Introduction
The recent failure of Sony and Zee to consummate their $10 billion merger agreement due to Sony Group Corporation’s withdrawal decision has ignited the issue of commercial necessity of accommodating a break-fee clause in such kinds of arrangements. Along with that, the legal nuances of including and invoking such a clause require a sound understanding of relevant laws and regulations that regulate such a situation. The deal referred to before had carried a $100 million break-up fee. This piece intends to explain what are break-fee and reverse break-fee clauses included in M&A transactions, their applicability in various jurisdictions along with India, examples of deals that carried such an obligation and why should they be specifically regulated in order to enhance the ease of doing business in India.
Concept of Termination Fee
Steven M. Bragg explains in his book ‘Mergers & Acquisitions, A Condensed Practitioner’s Guide’ that a termination fee is a certain amount that one party agrees to pay to the other in case of a failure of an M&A transaction. If it is to be paid by the seller (target company), it is a break fee. On the other hand, if it is to be paid by the buyer(acquirer), then it is a reverse break fee. Both of these types of clauses are deal protection mechanisms as M&A transactions are quite complex and costly. In case of listed companies, these transactions also have a long interval period which is the period between the announcement of the deal and its consummation.
Quantum of Break Fee
Generally, the range of break fees ranges from 1% to 3% of the total value of the transaction. A party considers the time, resources, and costs it has incurred in the transaction to calculate the supposed break fee. This provision is usually accommodated in the letter of intent (LOI).
Global Regulation of Break Fee
The Australian Government’s Takeover Panel’s Guidance Note 7 on Deal Protection prescribes the 1% guideline on break fees. Rule 48 prohibits break fees from exceeding 1% of the equity value of the target. Moreover, even within the 1% guideline, there can be facts that will make such a fee unacceptable if payment triggers are unreasonable. For example – coercion, fee reimbursing more than actual expenses, etc. Along with that, courts have followed the Bright Line approach according to which a break fee is characterized as a contractual provision for liquidated damages. It should not be anti-competitive. In O’Dea v Allstates Leasing System (WA) Pty Ltd, the court held that a large break fee is in the nature of an unenforceable penalty. This is important, especially in the context of Private M&A transactions. It can also be invalidated under Section 260 A of Corporations Act, 2001 if it constitutes financial assistance.
In the United Kingdom, the City Code on Takeovers and Mergers regulates takeover activity. Rule 21.2 prescribes a de minimis threshold. The break fee should not be more than 1% in proportion to the total cost of the deal. However, this is in the case of Private M&A, while in transactions related to Public M&A, break fees are generally prohibited under the Takeover Code as they deter potential bidders from applying for better bids.
In the United States of America (“US”), there is no uniform federal legislation that regulates break fees. There is no specific cap. Jurisdictions like that of New York follow a liberal approach and allow the enforcement of reasonable break fees. Courts have adopted tests like the Reasonability Test according to which the fee should not be unreasonable with regards to potential bidders as it should not deter them from bidding. Courts approach to evaluate whether a break fee involves shareholder coercion or not. Along with that, the directors should not breach their fiduciary duties by agreeing to an unconscionable value of break fee.
Impact of Break Fee
Research has shown that break fee has a positive and conclusive impact on deal completion. Studies performed by Bates and Lemmon (2003) and Officer (2003) have substantiated the same. Examination and categorization of break fees into low, medium, and high brackets recommend that medium quantum of break fee is appropriate while large is less beneficial for shareholders. Out of 300 M&A deals between publicly traded companies during 2005-10, 291 included the clause of break fee. A low or no break fee highly raises the probability of failure of consummation of the deal. It is important that the break fee should be explicitly explained in the agreement and it should not be vague. The clause should provide for the method of valuation of the break fee. For instance – for legal expenses only.
Notable Examples
1. Microsoft – LinkedIn
The deal carried a break fee of $725mn which LinkedIn had to bear in case of failure of the transaction.
2. AT&T – T-MOBILE
Due to anti-trust violations, the deal was not consummated and therefore AT&T had to pay breakup fees that totalled $4 billion.
Regulation in India
There is no legislation that explicitly regulates the inclusion of break fees in Indian M&A agreements and its upper limit. This issue is approached under the two following heads:
Private Transactions
It is easier to determine legal validity of break fee clauses (if any) included in private M&A agreements. Since these are in the nature of a contract, the Indian Contract Act, 1872 becomes the primary and most important legislation. Section 55 of the act lays down the provision relating to failure of performance at a fixed time and when failure of time is not of essence which allows the promisee to either rescind the contract or claim compensation according to the respective kind of violation. This can operate as a trigger for break fee for instance when regulatory approvals are not obtained before the due date. Along with that, Section 74 which deals with compensation for breach when penalty is stipulated ensures legal validity of inclusion of break fee. However, Indian courts have cautioned via judgments that such pre-inclusion must be reasonable and courts have ensured that only reasonable compensation is paid by the defaulting party. Therefore, a break fee which is in the nature of penalty will not be legally enforceable. However, since there are no strict guidelines regarding the same, it all comes down to the interpretation of courts with regards to factual matrix of each respective deal to decide whether a break fee incorporated is a penalty or not. Section 75 also supports the inclusion of a break fee in case of failure of consummation of private M&A transactions.
Public Transactions
When it comes to transactions involving listed companies, there are many facets that should be considered. If it is a cross-border merger, payment of break or reverse break fee shall be required to be approved prior by RBI. Along with that, The Foreign Exchange Management (Current Account Transactions) Rules, 2000 does not permit remittance of liquidated damages/ penalties. SEBI also can strike down such clauses during the required regulatory filings like the Draft Letter of Offer (DLOF) if it considers them to be irrational. Moreover, Section 67 of the Companies Act, 2013 prohibits financial assistance for purchase of securities. Unreasonably high break fees could be considered as such.
Conclusion
Break fee is not anymore uncommon in Indian M&A transactions. The Ministry of Corporate Affairs (MCA) should come up with guidelines that would articulate how parties to M&A transactions should inculcate break fee provisions in their agreements. The RBI should also publish guidelines under the Foreign Exchange Management Act, 1999 (FEMA) clarifying how approvals should be sought for inclusion of break fee in cross-border transactions. Instead of a strict standard, there should be a minimum percentage of total deal value that should qualify as the quantum of break fee permissible. Some deals will have considerations that will make it just and equitable to exceed any set standard and that is why the de minimis threshold is not suitable for India and is also absent in the United States. The courts till the absence of guidelines may refer to interpretations done by justices of Australia who have upheld such fees falling within the 1% guideline and sometimes even beyond that.
(This post has been authored by Kaif Anwar, a Penultimate Year Law Student at Campus Law Centre, Faculty of Law, University of Delhi.)
CITE AS: Kaif Anwar, ‘Negotiating Break Fees: The Conundrum Surrounding Regulation in India’ (The Contemporary Law Forum, 11 April 2024) <https://tclf.in/2024/04/11/negotiating-break-fees-the-conundrum-surrounding-regulation-in-india/>date of access.