Break fees (sometimes referred to as inducement or termination fees) have, since the late 1990s, become an increasingly common feature of corporate transactions in a range of jurisdictions, including the UK and Hong Kong. The increasingly international nature of corporate deal-making might lead to break fees being used in other jurisdictions where they are not widely used, or where their use is subject to few, or to no, applicable regulations.
For a comparison of the legal issues relating to break fees in some jurisdictions worldwide, see the table: Legal issues in relation to break fees: a comparative survey.
What are break fees?
Break fees take a variety of forms.
Break fees have traditionally taken the form of an arrangement between a potential bidder and a target company under which a fee is payable to the bidder if a specified event occurs that prevents the transaction from proceeding to completion (for example, because a higher competing offer is made, or if the target company's directors do not recommend, or withdraw their recommendation of, a bidder's offer). Break fee arrangements have also, in some cases, been entered into between a target company's shareholders and a prospective bidder under which the shareholders agree to pay a break fee to the bidder in specified circumstances.
On a number of recent transactions, reverse break fee arrangements have been entered into between a preferred bidder and the vendor or the target company. Under such arrangements the preferred bidder, in return for a period of exclusivity, agrees to pay a break fee if it decides not to proceed with the transaction.
Where the parties are of similar size or have similar negotiating strength, reciprocal break fee arrangements, which provide for either the bidder or the target company to receive the break fee depending upon which party is to blame for the failure of the bid to progress, are also becoming increasingly common.
Why use break fees?
The traditional rationale for a break fee is to discourage a party from leaving the negotiating table and/or from entering into discussions with a third party. Typically, a break fee is structured so that one party has to pay some or all of the costs of the other party (for example, advisers' fees) if the transaction does not proceed. Such arrangements were previously associated with public transactions, but they are now an increasingly common feature of private transactions in a number of jurisdictions.
Commercially, such arrangements give the party to whom the relevant fee is payable greater certainty that the transaction will proceed and a measure of financial recompense if it does not.
Features of break fees
Size
The amounts payable under such arrangements can be substantial. For example, the break fee arrangement between P&O Princess and Royal Caribbean reportedly required P&O to pay $62.5 million to Royal Caribbean when its board of directors withdrew its recommendation of the proposed merger with Royal Caribbean (in favour of the proposed merger with Carnival Corporation). The merger agreement between BP and Amoco reportedly contained a reciprocal termination fee of up to $1 billion that would have been payable had the merger agreement been terminated for certain specified reasons (for example, if either BP or Amoco had recommended a third party proposal, or had wilfully and intentionally taken certain prohibited actions with respect to the merger proposals).
In the UK, the legal restrictions discussed below mean that break fees cannot exceed more than 1% of the value of the target company, calculated by reference to the offer price. In the US, for example, such fees are generally greater, with fees of around 3% being common.
Timing
In public company transactions, break fee arrangements are conventionally entered into on the announcement of the transaction. However, where a prospective bidder is unwilling to incur transaction costs unless some form of break fee is in place, it may be entered into at an earlier stage. This was the case in relation to Debenhams in the UK in 2003.
In private company transactions, where announcement issues are not of such concern, it is conventional for break fee arrangements to be entered into at an early stage of the process, often in contemplation of either or both parties incurring the cost and effort associated with due diligence and in conjunction with a period of exclusivity.
Trigger events
The events that can trigger the payment of a break fee include:
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the entry by the target company into negotiations with a third party;
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the success of a competing bid;
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the failure of the target company's directors to recommend the bidder's offer;
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the withdrawal by the target company's directors of their recommendation of the bidder's offer;
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the failure of the prospective bidder to make an offer to do so at the agreed price; or
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the lapse of a bidder's bid.
Key legal issues
The legal issues to which a break fee arrangement will give rise will vary from jurisdiction to jurisdiction. However, some of the issues that commonly arise include:
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capacity and duties of good faith;
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financial assistance;
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takeover regulation;
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listing rules; and
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rules relating to the enforceability of contractual provisions.
