June 29, 2016
As you will all be aware, the UK electorate voted last week to leave the European Union. The Referendum does not itself trigger any immediate legal consequences and the actual timing for a UK exit from the EU (if at all) is uncertain. However, the vote to leave had an immediate and direct effect on the global finance markets, with Sterling falling to a 30-year low against the Dollar, and the ratings agencies announcing a UK ratings downgrade reflective of weakening investor confidence. UK equities are volatile, with many UK listed banks and corporates suffering heavy sell-offs, and the European bond market has recorded significant outflows.
There are mixed views as to the medium to long-term effects of recent events, but it seems likely that continuing political uncertainty will result in a gradual slowdown in the European finance markets for at least the summer months. As a result, focus has turned to the consequences for key players within the European loan, high yield and derivatives space – whether they be investors pulling monies, credits seeking alternative types and means of financings, or hedge counterparties raising risk profiles.
This Client Alert considers a number of factors, following the vote to leave, which have an impact on the European finance and derivatives space.
European loan market
Consequences for open commitments and deals in syndication
In the immediate aftermath of the vote to leave, a number of investors and credits have looked to question the viability of open commitments across both loan and high yield documentation. As bitter memories of the 2008 financial crisis bring out fears of hung bridges and drawdowns under interim facilities agreements, lawyers have been asked to consider whether there are immediate "vote to leave" or "BREXIT" loopholes and/or trigger points within underlying documentation.
Each set of papers must be considered on its merits. Unless there are specific "Brexit" or "Flexit" clauses, tight "certain funds-style" conditionality which is now typically included within European commitment papers and/or loan documentation means that it is unlikely that the vote to leave will permit a bank or other investor legitimately to pull a commitment, at least in the short term. Further, and as we noted in our previous Client Alert, it is thought unlikely that the vote to leave, or an eventual BREXIT, will itself lead a lender to call a material adverse change provision. However, there may of course be certain consequential effects e.g. prejudicial hedging exposures, negative trading positions etc., which could collectively make it more likely that a lender will formulate a case for invoking such a provision.
Even if open commitments are initially unaffected, to the extent that there are active deals in primary syndication, it is highly likely that lenders will continue to carefully scrutinize syndication and market flex provisions to see when and how they can be invoked, particularly in light of a general softening in the secondary markets, and going forward an expected rise in the cost of borrowing and the desire for tighter covenant and/or other documentation terms.
Scrutiny and reprofiling of existing transactions
Looking forward, the continuing volatility in the European loan and high yield markets referred to above may have an adverse impact on the availability and/or cost of some types of finance. Coupled with this, it is assumed that M&A and private equity activity will also decrease, and consequently the volume of pipeline deals and new money issuance will fall. For credits already laden with significant debt, we expect that there will be a resurgence of the types of debt reprofiling experienced after the 2008 financial crisis – for example, covenant resets and maturity extensions (i.e. "amend and extend" transactions). Borrowers will also need to ensure that any existing structures work notwithstanding any transitional arrangements put in place following the vote to leave but prior to BREXIT, particularly in relation to debt service and withholding tax exemptions.
As a result, we expect that both investors and borrowers will be spending significant time reviewing existing loan and high yield documentation to assess where there are inherent risks and/or flexibilities. In particular, we expect investors and borrowers will be considering the extent to which underlying documentation permits the disposing of, hiving out or acquiring of assets, extracting cash out of a distressed group by way of dividend or other cash leakage, or the incurrence of additional debt.
Tapping uncommitted facilities
Of direct relevance to this analysis will be the significant number of recent European loan documents – across the mid-market and "top-tier" space – that include sophisticated uncommitted incremental or additional facilities, with broad (if any) purpose clauses and minimal conditions for exercise, often tied only to compliance with a pro-forma leverage test. The flexibility within these incremental (or so-called "accordion") facilities will provide borrowers with a readily available hook to raise additional financing, and we expect that some borrowers will look to tap existing incremental structures rather than seek full refinancings. Of course, borrowers will still need to find lenders who are prepared to fund these additional facilities. However, notwithstanding market volatility, investors will still have capital that they need to deploy, and we expect that the number and dynamic of players in the market will increase. From a legal perspective, the advent of borrowers tapping incremental facilities will be likely to lead to interesting intercreditor discussions. Very few incremental facilities have actually been used to date, and, therefore, the mechanics remain largely untested, particularly within intercreditor agreements where so-called "hollow tranches" have been drafted blind to provide for future incremental debt issuance.
