Derivatives and the Withdrawal Bill - what it does and what it fails to do

As Brexit draws closer, commentary has focused on the nature of the future relationship between the UK and the EU and the progress in the Article 50 negotiations.

Less attention has been given to the effect that the Repeal Bill (the "Great" having been dropped along the way) would have on law and regulation in the United Kingdom if enacted in its current form.  The Bill is entering its Committee stage in Parliament and will be the subject of intense scrutiny given the large number of tabled amendments.

With that in mind we have asked ourselves the question: what would some of the key legislation relating to the derivatives industry look like if the UK were to exit on the basis of the Bill as drafted?  That analysis reveals significant anomalies and uncertainties.

Terms appearing in bold are explained in the Glossary below.

Overview

Preserving EU law in substance or in form

A key issue is whether the intent and effect of the Bill is to preserve the substance of EU law as it stands in the UK as if the UK were still a Member State or to preserve only the letter of EU law which, since the UK will no longer be a Member State after Exit Day, would mean that the UK and UK institutions would fall outside the scope of many key provisions of EU law and regulation.  This is not clear from the text of the Bill, and the answer may depend on the context and the extent to which the so-called "Henry VIII powers" are used to modify the literal meaning of EU legislation.

Henry VIII powers

In implementing the Bill, heavy reliance is being placed on those "Henry VIII powers" which allow Government ministers to amend retained EU legislation.  The powers appear wide in scope, and may lead to Government departments making fundamental policy decisions as part of what should, properly considered, be merely a process of administrative implementation.

Timing

A further issue is that the timing of amendments to be made under the Henry VIII powers is unclear.  It is not known whether such changes will take effect on the date the UK leaves the EU or at some later date, given that the powers last up to two years after Exit Day.  Given the practical challenge of amending the vast body of retained EU legislation in the next 16 months, the Bill raises the prospect of uncertainty as to the meaning and interpretation of key regulations continuing for an extended period after the date of exit.

Furthermore, the exercise of such powers could be subject to challenge in the courts by means of judicial review.

Reciprocity

Finally, the Bill as it stands does not (and cannot on its own) address the lack of reciprocity between the UK and EU Member States after Exit Day.  Absent an agreement with the EU, the UK and UK institutions may no longer benefit from mutual enforcement and recognition provisions under EU law which currently apply among Member States on a multilateral basis.  Whilst much could change if an agreement is reached between the UK and the EU covering financial services, for the purpose of this briefing our analysis is based on an assumption of "no deal".

As the issues are necessarily complex and involve some understanding of how EU law currently stands as part of the body of UK law, this briefing divides into three main segments.

First, we explain the types of EU law which currently form part of UK law but would fall away without the saving provisions in the Bill.

Then we go on to analyse the scope and content of the Repeal Bill, explaining the major clauses and their effects.

Lastly, we look specifically at certain key issues and deficiencies for the derivatives industry which looks at how individual pieces of regulation might fare in the post-Brexit UK, and where amendment may be required.  For convenience, we refer to this as "EU derivatives regulation" although this includes legislation relating to topics with a broader application such as bank resolution and insolvency. Our aim is to consider the complexities involved in translating the body of EU derivatives regulation into UK law, and to identify areas where, absent a clear agreement with the EU and/or the remaining EU Member States, even the saving of that body of EU legislation and regulation could be largely ineffective.

You can jump to any of these sections of this briefing using the navigation bar above.

Status and aims of the Bill

On 11 September 2017, the European Union (Withdrawal) Bill (the "Bill") passed its Second Reading in the House of Commons by 326 votes to 290.  The Bill is now in the Committee stage of its passage through Parliament.

Aims of the Bill

The Bill has the following stated aims:

• to repeal the European Communities Act 1972 (the "72 Act") on Exit Day and to end the supremacy of EU law in UK law;
• to convert EU law as it stands at the moment of exit into domestic law (commonly referred to as the "saving" of EU law); and
• to enable domestic law to reflect the content of a withdrawal agreement under Article 50 of TEU once the UK leaves the EU.

The Bill also creates powers to make secondary legislation to amend laws that would otherwise no longer operate effectively after Exit Day. These powers, widely referred to as "Henry VIII" powers, are widely drawn and as a result have been the subject of much debate in Parliament as well as discussion in the media.

Types of EU law

EU legislation currently either applies directly within the UK as a result of the 72 Act, or requires specific implementation through a UK legislative act. A UK legislative act implementing EU law may take the form of primary legislation, by an Act of Parliament, or of secondary (or delegated) legislation such as a statutory instrument.

The box below explains the principal categories of EU law and their effect within a Member State (such as the UK prior to Exit Day).

EU law: what it is and how it takes effect

EU Primary Legislation

The Treaties are the primary legislation of the European Union and form the basis for all EU action. They form a binding agreement between the Member States and set out the policy areas in which the Commission may propose legislation, and by which the EU institutions may make legislation which must be implemented in Member States.

Article 288 of TFEU sets out the effect of legal acts adopted by the EU institutions (which include, among others, Parliament, the Council and the Commission).

EU Secondary Legislation

These legal acts of the EU consist of Regulations, Directives and Decisions. Regulations are binding across the EU without further national legislation being required, and thus have "horizontal direct effect" or simply "direct effect" – that is, they apply as between individual entities within a Member State, who can take action directly against each other for breach of a Regulation.

Directives do not take horizontal direct effect within a Member State, although they are binding on Member States (so they are sometimes described as having "vertical direct effect") who must implement them in national law. However some provisions of Directives may also have full horizontal direct effect if they meet certain conditions prescribed by the CJEU in case law. Some Directives are "maximum harmonisation" Directives, and some are not. Maximum harmonisation Directives require uniform implementation in each Member State, without any "gold-plating" of the Directive through imposing more stringent requirements. Member States are required to publish their implementation measures, which can be found on the Commission's website.

Decisions are addressed to particular Member States or to individual entities within the EU, and are directly binding on those so addressed.

Private individuals can take action for breach of EU law by public bodies within a Member State, and under the rule in Francovich, are entitled to compensation for loss suffered by reason of that failure. Actions against other individuals or legal entities are, however, for the jurisdiction of the courts in the relevant Member State.

Under the so-called "Lamfalussy" process for financial services legislation, Directives and Regulations may require the preparation of "Level 2" technical and implementing measures, to be adopted by the Commission. The so-called "Level 3" bodies, being the EBA, ESMA and EIOPA, are responsible for the preparation of technical and implementing standards for adoption by the Commission as Level 2 Regulations. Most of the Level 2 Regulations we are concerned with take the form of regulatory technical standards ("RTS") which are adopted as delegated acts by the Commission.

EU Case Law

EU case law comprises the judgments of the CJEU, which interprets questions of EU law with the objective that it is applied uniformly across the Member States. The legal basis on which national law is required to be interpreted in accordance with EU law also stems from judgments of the CJEU. In the UK, the 72 Act provides that legal rights and obligations arising under EU law, including from judgments of the CJEU, are to be recognised, followed and given full effect.

Overlaying all of the above are what are known as the "general principles" of EU law. These are unwritten, but have a similar status to the Treaties, in that they reflect fundamental principles of law and justice which must be adhered to in interpreting any EU law. They are given effect when EU law is interpreted (primarily by the CJEU) and include the principle of proportionality, the right to a hearing, the liability of Member States for breach of EU law, the protection of basic rights, and the need for legal certainty.

The need to preserve existing EU legislation

In our briefing of 6 July 2016, we discussed the direct or indirect nature of a variety of provisions of EU derivatives regulation, and the need for saving provisions where the provision had direct effect. This is because, for EU law having direct effect, there will be no existing UK legislative act giving effect to the provision other than the 72 Act itself which is being repealed.

