Published : 8 years ago, on 05/07/2016

By McDermott Will & Emery

UK Withdrawal Process

The United Kingdom will continue to be an EU member until procedures are completed for exiting the European Union, which is likely to be a long process. Under EU Treaty rules, the process will begin when the United Kingdom gives notice to the European Union of its intention to leave. It seems unlikely that the UK Government will give notice until a new Prime Minister is in place, which will be in September 2016 at the earliest.

Any notice will trigger a two year deadline for the United Kingdom and the European Union to negotiate a withdrawal agreement, although the deadline can be extended with the unanimous consent of the remaining EU Member States. During the negotiation period, EU laws and treaties will still apply to the United Kingdom; which means that all laws currently in place will remain in place for at least two years. The final withdrawal agreement will clarify which EU laws and regulations will no longer apply, and which will continue to apply.

The withdrawal agreement will need to be ratified by the United Kingdom and the European Union before it takes effect, which is likely to take some time. If the two sides cannot come to an agreement on withdrawal after two years, EU treaties, laws and regulations will cease to apply to the United Kingdom, unless the EU Member States unanimously decide to extend the negotiation period.

The approach that the UK Government will take in negotiations with the EU is unlikely to become clear for some weeks. Some prominent figures have suggested that its key priority will be ensuring that the UK remains within the European single market, to ensure that it continues to benefit from rules guaranteeing the freedom of movement of goods, services, people and capital between participating countries.

Until the Government has decided on a negotiating position (which may necessitate a General Election first), it seems unlikely that notice will be served under the EU Treaty.  The EU has indicated that it is not prepared to enter into informal negotiations over the terms of a Brexit until notice has been served. It is entirely conceivable that the United Kingdom may not serve notice for some time to come.

Key Legal Implications

The impact of Brexit will depend on what approach the United Kingdom decides to pursue in its negotiations with the European Union, but the following are some of the most prominent issues for businesses to consider now.

Trade
Until the United Kingdom formally exits the European Union, all EU access rules and procedures will continue to apply to all intra-EU trade, including with the United Kingdom, and to imports entering UK ports from third countries.

Once the United Kingdom gives notice of its intention to leave, however, it will need to renegotiate a new trade relationship with the remainder of the European Union to take effect at the end of the two year period during which the existing treaties still apply. One option could be membership in the European Economic Area (EEA), an arrangement that grants Norway and certain other countries free access to the EU internal market, but doesn’t give them any vote in EU decision-making bodies. Another could be a bilaterally-negotiated agreement with the European Union similar to the arrangement Switzerland has.

The United Kingdom will also need to renegotiate on its own behalf the free trade agreements (FTAs) and other trade agreements the European Union currently has with dozens of countries around the world, and will likely also pursue trade agreements with the United States, Japan and other countries that are currently negotiating trade deals with the European Union. The United Kingdom may also have to renegotiate its World Trade Organisation (WTO) market-access commitments with WTO member countries.

To the extent that the European Union loses one of its largest members, it may also be required under trade rules to renegotiate certain of its WTO, regional and bilateral trade commitments. With the European Union’s attentions now primarily directed to managing Brexit fallout, the pace of its FTA trade negotiations with other countries (the United States, Japan, Mercosur and Mexico) may be affected.

Tax
One of the most significant potential implications relating to tax is that UK companies may lose access to the EU Parent-Subsidiary or Interest and Royalties directives, which eliminate withholding tax on payment flows between related entities, and may instead have to rely on double tax treaties, not all of which offer a complete withholding tax exemption.

It seems unlikely that the United Kingdom will be bound by the new anti-tax abuse directive that is scheduled to come into effect from 1 January 2019 and which has largely been inspired by the Organisation for Economic Co-operation and Development Base Erosion and Profit Shifting (BEPS) initiative. It is worth bearing in mind, however, that the United Kingdom is likely to remain committed to introducing BEPS reforms in any event.

VAT is likely to remain largely unchanged, although the UK Government may have greater freedom to vary the scope and rates of VAT once it is no longer constrained by the EU VAT Directive.

If the United Kingdom ultimately leaves the EU single market (which guarantees freedom of movement of goods, services, people and capital between member states), it could result in the imposition of customs duties on exports and imports to and from EU countries, with associated compliance costs.

Competition and State Aid
At present, the European Commission enforces EU competition law, and the UK regulator—the Competition and Markets Authority (CMA)—enforces both EU and UK competition law. Although both the CMA and the European Commission can enforce EU-wide competition rules, they do not engage in parallel enforcement of the same case. For instance, if a transaction fulfils the thresholds for notification to the European Commission, it will not need to be notified to the CMA, even if the UK thresholds for mergers are met.  Likewise, if the European Commission investigates an alleged infringement of EU competition law, the CMA would not undertake the same investigation. This arrangement essentially provides a “one stop shop” merger review process.