Consequences for distressed transactions
Inevitably, both investors and borrowers will seek more creative solutions to overcome immediate liquidity issues, and if the above reprofiling alternatives are unavailable, then credits will move into the distressed refinancing or restructuring space. As with the post-2008 world, this will necessarily lead to the increased scrutiny of pan-European insolvency regimes (in the absence of a holistic, Chapter 11-style approach). Unless alternative arrangements are agreed post-BREXIT, EU insolvency proceedings would no longer benefit from automatic recognition in the UK, and UK insolvency proceedings would no longer benefit from such recognition in the EU. The UK would have to rely on the cross-border insolvency rules of the member states. That said, many restructurings are concluded outside formal insolvency proceedings, and these arrangements will be largely unaffected by BREXIT.
As borrowers within the European loan market face challenges with new money financings, we expect to see a resurgence in so-called "Yankee loans", i.e., an increase in the number of European borrowers looking to access the US markets for loan financings. This may come hand in hand with increased cross-border investment in the UK, forecast by some commentators to increase as a result of a weaker Pound. Only time will tell whether or not this plays out, but in the meantime borrowers will be wise to explore financing opportunities in the US markets. Many of the key features of Yankee loans that were initially attractive to borrowers will continue to be so, notably: lower margins, incurrence based covenants and overall greater documentation flexibility. If a credit can manage any exchange rate costs associated with borrowing in Dollars, the US loan market is likely to be a viable alternative.
The European high yield market
The European high yield market is also expected to be light on new-money issuance for the short-term, and it would not be a surprise if the market is quiet for longer than usual over the summer months.
High yield issuance has suffered in any event through 2016, and inflows and new issuance levels have remained low compared to comparable periods for previous years. However, in this respect, the European high yield market may be more prepared and resilient for any fall-out from the vote to leave, particularly as issuers have already begun to explore taps to existing bond documentation, covenant flexibility and alternative capital structures, for example, the addition of holdco PIKs or other layers of subordinated debt within pre-existing structures.
Market conditions through the year have resulted in a dominance of refinancings, and there is potentially significantly more to be achieved in this space. In addition, investors, issuers and lawyers alike have already been faced with a number of restructuring scenarios involving high yield bonds and therefore are already beginning to test cross-jurisdictional issues and intercreditor challenges, including voting rights and enforcement regimes.
As borrowers look for more creative solutions in both the European loan and high yield markets, they are also likely to look towards less traditional debt providers, including alternative capital providers and direct lending funds. Banks are likely to be most affected by any transitional arrangements following the vote to leave; particularly in terms of a changing regulatory landscape, including as regards regulatory capital rules and their application, and passporting within the EU.
We have seen these non-bank players become increasingly active in recent years and there are several larger direct lending funds capable of offering a wide variety of alternative capital solutions with big ticket sizes. In part due to pre-existing concerns regarding regulatory enforcement, banks are showing a diminishing appetite for what are perceived to be higher risk credits, whether for sector, leverage or other reasons, and therefore, by contrast, direct lending funds who offer more flexibility in this area, become a viable option for borrowers. In this respect, we expect that the European market may move even closer to the US market, where alternative capital providers have a more significant role. Non-bank lenders are also likely to be capable of offering much of the structural flexibility and creativity required for the expected wave of reprofiling and refinancing transactions noted above, including second lien and PIK debt, as well innovative equity injections.
Derivatives and hedging
Given London’s position as one of the leading markets for global foreign exchange and over-the-counter derivatives activity, the impact of the vote to leave, on-going transitional arrangements and then eventual BREXIT on the global derivatives markets has the potential to be significant for all derivatives market participants. It is a good time for market participants to take stock of their existing derivatives contracts and understand their potential risks and exposures as a result of BREXIT. The full impact of the vote to leave on the derivatives markets is uncertain and will remain uncertain until the transitional arrangements and post-BREXIT negotiations are finalized and fully realized. However, market participants should be alive to the following potential future effects.
