurance companies.
Looking Ahead: This must be put in perspective with the two draft regulations laid down before Parliament by the UK government on July 25 and the Brexit negotiations that have just resumed and are now due to be carried out continuously. The HCJP working groups are expected to publish full reports in the fall.
The United Kingdom would be outside the European Union's framework for financial services in the unlikely scenario that the United Kingdom leaves the European Union without a deal. The capacity of UK firms to provide relevant regulated services to the EU 27 clients would then be determined by the default Member State and EU rules that apply to third-country firms.
The HCJP established three working groups to consider the potential impact on (i) banks and investment firms, (ii) asset managers, and (iii) insurance companies, respectively.
The working groups are expected to publish reports in the fall, but a synopsis of their conclusions was issued on July 19, 2018.
The working groups consistently concluded that risks need to be assessed differently for legacy trades (contracts validly entered into before the exit day) and new transactions (contracts to be entered into after the exit day).
The HCJP working groups generally do not believe that insurmountable legal issues would be created if the United Kingdom leaves the European Union without a deal. Key findings of the reports include:
- The loss of passport rights for UK firms will only affect their capacity to enter into new transactions, but should not prevent their ability to validly perform existing obligations;
- Brexit, whether "hard" or "soft," should not be a cause of termination, force majeure, or frustration of existing contractual arrangements; and
- UK firms, even after losing their passport rights, will be able to manage most lifecycle events of ongoing continued transactions. Only lifecycle events that require providing a new regulated service might raise issues and require the intervention of a EU 27 regulated entity.
The reports, however, acknowledge legal issues raised by the management of some lifecycle events—essentially those that require providing new investment services—and consider two more problematic types of contracts or services that would need specific attention, including:
- Long-Term Insurance Contracts. Although this is not a universally admitted opinion, some scholars consider that insurance activities—as opposed to banking or investment service ones—do require permanent licensing and passport rights for policies to comply with the law and indemnities being paid until the maturity of the relevant contract. The fact that regulatory license and authorization were in effect at the time the contract was entered into cannot satisfy the requirement; and
- Portfolio Management. Portfolio management is an investment service rendered on a continuous and permanent basis. As a result, carrying on any mandate or management service in relation to a portfolio or a fund falling into the scope of the monopoly after the exit day will (unless the benefit of certain derogations for professional clients) be a breach of such monopoly.
If the UK and the EU do not reach a deal, UK firms would need to wind down their EU-regulated activities and stop entering into new banking, financial investments, and insurance-related transactions. The loss of EU banking, investment services, and insurance passport rights will prevent any firm established in, or operating from, a third country from offering any related services to EU clients falling within the scope of the three monopolies. Breaches of these rules are criminal offenses.
The reports discuss in detail uncertainties and serious legal concerns raised by any businesses model that would seek—on the ground of equivalency, reverse solicitation, chaperoning, or passive booking theories—to maintain business as usual.
The reports finally conclude with a series of four key recommendations:
- UK firms willing to carry on activities on the continent are encouraged to begin the process of transferring their European business to a duly licensed entity in the European Union as soon as possible.
- The reports strongly advocate for EU legislation to create a new instrument authorizing any international group wishing to transfer part of its business or transactions portfolios run out of London to one of its EU incorporated entities, to be able to do so in a simplified, efficient, secured, and prompt manner. This could, for instance, be achieved by designating within the relevant group, an EU entity able to receive and run the relevant business and clients. Provided that a minimum number of objectives tests relating to the recipient structure would be met (e.g., credit rating, counterparty/risks/solvency prudential ratios, status and guarantees, proper license and authority, etc.) the concept would consist of authorizing a transfer of business and portfolios by mere notification to the counterparties—with no right to oppose, nor need to receive an express prior approval.
- The HCJP is also calling for the European Commission ("EC") to grandfather all transferred transactions vis-a-vis the European Markets and Infrastructure Regulation ("EMIR"), the Markets in Financial Instruments Directive ("MiFID"), and other similar regulations, so that a transfer could be done on an "iso" regulatory basis. This will mean extending currently applicable grandfathering regimes pertinent to clearing or mandatory collateralization, irrespective of the fact that the transferred transactions would, from a legal perspective, be regarded as a newly entered transaction, because of its novation.
- Finally, the reports are pleading for market authorities to accommodate a transition period for activities such as portfolio management. The objective of a transition period would be to allow currently active UK managers not replaced by EU managers on the exit day, to progressively run their relevant business off in a way comparable with the way EU firms losing their regulatory approval or license are dealt with. Existing UK managers would be authorized to handle any transactions strictly necessary to the preservation of their clients' interest during this transition period and with an ultimate objective of liquidating or transferring the relevant positions/portfolios.
The HCJP synopsis, reports, and recommendations are to be put in perspective with the two draft regulations laid down before Parliament by the UK government on July 25 and respectively relating to central counterparties ("CCPs") and passport rights. We should welcome the fact that there seems to be more determination on both the EU and UK sides to work together to accommodate the financial industry's practical and operational issues created by Brexit.
We know that the European Communities Act 1972 is due to be repealed on exit day by the United Kingdom and that the existing body of directly applicable EU law (including EU regulations) will be converted into UK domestic law.
- The CCPs Draft Regulation Proposes to Amend EMIR. Assuming this is legally possible, the intent of the draft regulation is to create a vernacular English law regime, as early as before the actual exit day, allowing the Bank of England to temporarily recognize third country CCPs in the United Kingdom and allow them to continue to provide services to the United Kingdom.
This is a positive and welcome development. Although Continental European CCPs account for a marginal share of derivatives cleared volumes and the offer of temporary recognition of non-UK CCPs should be of little interest to the market.
- Draft Regulation for European Economic Area ("EEA") Passport Rights. This draft regulation seeks to enable EEA firms and funds operating in the United Kingdom via a passport to continue their activities in the United Kingdom for a limited period after exit day (up to three years). Firms will need to submit an application for UK authorization or a notification of their intent to benefit from the temporary regime.
The explanatory note of the draft regulation creates a serious concern because it states that firms with unsuccessful or late applications will have to wind down their UK-regulated activities, including any outstanding contractual obligations, in an orderly manner. In contrast, the HCJP's reports conclude that under EU and French laws outstanding contractual obligations will not be at risk and should remain immune and preserved from the consequences of any loss of passport rights.
Two Key Takeaways
- Legacy trades should be able to continue without insurmountable legal challenges even if the United Kingdom were to leave the European Union without a deal.
- The HCJP encourages UK firms to begin transferring their European business in the European Union to preserve their ability to carry on their activities and enter into new transactions without any disruption in the event of a "hard" Brexit.
For further information, please contact your principal Firm representative or the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com/contactus/.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our "Contact Us" form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.