Capacity and duties
Care should be taken to ensure that the company has the necessary legal capacity, and is duly authorized, to enter into the break fee arrangement. For example, in the UK and Hong Kong, any contract that is entered into by a company in circumstances where it does not have the requisite legal capacity may be held by a Court to be void (although, in the UK, in the absence of bad faith, this risk is largely theoretical).
Careful consideration should also be given to whether the relevant arrangement is consistent with the duties of the directors of the companies involved. Obviously, this issue is more complex where (as is commonly the case) the relevant fee would be paid by the target company rather than by a bidder or major shareholder, but it is a relevant issue to consider in all circumstances.
Although the precise nature of the obligation will vary from jurisdiction to jurisdiction, it is generally the case that directors must act in good faith in the best interests of the company. The break fee arrangement must be properly regarded by the directors as being in the company's best interests, taking into account all relevant issues. In some jurisdictions, shareholder approval might also be required. Where the relevant break fee would be payable by the target company, its directors will need to balance the interests of the company (in securing an attractive offer from a bidder) against the risk that the arrangement would deter others from making an offer. They will also need to consider the cost involved if the target company actually has to pay the break fee.
Critically, any decision by the directors of a target company to enter into a break fee arrangement must be taken for proper purposes and must not, for example, be for the purpose of frustrating an offer by another bidder.
In many jurisdictions directors are not, as a matter of general law, permitted to fetter the exercise of their discretion. Where this is the case, the terms of the arrangement should allow the directors to satisfy their duties to the target company by, for example, recommending an unsolicited higher competing offer in a competitive takeover situation. Directors are subject to such a duty in (among other countries) the UK, Hong Kong and Spain. There is no explicit rule in German law that directors are not permitted to fetter their discretion, but they may still be in breach of their fiduciary duties if they do so.
Regard should also be had to any obligation on the directors of a target company to provide equivalent information to potential bidders. Where such a duty exists (for example, in the UK), any break fee arrangement with a preferred bidder should specifically allow them to provide such information to other potential bidders.
Generally, the directors should ensure that any proposed break fee arrangement is carefully considered and that an appropriate record of the decision-making process is kept.
Financial assistance
If the break fee would be payable by the target company or by one of its subsidiaries, one issue is likely to be whether the proposed arrangement would amount to unlawful financial assistance. In some jurisdictions, such as the US and Japan, there are no specific prohibitions on giving financial assistance. In others, such as the UK, Hong Kong, Germany, Spain and The Netherlands, there are.
Generally speaking, rules on financial assistance operate to prevent a company or any of its subsidiaries from giving financial assistance for an acquisition of its shares. Such assistance can take a wide range of forms, including granting loans or security or giving an indemnity in favour of a third party to enable it to buy the shares in the target company.
Historically, these rules were intended to maintain the capital of the target company for the benefit of its creditors. These rules are, arguably, somewhat anachronistic given the ability of creditors to take effective security by way of a charge over the company's assets. On the insolvency of the company, the secured creditor(s) are likely to exercise their security in respect of the company's assets, leaving nothing for distribution to any unsecured creditors.
Breach of these provisions is, in some jurisdictions, a criminal offence for which the company giving the financial assistance can be fined and its directors could be liable to imprisonment and/or a fine. Also, any contracts entered into as a result of such financial assistance may be held by a Court to be unenforceable. This is, for example, the case in the UK and Hong Kong.
Where rules on financial assistance apply, the parties should take a cautious approach in drafting any break fee arrangement that would, or that might, require the target company or any of its subsidiaries to pay a break fee. Appropriate drafting can help to minimize the risk that the break fee arrangement would constitute unlawful financial assistance. In the UK, drafting the break fee so that it is not construed as an indemnity (by requiring the payment of a pre-determined sum that is not calculated by reference to the costs incurred by the bidder in doing its due diligence and/or making an offer), will help to ensure that the relevant arrangement does not do so.