We also identified in that briefing that much of the body of EU derivatives regulation has been implemented into UK law by means of statutory instruments (UK secondary legislation) made under the powers given to the Secretary of State under section 2(2) of the 72 Act, and thus, absent saving legislation, such secondary legislation would fall away on repeal of the 72 Act.

Saving provisions in the Bill

The Bill purports to address both of these categories of EU legislation by way of saving provisions, discussed below. However, these saving provisions do not of themselves preserve the status quo represented by the body of existing EU derivatives regulation.  This is because much of the foundation for that body of law rests on reciprocal recognition and enforcement of rights, obligations and responsibilities on a multilateral basis between the UK and the rest of the EU, which cannot meaningfully be replaced by unilateral adoption of EU law by the UK. We outline some significant examples of this "mutuality gap" below.  Clearly, some of these issues may be resolved if the UK reaches an agreement with the EU covering the provision of cross-border financial services.

The Bill also attempts to address required amendments to retained EU legislation by granting wide-ranging – some would say excessively wide-ranging – powers to the Government.  These powers will not only allow the Government to enact changes to UK legislation, including primary legislation but apparently also to the provisions of the Bill itself, after it is enacted, by way of ministerial order rather than by Act of Parliament. We discuss these so-called "Henry VIII powers" in more detail in the box headed "Henry VIII powers" below.

The Bill: scope and content

In this section, we examine the provisions of the Bill in further detail.  A critical concept is "retained EU law", the body of law which is retained or transposed into UK law.

Repeal of the 72 Act

The UK's membership of the EU itself will be terminated by the process set out in Article 50 of TEU, which we discussed in our July 2016 briefing. However, this does not of itself remove EU law from the body of UK legislation.

For this reason, section 1 of the Bill repeals the 72 Act on Exit Day. This has the effect of reversing the implementation of the Treaties into UK law which was effected by section 2 of the 72 Act.  This will result in the formal removal of all laws arising from the UK's membership of the EU unless directly enacted into UK law under other legislation or saved by the saving provisions of the Bill itself.

Saving for "EU-derived domestic legislation"

Section 2 goes on to retain "EU-derived domestic legislation", which includes any enactment made under section 2(2) of the 72 Act. This saving provision is necessary because there are a large number of statutory instruments which have been made under section 2(2) of the 72 Act itself rather than under another Act of Parliament, and that secondary legislation would otherwise fall away with the repeal of their enabling provision in the 72 Act. Among them are:

• the FCA Regulations, which implemented the Financial Collateral Directive. This is a key enactment relied on by financial market participants to safeguard the enforceability of security over financial collateral and close-out netting provisions in financial contracts;
• the Settlement Finality Regulations, which implemented the Settlement Finality Directive into UK law. Again, this is a key enactment for financial markets as it underpins the enforceability of settlement systems and related collateral arrangements;
• the CIWUR, which implemented the CIWUD. This is a measure implementing EU law on the winding-up and reorganisation of credit institutions (banks) and is a critical component of UK insolvency legislation for financial institutions;
• certain amendments made to the Banking Act 2009 by statutory instrument to give effect to the bank resolution tools under BRRD; and
• many others affecting the financial markets.

Incorporation of "direct EU Legislation"

Section 3 of the Bill provides that "direct EU legislation" will form part of UK domestic law insofar as it is operative immediately before Exit Day.

The concept of "direct EU legislation" is EU law which is effective in the UK prior to Exit Day without any specific UK implementing legislation.  It includes any EU Regulation and "EU Tertiary legislation", which will include any provision made under an EU Regulation or Directive through the process set out in TFEU.  This includes delegated acts of the Commission setting out regulatory technical standards in relation to financial services legislation. The definition does not include EU Directives.

The Bill provides that such direct EU legislation is incorporated into UK law "as it has effect in EU law immediately before Exit Day".

Examples of EU derivatives regulation which is direct EU legislation include the following:

• EMIR (an EU Regulation) which governs mandatory clearing, reporting and margining for OTC derivatives, as well as other risk mitigation measures introduced by the EU to safeguard financial institutions in relation to OTC derivatives exposures in the aftermath of the 2007/8 financial crisis;
• the delegated acts made under EMIR - including the "Margin Rules" (enacted as Commission Delegated Regulation 2016/2251) (EU Tertiary legislation). These rules cover mandatory margining for non-cleared OTC derivatives;
• the Capital Requirements Regulation (Regulation 575/2013) (an EU Regulation) which covers capital requirements for certain financial institutions;
• the Markets in Financial Instruments Regulation (MiFIR) (an EU Regulation);
• SFTR (an EU Regulation) which regulates securities financing transactions including repo and stock lending, as well as certain collateral arrangements;
• the delegated acts made under SFTR to the extent they are adopted prior to Exit Day;
• the delegated act made under AIFMD (Commission Delegated Regulation 231/2013) (EU Tertiary legislation).  AIFMD is the key EU legislation regulating the alternative investment fund management industry.

What is the effect of incorporating direct EU legislation?

The wording "has effect in EU law immediately before Exit Day" is not, in itself, clear. It is not made explicit whether EU legislation is to be read as having effect as if the UK were still hypothetically a member of the EU (this could be called the "hypothetical" approach) or should be read literally on the basis of the reality that the UK will be outside the EU (the "reality" approach).

The hypothetical approach

The hypothetical approach takes that italicised phrase to mean that direct EU legislation is saved into UK law as though the UK were to remain a Member State of the EU.  In other words, all that is intended to happen on Exit Day is that no future changes to direct EU legislation will affect the UK. This requires reading "as it has effect in EU law" to be read as though it says "with all the consequences and legal relationships that it effects in EU law immediately prior to Exit Day".  This would mean that, for example, references in direct EU legislation to "Member State" or "the Union" should be taken to include the UK so far as UK domestic law is concerned, even after Exit Day.  In many cases, such a reading is helpful to give the relevant legislation logical meaning although it is by no means clear from the Bill that this interpretation is correct, and it may not be appropriate in many cases.

The reality approach

The reality approach interprets the italicised language to mean that the literal text of the law, in force on Exit Day, becomes part of UK law and applies in future to the new set of circumstances in which the UK is no longer a Member State. This requires "as it has effect in EU law" to be read as "as that law stands and is in force in EU law immediately before Exit Day" but without the UK being an EU Member State. On this view, terms such as "Member State" or "Union" would be read literally and would therefore exclude the UK after Exit Day.  This assumes that where the Government's intent is to apply such laws to the UK as if it were a Member State, this would need to be dealt with by amending the direct EU legislation subsequently, possibly using the Henry VIII powers.

Policy consequences

Direct EU legislation contains very many provisions under which Member States give each other reciprocity and recognition for the application of national law, regulation and supervision. The unilateral adoption of these provisions by the UK can never give the full effect to EU legislation that it has under EU law. To take the hypothetical approach would therefore assume that, politically, the UK is agreeing to the unilateral recognition of its obligations (and those of UK persons where applicable) to EU Member States (and EU persons where applicable) under EU derivatives regulation on Exit Day as though the UK remained a Member State, without any reciprocal arrangements for recognition of UK legislation and regulation (that is, unless and until a deal is struck with the EU).

The reality approach has the opposite effect. It construes EU law narrowly, so that UK law immediately following Exit Day would no longer give effect to the reciprocity and recognition provisions between Member States provided by EU law, as the UK would no longer be a Member State and would therefore fall outside the scope of many provisions of EU derivatives regulation as transposed into or saved in UK law. This approach assumes that if a deal is struck between the UK and the EU, the political intention will be to add any reciprocity and recognition provisions at that stage by way of Henry VIII powers.

As yet, it is not clear what the political intention is, and the Bill itself is not explicit. The Secretary of State for Exiting the European Union did not provide much clarity on this point during the debate at the second reading. The position may be clarified once the outcome of the trade negotiations between the UK and EU is known, although at the time of writing those negotiations have not yet begun.

