​​Brexit: the impact on commercial real estate loan relationships

The result of the UK’s EU referendum is in – and the voting public have decided to leave. The next two years will see a period of negotiated withdrawal, with the UK Government deciding which parts of EU law to adopt into domestic legislation, which parts to jettison, and which parts to park, for the time being at least. It is going to be a long process. In this update, we provide a quick heads-up on the impact of the outcome, and of Brexit itself in the relatively near future, on real estate finance loan documentation.

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Immediate concerns for the Commercial Real Estate Market

It is well documented that the real estate investment community has been attracted to the UK by its safe haven status coupled with its strong economic and governance fundamentals. The ‘’Leave’’ result has brought with it both political and economic uncertainty; not natural allies of investors looking to deploy their capital. As a result it is possible that institutional investors may, in the short term at least, suspend or reduce investment in the UK commercial real estate market.
How market factors, such as decreasing occupier demand and faltering investor sentiment interplay with the advantages arising from relative pricing and exchange rate arbitrage, will determine the direction of the real estate market and the speed of movement.

In relation to construction projects, the cost of labour and raw materials may be affected in the future by restrictions on migration and imposition of trade tariffs, as well as a weakening pound. Those developments which have not yet come onstream, may be postponed as a result, and those in progress will be conscious of tightening margins and perhaps covenants in loan documentation regarding budgeted costs and costs overruns (and any guarantees provided in relation to the same). Lenders may be considering whether cash collateralisation of such guarantees is required. Early indications from the real estate investment community are mixed and lenders are looking for indications of where value is heading and how to price the risk. The UK remains the most important investment market in the EU. Although volumes are expected to fall there are still abundant reasons why the UK will remain an attractive market for domestic and
international investors.

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What next for London’s role as financial centre for CRE lending?

 The relationship between London and the EU brings with it further considerations Will Brexit challenge London’s role as the venue of choice for global firms to conduct their European business? Notably, only countries that pay into the EU budget, and permit free movement of people from within the EU, currently benefit to any degree from flexible entry into the EU’s financial services single market. Much cross-border banking business within the EU is made possible by EU-level legislation relating to investment business, deposit taking and lending, trade reporting, clearing and custody, personal loans, mortgages and payment services. UK lenders and investment firms in Member States are able to carry on business and sell services throughout the EU without obtaining a licence or similar registration in each individual country. When the UK leaves the EU (assuming it does not retain membership of the EEA) UK-based lenders and investment firms would lose their current passporting rights, and as such, if they plan to continue to do business within the EU would need to benefit from equivalence provisions (which may take time to negotiate) or set up an EU subsidiary, so moving their UK operations elsewhere. Market commentary already suggests that property analysts are busy assessing the potential effect on demand for office space and high-end housing that may result if businesses and employees relocate to other EU financial hubs, such as Paris or Frankfurt.

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Real estate finance documentation – what diligence is required?

Typical loan relationships, based on standard Loan Market Association (LMA) terms or similar, will be unaffected by the ‘Leave’decision of itself. We expect that laws relating to land ownership, leases, transfers of land, security over land and property taxes such as stamp duty land tax, would be largely unaffected too due to the fact that the relevant laws are domestic, and not affected by EU legislation in the main.

However, in time it is likely that actual Brexit will necessitate a comprehensive due diligence exercise by all lenders and investment firms. Existing finance documentation will need to be thoroughly reviewed prior to Brexit to ensure that any potential pitfalls have been identified and, where possible, eliminated for future transactions or where necessary amended for those transactions that have already been documented.

In most cases, this would be likely to form part of a wider due diligence and re-papering exercise for lenders to address the implementation of any new regime. We would also expect the various industry bodies and trade associations, such as ISDA, LMA and CREFC Europe, to assist with this on a macro level and help to ensure a smooth transition wherever possible. This could give rise to additional industry protocols or standard form amendment agreements. Since ISDA Master Agreements do not generally contain construction clauses on change of law similar to those found in LMA documentation, any references to EU-derived legislation rendered obsolete or incorrect by Brexit would need to be actively managed. In the past, ISDA has handled such industry-wide issues by way of online protocols to which parties can adhere, updating all of their existing documentation in the process. We would expect a similar approach to be taken to update relevant provisions post-Brexit and indeed ISDA have already started this process. Some of the areas that we expect to be a focus of such due diligence are:

