The Impact of Brexit on Close-out Netting Opinions

By Robert Peat, Consultant, D2 Legal Technology

On 1 December 2020 ISDA published a high-level overview of certain considerations regarding contractual arrangements between EU/EEA-based counterparties and contractual arrangements governed by the law of an EU/EEA Member State in the light of the UK’s exit from the EU (“Brexit”). The implications of Brexit will clearly have an obvious impact on many areas of the financial sector. This includes the analysis conducted for regulatory capital purposes through close-out netting legal opinions. Many, if not all, EU jurisdiction legal opinions will be impacted to some extent by Brexit’s impact on contractual arrangements.

More specifically, ISDA focussed on outlining the impact on Directive 2002/47/EC (“Financial Collateral Directive”) and Article 30 of Directive 2001/24/EC (the “Winding Up Directive”) of Brexit.(1)(2) To a lesser extent, the impacts of Brexit on Article 16 of Regulation (EU) 2015/848 (“EIR Recast”) and Directive 2014/59/EU (“BRRD”) were also considered.(3)(4) All these EU legislative instruments provide certain benefits with respect to contractual relations between EU/EEA counterparties and relationships governed by the law of an EU/EEA Member State.

Bank Recovery and Resolution

BRRD entered into force in January 2015 and set out a common framework for recovery and resolution of credit institutions and investment firms within the EU. At its centre, BRRD allows regulatory and resolution authorities to protect critical functions of a large, failed credit institution by forcing creditors and shareholders to bail-in the credit institution’s debt. Additionally, it requires credit institutions to draft recovery and resolution plans to overcome liquidity stress situations and if required, ensure an orderly resolution if the institution fails.

For BRRD, the impact of Brexit is clear and consistent. BRRD sets out the requirement that where an agreement is governed by the law of a ‘third country’ (non-EU/EEA law) the contractual language must contain a bail-in clause. Therefore, any agreements governed by English law would, following Brexit, be required to include this language.

Recast European Insolvency

The EIR Regulation built on and enlarged an earlier EU framework on recognition of insolvency proceedings and serves to ensure that an insolvency proceedings started in one EU member state, is without formality, recognised in all other EU member states (excluding Denmark). It aims to ensure efficient cross border insolvency proceedings and to avoid parties shifting assets or proceedings across EU member jurisdictions to obtain more favourable treatment. Article 16 establishes an EU/EEA Member State requirement to create an exemption for detrimental acts.

The impact of Brexit for the EIR Recast Regulations is mixed. In many instances, EU/EEA Member States have not passed domestic legislation supplementing EIR Recast. This means that any person claiming an exemption in connection with a detrimental act, must show that the act is governed by the law of an EU/EEA Member State and that this law does not allow any means of challenging the enforceability of the legal act in question. ISDA’s publication notes several jurisdictions where additional considerations need to be accounted for. Markedly, Portugal does not require the law governing the detrimental act to be an EU/EEA Member State’s law. In Germany, the EIR Recast Regulation means that if the relevant assets are in an EU/EEA Member State, the opening of insolvency proceedings shall not affect the rights in rem of creditors or third parties in respect of tangible or intangible, moveable or immoveable assets belonging to the debtor which are situated within the territory of another Member State at the time of the opening of proceedings. Evidently with Brexit, in most circumstances EIR Recast will no longer enable the challenge of detrimental acts or their voidability on the basis that such an act was governed by English or Scottish law.

Winding Up Directive

The Winding Up Directive was created to ensure that a credit institution and its branches in other EU/EEA Member States are reorganised or wound up according to the principles of unity and universality. As such, the effect is aimed at ensuring there will only be one set of insolvency proceedings to which a credit institution is subject to and under such proceedings it will be treated as a single entity.

Similar to EIR Recast, the Winding Up Directive allows for the disapplication of rules around voidness or unenforceability of legal acts detrimental to the creditors as a whole where such acts are subject to laws of other EU/EEA Member States. ISDA notes that in the majority of Member States the effects of the Winding Up Directive are limited to the laws of other Member States (with variation on whether this extends to both EEA and EU Member State laws). In these cases, jurisdictions are mixed in their approach, either applying the Winding Up Directive directly from EU law or transposing it with certain conditions. However, certain jurisdictions do not require a nexus to EU/EEA Member State law. Germany, for example, through Section 339 German Insolvency Code, does not limit the non-avoidance privilege to the law of Member States. In the Netherlands, the Dutch Bankruptcy Act draws distinctions for the types of protection offered and applicable processes based on whether the act was governed by EU/EEA or non-EU/EEA Member State laws. Clearly, the impact of Brexit on the Winding Up Directive will be very specific to the jurisdiction in question with the greatest impact being in jurisdictions which require an EU/EEA Member law nexus.

Financial Collateral Directive

Finally, the Financial Collateral Directive aimed to simplify the process for creating and enforcing financial collateral. The primary aim was harmonising the status of financial collateral arrangements across the EU. It additionally had the beneficial impact of ensuring the recognition of close-out netting for derivatives master agreements where there was a form of financial collateral arrangement in place.

The Financial Collateral Directive provides significant benefits to contractual netting relationships where conditions are met. At an EU level, Article 1 of the Financial Collateral Directive requires the parties to belong to a stated category but there is no requirement in many EU/EEA Member States that each party be domiciled in the EU/EEA. Nevertheless, in Germany, the law is unclear on whether it includes collateral arrangements with non-member state collateral receivers and in Romania there is a more complex interpretive exercise to conduct against substantive Romanian law. Hence, while Brexit will seemingly have a minimal impact there may perhaps be some occasional complications.

Conclusion

Whilst the majority of the world understood Brexit to have been a relatively closed book from 1 January 2021, there is much excitement to come for law firms due to the expected changes in the analysis regarding close-out netting legal opinions. Not unlike many other aspects of Brexit, we certainly believe there are stimulating developments to come as these new legal opinions are produced and reviewed by institutions.

A more detailed analysis of the implications of Brexit with respect to each of these regulations can be found in ISDA’s paper [https://www.isda.org/a/UUfTE/ISDA-Opinions-and-Brexit-Overview-Table-011220.pdf].

1. Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements.
2. Directive 2001/24/EC of the European Parliament and of the Council of 4 April 2001 on the reorganisation and winding up of credit institutions.
3. Regulation (EU) 2015/848 of the European Parliament and of the Council of 20 May 2015 on insolvency proceedings (recast).
4. Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms.