Commercial contracts - Preparing for a no-deal Brexit future
With the Prime Minister seemingly determined to take the UK out of the EU without a deal, the threat/promise of a no-deal Brexit is looking increasingly likely to become a reality on 31 October.
The commercial and economic implications of a no-deal Brexit and changes in the legal and regulatory environment following a no-deal Brexit will potentially have numerous effects on commercial contracts, both on exit day (when various legal and practical changes will automatically take effect) and before exit day (as financial markets, counter-parties and supply-chain businesses pre-emptively react to the impending changes).
This article discusses likely effects of a no-deal Brexit on commercial contracts and what companies can do to address this. It does not explore the implications of Brexiting with a withdrawal agreement given the current uncertainty surrounding this – with the Prime Minister insisting that well will negotiate an improved deal and the European Commission negotiators insisting there will be no further changes to it. Suffice to say that if there is a deal (in its current form) the effects discussed in this article will be postponed until the end of the ‘transition period’, which is currently 31 December 2020 but subject to one extension by mutual agreement.
Potential effects of a no-deal Brexit on commercial contracts
The potential effects of a no-deal Brexit on commercial contracts are likely to fall into several categories:
- commercial – affecting the profitability or costs of performing contracts
- practical – affecting the ability to perform obligations under contracts
- legal/regulatory – affecting the ability to comply with the laws applicable after exit day in connection with performing contracts
- interpretational – affecting the meaning or functioning of contracts
- jurisdictional – affecting the enforcement of governing law and jurisdiction clauses in contracts and enforcement of English court judgments arising from contractual disputes
How a business’s contracts will be affected by a no-deal Brexit will depend on its own particular circumstances such as its location and that of any group companies, the industry and associated regulatory environment it operates in, the location of its staff, customers and suppliers and the make-up of its workforce.
Examples of potential effects of a no-deal Brexit on commercial contracts include:
- Imposition of tariffs on import/export of goods (whether raw materials, components or finished products), both to and from the EU and to and from countries with which the EU has trade deals (which UK businesses would no longer benefit from): Which party will pay the new tariffs? Will it become too expensive to provide or receive goods? Will tariff payments make the contract unprofitable?
- Introduction of border controls and customs checks: Will delays result in breaches of delivery timetables in the contract? Which party will be responsible for the additional cost and expense of managing this?
- Loss of freedom of movement of people: Will personnel still be able to travel between the EU and UK to perform services as required under contracts? Will labour costs increase, making fees payable under contracts too low? Will labour shortages affect the ability to provide goods or services under contracts?
- Loss of freedom of movement of services: New restrictions may apply to the provision of services to EU member states or other countries, and complying with the new restrictions (if possible) may involve costs. Will this affect the ability to continue providing services under contracts or increase the costs of providing them, making fees payable under contracts too low?
- Loss of parallel regulation (mutual recognition of licensing or professional qualifications): UK businesses will no longer benefit from EU-wide approval schemes or reciprocal arrangements between the EU and other countries, and will need to comply with different regulatory regimes and conformity assessments. For example, after exit day:
- all goods placed on the EU internal market will need to comply with EU goods regulations and undergo conformity assessments by an EU-recognised assessment body (assessments carried out by UK bodies will no longer be recognised in the EU, even if carried out before exit day)
- UK financial services firms will lose passporting rights currently provided by EU single market legislation, resulting in a loss of access to EU markets for UK firms (and vice versa), meaning that UK firms may no longer be able to provide certain financial services that they are contracted to provide to EU clients
- UK pharmaceutical companies will no longer be able to apply for and hold marketing authorisations, clinical trial authorisations and orphan designations, or have access to EU regulatory procedures, and UK importers, manufacturers and distributors would no longer automatically be able to supply pharmaceutical products into the EEA
These barriers are likely to affect UK businesses’ ability to continue to perform services and other obligations under contracts and/or to increase the costs and delivery timetables of performance.
- Brexit-related exchange rate fluctuations: Uncertainty about the UK economy may result in fluctuations in the exchange rate between sterling and other currencies. This may have an impact on the value of sums paid and received under contracts depending on what currency fees are paid in. Which party bears the risk of exchange rate changes during the contract term? Can charges be varied in light of exchange rate changes?
- Changes in laws applicable to contracts: UK business will be affected by EU law ceasing to apply to them (as the UK ceases to be an EU member state) or starting to apply to them (as the UK becomes a ‘third country’). The implications of this in various sectors have been noted in a series of "notice to stakeholders", issued by the EU Commission (https://ec.europa.eu/info/brexit/brexit-preparedness/preparedness-notices_en). These implications are likely to affect the ability of UK businesses to perform certain obligations in contracts or introduce/increase costs of performing them.
- Tax changes: Will tax treatment of payment under contracts change, e.g. the way VAT is applied?
- Personal data transfers: Is personal data transferred from the EU to the UK in connection with contracts? On exit day the UK will become a ‘third country’ for the purposes of EU data protection law and a ‘transfer mechanism’ will be required for any continuing transfers of personal data to UK businesses. Contracts will need to address the transfer and cite the applicable transfer mechanism, which is likely to include a requirement to enter into the EU Commission’s ‘Standard Contractual Clauses’ with counterparties based in the EU. Any contractual prohibitions on transferring personal data outside the EEA will immediately be breached on exit day if a UK company continues to receive or process personal data, as this will automatically become transferring/processing outside the EEA on exit day.
- EU references: any territorial references to the EU or EEA will by default not include the UK after exit day. This will need to be addressed to make the intended territory clear, particularly in distribution or reseller agreements and in respect of IP licences. Any references in contracts to EU regulators or bodies, licences or consents or legislation will need to be reviewed and possibly replaced to reflect the regulatory regime that will apply post-Brexit.
- Dispute resolution: EU courts might no longer respect an exclusive English court jurisdiction clause and it may become more difficult to enforce English court judgments in EU countries after exit day as the relevant EU regulations will no longer apply to the UK. Will it be possible to enforce a judgment against counterparties after Brexit? Will arbitration be more suitable in contracts with an EU counterparty, as enforcement of arbitral awards is not reliant on EU regulations?
Addressing no-deal Brexit effects in contracts
Businesses should review their existing contracts to check whether any contract amendments or other actions are required to avoid possible negative effects and contractual uncertainties caused by a no-deal Brexit, and to future-proof new contracts to pre-empt these effects and uncertainties.
Reviewing existing contracts
The first step is to assess the term (duration) and flexibility of existing contracts to work out whether it would be best to leave them as they are, amend them or terminate them.
- Term: Does the contract continue past exit day? Is the contract a framework agreement under which order forms/work orders may come into effect before exit day and continue past exit day, or come into effect after exit day?
- Flexibility: are there any existing provisions in the contract that could assist with avoiding or mitigating negative effects of a no-deal Brexit, such as:
- Termination rights – can you terminate the contract for convenience/without cause? If so, what is the notice period? Will any penalties/cancellation fees apply to early termination?
- Price variation clause – is there provision allowing the provider to vary prices/charges that could be used to mitigate any cost increases?
- Change control clause – is there a change control process in the contract that could be used to introduce any required changes to the goods/services/price? Which party bears the costs of those changes?
- Contract variation clause – how can changes be made to the contract? Could the contract variation provisions be used to force through required changes, e.g. by using a unilateral right to vary certain terms?
- Force majeure clause – does the contract contain force majeure provisions and would Brexit or related changes constitute ‘events outside the control of a party’? How long will any suspension of obligations last? Will invoking the clause allow the other party to terminate the contract after a certain time period?
- Hardship clause – some long term contracts contain clauses dealing with which party bears the burden of increases in costs of supply, fluctuations in exchange or interest rates and other relevant factors. Is there such a clause and could it be invoked for no-deal Brexit reasons? Will any changes be agreed according to an agreed mechanism or simply negotiated? What happens if no changes can be agreed?
- Material adverse event clause – usually only seen in lending and corporate acquisition agreements, these allow a party to walk away from the arrangement if certain changes occur that mean it is no longer viable to perform the agreement (e.g. lend the money or buy the company). If there is one, could it be triggered by a no-deal Brexit or related changes? A barrier to relying on force majeure, hardship or material adverse event clauses is that they will often exclude events that the party knew were a possibility at the time of entering the agreement and could have taken steps to avoid or mitigate.
