Brexit—whether it happens or not, and in what form it might (or might not) take—will shock the global marketplace. Yet despite the known unknowns in these tumultuous times, there is one certainty for public reporting companies in the United States: Brexit risks must be disclosed.
On March 15, 2019, William Hinman, Director of the SEC’s Division of Corporation Finance, spoke in London at PLI’s 18th Annual Institute on Securities Regulation in Europe and reiterated that reporting companies in the U.S. (including foreign issuers with U.S. reporting obligations) must disclose the material risks they face arising from Brexit. Director Hinman identified several risk areas and cautioned that the SEC will focus on the quality of the disclosures in the context of the specific risks a company faces. Generic, formulaic statements will miss the mark.
Also useful to reporting companies are the March 21 remarks by Nausicaa Delfas, Executive Director of International of the UK’s Financial Conduct Authority. Among other items, Executive Director Delfas identified residual risks arising from Brexit that might remain despite mitigation efforts by UK regulators.
After reviewing the current status of Brexit, we compile several impacts that U.S. reporting companies should consider disclosing.
Brexit: Where We Are
Article 50 of the Treaty on European Union provides that a Member State shall leave the European Union (“EU”) on the date of entry into force of a withdrawal agreement, or failing that, two years after the Member State had notified its intention to leave, unless the European Council, in agreement with the Member State concerned, agree to extend the period.
On March 29, 2017 the UK gave notice of its intention to leave the EU, thereby starting the clock under Article 50. After months of negotiations, UK and EU officials agreed to the draft text of a withdrawal agreement and a political declaration on the future UK / EU relationship on November 14, 2018. Among other things, the draft withdrawal agreement provides for a transition period whereby the UK will remain bound by EU law until December 31, 2020 (this may be extended to the end of 2022 at the latest).
The draft withdrawal agreement must be approved by the UK and EU in accordance with their own constitutional procedures. From the UK perspective, Parliament’s role in the process has been enhanced by statute with members of the House of Commons (“MPs”) having a “meaningful vote” on the content of both documents. MPs must approve them and at the same time pass implementing legislation. So far, MPs have twice rejected the documents.
With Parliament deadlocked, the UK and EU faced the real possibility of a cliff edge scenario involving the UK leaving the EU without a deal on March 29. However, a week before this deadline, the UK and EU agreed to extend the Article 50 period. If the draft withdrawal agreement is approved by MPs the extension will last until May 22. If the draft withdrawal agreement is not approved by MPs, the extension will last until April 12 and the UK is expected “to indicate a way forward before this date for consideration by the European Council.”
At the time of writing MPs had rejected the draft withdrawal agreement for a third time on March 29, 2019. On April 1, 2019 MPs will take part in a second round of indicative votes on ways the UK Government could proceed as regards its Brexit strategy. The first round of indicative votes were held on March 27, 2019, although none of the proposals secured a majority. The legal default following the extension of the Article 50 period is that the UK will leave the EU on April 12, 2019. However, the UK Government is expected to give an indication of a way forward to the European Council before then. To depart from the legal default outcome one or more of three things must happen: (i) the draft withdrawal agreement needs to be ratified before the extended Article 50 period expires on April 12; (ii) a further extension of Article 50 must be agreed; or (iii) the UK must unilaterally revoke Article 50. A special European Council summit will be held on April 10, 2019.
Nature of Brexit Disclosures
In his March 15 remarks, Director Hinman noted that the US “disclosure regime emphasizes materiality” and “[p]rinciples-based disclosure requirements articulate an objective and look to management to exercise judgment in satisfying that objective by providing appropriate disclosure when necessary.” To date, the SEC has observed that some companies make a “generic disclosure, merely stating that Brexit presents a risk, that the outcome is uncertain and that it could materially and adversely impact the business and its operations.” In Director Hinman’s opinion, “this type of disclosure does little to explain to investors the potential specific impact of Brexit on a company’s business and operations and is insufficient to guide investors in a meaningful manner.”
Director Hinman also recognized that “each company has its own considerations” and that “[g]iven the differences across industries and companies, there is no one specific data point or prescriptive piece of information that all companies could provide to disclose material information relating to their Brexit-related risks.”
To that end, Director Hinman asked the audience, “For those of you involved in crafting disclosure documents, you can ask yourself a straightforward question: would these disclosures satisfy the curiosity of a thoughtful, deliberative board member considering the potential impact of Brexit on the company’s business, operations and strategic plans?”
With the aforementioned principles in mind, we break down the most significant Brexit risks into three categories: operational risks, financial risks and accounting risks.
Examples of operational risks include the following:
- Regulatory risk: Exposure to different laws and regulations might impact businesses. Significantly, Director Hinman identified the loss of passporting arrangements that permit UK entities to serve EU businesses and customers and efforts required to relocate UK operations or use EU subsidiaries. Industry-specific examples include risks to clinical trials due to varying regulations for biopharmaceutical companies and regulatory and antitrust issues impacting airlines.