Increased Collateral Calls
Now that credit rating agencies have downgraded UK sovereign ratings, counterparties with exposure to the UK may see their own creditworthiness impacted. As a result, the cost of credit could become more expensive, leading to increased collateral requirements. General volatility in the markets could also increase margin requirements and additional margin obligations could be triggered by exposure to collateral such as Sterling or gilts. These additional margin calls could lead to potential issues with respect to the movement of collateral among counterparties in addition to the costs of collateral.
While there do not appear to be any immediate impacts of the standard termination events and events of default under the International Swaps and Derivatives Association (ISDA) Master Agreement, the extent to which derivatives documentation is affected will depend on the specific negotiated terms of the agreements, as well as the specific terms of the transitional arrangements and the agreed position post-BREXIT. For example, downgrades that result from exposures to the UK may trigger certain negotiated provisions such as Additional Termination Events, Material Adverse Change clauses or Additional Events of Default. Additionally, as financial institutions and other entities begin to reorganize and move positions as a result of the vote to leave, market participants should take note of any modifications to the Transfer provisions under the ISDA Master Agreement, as well as other provisions, such as Credit Event Upon Merger and Force Majeure. Further, tax provisions, provisions regarding governing law, as well as any references to the European Market Infrastructure Regulation (EMIR) and other EU regulations could be affected. Finally, many ISDA Agreements and other derivatives documentation are governed by English law and require submission to the jurisdiction of the English courts. BREXIT is unlikely to affect the validity of these choices.
Regulatory and effects on Central Counterparties and Trade Repositories
The vote to leave and the subsequent transitional arrangements create significant uncertainty around how existing EU derivatives regulation and directives such as EMIR, the Markets in Financial Instruments Regulation (MiFIR) and the Markets in Financial Instruments Directive II (MiFID 2), will apply in the UK. The UK will need to determine how regulations applicable to the EU, such as EMIR and MiFIR, will apply going forward. Similarly, the UK will need to determine whether to retain directives that have been implemented and whether amendments should be made. Additionally, it is possible that the UK could decide to implement its own parallel regulatory regime for derivatives to complement EMIR, MiFIR, MiFID 2, and similar regulation. Market participants subject to UK law and trading with UK counterparties, including UK affiliates or UK branches of non-UK counterparties, should continue to track these regulatory developments. Further, if the UK is not a member of the EU or EEA, English law contracts may need to address the contractual bail-in provisions under Article 55 of the Bank Recovery and Resolution Directive.
Additionally, the UK is home to some of the largest Central Counterparty Clearing Houses (CCPs) and trade repositories. As a result of BREXIT, those entities may be viewed as "third country" CCPs or trade repositories under EMIR. This would require an equivalence determination or other arrangement for the UK-based CCPs and trade repositories to continue to be able to offer services to market participants subject to EMIR.
Although not without immediate challenges for those looking to either raise capital or lend new money across the European loan and high yield markets, the vote to leave will also provide opportunities for participants across the financing space. It is a good opportunity for market participants to assess existing debt and investments, and to review existing derivatives contracts and understand potential risks and exposures. It is clear that the transitional arrangements will play a large role in shaping the European finance world for the medium to long term, and it will be key for all to continue to monitor changing regulatory invention to assess the impact for on-going finance needs, evolving structures and market dynamics.
 Certain investors introduced clauses into documentation allowing them to increase margin / interest rates in the event of a vote to leave / BREXIT taking place.
This client alert was prepared by London partner Stephen Gillespie and London Senior Associate Amy Kennedy, with assistance from New York Partner Arthur Long and Washington, D.C. Counsel Jeff Steiner (both focusing on derivatives), and London Of Counsel Anne MacPherson. We have a working group in London (led by Stephen Gillespie, Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) that has been considering these issues for many months. Please feel free to contact any member of the working group or any of the other lawyers mentioned below.
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