Other events of default and/or early termination rights

Most financial contracts, including those based on industry standard forms such as the ISDA Master Agreement and the LMA documentation, contain representations relating to the parties’ authorisation to transact thereunder. Typically, breach of that representation will be an event of default entitling the non-defaulting party to terminate the contract. Whilst in most loan and bond documents those representations are only given by the borrower or issuer, in the case of derivatives contracts, these are given by both parties. For example, the ISDA Master Agreement contains a representation to the effect that the parties have obtained all necessary governmental and other consents, which representation is repeated every time the parties enter into a transaction under the agreement. If a lender were relying on, for example, an authorisation under MiFID which were to fall away as a result of Brexit, the lender would (i) be in breach of its contractual obligations under the ISDA Master Agreement and (ii) no longer be authorised to transact, and would therefore need to transfer all transactions to, and enter into all future transactions through, an appropriately authorised entity. The ISDA Master Agreement also contains an “Illegality” termination event, which is triggered when it becomes illegal for a party to make or receive payments or deliveries or otherwise to comply with obligations under the Master Agreement in question; however, we consider it unlikely that this termination event would be triggered by Brexit in relation to existing trades. If specific termination events had been built into an agreement to deal with, say, the investment manager of a transacting fund losing the right to do business in a relevant jurisdiction, Brexit could result in the early termination of a number of transactions.

Credit deterioration

A disorderly Brexit, or poorly or inadequately negotiated Brexit terms, or simply market reactions to Brexit, could potentially lead to ratings downgrades for specific issuers, CMBS notes, guarantors, tenants, insurers, hedge counterparties, liquidity facility providers and/or account banks. These could in turn lead to:

• higher financing costs for the issuers/borrowers affected;
• difficulties in raising new debt;
• early termination of transactions under ISDA Master Agreements or a requirement to post collateral; and/or
• a requirement to replace insurers/account banks.

Risk of breach of or stress on financial covenants and performance covenants in loan documentation

Depending on the impact Brexit has on market conditions, including on value, occupancy and rent levels as well as the performance of tenants, lenders may feel it is prudent to due diligence the financial covenant tests in loan documentation. Test dates, rights to instruct a valuation (method and who pays), and ability to cure (and cure periods) will all be of interest in any contingency planning. Lenders may also wish to consider any effect on regulatory capital requirements and slotting should a loan be categorised as being in default.

Valuers may caveat valuations heavily and may provide ranges which will not enable financial covenant calculation to be conclusive. The pressure on construction costs, as detailed above, may translate into cost overruns or delayed programmes/missed milestones, which may in turn lead to margin ratchets and/or calls on sponsor guarantees. Furthermore, in multi-creditor financings, the effect of any change in the level of financial covenant compliance may impacton the powers of a particular creditor class, where control valuation or collateral coverage tests are included.

EU legislation embedded in current loan documentation

A large number of current facility agreements will bridge a Brexit date. LMA based documentation is very light on provisions which rely, directly or indirectly, on EU legislation. Standard LMA construction provisions provide that “a provision of law is a reference to that provision as amended or re-enacted” – and this will be helpful in smoothing over Brexit transition “bumps”. The following considers typical areas of loan finance documentation which rely on EU derived legislation:

• Appropriation as an enforcement remedy: It is routine for security documents to include a right to appropriate financial collateral, as part of the secured parties’ enforcement arsenal. This right derives from the Financial Collateral Arrangements (No 2) Regulations 2003, made under the European Communities Act 1972 and therefore now due for repeal. Our view however is that the Financial Collateral Regulations are of clear benefit to the UK financial services industry – and therefore would be adopted into national law post Brexit.
• Increased costs provisions: LMA documentation is drafted widely and generically, to require that borrowers compensate lenders for increased capital costs during the life of the facilities. In negotiated documents however, EU legislation which implements globally recommended standards for bank capital and liquidity is often directly referenced. It is without doubt however that equivalent legislation will be adopted in the UK and we see no difficulty in transitioning to new documentation provisions in respect of this.
• Sanctions undertakings and representations: There is no single standard for loan documentation provisions relating to economic sanctions. Negotiated documents will however routinely provide that the borrower group complies with sanctions legislation administered by a number of sanctions authorities - including the EU. Our view is that Brexit will have no effect on that position.
•  Environmental provisions: Notwithstanding that much environmental law is based on EU legislation, it is unlikely that the UK will seek to change that law in any material way. Many aspects are based on international treaties to which the UK is a party in its own right. Our view is that the environmental provisions in documentation are unlikely to require amendment.
• Planning provisions: Similarly, the planning law regime is unlikely to change in any material way, albeit that much planning law is based on EU legislation. The UK planning system is focused on the domestic and local market with different rules, policies and codes in place for England, Wales, Scotland and Northern Ireland. The main difference is likely to be in the environmental assessment rules which are based on EU legislation. We anticipate that there will be a desire to retain many of the rules and guidance relating to the environmental assessment of large-scale developments but that ‎the government will take the opportunity to simplify the rules and change the thresholds so that there is only a need to carry out an environmental assessment for major large-scale developments. Our view is that the planning provisions in documentation are unlikely to require amendment.
• EU provisions relating to choice of auditor: Recently adopted EU Regulations concerning statutory audits of annual accounts and relating to public-interest entities limit the degree to which lenders can influence a borrower’s choice of auditor. Lenders can still impose qualitative/capability requirements though and this legislation, in our experience, has not caused significant issues for the lender community. The EU measures were introduced to improve competition (in particular expanding competition beyond the big-four accountancy firms) and it seems likely that equivalent provisions would be retained in respect of audits relating to UK entities post-Brexit