- Supply chain risk: The impact of changes in the UK’s access to free trade agreements and any resulting tariffs or custom changes might materially impact a company’s supply chain. Director Hinman singled out the impact on businesses that rely on just-in-time supply chains.
- Customer risk: Tariffs and other market and regulatory impacts from Brexit could create a material risk of losing customers or decreases in sales and revenues. Director Hinman identified “products especially sensitive to exchange rates or changes in tariffs” and noted that “[t]o the extent management sees the potential impact of Brexit in terms of anticipated costs, reductions in forecasted sales or changes in working capital, it may be appropriate in some cases to include estimates or ranges of quantitative changes, as well as qualitative disclosures.”
- Contract risk: Director Hinman asked whether companies have reviewed their contracts with UK or EU counterparties “to determine whether renegotiation or termination is necessary in light of contractual obligations” and stated that “[t]o the extent these discussions involve material contracts, we would expect disclosure to reflect these discussions.” Despite risk mitigation efforts by the UK and EU Member States, Executive Director Delfas cautioned “there are likely to be some remaining areas where the legal risks relating to the ongoing service of existing customers have not been fully mitigated.”
- Migration risk: Executive Director Delfas advised that “the process of migrating businesses, assets and contracts in a short period could pose operational risks.”
- Data protection risk: The EU General Data Protection Regulation governs the processing of personal data and information by which individuals might be identified. Unless otherwise addressed, the UK will no longer be an EU “safe data” zone under the GDPR and data transfers will become more complex.
- Labor risk: Brexit might impact the hiring and movement of employees and subject companies to local labor laws.
- Structural risk: Companies might undertake structural changes to mitigate Brexit risks, such as modifying corporate structures and creating or eliminating subsidiaries.
- Intellectual property risk: Brexit will change the landscape of UK and EU trademark and design portfolios. IP right owners need to be ready for its impact and take steps to mitigate the effect.
Brexit will intensify existing financial risks and create new risks, including the following:
- Currency risk: Director Hinman identified the potential for heightened foreign exchange volatility in connection with foreign currency exchange risks, currency devaluation risks and other market risks, and stated that the SEC is “aware of reports that companies are increasing their hedging activities. We will look at quantitative and qualitative disclosures about market risk to better understand each company’s approach to market risk management in this area.”
- Banking risk: Executive Director Delfas noted that “UK and global banks are transferring activities to EU-incorporated entities, but are to some extent dependent on their clients agreeing to move contracts to these new entities, and we are aware there is varying progress with this.”
- Trading risk: Executive Director Delfas flagged “implications of a lack of equivalence in certain areas” affecting shares and derivatives, such as certain cases where “firms may be limited to trading certain shares only in either the UK or the EU or in some cases be caught by overlapping obligations.”
- Lending risk: In a no-deal Brexit scenario UK-based entities immediately lose passporting rights into the EU, although some EU27 States are implementing certain emergency relief measures for UK firms. Difficulties arise because local licensing regimes can differ throughout the EU27. Some EU27 States have relatively light regulatory requirements for corporate lending, while others require lenders to be licenced locally. Ancillary services may also require local authorisation. For example, the issuance of letters of credit or third-party guarantees in Ireland is an activity which is, in the absence of passporting rights, subject to local licensing requirements. Other ancillary services can form part of a loan package and may also be subject to bespoke local licensing, including the provision of hedging and payment services within the relevant EU27 State.
- Syndicated loan risk: English law governs the content of and the transferability of a large portion of syndicated loans within Europe and the vast majority of hedging agreements within the EU. English law-governed finance agreements will continue to be interpreted by the English courts and a no-deal Brexit will not prevent courts from entering judgments. However, a no-deal Brexit may affect the degree to which those judgements are enforceable within the EU27.
- Collateral and netting risk: Currently EU Member States (including the UK) benefit from rules which protect collateral and netting rights of contractual counterparties. Unless reciprocal arrangements are put in place by the UK and EU27, the regime will no longer apply.
Director Hinman identified accounting considerations for companies to consider:
- Do Brexit-related issues affect financial statement recognition, measurement or disclosure items, such as inventory write-downs, long-lived asset impairments, collectability of receivables, assumptions underlying fair value measurements, foreign currency matters, hedge accounting or income taxes? We expect that boards and audit committees are considering these reporting implications and that these considerations will be discussed in company disclosures, as appropriate.
Reporting companies should heed the SEC’s instructions and carefully disclose company-specific Brexit risks. For more information on the progress of Brexit, please review Norton Rose Fulbright’s web page on Brexit, as well as the Norton Rose Fulbright Regulation Tomorrow Blog and the Norton Rose Fulbright Securities litigation and enforcement blog.
Gerard G. Pecht, based in Houston, is the Global Head of Dispute Resolution and Litigation at Norton Rose Fulbright. Seth M. Kruglak is a Disputes partner based in the Firm’s New York office. Simon Lovegrove, based in London, is the Firm’s Global Head of Financial Services Knowledge, Innovation and Products.