A further point on section 3 is that direct EU legislation is only saved to the extent it is "operative immediately before Exit Day". This means that in order to be caught, the provision must both be in force and apply. In other words, any provisions of EU legislation should only apply in the UK to the extent that they have been phased in prior to Exit Day. This will create disparities where "phase-in" of existing EU legislation is scheduled to occur after Exit Day.

Saving for Treaty Rights

Treaty Rights under the 72 Act

Section 2(1) of the 72 Act brought into UK law all rights, powers, remedies etc. that are created by or arising under the EU Treaties ("Treaty Rights"). Section 4 of the Bill preserves Treaty Rights in UK law after Exit Day which are recognised and available in UK law immediately before Exit Day. Section 4 does not operate to transfer the text of the EU Treaties into UK law, just to preserve these Treaty Rights.

The explanatory notes to Section 4 explain that these preserved rights are those which are sufficiently clear, precise and unconditional as to confer directly on individuals or entities rights which can be relied on in national law without the need for implementing measures, such as rights of non-discrimination, rights of freedom of movement, prohibition of imposition of customs duties, rights to equal pay, and others.

Exclusions for provisions not having direct effect prior to Exit Day

Section 4 carves out from preserved Treaty Rights any rights etc. which already form part of UK law because of section 3 (which preserves direct EU legislation), and any rights which arise under an EU Directive and have not been recognised by the CJEU or a UK court or tribunal in a case decided prior to Exit Day. This appears to mean that CJEU or UK court judgments which are handed down prior to Exit Day, and which recognise rights with direct effect arising under an EU Directive, will continue to be recognised in UK law after Exit Day. Conversely, CJEU judgments handed down on or after Exit Day which recognise rights having direct effect under an EU Directive would not appear to be protected in UK law after Exit Day. This does leave open to interpretation how specific the relevant court judgment must be in recognising the relevant rights and obligations as having direct effect.  It would appear unclear whether rights which have not been the subject of a specific court judgment upholding the relevant rights prior to Exit Day can be relied upon.

It is possible that section 4 of the Bill also has the effect of preserving directly effective rights under EU Regulations which existed prior to Exit Day and which are not otherwise transposed into UK law under section 3.  For example, if section 3 fails to preserve rights and obligations which existed and were enforceable under EU Regulations prior to Exit Day due to anomalies arising in transposing such laws into UK law, it may be that section 4 would have the effect of preserving those rights.

It is however not made clear whether it is only rights which have actually been acquired prior to Exit Day which are protected.  This leaves open the question whether rights acquired, for example under new transactions, after Exit Day would benefit from the same rights and remedies under EU law by virtue of section 4. This is an area where further clarity as to the meaning and effect of the Bill would be helpful.

Factortame

In Factortame¹, Treaty Rights allowed Spanish fishing vessels access to fishing quotas under the common fisheries policy which the UK Government had ostensibly attempted to restrict by enacting the Merchant Shipping Act 1988 (the "Shipping Act"), which required that UK vessels must have UK beneficial ownership. The Spanish fishing companies sought judicial review of the Secretary of State for Transport's enforcement of the Shipping Act, on the basis that the statute and regulations made under it were contrary to EC law and deprived EC citizens of enforceable Community rights. The House of Lords held that the prohibitions and rights in the Treaty of Rome (i.e. the prohibitions on discrimination against nationals of other Member States and on restrictions on exports, and rights to free movement, freedom of establishment, freedom to provide services, rights under the common agricultural policy, and the free movement of capital in EU Member States), were to be given supremacy over an Act of the UK Parliament which conflicted with rights and restrictions granted by the EU Treaties, and that the case should therefore be referred to the CJEU to determine whether the Shipping Act was contrary to EU law.

Exceptions to the Bill's saving of EU law

Section 5 and Schedule 1 limit saved EU legislation in that:

• Section 5 continues the principle of supremacy of EU law after Exit Day insofar as relevant to interpretation, disapplication or quashing of enactments or rules made before Exit Day and disapplies the principle in relation to enactments on or after Exit Day (other than limited modifications).
  
  Without this exception, section 4 could be read as preserving the effect of the Factortame case indefinitely. As drafted however, the Factortame principle will only remain relevant after Exit Day to the extent that it is relevant to questions concerning retained EU law at the point immediately before Exit Day.
• Schedule 1 removes the right on or after Exit Day to challenge any retained EU law on the basis that prior to Exit Day that law was invalid, unless the CJEU has ruled the instrument invalid prior to Exit Day. The clause envisages that instead any rights to challenge validity of retained EU law will be set out by statutory instrument instead.  This means that, for example, the challenge to the legality of the FCA Regulations raised in Cukorova² to the effect that in allowing a financial collateral arrangement to be entered between any two non-natural persons those regulations went beyond the options permitted by the Financial Collateral Directive, would no longer be able to be brought in the UK courts unless permitted by a future statutory instrument.
• Schedule 1 also removes any right of action for breach of the general principles of EU law. However, the general principles appear to be saved after Exit Day to the extent they were recognised by the CJEU in a case prior to that date.
• Schedule 1 also removes any right for individuals to seek damages from Member States for failure properly to implement an EU Directive – the so-called "rule in Francovich"³. This right is removed in its entirety, and is not preserved even for any breach by the UK of EU law which has taken place prior to Exit Day.

Interpretation of retained EU law - application of EU case law

This body of law saved by sections 2, 3 and 4 is together referred to in the Bill as "retained EU law".  Section 6 of the Bill provides that in interpreting retained EU law, UK courts are not bound by any decisions of the CJEU made after Exit Day, but it may take those decisions into account.

Any question as to the validity, meaning or effect of any retained EU law, so far as that law is unmodified after Exit Day, must, however, be decided by the UK courts in accordance with retained case law and any retained principles of EU law.

"Retained case law" includes any principles or decisions made by a UK court or the CJEU as they have effect immediately before Exit Day and relate to any of the retained EU law covered by the Bill. By way of an example, using the cases on "possession or control" of financial collateral:

• domestic cases on the Financial Collateral Regulations, such as the Gray⁴ and Extended Liens⁵ cases will be preserved, as they cover issues decided in relation to EU-derived legislation preserved by Section 2 of the Bill; and
• Swedbank⁶ will also continue to apply to the interpretation of the Financial Collateral Regulations as it is a case decided by the CJEU prior to Exit Day and relates to EU-derived legislation, even though the FCD itself will cease to apply to the UK.

However, retained EU case law is subject to an additional qualification that the Supreme Court will not be bound by retained EU case law, nor will the High Court be bound by it when sitting as a court of appeal. Effectively then, the Supreme Court in the UK could decide against applying the decision in Swedbank within the UK.

Delegated powers - Henry VIII clauses

Sections 7 to 9 of the Bill provide for a minister of the Crown to make such regulations as the minister considers appropriate for the following purposes:

• to prevent, remedy or mitigate any failure in retained EU law to operate effectively or any other deficiency in EU law arising from the withdrawal of the UK from the EU;
• to prevent or remedy any breach of the international obligations of the UK arising from the UK's withdrawal from the EU; and
•  to implement the "withdrawal agreement" where the minister considers that provision should be in force before Exit Day.

These so-called Henry VIII clauses are broadly drawn and were the subject of much of the political discussion and disagreement during the second reading. An explanation of the breadth and scope of these powers in the Bill as drafted,  is set out in the box below.

The "Henry VIII" Clauses

Section 7 of the Bill would allow a Government minister, in order to deal with any perceived deficiencies in retained EU law, to make any regulations which could be made by an Act of Parliament, provided that they do not:

• impose or increase taxation,
• create a criminal offence with a penalty of more than two years in prison,
• make retrospective provisions, or
• amend or repeal the Human Rights Act

(together, "prohibited effects"); or

• make certain provision with respect to the devolution of Northern Ireland.

