This briefing provides an overview of the latest news and views on Brexit, and looks at the legal risks for UK businesses, giving some insight into the prospects for M&A and the public markets, and issues which should be factored into contingency planning over the coming months.
Parliamentary process and timing
Parliamentary process and timing The short Bill approving the exercise of Article 50 of the Treaty on European Union, which initiates the exit process, having been approved on second reading by the House of Commons, is now being considered by a Commons Committee before it goes to the House of Lords. Most commentators think it unlikely that the House of Lords, as an unelected Chamber, would seek to block the Bill outright in defiance of the referendum result, but opponents may nonetheless attempt to introduce delay or to secure additional commitments from the Government on matters such as the UK's negotiating objectives and further Parliamentary involvement in the Brexit process (notwithstanding the Government's recent commitment to give Parliament a vote on the eventual exit deal).
The Government, meanwhile, insists its Brexit timetable is unaffected by the outcome of the Miller case (see The Article 50 case and other legal challenges below), and is expecting the Article 50 Bill to be approved by both Houses shortly, to pave the way for the exercise of the Article 50 notification in March. The Bill is deliberately short and the Parliamentary process expedited, to curtail scope for debate and amendment.
Assuming the Bill gets through Parliament, the Government will then give formal notice, under Article 50, of the UK's intention to leave the EU. Article 50 only allows 2 years for agreement to be reached on exit terms, which many commentators believe is unlikely to be sufficient to resolve all the issues over the UK's future relationship with the EU, including highly sensitive matters such as the level of the UK's "divorce payment" to the EU and the status of Gibraltar and Northern Ireland.
Importantly, though, Theresa May has now acknowledged the need for an "implementation phase" following Brexit day (transitional arrangements by another name) which will be key to ensuring an orderly, managed exit. Any such transitional arrangements would potentially allow additional time for a free trade agreement to be negotiated, but may be subject to a "sunset" clause, automatically ceasing to apply within a certain period, to allay the fears of ardent leavers that transitional arrangements may become permanent.
The Government's recent White Paper confirms the "clean Brexit" principles on which the Government's negotiating strategy will be based, as previously outlined in the Prime Minister's Lancaster House speech, namely:
- full exit from the EU (no partial or associate membership);
- exit from the Single Market for goods and services (which effectively rules out the "soft" Brexit options involving EEA membership);
- exit from the EU Customs Union;
- an end to the jurisdiction of the European Court of Justice over UK matters
- full control of UK immigration policy; and
- contributions to the EU budget only for specific projects.
The intention is that the eventual future trading relationship with the EU will be based on:
- a comprehensive free trade agreement with the EU which will, as far as possible, continue tariff-free trade with the EU and provide access to (rather than membership of) the Single Market; and
- some form of customs agreement which will aim to minimise border red tape for trade in goods with the EU but enable the UK freely to negotiate trade deals with third countries.
Prospects for new trading relationships
There are positive signs from the US and other third countries that bilateral trade deals with the UK will be on offer. A UK-US trade deal in particular could provide major new growth opportunities for UK businesses and it may be possible to accelerate the negotiation process by “borrowing” aspects of the EU-US TTIP agreement, which appears to have stalled.
However, the 2-year timetable following the Article 50 notification to negotiate (i) the UK's exit arrangements and (ii) a new trading relationship with the remaining EU27 still looks extremely ambitious. Whilst the UK Government's wish list is now clearer, it will take some time before the shape of the UK's future trading relationships becomes clear.
With elections in Germany, France, the Netherlands and possibly Italy this year, the UK may struggle to make headway with EU negotiations whilst the attention of key players is elsewhere.
Recent experience also shows that wide-ranging trade agreements typically take years to conclude because they are complex and politically sensitive. The 2-year period is in practice much shorter than that, given the need to allow time for an approval process. The European Commission has made clear that if notice is given under Article 50 in March, it expects negotiations to be concluded by October 2018, so as to leave 4-5 months for approval of the draft deal by the EU Council of Ministers and the UK and the European Parliaments.
