This article is written by Arushi Seth, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

Imagine you are an independent baker, and a customer approaches you with an order, asking you to bake a customized theme cake for them. You bake the cake as ordered, but on the date of delivery, the customer refuses to accept the cake, suggesting that they have got a better and a more desirable cake somewhere else. Now, certainly, you would want them to recompense you for the time and efforts that you have put in to bake the customized cake. This, precisely, is the guiding principle behind incorporating break fee and reverse break fee clauses in an M&A deal. 

M&A transactions are not completed in the blink of an eye. There is almost always a considerable time difference between the signing and the closing of the deal, and a possibility of the change in circumstances during this time period, cannot be ruled out. The parties are, therefore, forced to look out for themselves in this scenario, and one of the measures adopted by them is the break fee clause, which ensures that the disappointed party would be able to recover certain expenses incurred by them in the course of the transaction if due to some pre-specified reasons, the deal is not closed. 

Break Fee and Reverse Break Fee Clause

What are Break Fee and Reverse Break Fee?

A Break fee, also referred to as a break-up fee or a termination fee, is an amount payable by the target company to the potential buyer in the form of compensation, when certain specified events trigger the termination of the transaction. The objective of the break fee is largely to compensate the disappointed buyer for the time and money spent by them in the course of the transaction before the deal was terminated. Generally, the costs incurred on negotiations, due-diligence, and certain out-of-pocket expenses, are covered within the ambit of the break fee. While, in India, there are no provisions regarding the quantum of break fee, a cue can be taken from major countries like the USA and Canada, where the average break fee falls within the bracket of 1-3% of the total deal value. 

Similarly, a reverse break fee is an amount payable by the potential buyer to the target company, to compensate the target company for similar expenses incurred by it in the course of the transaction, if the deal fails to consummate due to pre-specified reasons. 

Understanding the Break fee and Reverse Break fee Clauses

A Brief History

Break fee Clause

Deal-protection devices, such as break fee and match rights, emerged mainly in 1980s in the USA, particularly in Delaware, which interestingly is a hub of publicly traded companies. But, these deal protection devices faced their fair share of criticism and controversy. One of those criticisms surrounding such devices was that these devices contemplate a breach of fiduciary duty by the target directors. The court was also not very helpful, in the initial years. In both, Revlon v. MacAndrews and Forbes and Paramount v. QVC, The Supreme Court of Delaware treated these deal protection devices rather harshly, forcing the target companies to eliminate them. 

Over time, the courts became lenient in their approach to deal with the deal protection devices, particularly towards the break fee. This can be seen in the case of Brazen v. Bell Atlantic when The Supreme Court of Delaware permitted the payment of the termination fee as a means of compensating the disappointed buyer and also established that the termination fee does not violate the fiduciary duties of the directors of the target company. 

Reverse Break fee Clause

The concept of reverse break fee does not go as long back as the concept of other deal protection devices. What is more interesting is that the concept, which is gaining widespread popularity in M&A transactions in recent years, wasn’t even invented by strategic buyers. It is the private equity industry that initially devised a reverse break fee, to allocate the risk of financing failures. The concept was later modified to the “pure option” form of reverse break fee, in which the buyer could not be made to specifically perform their duties and their entire liability could be limited only to the amount of reverse break fee specified in the agreement. Then came the demonic 2007 credit crisis, and the sellers started to demand pre-termination remedies in order to force the buyers to perform their obligations. This made the reverse break fee an effective remedy for financing failures, which soon became very popular in M&A transactions.

The Present Times

Break fee and reverse break fee clauses are more popular in Western countries, such as the USA, Canada, and the UK. Back in India, these are relatively newer concepts, which can be viewed from the fact the term ‘break fee clause’ is nowhere defined in The Companies Act, 2013 or in the SEBI Regulations. However, these devices are gradually catching the attention of the M&A world in India, especially, where the parties or one of the parties to the transaction is a public company. Indian companies follow the ‘Board Neutrality’ rule, where the management of the company has little to no say in the affairs of the company, and it is the shareholders who are the decision-makers of the company. The Board of Directors of these companies owes a greater duty towards the shareholders of the company, which forces it to secure the best deal for the company. This often results in the Board accepting a higher bid and terminating the deal with the potential buyer. The potential buyers, for this reason, have started insisting on the incorporation of the break fee clauses, so that in such events, they can get compensation for the costs incurred by them before the deal was terminated.

Break fee and reverse break fee clauses are amongst the most heavily negotiated clauses in an M&A transaction, especially in countries like India, where there are no regulatory provisions concerning the break fee, much reliance is placed on the contracts between the parties and the test of reasonability of such fee. Therefore, agreeing on a reasonable break fee and reverse break fee becomes the need of the hour in such cases.

The forms of Break Fee and Reverse Break Fee Clauses 

The break fee and reverse break fee clauses are included in the letter of intent or the preliminary agreements of an M&A transaction. These clauses can be incorporated in the following form:

• No shop clause 

The ‘No shop’ clause is incorporated either in the letter of intent or in the agreement between the potential buyer and the target company, to prevent the target company from soliciting higher bids from a third party, for a specified period of time, after the signing of the letter of intent. The potential buyer includes this provision, mainly to reduce the competition and maximize the certainty of the completion of the deal. However, this provision does not prevent the third party from making an offer to the target company on its account.