Section 9 of the Bill allows a Government minister, in order to give effect to any withdrawal agreement with the EU, to make any provision that could be made by Act of Parliament, including modifying the EU Withdrawal Act itself, once in force, provided that such provision does not give rise to the prohibited effects.

These powers are subject to "sunset clauses", which purport to end the section 7 powers two years following Exit Day, and the section 9 powers on Exit Day itself.

However, as the extension of the sunset clauses is not included in the list of prohibited effects, it appears to be possible that the sunset clauses could also be extended by the minister.

Any regulations made by the minister under either of these clauses will be subject to the Parliamentary scrutiny procedure applied by schedule 7 of the Bill. Most instruments will be subject to negative scrutiny, meaning that they will become law but can be annulled by a resolution of either House of Parliament. Instruments purporting to amend the Bill itself (once an Act), or to create any power to legislate, to create criminal offences or to transfer function of EU bodies to UK public authorities, will be required to be laid before Parliament and approved by resolution prior to becoming law. However, even this level of Parliamentary scrutiny can be dispensed with should the minister decide that the need to legislate is urgent, in which case emergency orders in council can be made which remain effective for a month, but can be extended for a month at a time, apparently without limit, by the minister.

Key issues and deficiencies for the derivatives industry

We have considered several of the major pieces of EU legislation which shape trading and transactions in derivatives to determine the effect on UK law on Exit Day.

EMIR

As "direct EU legislation", EMIR will be incorporated into UK law under section 3 of the Bill, along with all of the delegated acts made under it insofar as they are operative before Exit Day. However, there are very many provisions of EMIR which are founded on the assumption that the state applying those provisions is a member of the EEA and these provisions are not designed for direct transposition into the law of a non-Member State. A few examples of these are:

Clearing Services in the UK

EMIR requires that entities established in the Union wishing to provide clearing services as a CCP must be authorised to do so by the competent authority in their home Member State.

These provisions lose their meaning in relation to UK CCPs when transposed into UK law, as the UK will no longer be a Member State and therefore UK CCPs will no longer be "established in the Union".  Either this provision will need to be read as if the UK is still a Member State after Exit Day or it will need to be modified to tie in with provisions under FSMA for CCPs to be authorised by the Bank of England to provide clearing services in the UK.  The existing FSMA provisions cross refer extensively to EMIR and would need to be modified to remove, for example, references to ESMA's regulatory role. 

Article 14(2) of EMIR provides that, once authorisation has been granted to a CCP by its home Member State competent authority, it is effective for the entire territory of the Union.  This would not apply to the provision of clearing services by EEA CCPs in the UK after Exit Day since the UK would no longer be part of the Union, unless "Union" is to be read in UK law as including the UK for this purpose.  This could limit access of UK-based financial institutions to clearing services provided by EEA CCPs.

Clearing Services in the EU

EMIR also requires that third-country CCPs who wish to provide clearing services to clearing members within the EU must first be recognised by ESMA. The UK will become a third country after Exit Day and therefore, without agreement from the EU it is unlikely that CCPs based in the UK will be recognised to provide clearing services to clearing members based in the EU. Furthermore, under the proposals published by the Commission in June 2017, third-country CCPs seeking recognition by ESMA would be divided into tiers, depending on their systemic importance. Those CCPs considered to be "substantially systemically important" would be required to establish themselves within the EU and be authorised by ESMA. This proposal is specifically explained in the Commission's Q&A accompanying the proposal as addressing "shortcomings as regards ongoing supervision in third countries, meaning that EU authorities may not become aware of new or growing risks to the EU financial system". The proposals appear to be aimed at CCPs in the UK as a result of its leaving the EU, "as a substantial volume of derivatives transactions denominated in Euro or other EU Member States' currencies are currently cleared via CCPs located in the UK". 

These are controversial proposals, and they have been the subject of extensive commentary in the press, as well as lobbying efforts from ISDA and other industry groups. While there have also been reports in the press that the Council has proposed restrictions on the Commission's proposals, in particular to prevent legacy trades from falling within their scope, the outcome for clearing of OTC derivatives in London remains uncertain, regardless of the adoption of current EU legislation under the Bill which would apply similar supervision standards to UK CCPs as those applied under EMIR.

Classes of derivatives for clearing are also effectively designated by ESMA through the CCP approval mechanism. The UK could choose simply to mirror the clearing classes within the EU rather than introduce a separate mechanism for designating new clearing classes of derivative, but amendments to EMIR on its incorporation into EU law would be required either way.

Trade reporting

Similarly, EMIR (in article 9) requires that derivative contracts must be reported to a trade repository established in the EU and registered with ESMA or recognised by ESMA if established in a third country. Recognition will only be possible if (i) there is an equivalence decision from the Commission, and (ii) there are cooperation agreements in place between the third country and the EU to allow for the sharing of information.  Absent an equivalence decision, reporting a trade to a trade repository established in the UK would not comply with EMIR, or the UK version of EMIR as transposed into UK law by the Bill.

It is also questionable whether the reporting obligation will apply at all to UK-established counterparties as they will no longer be "established in the Union".  Presumably, it is not intended that the obligation should cease to apply to UK entities, but if the intention is that counterparties subject to UK jurisdiction should be able to report trades to trade repositories in the UK, the reporting provision will need to be amended on transposition of EMIR into UK law. Furthermore, as EMIR requires two-sided reporting, any report of a trade between an EU counterparty and a UK counterparty made to a trade repository in the UK will not satisfy the EMIR reporting requirement under EMIR.

Financial and non-financial counterparties

Under EMIR, clearing and margining requirements apply to financial counterparties authorised under various EU Regulations as well as to certain non-financial counterparties if they are established in the Union. If these provisions are transposed into UK law without amendment they are rendered meaningless, and fail to impose any clearing or margining obligation on financial or non-financial entities in the UK following Exit Day, unless the Bill is read in such a way that the UK is hypothetically assumed to be an EU Member State for the purposes of these rules.

These definitions will therefore need to be amended so as to apply the clearing and margining obligations to UK firms. At that point, for trades by UK firms with EU counterparties there will potentially be two sets of applicable margining rules for trades between UK firms and EU counterparties. This would be unproblematic if the UK margin rules were to be determined to be equivalent by the Commission to those in the EU (and vice-versa, assuming the UK enacts a reciprocal equivalence provision), because in that event counterparties would be permitted by EMIR to choose to comply with the equivalent rules. However some changes will be required to be made to  the margin rules as preserved in UK law simply to enable them to operate effectively even for solely UK trades (for examples see "Margining – Eligible collateral", "Initial Margin – custody arrangements", "Intragroup transactions" and "Straddling" effect of section 3" below). The extent of any changes could have an impact on whether the UK rules are found to be equivalent by the Commission.

Margining - Eligible collateral

The Margin RTS require that eligible collateral consisting of debt securities must meet certain credit standards.  However, where the issuer of the collateral is the central government or central bank of an EEA Member State, or the local government or equivalent public body in a Member State, no credit assessment is required where the debt is issued in the issuer's domestic currency. 

However, where such a collateral issuer is not in an EEA Member State, the collateral must meet certain internal or external credit ratings in order to be eligible. The use of internal ratings-based approaches requires the counterparty to be permitted to use the internal ratings-based approach under CRR, or an approach which has been assessed as equivalent by the Commission under CRD. As an alternative, an external rating can be used provided it is sufficiently high (at least BBB) and issued by an EU-authorised credit rating agency. 

The saving of this provision without amendment has the anomalous consequence that, for example, two UK-established counterparties trading OTC derivatives through accounts in London using UK custodians would be unable, absent an equivalence decision from the EU allowing them to use internal ratings, to post collateral issued by a public entity in a non-EU jurisdiction, including the UK itself, without an external rating of at least BBB for that collateral.

Conversely, the same two counterparties could post collateral issued by a public entity in an EEA Member State without meeting any rating criteria at all, provided that it is issued in the issuer's domestic currency, and if issued in a different currency, such collateral would only need a rating of BB or equivalent.