Takeover regulation
In the US and the UK (and, to a lesser extent, in Hong Kong) public takeovers are common and their regulation is well developed. In other jurisdictions, such as Japan, public takeovers (and in particular hostile takeovers) are far less common. As a result, although the use of break fees is specifically addressed in takeover regulation in some jurisdictions, in many others it is not.
For example, as mentioned above, the UK City Code prohibits a target company from taking certain measures to frustrate a takeover without shareholder approval (General Principle 7 and Rule 21.1). Broadly, this applies when an offer has been communicated to the target company's board or after it has reason to believe that an offer might be imminent. Hong Kong's Code on Takeovers and Mergers contains similar provisions (and its Rule 33 is identical to Rule 21.2 of the City Code).
Rule 21.2 specifically limits the size of inducement fees that can be paid by target companies. The fee must not exceed 1% of the value of the target company, calculated by reference to the offer price. The UK Takeover Panel has made it clear that if there are several bidders for a target company, each break fee should not exceed 1%.
Although most other jurisdictions do not have rules as specific as those in the UK and Hong Kong referred to above, there are often other requirements that should be considered.
For example, the German Securities and Acquisitions Law of 2002 provides that the management board of a target company may not take any action that could prevent the success of an offer. There are, however, specific exemptions from this rule that allow break fees to be entered into by a target company in some circumstances, even if doing so could affect the likelihood of success of a third party offer. While there are no specific rules or court decisions in Germany on the maximum size of such break fees, some German legal academics have pointed to the UK as the benchmark for such rules.
In The Netherlands a break fee might be regarded as a poison pill, and any such arrangements have to be made public immediately.
Listing Rules
In some jurisdictions the listing rules of the relevant listing authority or stock exchange contain specific rules relating to break fees. However, such rules remain comparatively uncommon.
For example, in the UK and in Hong Kong, consideration should be given to whether the break fee arrangement would constitute a class transaction (for the purposes of the listing rules) and require prior shareholder approval. It might do so because, either:
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of its size, calculated by reference to the financial thresholds set out in the listing rules; or
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it constitutes an exceptional indemnification arrangement (break fees are specifically addressed by the relevant rules).
In the UK or Hong Kong, a properly structured break fee arrangement should not be caught by these provisions.
The New York Stock Exchange does not apply substantive corporate law provisions to break fees, but there are some disclosure obligations that might apply to them (as there are, for example, in the UK and Spain). By way of comparison, in Germany there is no specific obligation to disclose the existence of a break fee arrangement.
Unenforceable contractual provisions
In some jurisdictions, such as the UK, the US and Hong Kong, break fees should be carefully drafted so that they do not constitute a penalty. Broadly, they will do so if they require the party in breach to pay to the other party a sum that does not represent a genuine pre-estimate of the loss suffered by that party if the trigger event occurs. Where a break fee arrangement does constitute a penalty it might be held by a Court to be unenforceable.
In many cases, this issue should be able to be addressed through careful drafting of the break fee arrangement. In the UK for example, the trigger events for payment of the fee should be specific events (for example, failure to recommend an offer), rather than breach of contract. Particular care should also be taken if the relevant fee is stated to be payable on breach of a non-solicitation, exclusivity or other provision.
In contrast, in certain other jurisdictions, such as Germany and Spain, a break fee in the form of an independent penalty clause is fully enforceable if it is not excessive.
Conclusion
Whenever a break fee arrangement is being considered local law and regulation should be analyzed carefully to identify whether the proposed arrangement is permitted and, if so, how it must be structured and drafted to ensure that it is legally effective. The law and regulation relating to break fees looks set to continue to develop in a number of jurisdictions. However, the extent to which these rules and related market practice will converge over time remains to be seen.
Legal issues in relation to break fees: a comparative survey
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Legal issues
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Specific takeover regulations
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Listing rule requirements
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Financial assistance and permissibility
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Directors' duties
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Contractual effect
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Belgium
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There are no specific regulations relating to break fees. But it is unlikely that listed companies could enter into such an arrangement.
Shareholders who enter into such arrangements are likely to be treated as acting in concert (1989 Royal Decree on Takeovers).