This initial assessment will provide context to the more detailed review and help businesses identify which contracts to prioritise to be amended. It may not be necessary to amend contracts to address no-deal Brexit effects where, for example:
- there will be no material effect on performance or costs
- the contract already caters for such effects (e.g. through the provisions listed above)
- the risks of not amending the contract are less than the risk of introducing Brexit-related clauses (e.g. alerting the counterparty to the risk of service level breaches or future supply problems or having to re-negotiate contract terms from a weak bargaining position)
- contracts are short-term and can be revised to address Brexit effects as they happen
- parties can terminate without penalty on short notice to escape contracts that will become unprofitable, onerous or impossible to perform
Amending existing contracts
Contract variation. Where the review shows that contracts will need to be amended to avoid negative effects of a no-deal Brexit, this will have to be carried out in line with the contract variation provisions of each contract. Usually this requires the written agreement and signature of both parties, although sometimes one party may have limited rights to vary the contract unilaterally, often with a right for the other party to terminate the contract if it objects to the changes.
A business’s ability to amend existing contracts for no-deal Brexit reasons is therefore likely to be dependent on the cooperation of its counterparties or, if relying on rights to unilaterally amend contract terms, may risk the counterparty terminating. Both the issues should be considered before approaching a counterparty with requests to amend a contract. Where both parties are likely to be adversely affected, cooperation is more likely, but if only the party requesting the changes is likely to be adversely affected, the counterparty will be in the stronger bargaining position and could use the re-negotiation to attempt to secure more favourable terms for itself.
“Brexit clauses”. Assuming the counterparty is willing to agree amendments, the contract can be amended to address potential no-deal Brexit effects by introducing ‘Brexit clauses’. There are two general types of Brexit clause:
- specific event and consequence clause: this would specify particular events and specified consequences of those events, e.g. if tariffs are imposed, the price will be adjusted by a set amount or using an agreed formula
- trigger, renegotiation and termination clause: this would provide that if certain specified events occur, this would trigger an obligation on the parties to renegotiate the contract terms and give a right to terminate if the renegotiation fails to produce a mutually acceptable revised contract
Both types of clause will have to be bespoke to address the particular issues arising from the particular circumstances of the contract. The choice of Brexit clause will depend on whether the parties feel confident that they can specify particular contractual consequences of an event in advance or would prefer to negotiate an appropriate outcome at the time in response to the event.
Careful thought will be needed to determine the relevant event or trigger (e.g. changes in law, imposition of tariffs, loss of licences), the relevant adverse effects (loss of ability to perform, increased costs of performance, price too low/high, customer cannot use/sell/licence products or services) and whether the party relying on it has to prove that the event or trigger caused a specific adverse impact on that party.
Novation? An alternative to amendment which may be available is novation – where one or more parties to a contract is replaced by a new party, who then assumes all the obligations and rights of the party it replaced. If the negative effects of no-deal Brexit arise because one party is in the UK and the other in the EU and would effectively disappear if both parties were in either the UK or EU, depending on the parties’ international corporate group structure, the contract could be novated to a group company based in the relevant jurisdiction. Novation requires the agreement of all current parties and the new party using a deed of novation, so this solution very much relies on the cooperation of counterparties.
Future proofing new contracts
Potential no-deal Brexit effects can be pre-emptively addressed in contracts that are in the pipeline or currently being negotiated and likely to be in force on exit day. In practice this will involve businesses amending their own standard terms/contracts and reviewing and amending counterparties’ standard terms/contracts.
Steps that can be taken in advance of entering into new contracts include:
- clarifying EU/EEA-related definitions or references where possible
- considering having both parties in the EU/UK
- include a Brexit clause (see above)
After exit day
If we do Brexit without a deal, most new contracts will have to be adjusted to align with the new legal and economic reality we find ourselves in. The one advantage after exit day will be that we will at least finally know what that reality is and be able to draft contracts in light of it, rather than the perpetual uncertainty and guessing game UK businesses are currently subjected to.
This guidance note was written by commercial contract specialist Hannah Kirby. Hannah is a commercial solicitor with over three years’ experience advising on, drafting and negotiating a wide range of agreements, particularly those relating to technology, research and intellectual property.