Initial Margin – custody arrangements

The Margin RTS provide that that cash collected as initial margin is maintained in cash accounts at central banks or credit institutions which are authorised either under CRD or in a third country whose regulatory regime has been recognised by the Commission as equivalent.

The saving of this provision without amendment would mean that, absent an equivalence decision, two UK counterparties trading in London would be unable to hold cash collected as initial margin in an account with a UK bank but would need to use an EU bank instead.

Intragroup transactions

EMIR provides various exemptions from mandatory margining and from clearing for "intragroup transactions", which are defined by reference to criteria which depend on counterparties being either EU counterparties or counterparties in third countries for which an equivalence decision has been made by the Commission.

In the absence of an equivalence decision, the transposition of EMIR as it stands would mean that a UK counterparty trading with another UK counterparty cannot take advantage of the intragroup exemption. The UK could correct this specific case using the Henry VIII powers to remove the equivalence requirement, but because EMIR requires that even two non-EU financial counterparties or NFC+s must clear OTC derivative contracts where there is a direct, substantial and foreseeable effect in the EU, this may still not address the issue fully.  An equivalence decision will also clearly be needed should a UK counterparty wish to use the intragroup exemptions when trading with an EU group member.  

"Straddling" effect of section 3

The "straddling effect" of section 3 could result in changes to the phase-in of initial margin requirements. If Exit Day falls, as expected, two years following the notice given under Article 50 of TEU (i.e. on 29 March 2019) the initial margin requirements will not have been fully phased-in at that stage, as the final dates for application of initial margin requirements fall in September 2019 and September 2020. As a result, this final initial margin requirement will not be "operative" as required by the Bill and thus it would appear that those requirements would not be automatically transposed into UK law under section 3 of the Bill.

The UK will therefore have to make its own policy decision regarding whether the phase-in of initial margin will take effect as it does under EMIR. 

Financial Collateral Regulations

The Financial Collateral Regulations, being a statutory instrument made under section 2(2) of the 72 Act, will be saved into UK law under section 2 of the Bill. As such, there are no significant problems with transposition under the Bill, as the rules are already drafted as UK legislation. A few definitional changes will be required, but these should not present significant problems. 

However, a potentially more significant issue is that FCD requires that one of the parties to a financial collateral arrangement is a financial entity, including a credit institution as defined in the Banking Consolidation Directive or an investment firm as defined in MiFID. Whilst these definitions do not of themselves require the bank or investment firm to be established in the EU, there is a view that "defined in" when used to refer to banks and investment firms should be read as meaning that the bank or investment firm must be authorised in the EU under the relevant Directive. Where a national court in a Member State takes that view in applying that state's domestic rules implementing FCD, it may not recognise a financial collateral arrangement where one of the parties is a UK bank or investment firm after Exit Day. The Bill does not, and cannot unilaterally, cure this issue.

A separate point is that UK persons will, following Exit Day, lack the right to enforce rights under the FCD in EU Member States if the Directive has not been implemented properly in the relevant jurisdiction. Prior to Exit Day, UK persons potentially have the ability to do so under the doctrine of vertical direct effect.

Conflict of law provisions in both the Financial Collateral Regulations and FCD apply the rule that the law applicable to certain questions relating to provision of financial collateral in the form of book-entry securities will be the law of the place in which the account is maintained. This provision does not, in either case, require such law to be the law of a Member State, so it appears that English law will continue to be recognised under FCD as governing these matters in relation to book-entry securities held in accounts located in London and pledged to EU counterparties following Exit Day. 

FCD does not attempt to set out other conflict of law rules in relation to financial collateral.  Therefore, the question as to which law determines whether there is a financial collateral arrangement in existence will therefore continue to fall to principles of private international law.

SFTR

As a Regulation, and therefore direct EU legislation, SFTR would be saved into UK law by section 3 of the Bill along with all of the delegated acts made under it so far as they are operative before Exit Day. As with EMIR, however, there are several provisions of SFTR which are based on the state applying the law having membership of the EEA and are not designed for direct transposition into the law of a non-Member State. Some potential issues are:

• Reporting and transparency obligations
  
  The obligation to report transactions within the scope of SFTR (e.g. repo, securities lending transactions, margin loans etc.) apply to counterparties which are either (i) established in the EU or (ii) established in a third country and the SFT is entered through an EU branch of that counterparty.
  
  Transposition of these provisions into UK law without amendment would mean that the reporting obligation would only apply within the UK where transactions are entered into through the UK branch of an EU counterparty or an EU branch of a UK counterparty. One solution that the Treasury could adopt would be to amend the scope of covered counterparties so as to apply the obligation to UK counterparties and UK branches.  However, the question of whether transactions through EU branches of UK counterparties would be required to report under both regimes and vice-versa would still remain. An equivalence decision from the Commission would be needed in order to allow reporting under UK rules to satisfy the requirements of SFTR. Furthermore, as SFTR stands, reporting must be made to a trade repository which is either (i) established in the EU and registered with ESMA, or (ii) established in a third country and recognised as meeting equivalent requirements to those for registration under SFTR. It is not clear whether in the UK this role would be given to the FCA, and if so, whether a trade repository registered with the FCA would be recognised through an equivalence decision.
• Requirements relating to re-use of financial instruments under a collateral arrangement
  
  The obligations to inform the collateral-provider of the risks of, and to obtain its consent to, the re-use of financial instruments under collateral arrangements within the scope of SFTR (being title transfer and security financial collateral arrangements as well as SFTs) apply where a counterparty is either (i) established in the EU or (ii) established in a third country and such re-use is effected in the course of operations of an EU branch of that counterparty, or where the collateral-provider is in the EU or is an EU branch of a counterparty established in a third country.
  
  Again, transposition of these provisions into UK law without amendment would mean that the re-use conditions would not apply to UK counterparties within the UK. However this should be less problematic as the re-use conditions (i.e. information and consent to re-use) can be complied with by provisions set out in transaction documents and do not depend upon any equivalence decision.
• Disclosure by funds of their use of SFTs
  
  SFTR also provides that EU-authorised or registered AIFMs must disclose in their annual reports (as required under AIFMD) certain information about their use of SFTs and total return swaps. As AIFMD is not direct EU legislation, it will not itself be saved into UK law by the Bill. However the requirements relating to annual reports were incorporated into UK law by provisions made under FSMA and amendments to the FCA handbook.  The SFTR provisions will need revision to preserve the disclosure requirement by reference to those UK reporting requirements. It is possible under AIFMD that non-EU established managers could in future become authorised to market AIFs into the EU in certain circumstances, and UK managers would be subject to the AIFMD reporting requirements, including disclosure of the use of SFTs, should they do so.

"Straddling" effect of section 3

As explained above, section 3 of the Bill incorporates direct EU legislation into UK law only insofar as the EU law is operative on Exit Day. The timetable for full application of SFTR provisions is not yet set in stone, as the implementation of the trade reporting obligations depends on the date of adoption of the Commission delegated act on trade reporting for SFTs which was published on 31 March 2017 but is still in draft form. According to the timetable for implementation, the reporting requirement for non-financial counterparties and certain financial counterparties (other than banks or investment firms) will not now be operative on Exit Day.

Settlement Finality Regulations

The Settlement Finality Directive did not take direct effect in UK law and was implemented by the Settlement Finality Regulations made under section 2(2) of the 72 Act. As a result, the Settlement Finality Regulations are preserved by section 2 of the Bill.

The Settlement Finality Regulations provide that UK insolvency law takes effect subject to the Settlement Finality Regulations, which preserve the effectiveness of instructions for the transfer of collateral made prior to the onset of insolvency, and disapply certain of the clawback provisions in the Insolvency Act 1986 with respect to arrangements for the netting of amounts to be transferred through designated clearing systems. 