This is a very tight timetable given the number and complexity of issues that need to be dealt with.
No deal preferable to a bad deal?
Theresa May clearly stated that no deal would be preferable to a poor deal for the UK, which raises the stakes for the negotiations and the promised Parliamentary vote on the final deal (including any transitional arrangements).
Once the final deal is on the table, Parliament will be faced with the unenviable decision to either approve it, or reject it and precipitate a "hard" Brexit, and by this we mean exit from the EU, the Single Market and Customs Union without a preferential UK/EU free trade agreement on goods and services in place, forcing the UK to fall back on its membership of the WTO.
For many in the business community, this is not an appealing prospect. The cost of a hard Brexit to the financial community alone (assuming the UK has third country status with no regulatory equivalence) has been estimated at £18-20bn, with the loss of 31-35,000 jobs and a fall in tax revenues of £3-5bn pa1.
Issues with the WTO option
The UK's continued membership of the WTO should be unaffected by Brexit. However, the terms of its membership (schedules of tariff commitments etc.), currently predicated on being part of the EU, would require renegotiation and agreement among the other 163 WTO members. This may prove challenging and time-consuming.
Pending agreement with the other WTO members, including the EU bloc, on the UK’s new schedules of commitments, a realistic outcome is that the UK maintains its existing WTO EU trade schedules, but copying across the EU's commitments will not work for all products/services.
For example, the EU has agreed to allow imports of many agricultural products (such as beef) at a lower preferential tariff rate only up to the level of an EU-wide quota (beyond which a much higher standard tariff applies – in many cases effectively making it uneconomic to import). Clearly, measures such as quotas will have to be divided up between the UK and the EU, which will be sensitive from a domestic as well as international perspective. Agreement with the EU is needed on these issues before a UK-specific set of commitments can be presented to the WTO.
In terms of trade with the EU, WTO rules also mean significant tariffs on certain categories of goods (such as 10% on cars and 20%+ on many food products) which will make UK exports more expensive and increase the cost of imports from the EU.
More generally, WTO rules also provide for a significantly lower level of market access than EU membership; in particular, some UK goods and services providers may face significant "behind the border" barriers to trade such as regulatory or technical requirements which may be more difficult to meet for non-EU businesses.
Cliff edge risks
The UK will also face a number of “cliff edge” risks if it leaves the EU without reaching agreement with the remaining Member States on future trade and transitional arrangements, thereby resulting in an abrupt, disorderly Brexit. Examples of cliff edge risks include:
- Disruption to goods trade: the reintroduction of customs controls may lead to delays at major ports (both in the UK and on the continent), especially those handling HGV traffic. This is a particular concern for perishable goods and distribution systems reliant on “just in time” delivery. These are not insoluble problems but will require time and additional resources for new infrastructure to be put in place, together with agreement with EU partners on customs cooperation and mutual recognition of e.g. product testing/certification.
- Disruption to services contracts and financial markets: certain contracts may become illegal to perform, such as contracts dependent on financial services passports, potentially disrupting financial markets. Financial services firms may well be able to ensure continuity by, for example, moving business units to the remaining EU member states and/or obtaining any required regulatory authorisations in such jurisdictions, but such changes would need to be planned some time in advance (which may prompt some firms to decide that they cannot afford to await the outcome of Brexit negotiations).
- Disruption to export licensing and sanction regimes: for example, export licenses are currently required for military goods and "dual-use"2 products emanating from non-EU countries. Affected companies will need to ensure that red tape does not impede their exports and that licenses can be obtained without undue delay, otherwise UK firms stand to lose business to EU competitors which can supply immediately. There may also be sanctions issues – for example, EU sanctions against Russia do not prohibit EU firms from dealing with EU subsidiaries of blacklisted Russian firms. After Brexit, UK firms (including financial institutions) may not be able to deal with such UK subsidiaries. More generally, the UK's approach to policy and mechanics of such trade control and sanction issues remains to be seen.