There are many unknown variables at this stage, but it appears that Brexit could lead to increased competition law scrutiny, penalties and uncertainty for businesses.  For instance, post-Brexit, merging companies may be obliged to notify the same transaction to both the CMA and the European Commission, no longer benefiting from the European Commission’s one stop shop merger review.  Similarly, the CMA and European Commission could investigate the same antitrust infringements, leading to multiple fines for the same conduct.

EU State aid law applies across the European Union, enforced by the European Commission. In the absence of EU State aid law, the United Kingdom would, in principle, be subject only to WTO rules, but this scenario assumes no trade arrangement between the United Kingdom and the European Union, which is highly unlikely. Alternative scenarios could involve the application of EU State aid law subject to an EU-UK trade agreement, or the promulgation of a UK State aid law.

Mergers & Acquisitions
Although transaction volumes may suffer in the short term, and some transactions in the UK market may now be put on hold or simply not take place, the effect of the United Kingdom withdrawing from the European Union will have a marginal effect on the legal principles and practice of M&A transactions under English law.

In UK public M&A, transactions involving UK public companies will continue to be regulated by the UK Takeover Panel through the City Code on Takeovers and Mergers. While many of its provisions are incorporated into (rather than derive from) the EU Takeover Directive, the Code would not be affected by EU withdrawal, as it is a standalone set of rules subject to resolution ultimately at the Panel level.

As far as private company M&A is concerned, little if any EU law overrides principles of English contract law and parties are likely to continue to use English law as the basis for commercial transactions—even where there is no UK nexus—owing to the English courts’ long history of commercial case law precedent, tried and tested contractual terms for use in documentation, the impartiality and consistency of the English courts in resolving disputes, and the large body of professionals in London and elsewhere competent to execute transactions effectively under English law.

There are a few areas where EU law does impact on M&A transactions, such as the Acquired Rights Directive, which is incorporated into UK employment law and acts to automatically transfer employment contracts to a buyer on completion of a business or asset transaction, but this is unlikely to be repealed by the UK Government in the short term.

The competition implications of Brexit are dealt with above, but the effect of EU withdrawal may act to prolong competition clearance where there is a UK component in a transaction, as the UK component would no longer be aggregated within the EU market calculation and would instead be assessed separately by the domestic UK competition authority.

Intellectual Property
Brexit is unlikely to have an impact on European Patents, neither with regard to existing patents and applications, nor with regard to future applications. This is because, despite the name, European Patents are unrelated to the European Union and are therefore not directly affected by Brexit.

The situation is different with regard to the new European Unitary Patent scheme, which was expected to come into force in early 2017. The United Kingdom will now most likely not be able to join the Unitary Patent system. As a non-EU Member State, the United Kingdom is also unlikely to be able to host a branch of the European Patent Court as previously planned   It is extremely likely that the Unitary Patent system will now be renegotiated altogether and that its entry into force will be delayed, for at least one year.

The destiny of EU trade marks and designs is less clear than that of European Patents as these are linked to the European Union. One possible scenario is that the UK element of such rights will be split off, with a grace period within which the United Kingdom portions of Community IP rights may be converted into national UK rights.

Health, Pharmaceuticals and Life Sciences
The European health service sector in Europe will likely not be affected as health services are one of the few industries that are fundamentally not harmonised on a European level at all. As a result, market entry barriers for foreign investors vary considerably among European countries.

The United Kingdom traditionally has a long history of one predominant public payer (the National Health Service (NHS)) and plans to privatise elements of the NHS in the early years of the Cameron government were largely abandoned due to severe political resistance. In view of the current political turmoil in the United Kingdom following the Brexit vote, it appears very unlikely that a new government, once appointed, will focus on opening the UK health care market to foreign investors.

The health services of EU Member States will be entirely unaffected by political issues within the United Kingdom.

The potential for change in the pharmaceutical sector is higher, given that the pharma industry is, to a large extent, harmonised on a European level. The current UK pharmaceutical legislation— from the development of a medicinal product to its approval and post-approval monitoring—derives mostly from European legislation.  Only pricing and reimbursement depend on national laws, as European attempts to harmonise them have been limited.

If the United Kingdom becomes part of the EEA alongside Iceland, Liechtenstein and Norway, most of the EU pharmaceutical legislation will remain relevant, e.g., a marketing authorisation for a medicinal product approved by the European Commission is also valid in the EEA countries.  If the United Kingdom adopts the Swiss approach and negotiates multiple bilateral trade deals, with no automatic recognition of EU legislation, the situation will be more complicated.

What appears very likely, is that the harmonisation of the European pharmaceutical market would not directly apply to the United Kingdom any further. Consequently, the European authority in charge of granting EU market authorisations, the European Medicines Agency (EMA), which is based in London, will have to relocate to an EU Member State. Italy, Sweden and Denmark have already indicated their interest in hosting the EMA.

Wherever the EMA relocates, it is very likely that foreign, in particular US, pharmaceutical companies that still have their European headquarters in the United Kingdom will relocate those headquarters to the new location.

Private Client
Announced in outline only, further details of the proposed changes were expected to follow after the Referendum, with a consultation anticipated in autumn 2016 and the intention of the law coming into force from 6 April 2017. It seems unlikely that these reforms will be a priority of either the present or successor government. If the changes are not enacted as previously expected, the taxation of “non-doms” will continue as before.

Individuals currently resident in the United Kingdom who were formerly resident in certain other EU jurisdictions, and who are subject to a deferred payment of exit tax liabilities in relation to their prior residence, may find that Brexit triggers payment of the deferred liability by virtue of the individual ceasing to be resident in the European Union. We expect this would occur on the earlier of the date of entry into force of the withdrawal agreement (under Article 50(3)) or on expiry of the two-year notice period (if no withdrawal agreement is in place).

Finally, individuals resident in the United Kingdom who own assets in an EU country may eventually be subject to a less favourable tax treatment than they currently enjoy.

Private Equity
The European operations of many international private equity (PE) sponsors are based in London and authorised by the Financial Conduct Authority. The Alternative Investment Fund Managers’ Directive (AIFMD) currently allows these PE sponsors to market funds to investors across the European Union via a “passport” regime, which will continue to apply for the two year negotiation period.

If the United Kingdom joins the EEA, access to the single market would be maintained and the impact on financial regulation, including AIFMD, likely to be relatively minimal. A full exit would theoretically result in UK-headquartered PE sponsors losing their passport right to market to investors across the European Union, which could prompt some to set up parallel operations in EU Member States. It is, however, anticipated that the passport regime will be extended to non-EEA PE sponsors by 2018 so, in practice, this extension may address and allay concerns.

Access to the EU markets by third country investment firms is currently governed by the Markets in Financial Instruments Directive and the Markets in Financial Instruments Regulation (MiFIR), together known as MiFID II, which essentially, grants access to countries that have “equivalent” standards of regulation. One issue to consider is that the MiFIR provisions relate only to segments of the businesses that currently benefit from passporting rights. For example, asset managers that have Undertakings for Collective Investment in Transferable Securities funds domiciled in the United Kingdom for distribution throughout the European Union are not covered. In theory, the United Kingdom should be able to take advantage of the MiFIR provisions because the country meets the guideline for equivalent standards of regulation. That could change, however, if, for example, the United Kingdom revokes the part of the EU bank capital rules that cap bankers’ bonuses, in which case the EU Commission, which must decide on MiFIR eligibility, could turn down the application.

An alternative, which is currently used by non-EU firms, and which could also be used by UK firms before the passport regime is extended, would be to take advantage of the national private placement regimes of each country where they want to do business. The national private placement regimes allow non-EEA PE sponsors to market and carry out regulated activities on a country-by-country basis. This is a temporary, short term solution if the need arises.

In respect of transactional matters, as well as the considerations highlighted in the M&A section above, the ability of PE sponsors to conclude UK and EU deals will be dependent on the response of banks and financial institutions both in the United Kingdom and elsewhere to Brexit, and their appetite to lend in the short term.

In general, PE sponsors and management teams should review the terms of their existing financing arrangements and consider short/medium term liquidity options. Although, based on standard Loan Market Association (LMA) provisions, Brexit is unlikely to constitute an event of default under material adverse changes or force majeure clauses, bespoke arrangements and financial covenants should be reviewed carefully. In the case of the latter, the impact of a devaluation of sterling should be considered in the context of exchange rates to be applied for foreign borrowings. This is of particular importance to those companies due to test covenants on 30 June.

Litigation
The market volatility arising from Brexit will undoubtedly generate a number of contractual disputes.  One key area that will be affected is the relevant jurisdiction of disputes. Currently, the jurisdiction of EU Member States is largely governed by Regulation No 1215/2012 of 12 December 2012, which governs all main civil and commercial matters, apart from certain, well-defined matters, including maintenance. It is likely that the United Kingdom will eventually withdraw from these provisions and return to a conventional common law approach, subject to bilateral and multi-state agreements.

This could, however, only occur once the two year negotiation period is completed, or a withdrawal agreement is reached, whichever comes earlier. In the meantime, businesses should revisit any jurisdictional advice they have received on disputes involving EU Member States and the United Kingdom to ensure that this will not be adversely affected by a return of a conventional common law approach and/or bilateral and multi-state agreements.

Energy
We have been here before; the trading and downstream world has faced seismic shifts over the last 20 years comparable to working through the implications of Brexit. We can draw upon experience of events such as Enron’s demise and the 2008 financial crash. These events had significant knock-on effects and unintended consequences, from which the industry learnt and emerged.

As far as immediate and forward-looking issues are concerned, careful consideration will have to be given as to whether or not to reopen provisions in ongoing agreements, particularly in the trading and projects space. The circumstances may be remote, but counterparties may need to consider the scope of material adverse change clauses and, potentially, force majeure provisions.

Going forward, careful attention will, as ever, have to be given to clauses anticipating future changes such as identifying the circumstances that will trigger them, the correct test for the relevant change, the mechanism to settle any differences, and the consequences of any failure to agree or fulfil contracts.

From the perspective of investment in the United Kingdom, energy policies and laws are driven by many factors, both national and international. The European Union was one dimension of the United Kingdom’s energy sector, but numerous other drivers remain in place. Security of supply, geology, skills within the workforce, local investment priorities and worldwide climate change considerations will all remain in the policy mix going forward.

It could be argued that the United Kingdom could benefit from potentially greater control over its energy generation mix. While there will be obvious questions raised as to the long term investment profile of projects such as Hinckley Point nuclear power station by companies like EdF, the future for carbon capture and storage and coal fired output may be revisited.

As far as the outlook for renewables is concerned, from an investment perspective, comfort can be taken from the United Kingdom’s long standing support of these technologies, which is enshrined within the original Electricity Act 1989 on privatisation. Many of the non-political drivers also remain in place.

In the commodities world, an already complex and evolving picture has simply become more so. Unravelling the financial services regulatory impact will require additional thought by an industry which has already been facing changes for the last eight years.

Finance
Existing EU-based legislation underpins much of the cross-border and domestic activity of banks and financial institutions based in the United Kingdom, including through the EU passporting regime. It also facilitates the activities of non-EU-based banks and financial institutions that access EU markets using the United Kingdom as a base, relying on the equivalence process.

Parties that have transacted under agreements that are governed by English law, or which are subject to the jurisdiction of the English courts, will be considering the immediate and longer term impacts of Brexit, as will parties to agreements entered into by non-UK parties (whether in the European Union or elsewhere) with parties located in the United Kingdom, and vice versa, whether they are banks or financial institutions (or UK branches of the same), borrowers or guarantors.

In the immediate term, in the vast majority of instances there should not be any immediate impact on such agreements.  On 24 June 2016 the Loan Market Association (LMA) issued a statement to this effect in relation to LMA based agreements. All applicable contractual and legislative regimes continue for now.  Except in transaction- or party-specific scenarios, it is unlikely that default provisions, e.g., material adverse effect clauses, will have been triggered by the Referendum or the subsequent market turmoil. Parties should, however, give some consideration to their position under their relevant existing contracts.

As the Brexit process moves forward and the shape of the post-Brexit regime becomes clearer, additional detailed due diligence will be required.  In due course some amendments may be required to existing agreements.  Currently these are anticipated to be relatively minor, but this will depend on what Brexit arrangements are agreed (or not agreed).  Parties currently negotiating relevant agreements will also need to consider the Brexit process.

Employment
A significant proportion of UK employment laws derive from the European Union. Those laws will continue to apply unchanged during the two year period of negotiation. Notably, for corporates doing deals in the United Kingdom, this includes Transfer of Undertakings (Protection of Employment) legislation governing automatic transfers of employees in many corporate transactions.

It seems highly unlikely that there will be any substantial downgrade of UK employment protection for employees. The political consequences of doing so are all too obvious and, in any event, it seems inevitable that any trade agreement negotiated with the European Union would require adherence to the vast majority of EU employment and social protections.

Nevertheless, there may remain some scope in the longer term for the UK Government to gradually modify UK employment laws to make them more palatable to UK businesses and outside investment.

The liability of internationally mobile employees for social security contributions is governed by a European directive that would presumably cease to apply if the United Kingdom leaves the European Union. Unless suitable arrangements are put in place, such individuals could find themselves liable to double contributions.

For many organisations operating in the United Kingdom, the most immediate concern from a human resource perspective is likely to be addressing the negative impact on staff morale caused by the wide-ranging uncertainty Brexit has created. An effective internal communications strategy will be required to address this.