Contractual recognition of bail-in

Under Article 55 of the Bank Resolution & Recovery Directive (BRRD) any contract which is governed by the law of a non-EEA country and which contains a liability of an EEA financial institution must include a provision through which the counterparty acknowledges that such liability may be subject to bail-in by the applicable regulator (the Article 55 Requirement). Post-Brexit, the UK will be free to repeal all legislation transposing the BRRD into national law, including the Article 55 Requirement. However, it is unlikely that the UK would take this step; it is an advocate of the wider regime of which the BRRD forms part and hence UK banks are likely to need to include provisions designed to meet the Article 55 Requirement in their contracts, even post-Brexit. 

Currently, EU Member States are required to recognise each other’s reorganisation measures with respect to banks and investment firms (including application of the bail-in tool). However, post-Brexit, while the UK could legislate for Member States’ resolution measures to be recognised in the UK, there would be no guarantee of reciprocal recognition in EU countries of resolution measures taken by the UK. This could jeopardise the effectiveness of any action taken by the Bank of England (as the UK’s resolution authority) and may lead the PRA to require all UK-based banks, post-Brexit, to include a contractual recognition clause similar to the Article 55 Requirement.

If, following Brexit, the UK did not retain EEA membership, EEA financial institutions would need to include the Article 55 Requirement in almost all English law governed contracts, including facility and security documentation, from the time the UK ceased to be an EEA state. Market practice, and guidance from industry bodies such as the LMA, will likely guide the approach taken in the interim period.

Governing law and jurisdiction

At present, all EU Member States apply the same set of rules to determine the governing law of an agreement and generally courts will recognise and give effect to the parties’ express choice of law, irrespective of whether the contracting parties are located in a Member State. EU legislation is also in place to determine which court has jurisdiction and to provide for the reciprocal recognition of judgments across the EU. Governing law and jurisdiction clauses are also often extended so that they apply to disputes relating to non-contractual obligations.

In a post-Brexit context there is uncertainty as to whether the English courts would have jurisdiction to hear a specific case and/ or whether an English judgment could be enforced elsewhere in the EU (and vice versa). There are several other international conventions to which the UK is either already a signatory or could become a signatory, which could help to mitigate this uncertainty, for example the Lugano Convention or the Hague Convention (although the latter only deals with exclusive jurisdiction clauses). So, while Brexit could result in initial uncertainty and relatively minor changes to contractual documentation – perhaps a shift to exclusive jurisdiction clauses or even to arbitration clauses – it is unlikely to be particularly problematic in the medium to long term.

And what of English law’s current privileged position as the most popular choice of governing law for international contracts? Whilst English law has benefitted in terms of its popularity from being, in effect, the domestic law of the EU in financial matters, it is possible that following Brexit that position may be weakened, although our view is that this is unlikely to be the case.

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Are we heading for a period of uncertainty for CRE restructuring and enforcement?

Restructuring tool-kit available

Over recent years the UK has become the restructuring capital of Europe. This is due to a combination of the UK’s flexible and sophisticated restructuring laws and the impact of the European Regulation on Insolvency Proceedings (ECIR). Whilst Brexit should not affect the validity of restructurings entered into prior to its occurrence, there is now uncertainty in respect of the post Brexit restructuring landscape. While the remedies of the appointment of a receiver to English real estate should not be affected by Brexit, other remedies that may be considered useful in the “restructuring tool-kit” may be affected.