Hoping for the best, planning for the worst
Given the level of uncertainty, whilst we are hoping for the best outcome for the UK in the negotiations, our view is that UK businesses should plan for a hard Brexit scenario, as the downside risks of this are easier to predict - but as far as possible adopt a “wait and see” approach before actually implementing any such plans, so as to minimise disruption or expenditure that may prove to be unnecessary. Some businesses may find that the risks of a “hard Brexit” are largely manageable and may even present opportunities. Others may conclude that they need to take some steps now to protect themselves against certain risks since, despite Theresa May's attempts to provide some certainty as to the direction of travel, it may be some time before the shape of our future trading relationships with the EU and other territories becomes clear.
At the end of this briefing you will find a checklist of actions you might consider taking during the period between now and the date on which the UK exits the EU.
The Article 50 case and other legal challenges
ARTICLE 50 CASE
As has been widely reported, the Supreme Court in the Miller case dismissed the Government's appeal against the judgment of the Divisional Court that both Houses of Parliament must approve the giving of notice to exit the EU under Article 50 of the Treaty on European Union, by means of an Act of Parliament.
The claimants, led by Gina Miller, a fund manager, successfully argued that the scope of the Government's Royal prerogative to conduct foreign policy does not extend to the withdrawal of individual rights under domestic law, which would be the inexorable result of the process begun by triggering Article 50.
The Supreme Court also ruled that, whilst the Sewel Convention (that consent of the devolved administrations is required for legislation which affects devolved matters) operates as an important political constraint on the activity of the UK Parliament, it has no legal force, and neither it, nor the devolution Acts give the devolved administrations in Scotland, Wales and Northern Ireland a right to veto the decision to withdraw from the EU.
Having lost its appeal, the Government acted swiftly to seek Parliament's approval to give notice under Article 50. There are, however, further ongoing legal challenges which may have an impact on the Government's strategy.
OTHER LEGAL CHALLENGES
A lobby group called British Influence applied for judicial review of the decision to exit the EU on the basis that the UK does not automatically leave the EEA (and with it the Single Market) upon leaving the EU. Their action was swiftly dismissed by the High Court as being premature, leaving open the possibility that the action could be relaunched later in the process. If it were to succeed, it could make it easier to negotiate transitional arrangements to stay in the Single Market for a period – but it would leave the Government with a difficult political choice, given its stated desire to leave the Single Market.
In addition, Jolyon Maugham QC is bringing a crowdfunded action in the name of a group of MEPs claiming that notification under Article 50 is revocable. If this argument were to succeed, and if the UK/EU deal on offer proves not to be sufficiently attractive to the UK, it could decide to withdraw its notice of intention to leave the EU.
The revocation argument was not raised in the Miller case, but the outcome of this action is particularly significant given the ramifications of Parliament refusing to ratify the final deal agreed with the EU prior to Brexit day, and the Government's stance that no deal is better than a poor deal. As the revocability of Article 50 notification is a matter of EU law, the action is going through the Irish courts with a view to giving the European Court jurisdiction over this key issue, although it is unlikely to be decided for some time, certainly not before the Article 50 process is initiated.
The Great Repeal Bill – what will happen to UK law and regulation?
For over 40 years, EU law has been intertwined with UK law, in the form of EU Treaties, Regulations, Directives and decisions of the European Court (CJEU), and that body of EU law will remain intact until Brexit.
The content of Directives which have been enacted into UK law by Act of Parliament (such as large parts of the Companies Acts) will remain untouched by Brexit. By contrast, secondary legislation made under the ECA (European Communities Act) 1972 (such as the Working Time Regulations) would fall away, along with directly applicable EU law (such as the REACH Regulation on chemicals), instantly creating significant gaps in UK law and regulation upon Brexit.
The Government proposes to deal with this potential legal vacuum with its Great Repeal Bill, which will repeal the ECA, preserve secondary legislation made under the ECA, and incorporate into UK law all EU law not already implemented in UK statute, pending review of EU-derived laws which we may ultimately decide to keep, amend or repeal.
This approach does not work for all EU-derived law, however. Laws which are predicated on membership of the EU, or on reciprocity with other EU members, are not amenable to this treatment without modification, so will need to be identified and addressed separately and in some cases, in short order.
Moreover, the UK may be deprived of the administrative and technical resources of institutions linked to this legislation, such as the European Chemicals Agency (in the case of chemicals) or the European Medicines Agency (in the case of various medical products) and the European Commission. This expertise may need to be re-patriated to a national infrastructure going forward, requiring considerable time and resource allocation, and having the potential to increase the burden on industry (particularly those who also export to the EU and risk having to deal with any duality in regulation).
Our Brexit Working Groups are working through the body of laws applicable to business with a view to identifying those which are predicated on EU membership and require more urgent attention, and what needs to change to accommodate Brexit.
We do not anticipate a “bonfire of regulations”, however, and many of the changes will be procedural, to make the legislation work as intended, rather than substantive.
Impact on debt and equity funding for your business and prospects for the M&A and IPO markets
EXISTING FINANCING ARRANGEMENTS
Some existing debt/equity funding arrangements in place for UK businesses will mature before Brexit actually occurs. Loan documentation typically has a life cycle of 5-7 years, however, so depending on the timetable for Brexit, some may not be repaid until after Brexit.
It is unlikely that many financing arrangements concluded prior to the referendum will have specifically contemplated Brexit and we have seen few attempts to introduce contractual Brexitrelated rights and obligations in the months leading up to and following the referendum. In most cases we believe such rights to be unnecessary and potentially unenforceable given how difficult it is now to prescribe the circumstances of Brexit.
However, we are advising clients to make minor amendments to ensure debt documents envisage Brexit (e.g. tailoring references to the EU and to EU-derived legislation).
NEW FINANCING TRANSACTIONS
The availability of new finance may be impacted by economic uncertainty and financial market volatility, particularly around the time of exercise of Article 50 which may result in transactions being postponed or delayed (with lenders invoking “market MAC” clauses), or borrowing costs increasing. New debt documentation is likely to focus more closely on the likely consequences of Brexit, e.g. lenders introducing “bail-in clauses” (relevant assuming the UK ceases to be an EEA member) or “designated entity clauses” (allowing lenders to perform lending obligations in other jurisdictions through affiliates).
As Brexit approaches, existing deals will need to be checked and possibly amended to ensure that repeating representations, negative undertakings etc. will not trigger technical defaults.
THE IPO MARKET POST-REFERENDUM
Whilst the London equity markets have performed strongly following the initial shock of the referendum result, the volume and value of IPOs was down in 2016, being the slowest year for IPOs since 2012. Uncertainty created by the referendum and the US election led to a number of high profile listings being postponed or withdrawn.
Overall, there were 55 completed IPOs in 2016 compared to 62 in 2015 with 60% of the IPOs completing in the first half of the year. Many IPOs were priced at the bottom of anticipated ranges and, as a consequence, those companies that did list in 2016 have generally experienced positive share price performance post-IPO when compared to the wider market, providing better opportunities for PE houses to sell shares following the expiry of IPO lock-ups.
Whilst the outlook for the first half of 2017 continues to be cautious, an increase in activity is expected later in the year and it is important that companies seeking a listing are well prepared so that they are ready to launch a listing quickly when the IPO window re-opens.
In terms of the legal and regulatory regime for UK listings, much of the UK equity capital markets regime is derived from EU Regulations and Directives, and whilst there may be an opportunity for the UK to relax the rules post-Brexit to attract non-EU issuers and investors, e.g. to widen prospectus exemptions, the need for an ongoing relationship with EU investors and institutions is likely to limit scope for doing so, regardless of whether the UK achieves regulatory equivalence outside the Single Market or adopts some other model.
We would therefore expect the legal and regulatory environment for the IPO market to remain relatively stable.
Meanwhile, we expect to see Brexit risk factors in prospectuses, and Brexit risks noted in some annual reports.