The Settlement Finality Regulations can stand alone as a piece of UK legislation without a significant degree of amendment. However, without amendment they would continue to take effect to protect instructions and arrangements through UK-recognised clearing houses and also EEA clearing houses authorised under EMIR, in the event of insolvency of a UK clearing member. The Settlement Finality Regulations would also apply, to questions relating to collateral securities, the law of the place of the register, the account or central deposit system in which the collateral securities are held.  This means that the rights of a collateral-holder are insulated from the effects of the insolvency of the provider. 

Whilst prior to Exit Day the SFD would mean that this treatment applies on a reciprocal basis between the UK and other Member States, following Exit Day transactions made through UK clearing houses will no longer be afforded the same protection provided by the SFD.

The result would be that where insolvency proceedings are opened in respect of a participant in a UK clearing system where the participant has its COMI in a Member State, transactions cleared through the UK clearing house may not be as well protected from the insolvency of the EU clearing member. As mentioned above, due to the political unwillingness on the part of the EU Member States to allow the UK to keep its share of clearing activity, the prospect of an agreement for mutual recognition of settlement finality is uncertain. 

EUIR/CIWUD

Questions of jurisdiction and applicable law in the event of the insolvency of derivatives counterparties arise on a daily basis, and affect issues such as the applicable law for enforcement of netting provisions, the priority of security interests, and the application of any insolvency moratoria on the enforcement of security. Where the counterparty is a corporate client (i.e. not a bank or investment firm or certain other financial firms), issues of insolvency jurisdiction, recognition and applicable law are addressed by EUIR. Where the counterparty is a bank or investment firm subject to prudential supervision rules, these questions are addressed by CIWUD.

EUIR - jurisdiction and recognition of insolvency proceedings

The existing regime under EUIR

Article 3 of EUIR provides the mechanism by which EU Member States agree that a court in the Member State in which a firm has its "centre of main interests", or "COMI" has jurisdiction to open insolvency proceedings in respect of that firm (the "jurisdiction provision"). The courts of another Member State can then open insolvency proceedings only if the debtor has an establishment within that second Member State and only in respect of local assets (the "establishment restriction"). Article 7 provides that the applicable law for most purposes in such insolvency proceedings will be the law of the Member State in which the proceedings were opened (the "applicable law provision"), and Articles 19 and 20 go on to say that judgments of the court in the Member State of the opening of proceedings will be recognised by and will have the same effect in other Member States (the "recognition provision").

Incorporation of EUIR into UK law

EUIR will be incorporated into UK law by section 3 of the Bill as direct EU legislation.  This will mean that in the case of a company (whether or not UK-incorporated) which has its COMI in an EU Member State, UK law will continue to provide that the courts of that EU Member State have jurisdiction to open insolvency proceedings.  Without further agreement with the EU, however, reciprocal recognition by the remaining EU Member States of the UK jurisdiction to open insolvency proceedings in respect of a company with its COMI in the UK would no longer apply under EUIR.  Also, where the COMI is situated in the UK the current restrictions on opening proceedings in other EU Member States (the establishment restriction) would fall away. A further concern is that mandatory recognition by the courts in EU Member States of the effect of UK insolvency proceedings would no longer apply.

Winding-up

The Insolvency Act 1986 allows the winding-up by the English courts of any company registered in England and Wales, although this is expressed to be "subject to" Article 3 of EUIR.  Accordingly, the English courts' winding-up jurisdiction will survive exit as it derives from UK legislation, but the interaction with Article 3 is somewhat unclear.  

If the text of the Article 3 jurisdiction provision in EUIR is read literally, the jurisdiction of UK courts arguably may no longer be formally subject to the "COMI" or "establishment" tests under EUIR. This is because, whilst Article 3(1) will still acknowledge the jurisdiction of the Member State in which the COMI is situated to open insolvency proceedings, this might not be viewed as limiting UK jurisdiction after Exit Day given that the restrictions in article 3(2) of EUIR will no longer apply to the UK when it is no longer an EU Member State.  Article 3(2) provides that where the COMI is situated in an EU Member State, a second EU Member State shall only have insolvency jurisdiction if there is an "establishment" in that second Member State, and that the effects of those proceedings are limited to assets situated in the territory of that second Member State.  

This could mean that in relation to companies incorporated in England and Wales the domestic courts will have jurisdiction even if the COMI is located in another EU Member State and the company has "no establishment" in the UK.

Similarly, in relation to a company registered in an EU Member State, as a matter of UK law the "COMI" and "establishment" tests may not apply after Exit Day and the broader domestic rules of jurisdiction under section 221 of the Insolvency Act 1986 may instead be applied.

The position described above would be different if the EUIR is incorporated into UK law on a "hypothetical" basis so that references to "Member States" are taken to include the UK, but this would still not preserve the reciprocal benefits and protections under EUIR unless an agreement is reached between the UK and the EU on the matter. It would be helpful if the interaction between the Insolvency Act and Article 3 of EUIR could be clarified.

Administration

Under Schedule B1 to the Insolvency Act 1986, the UK courts can make an administration order in respect of a UK-registered company, a company registered in an EEA Member State, or a company registered elsewhere but with a COMI in an EEA Member State other than Denmark. English law administration is not expressed to be "subject to" the jurisdiction provision – thus, there seems to be scope to have conflicting administration procedures in the UK and in another Member State.

Recognition of judgments of courts in Member States during insolvency proceedings

Recognition of insolvency proceedings and insolvency judgments by courts of Member States during insolvency proceedings will be unpredictable after exit where the UK is involved.  Depending on whether the hypothetical or reality analysis is correct, the UK may (or may not) be obliged to recognise EU insolvency proceedings under Article 19 of EUIR as transposed into UK law, and other judgments handed down in the course of those proceedings by EU Member States' courts.  This is unclear because, read literally, Article 19 only requires judgments opening insolvency proceedings in one EU Member State to be recognised in other EU Member States, which will not in reality include the UK after Exit Day.  In the absence of recognition pursuant to the preserved effect of the EUIR, the Cross-Border Insolvency Regulations 2006 can be used to recognise foreign insolvency proceedings, but they are of no help in enforcing other insolvency judgments.  Rules of private international law may also help.

Fallback to the Model Law

The UNCITRAL Model Law on Cross-Border Insolvency (the "Model Law") provides for cross-border recognition of foreign insolvency proceedings and administration by those jurisdictions in which it has been implemented. In the EU these are currently only Greece, Poland, Romania, Slovenia and the UK.

However, the Model Law cannot be used to recognise and enforce foreign insolvency judgments or to implement foreign law.

Rights in rem

Article 8 of EUIR preserves "rights in rem" in the event of the insolvency of an EU company, so that although the Member State of the company's COMI will have jurisdiction to open insolvency proceedings, and for the most part the law of that COMI state will apply to that insolvency, this will not affect rights in rem over assets situated in another Member State at the time of opening of insolvency proceedings. Rights in rem will include many of the types of security interests typically granted between financial entities.

Effectively, this means that where a security interest has been granted over an asset located in a Member State, the creditor can usually count on that security remaining enforceable despite a moratorium applying in the insolvency proceedings in the COMI state.

After Exit Day, as the UK will not be a Member State, it is not clear whether rights in rem over assets located in the UK will be recognised by the insolvency court in other EU Member States, as the right in rem under Article 8 is preserved only if the asset is "situated in another Member State" from the state of opening of proceedings. 

Furthermore, the effect of the incorporation of Article 8 into UK law by section 3 of the Bill, if un-amended, is not clear. It appears to preserve the rights in rem of creditors over assets of a UK debtor where those assets are situated in "another Member State", which seems to be predicated on the UK being a Member State.  Again, if the treatment of rights in rem is to be reciprocal then this will need to be agreed with the EU, because EUIR as it stands will not require the courts of EU Member States to give protection to rights in rem situated in the UK in the event of insolvency proceedings in the EU.

Set-off

Article 9 of EUIR provides that the opening of insolvency proceedings shall not affect the rights of creditors to demand the set-off of their claims against the claims of a debtor, where such a set-off is permitted by the law applicable to the insolvent debtor's claim.

This currently protects rights of set-off in a financial contract governed by English law in the event of challenge in insolvency proceedings in another Member State, provided the set-off provisions are enforceable under English law.

Whilst this protection is not expressly limited to set-off rights contained in contracts governed by the law of a Member State, it may not be possible for a UK creditor to enforce the Article 9 protections directly in EU Member State courts after Exit Day given that a UK creditor would no longer benefit directly from rights having horizontal direct effect.

Detrimental acts

Article 16 of EUIR provides a defence to actions under the law of the state of opening of insolvency proceedings to set aside of transactions such as the grant of security interests where the law applicable to such grant of security does not provide a means of challenge.

Again, this provision is drafted so as to apply only as between Member States.  Currently, this means that a court in a German insolvency will not set aside as a voidable preference the grant of English law security over assets in England, if English law provides no means to set that transaction aside (e.g. if it took place outside the hardening period applicable under English law). However once the UK is no longer a Member State, this provision will need to be re-considered, as the incorporation of EUIR into English law cannot give it a reciprocal effect.

CIWUD

EUIR does not apply to banks and investment firms subject to prudential supervision. Instead, CIWUD provides for the courts of the Member State in which the bank is supervised to have jurisdiction over insolvency proceedings (and resolution action) in respect of the bank and its branches in other Member States and for those proceedings to be recognised by other Member States. Rights in rem are unaffected by the opening of those proceedings in much the same way as under EUIR, and the provisions relating to actions for avoidance operate in the same way as under EUIR. 

As CIWUD is a Directive, however, it was implemented in the UK by the CIWUR. The CIWUR will be preserved in English law, thereby preserving the UK's side of the bargain in recognising insolvency proceedings and rights in rem. While any reciprocal arrangements will depend on how CIWUD has been implemented in individual Member States, it is unlikely that any of the Member States' implementing regulations are effective to recognise UK insolvency proceedings or rights in rem once the UK has left the EU.

The Model Law does not apply to banks, investment firms and other entities who are out of scope of EUIR, so does not provide any fallback recognition of bank insolvency proceedings or protection of security rights in the case of a bank entering insolvency.

BRRD

Whilst recognition of resolution action by the resolution authorities in Member States is dealt with by CIWUD, there are also some specific provisions of BRRD which are particularly relevant to the derivatives market.

BRRD gives Member State resolution authorities the power to:

• suspend rights of any party to terminate a contract with an institution in resolution for events based on the institution's insolvency or financial condition, provided the institution's obligations under the contract continue to be performed;
• restrict secured creditors of an institution in resolution from enforcing security interests; and
• suspend payment and delivery obligations under a contract with an institution in resolution.

Furthermore, resolution measures taken in Member States cannot constitute a trigger for contractual termination, netting or set-off rights under a contract with an institution in resolution. These resolution provisions all take precedence over the provisions in the FCD protecting netting and enforcement of financial collateral arrangements.

These aspects of BRRD were all implemented in the UK by amending the Banking Act 2009, and, being EU-derived legislation, those amending provisions are saved in UK law by section 2 of the Bill.

This means that in UK law, the effect of implementation of BRRD will remain after Exit Day, but this will be unilateral. The UK may therefore take any of these resolution actions in respect of a UK institution, but this action will not necessarily be recognised by EU Member States or their courts. As a result, in order to preserve fully the effects of BRRD, the UK and EU will need to come to an agreement to recognise resolution action on a reciprocal basis. In the absence of such agreement, it may be possible for the UK to require all firms subject to prudential supervision to include in any contracts governed by the law of an EU Member State a provision recognising any UK resolution action, with the effect that resolution action by the UK authorities will take precedence over contractual termination, enforcement and netting provisions. The ISDA Resolution Stay Protocol could facilitate recognition of the post-Exit Day UK resolution regime as between derivatives counterparties.

Meanwhile, as resolution actions taken by other Member States' resolution authorities are recognised by CIWUR as described above, as the Bill stands the UK will continue to recognise those actions after Exit Day despite the lack of reciprocal recognition. 

Bail in and contractual recognition – Article 55 of BRRD

Under Article 55 of BRRD, Member States are required to ensure that where banks and investment firms enter contracts creating liabilities which could be subject to the bail-in tool, and those contracts are governed by the law of a third country, the contract includes a term by which the counterparty agrees that liability may be subject to the write-down and conversion powers and agrees to be bound by any reduction, conversion or cancellation of the liability resulting from exercise of those powers by a resolution authority.

The UK implemented Article 55 through provisions in the PRA and FCA rulebooks, made under the authorities' rule-making powers in FSMA. These rules will remain unaffected by the Bill. As the effect of the contractual recognition requirement is, by definition, limited to contracts which are not governed by EU law, the UK provision will continue to apply following Exit Day as it does currently. 

However, because UK law will cease to be the law of a Member State, there are two potential changes needed. Firstly, Article 55 may mean competent authorities in other EU Member States will start to require firms they supervise to include a contractual recognition clause in English law governed contracts, unless they take the view that recognition of EU resolution action under CIWUR remains sufficient. Secondly, the PRA and FCA may decide to require contractual recognition of bail-in to be included in contracts that are entered into by UK banks and are governed by the law of an EU Member State, as well as (as is currently the case) contracts governed by the law of a third country.

Capital Requirements

The detailed provisions of the pipeline of revisions to the BCBS Frameworks and the changes required to CRR to implement those changes are too extensive to cover here. There are many instances in CRR where a risk weight or eligibility for a particular treatment depends on whether an exposure is to an entity in a Member State, or whether a collateral instrument is issued by entities defined by reference to establishment in a Member State. There is no overriding concept of equivalence for third-country rules which applies across CRR, and the adoption of CRR into UK law by section 3 of the Bill appears to have the effect that favourable treatment will be given to exposures to EU entities and EU collateral, rather than exposures to UK entities, or UK collateral. While the Henry VIII powers could be used to correct these references so as to apply at least as favourable rules to UK assets within the UK, cross-border treatment of UK assets will again require agreement with the EU.

It is also worth noting that the current timelines for implementation of many of the revised BCBS requirements (such as the revisions to the Counterparty Credit Risk Framework and the Fundamental Review of the Trading Book) are likely to straddle Exit Day. As section 3 of the Bill incorporates direct EU legislation into UK law only so far as operative, it may be that parts of these requirements will apply in the UK and other parts will not, at least until the UK legislates further to incorporate provisions that are not operative as at Exit Day.

Governing law, Jurisdiction and Recognition of Judgments

The EU Rome I Regulation ("Rome I") requires all EU Member States to apply the same set of rules to determine the governing law of contractual obligations. The parties’ express choice of law will, in most cases, be recognised by courts in EU Member States regardless of whether the contracting parties are located in a Member State and regardless of whether the parties have chosen the law of a Member State. After Exit Day therefore, the courts of the remaining Member States should continue to recognise English governing law clauses in the context of contractual obligations. The Bill will also save the Rome I Regulation into English law under section 3, so there should be no change to the English courts' recognition of EU governing law clauses.

The recast EU Brussels Regulation (the "Brussels Regulation") determines which court has jurisdiction over a particular matter and also provides for reciprocal recognition across the EU of judgments handed down in Member States (other than in insolvency proceedings, which are governed by EUIR and CIWUD). The general rule is that proceedings must be brought in the defendant's place of domicile unless the contract in question contains an express jurisdiction clause (as is the case in the majority of financial contracts, including the ISDA Master Agreements). 