Real estate transactions often involve structures that include EU entities such as, for example, Luxembourg or Dutch special purpose vehicles. Many corporates have used English schemes of arrangement to restructure or reduce their debt without filing for formal insolvency or rehabilitation procedures in their home Member State. One of the conditions for obtaining the English court’s sanction for a scheme of arrangement is that the scheme should be recognised and effective in any other relevant jurisdiction, so that creditors in those other jurisdictions cannot avoid the effects of the scheme in foreign courts and gain an unfair advantage over other scheme creditors. Post-Brexit it may be necessary for the UK to negotiate accession to the Lugano Convention (by which certain other non-EU states have secured mutual recognition of judgments with EU states) to ensure that English schemes of arrangement continue to be recognised and enforced in EU Member States. However, the legal analysis in respect of this is complex and on-going.

Real estate transactions often involve structures that include EU entities such as, for example, Luxembourg or Dutch special purpose vehicles. Many corporates have used English schemes of arrangement to restructure or reduce their debt without filing for formal insolvency or rehabilitation procedures in their home Member State. One of the conditions for obtaining the English court’s sanction for a scheme of arrangement is that the scheme should be recognised and effective in any other relevant jurisdiction, so that creditors in those other jurisdictions cannot avoid the effects of the scheme in foreign courts and gain an unfair advantage over other scheme creditors. Post-Brexit it may be necessary for the UK to negotiate accession to the Lugano Convention (by which certain other non-EU states have secured mutual recognition of judgments with EU states) to ensure that English schemes of arrangement continue to be recognised and enforced in EU Member States. However, the legal analysis in respect of this is complex and on-going.
An EU entity may find its financial difficulties so acute or its creditors so un-cooperative that it cannot use a scheme of arrangement to stave off formal insolvency. It may also conclude its home state bankruptcy regime will lead to liquidation rather than rescue. If that entity has its centre of main interest (COMI) or an establishment in the UK (or if it can relocate its COMI to the UK) then it can initiate administration proceedings in the UK and, under the ECIR, those proceedings will have automatic EU-wide recognition and effect. This facilitates an orderly and coordinated approach to pan-European insolvencies with, hopefully, a better overall outcome for creditors and the continuation of the underlying business. The ECIR has proved a major tool in the facilitation of cross border insolvencies and it remains to be seen whether the UK can negotiate a mechanism which keeps its considerable advantages alive

Enforcement of security

One benefit of the ECIR in the EU is that, if an entity becomes subject to insolvency proceedings in one Member State, any rights ‘in rem’ (i.e. proprietary rights) granted to its creditors in respect of assets located in a different Member State when the insolvency proceedings commence are protected. So if, for example, a borrower with its COMI in the UK becomes subject to main insolvency proceedings in, say, Luxembourg or the Netherlands, and its lender has taken effective English law governed security over the borrower’s UK located assets, any stay imposed by or similar action taken under the Luxembourg or Dutch insolvency proceedings would not affect the English security rights in respect of the UK-based assets – so the lender would not be prevented from enforcing its security over those assets. Without knowing what arrangements would supersede this regime post-Brexit, it is difficult to speculate on the effects that the ECIR ceasing to have effect in the UK might have on EU-wide insolvency proceedings. In our scenario, the protection granted by the ECIR in respect of the security rights would no longer exist, but neither would the Luxembourg or Dutch proceedings have automatic recognition in the UK. The Luxembourg/Dutch office holder would, however, have the option of applying for recognition in the UK under the UNCITRAL Model Law (implemented in the UK pursuant to the Cross Border Insolvency Regulations 2006), although the benefits under these latter Regulations are less than those conferred by the ECIR. The pre-ECIR position was complex and frequently gave rise to conflict of law issues. Post-Brexit, if the UK and the EU are not able to negotiate a coherent set of arrangements for managing EU-wide insolvencies, we may well find ourselves back in this situation.

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Capital Requirements, AML and KYC

As part of ongoing global efforts to eradicate money laundering, the Financial Action Task Force (FATF) has established an international AML framework, applicable to all FATF members (which includes the UK, regardless of its EU membership status). Should the UK wish to continue to have access to the EU’s single market following Brexit, it would either need to submit to the same legislative measures or be able to prove equivalence. Achieving technical equivalence is unlikely to be an issue, but the political obstacles to such an agreement with the EU could be considerable. For example, the EU/US discussions on equivalence for the regulation of CPPs under EMIR took several years. 

In a post-Brexit environment, both the UK and the EU would presumably continue to take their lead from the FATF with regard to their respective AML requirements – for example, the Fourth EU Anti-Money Laundering Directive (the Fourth Directive), based on recommendations from the FATF, is set to come into force in June 2017 and will remove banks’ ability to rely on the simplified “Know Your Client” (KYC) or “Client Due Diligence” regime currently available in respect of certain, low-risk, clients such as listed companies. This could significantly increase the time taken to complete the KYC process. As a result, usual KYC processes and the wider AML environment is unlikely to change significantly post-Brexit.