THE M&A MARKET POST-REFERENDUM
THE MARKET SO FAR
Whilst the weakness of sterling has encouraged some overseas buyers into the UK market, it has struggled against the uncertain economic outlook since the referendum. For example, in terms of value, the UK buyout market was down 44% in 2016 to its lowest level since 2009 (£11.9bn compared with £21.2bn in 2015).
Deal volumes also suffered, although by a smaller margin (down 6% on 2015). The number of exits fell more sharply in 2016, down around 50% on the record levels set by 20153.
Markets and investors clearly dislike uncertainty so it is to be hoped that as more detail of the direction of travel towards Brexit emerges in the coming weeks and months, investors will be encouraged back into the market.
On the positive side, the continued availability of debt for acquisitions and re-financings (in part driven by the rise of credit funds) is cause for optimism for UK-based companies and investors seeking M&A opportunities.
DOMESTIC M&A – LEGAL FRAMEWORK
The legal and regulatory regime for domestic M&A involving private companies is little-influenced by EU law and is unlikely to change significantly postBrexit. The rules facilitating cross-border M&A between EU entities (the Cross-Border Mergers Regulations) are derived from an EU Directive, but have so far been little used by UK companies and may be reviewed as part of the Great Repeal Bill process.
Interestingly, the Cross-Border Mergers regime has recently been used by a UK private company, Formenta Limited, for a restructuring prompted by Brexit. In a "reverse" cross-border merger, Formenta was absorbed by its Italian subsidiary, reportedly the first time the regime has been used in this way, which may prompt others to do the same.
In the public M&A sphere, the UK Takeover Code does give effect to the EU Takeovers Directive but much of the UK Takeover Code was in place prior to the Directive coming into force, and is widely accepted as a model for public takeover regulation, so is unlikely to change substantially post-Brexit.
BREXIT DUE DILIGENCE
Contingency planning for Brexit will be an important part of the DD process in M&A transactions in the coming months and years. The key Brexit-related issues for DD will include many of those mentioned in the contingency planning checklist at the end of this briefing, but in particular, should focus on the state of readiness of the target company in key areas likely to be affected by Brexit, including:
- Geographic structure and potential for business interruption: dependence on EU markets for customers or supplies and the strategic, financial and practical impact of customs controls on those trading relationships
- Passporting/licensing: reliance on any EU passporting or licensing rights allowing supply across the EU from the UK (or vice versa)
- Key contracts: potential for termination as a result of MAC or similar conditions and impact on EU-wide contracts
- Staffing: dependence on employees who are EU nationals and position of UK staff based in the EU, pending clarification of their immigration status
- EU funding: any reliance on, or benefit from, EU funding or other EU advantages.
BREXIT – ISSUES FOR M&A DOCUMENTATION
We also anticipate:
- possible attempts to negotiate MAC clauses to protect against general economic uncertainty and currency fluctuations. However, we have seen little evidence of this happening thus far, and given that a party to a transaction cannot rely on a MAC on the basis of circumstances known to it at the time of the transaction, such clauses may be difficult to enforce
- increased concern about certain funds at the time of signing
- where transactions involve EU-based parties or assets and enforceability of an English law judgment throughout the EU is important, issues arising over choice of law and jurisdiction for disputes relating to M&A documents, as a result of concerns over the effectiveness of a UK jurisdiction clause if English law judgments become less readily enforceable in the EU (for more on this, see the Disputes section of our checklist)
- companies continuing to take advantage of sterling value-driven opportunities.
We would be happy to discuss with you the impact of Brexit on your business and your options for mitigating risks and making the most of opportunities presented by Brexit, both now in the future.
For more information see the checklist of issues for contingency panning.
1 Oliver Wyman: The impact of the UK’s exit from the EU in the UK-based financial services sector (2016)
2 Dual-use products are essentially goods, software, technology, documents and diagrams which can be used for both civil and military applications.
3 CMBOR UK Buy-outs Report Fourth Quarter 2016