Although the Brussels Regulation would be saved by the Bill, as it currently operates on a reciprocal basis there will need to be an agreement with the remaining Member States for it to operate as it currently does following Exit Day. As a fallback, there are several other international conventions to which the UK could become a signatory in its own right (as opposed to as a Member State of the EU), which could go some way to replicating the current position, but they have drawbacks. These include the Lugano Convention, which applies between all EU countries and Norway, Iceland and Switzerland, and the Hague Convention, which has a similar effect to the Brussels Regulation (although prior to it being recast) but arguably applies only where exclusive jurisdiction clauses are used. As the ISDA Master Agreement jurisdiction clause is currently non-exclusive, this would need to be reconsidered if the UK were to rely on the Hague convention. We understand that ISDA is currently considering this issue.

MiFID and Authorisation

This briefing does not attempt to cover the myriad conduct of business and authorisation issues which will arise under MiFID and MiFID II as a result of the Bill. Any derivatives trading activity will involve the conduct of various regulated activities, and continuance of those activities across the EU Member States will require a mechanism replacing the MiFID passport either on a bilateral basis between the UK and individual Member States (reliance on which will require identifying the individual Member State in which the activity is deemed to take place) or between the UK and the EU as a whole, based on equivalence. The Bill cannot attempt to replicate the effect of the passport on a unilateral basis.

This not only raises the obvious issue of future conduct of business into the EU by UK firms, but also whether the performance after Exit Day of an obligation under a pre-existing contract could become unlawful if it constitutes a regulated activity in another jurisdiction, and whether such unlawfulness could affect the enforceability of the relevant transaction. Whilst simple settlement of existing trades should not give rise to the new conduct of regulated activity, actions such as the unwind of hedges, novations or material amendments to existing transactions could give rise to new regulated activities. In the event of illegality, a "hedging disruption event" could also occur under certain transactions such as equity derivatives, should hedging activity become illegal on withdrawal of the MiFID passport.

The House of Lords European Union Financial Affairs Sub-Committee highlighted the need to address the grandfathering of existing derivatives contracts under EU law in its letter to the Chancellor of the Exchequer, Philip Hammond, on 9 November 2017. The letter stressed the "urgent need for an agreement on a standstill transition period as a priority for the UK Government in the negotiations". Although the Secretary of State for Exiting the EU has indicated that the Government would like an implementation agreement in the first quarter of 2018, the letter argues that the evidence from the Bank of England and the financial markets industry suggests that leaving an agreement so late would result in a significant number of relocation plans being put in motion, and the need for large-scale novation of derivative contracts to ensure contractual continuity in the absence of a reciprocal agreement to grandfather existing transactions.

What happens next? 

Following the vote to pass the Bill at the second reading, the Bill now enters the Committee stage, during which each clause will be considered closely, and amendments may be made. The Committee can draw on expert evidence and amendments proposed by MPs are published daily on the UK Parliament's website. Each clause in the Bill must be either agreed to, changed, or removed.  There have been a considerable number of amendments tabled by MPs for consideration at the Committee stage.

Once the Committee stage is concluded, the Bill returns to the floor of the House of Commons for its report stage, during which it is debated by MPs and further amendments may be proposed. The report stage would normally be followed immediately by the Bill's third reading and the final vote in the Commons, after which the Bill should be passed for consideration by the House of Lords. 

The stages of a bill are similar in the House of Lords to those in the Commons, but the Government may not restrict the subjects under discussion by, or impose a time limit on the Lords. Following the third reading of the Bill in the House of Lords, the two Houses of Parliament will consider the other's amendments, and if they agree, the Bill will proceed to Royal Assent.

A critical factor will be the interaction between the terms of the Bill and any agreement reached between the UK and the EU on any transitional arrangements and the terms of the future trading relationship. The latter point in particular may influence the eventual approach of the Bill to the transposition of EU law, especially if any of the elements of reciprocity inherent in EU law can be preserved.

The Bill clearly therefore has some way to go before it appears on the statute book. 

1. R (Factortame Ltd) v Secretary of State for Transport [1990] UKHL

2. R Cukurova Finance International Ltd. and another v HM Treasury and another [2008] EWHC 2567 (Admin)

3. Francovich v Italian Republic Joined cases C-6/90 and 9/90

4. Gray v G-T-P Group Ltd [2010] EWHC 1772 (Ch)

5. Re Lehman Brothers International (Europe) (in administration) [2012] EWHC 2997 (Ch)

6. Private Equity Insurance Group SIA v Swedbank AS [2016] EUECJ C-156/15

Glossary

AIFM means an alternative investment fund manager which manages an AIF and is authorised to do so in accordance with AIFMD.
AIFMD means the Alternative Investment Fund Managers Directive (Directive 2011/61/EU).
AIF means an alternative investment fund which is managed by an AIFM as defined in AIFMD.
Banking Consolidation Directive means Directive 2006/48/EC.
BCBS means the Basel Committee on Banking Supervision.
BRRD means the Bank Recovery and Resolution Directive (Directive 2014/59/EU).
CCP means central counterparty.
CIWUD means the Credit Institutions Winding Up Directive (Directive 2001/24/EC).
CIWUR means the Credit Institutions Reorganisation and Winding Up Regulations 2004 (SI 2004/1045) (as amended).
CJEU means the Court of Justice of the European Union.
COMI means the Member State in which a firm has its "centre of main interests".
CRD means Capital Requirement Directive (Directive2013/36/EU).
CRR means Capital Requirement Regulation (Regulation (EU) 575/2013).
EBA means the European Banking Authority.
72 Act means the European Communities Act 1972 (as amended).
EEA means the European Economic Area, which consists of the EU Member States and the Additional EEA Member States.
EEA Member States means the contracting parties to the EEA Agreement, being the EU Member States and the Additional EEA Member States.
EIOPA means the European Insurance and Occupational Pensions Authority.
EMIR means the European Market Infrastructure Regulation (Regulation (EU) No 648/2012).
ESMA means the European Securities and Markets Authority.
EUIR means the EU Regulation on Insolvency Proceedings 2015 (Regulation (EU) 2015/848).
EU Member States means those countries which are party to the EU Treaties and are, as a consequence of such, members of the EU.
EU Treaties means the treaties establishing the European Union, and by which the UK joined the EU, including, among others, TEU, TFEU, and the Charter of Fundamental Rights of the European Union.
FCA Regulations means the Financial Collateral Arrangements (No. 2) Regulations 2003 (SI 2003/3226).
FCD or Financial Collateral Directive means the Financial Collateral Directive (Directive 2002/47/EC).
Financial counterparties are, under EMIR, essentially, financial entities regulated in the EEA (or alternative investment funds managed by EEA-regulated managers in the EEA).
FSMA means the Financial Services and Markets Act 2000. 
MiFID means the Markets in Financial Instruments Directive (Directive 2004/39/EC).
MiFID II means Directive 2014/65/EU on Markets in Financial Instruments and Amending Directive 2002/92/EC and Directive 2011/61/EU.
MiFIR means Regulation (EU) 600/2014 on Markets in Financial Instruments and Amending Regulation (EU) 648/2012.
NFCs or non-financial counterparties are, under EMIR, EEA counterparties to OTC derivative transactions (other than central counterparties) that are not FCs.
NFC+s are, under EMIR, NFCs which are part of a group in which the aggregate notional amount of outstanding derivatives, excluding hedging transactions, entered into by all NFCs within that group, exceeds the applicable “clearing threshold”.
SFD means the Settlement Finality Directive (Directive 98/26/EC).
Settlement Finality Regulations means the Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979).
SFT means a security financing transaction as defined in SFTR.
SFTR means the Securities Financing Transactions Regulation (Regulation (EU) 2015/2365).
TEU  means the Treaty on European Union, signed at Maastricht on 7 February 1992.
TFEU means the Treaty on the Functioning of the European Union, being the Treaty signed at Lisbon on 13 December 2007 amending the Treaty on European Union and the Treaty Establishing the European Community.
Third countries means those countries that are not EEA Member States.