Similarly, regulatory capital requirements are unlikely to be relaxed in a post-Brexit regulatory environment. The minimum prudential capital requirements for banks and investment firms are set out in the Basel Capital Accords (published by the Basel Committee on Banking Supervision). Implementation in the EU is through the Capital Requirements Regulation (CRR) and the related CRD. However, signatories to the Basel Capital Accords, which includes the UK, are required to give effect to the accords in their national legislation, so even after Brexit we would be unlikely to see substantial changes to the current requirements. In fact, when the UK becomes a third country for the purposes of the CRR, any preferential risk weights currently applicable to exposures to CRR-regulated institutions would only apply if the UK was deemed to have a capital regime equivalent to that implemented under the CRR. If the UK did not implement an equivalent capital regime, UK institutions could be at a disadvantage when obtaining credit from EU institutions, as the cost of such credit would be likely to increase.

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Key Take-Aways

UK Market

UK Market The UK remains the most important investment market in the EU and there are abundant reasons why the UK will remain an attractive market for domestic and international investors. Gains brought about by the weakness of the pound will need to be carefully balanced with the risks brought about by longer term political and economic uncertainty.

Investment Market

Some EU markets may benefit from investment activity re-directed away from the UK. London is expected to be impacted by weaker occupier demand (particularly in the central London office space) particularly as financial services are concerned by the possible loss of ‘’passporting rights’’ into the EU.

Development 

The cost of labour and raw materials may be affected by restrictions on migration and trade tariffs, as well as the weakening pound. Postponement of developments not yet on-stream is expected. High end residential development already impacted by the slowdown in the Chinese economy may, however, see an upsurge in demand owing to the weakness of the pound.

Debt

Leverage across the EU remains well-funded and investment is characterised by moderate levels of leverage (average of 45% LTV in  2015). The impact on pricing and volumes remains to be seen

Due Diligence

Due Diligence Wider due diligence and/or a repapering exercise for lenders in respect of their loan documentation is likely to be assisted by input from industry bodies such as the Loan Markets Association and CREFC. Areas of focus are likely to include:

• MAC/Term Sheets: Consideration of use of material adverse effect clause to trigger an event of default (although this is unlikely to have ‘’teeth’’ in the context of a real estate transaction) and ability of lenders to trigger flex clauses or indeed renegotiate pricing on deals that have not yet been papered.

• Authorisations and Illegality: Representations to the effect that the parties have obtained all necessary government and other consents will need to be analysed. Representations as to authority in documentation and any Illegality termination right in ISDA documentation should be carefully reviewed.
• Credit deterioration: We have already seen that S&P and Fitch have downgraded the UK to AA since the ‘’Leave’’ decision. The impact on financing costs and the ability to obtain debt will need to be monitored. Early termination events under ISDA and requirements to replace insurers and/or account banks in loan documentation should also be analysed.
• Stress on financial covenants: The impact of Brexit on value, occupancy and rent levels may lead to a revisit of the financial covenant tests in loan documentation. EU legislation embedded in current loan documentation: Monitor progress of the UK Government in its decisions to adopt or jettison EU legislation that is embedded in provisions in finance documentation and “future-proof” for financings likely to extend beyond Brexit.
• Restructuring: Potential remedies considered useful in the “restructuring tool-kit” may be affected. Recognition and enforcement of English schemes of arrangement and the ability of EU entities to initiate administration proceedings in the UK under the ECIR may be called into question. The preECIR position was complex and frequently gave rise to conflict of law issues. Will we find ourselves back in this position again post-Brexit?
• Bail-In Clauses: If, following Brexit, the UK did not retain EEA membership, EEA financial institutions would need to include the Article 55 Requirement from the time the UK ceased to be an EEA state. In time the UK may introduce equivalent regulations to protect its own resolution powers. Industry bodies are watching this point closely.
• Governing law and jurisdiction: Choice of governing law in contracts and the jurisdiction of English courts will be tested by Brexit. That said there are several other international conventions to which the UK is either already a signatory or could become a signatory, which could help mitigate the uncertainty.
• Capital requirements, AML and KYC: Usual KYC and the wider AML environment is unlikely to change significantly post-Brexit. For the UK to continue to have access to the EU’s single market, it will need to submit to the same legislative measures or be able to prove equivalence. Similarly, regulatory capital requirements are unlikely to be relaxed in a post-Brexit regulatory environment