• Fiduciary Clause

The Fiduciary clause is included in the agreement by the target company with the object to prevent the target company from compensating the buyer with the break fee, in certain pre-specified events, mentioned in the agreement.

• Events that can trigger the break fee and reverse break fee clauses

Not only the quantum of the fees is heavily negotiated while drafting the break fee and reverse break fee clauses, but the events which will lead to the termination of the transaction and the payment of such fees, is also subject to a very heavy negotiation, as both the parties try to restrict their liability in the event of termination.

However, some events are frequently agreed upon by the parties as triggering events.

Break Fee Clause

Some of the events that may result in the break fee clause becoming operative are –

1. The target company accepting a higher bid from the third party.
2. Shareholders of the target company do not approve of the deal.
3. The target company fails to fulfill the conditions precedent.
4. A material breach in the representations and warranties by the target company.

Reverse Break Fee Clause

The events which can force the potential buyer to recompense the target company are –

1. The inability of the potential buyer to secure the required financing for the deal.
2. Failure to get the requisite approvals from the regulatory bodies, such as SEBI, CCI, etc.
3. Failure to complete the transaction on the date agreed upon.
4. Failure to get the shareholders’ approval.

The Limitations in India

In India, the break fee and reverse break fee clauses are primarily governed by the terms set out in the contract, as there are no provisions under Indian law to regulate such clauses. However, these clauses are subject to some scrutiny, some of which are –

1. The fee prescribed in the agreement has to pass the ‘reasonability test’. The court has the power to strike down such fees if it finds the amount unreasonably high. 
2. If the target company is a listed company, SEBI may not allow it to pay the reverse break fee to the buyer.
3. If the transaction is between an Indian Company and a foreign company, and the fee has to be paid by the Indian company,  prior approval may have to be taken from the RBI.

Significance

An M&A transaction is a very risky venture. A tremendous amount of money, time, and effort goes into it, right from drawing up the term sheet to finally closing the deal, not to mention the number of hurdles leveled up against the parties, adding on to the uncertainty of the completion of the deal. Amidst such uncertainty, these deal protection devices come to the rescue of the parties. The main purpose of these devices is to help the disappointed party in mitigating the loss suffered, but, they also provide an incentive to the parties to perform the terms and conditions of the contract, and ensure that they remain invested in the deal and not just walk away without facing any consequences. Sometimes, it even prevents the other companies from bidding, as they would be forced to pay the price which would include the break fee. 

Noteworthy Examples

The Apollo-Cooper Deal

In 2013, Apollo Tyre’s Limited announced that it would acquire Cooper Tire & Rubber Company in an all-cash transaction valued at $2.5 billion. One notable thing about this deal is that the parties included both, a break fee of $50 million and a reverse break fee of $112.5 million, in the agreement. The marriage was ultimately called off by Cooper, even before the wedding took place, citing Apollo’s inability to secure financing for the deal, as the reason, making Apollo liable to pay the reverse break fee of $112.5 million to Cooper.

Microsoft’s acquisition of LinkedIn

In 2016, during the negotiation talks between Microsoft and LinkedIn, the parties agreed to include a ‘no shop’ clause in the agreement, with a break fee of $725 million in case LinkedIn tries to solicit higher bids from third parties. However, Microsoft was ultimately forced to raise its bid as Salesforce offered a bigger price to LinkedIn. Since, LinkedIn received an open offer from the third party and did not by itself solicit the bid, the break fee clause never came into operation.

Verizon Communications, Inc. and Vodafone Group Plc. Deal

On 2nd September, 2013, Verizon Communications, Inc. entered into a purchase agreement with Vodafone Group Plc, to acquire a 45% interest in their Verizon Wireless joint venture. While the transaction, which was valued at $130 billion, was lauded for being the third largest deal by dollar value, the thing which took everyone by surprise was that the parties agreed to a whopping $10 billion reverse break fee. This deal, without the slightest competition, set the record for the largest reverse break fees by dollar value ever agreed upon.

Conclusion

Uncertainty is the biggest threat to an M&A transaction, and with the pandemic creating havoc and disrupting the businesses, uncertainty has become an even bigger threat to the M&A industry. Even though the deal protection devices are not common in India, but with the fear of potential losses, arising due to an incomplete transaction, grappling the parties, there is a chance more parties adopt these measures in near future, to seal pack the transaction to save themselves from losing a significant sum of money in an already crashing economy. 

References

• https://www.vccircle.com/why-m-as-need-break-fee-and-reverse-break-fee-clauses-more-often
• https://corporatefinanceinstitute.com/resources/knowledge/deals/breakup-fee/
• https://contract-economic-organization.law.columbia.edu/sites/default/files/content/Deal%20Protection%20Devices%20200215.pdf
• https://content.next.westlaw.com/9-541-0785?__lrTS=20201015093602665&transitionType=Default&contextData=(sc.Default)&firstPage=true
• https://mnacritique.mergersindia.com/apollo%E2%80%90cooper-deal-how-it-collapsed/

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