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There are no specific rules relating to break fees.
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There is a general prohibition on giving financial assistance (Article 629, Company Code). If carefully drafted, a break fee is unlikely to breach these provisions.
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Directors must act in the best interests of the company.
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If a break fee constitutes a penalty it might be held by a Court to be void or might be amended.
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France
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There are no specific regulations relating to break fees.
There is a general principle that the board of a target company cannot take any action to frustrate an offer (Article 4, Reg 2002, May 4 2002).
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There are no specific rules relating to break fees.
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There is a general prohibition on giving financial assistance (Article 225-216, Commercial Code). However, these rules are unlikely to apply to break fees.
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Directors must act in the best interests of the company.
An agreement to pay an improper break fee would not be void but would constitute a breach by the directors of their fiduciary duties.
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Under French law penalty clauses are enforceable.
The Court can reduce the amount stated in a penalty clause in exceptional cases (although it cannot be reduced to an amount that is less that the damage/loss suffered) (Article 1152 AL 2 para 2, French Civil Code).
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Germany
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German Securities and Acquisition Law 2002 (WpÜG) does not impose any specific restriction on break fees.
The management board of a target company may not take any action that could prevent the success of an offer, unless approved by the supervisory board or by a resolution of the shareholders (Section 33, WpÜG).
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There are no specific rules relating to break fees. However, a target company has disclosure obligations in relation to a takeover that will apply when a break fee arrangement is signed.
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Under general principles, a break fee is permissible if:
- it is required for the proposed transaction (the transaction being in the target company's best interests);
- the amount of the inducement fee is reasonable (generally up to 1% of the value of the offer); and
- it does not contravene the rules on financial assistance: Section 71(a) of the Stock Corporation Law prohibits a target company from advancing funds or granting loans or security to a purchaser. There are no reported court decisions on whether a break fee can constitute financial assistance.
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Directors must act in the best interests of the company.
An agreement to pay an improper break fee would not be void but would constitute a breach by the directors of their fiduciary duties.
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A break fee in the form of an independent penalty clause is enforceable if it is not excessive.
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Hong Kong
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The same considerations apply as in the UK, as to which see below (General Principle 9, Rules 3.5 and 33.1, Hong Kong Code on Takeovers and Mergers (Code)).
The Securities and Futures Commission is proposing to amend the Code to include new provisions similar to Rules 2.5(b)(vi) and 21.2, City Code.
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A break fee arrangement could constitute a notifiable transaction (under Chapter 14, Hong Kong Listing Rules) or require disclosure pursuant to the company's general duty to disclose price-sensitive information. If the break fee arrangement is with a connected person a more stringent disclosure/approval regime will apply.
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The rules on financial assistance are similar to those in the UK, as to which see below (Section 47A–47B, Hong Kong Companies Ordinance). Market practice is also similar. There are criminal sanctions for breach by company and/or directors.
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Directors must act in good faith in the best interests of the company and must not fetter their discretion.
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Penalty clauses are unenforceable.
Care is required in drafting trigger events . Need to be wary if the arrangement relates to breach of a non-solicitation or exclusivity undertaking.
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Italy
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General prohibition on frustrating action by a listed target company without shareholder approval (Article 104, Italian Consolidated Financial Act).
Details of break fee arrangement must be disclosed in any offering circular.
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N/A
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There are no specific rules relating to break fees. Sometimes, break fees are agreed with major shareholders for the sale of their own shares.
The financial assistance legislation has not yet been applied in the context of break fees, but if the relevant fee is payable by the target company rather than the shareholders it might contravene the prohibition on such assistance.
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Directors must act in accordance with their fiduciary duties, and in the best interests of the company.
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Pre-agreed penalty clauses are permitted so long as they are not excessive (Article 1382, Civil Code).
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Japan
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There are no specific regulations relating to break fees.
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There are no specific rules relating to break fees.
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There is no prohibition on the provision of financial assistance.
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Directors must act in good faith (Japanese Commercial Code).
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Penalty clauses are enforceable unless they are unjustifiable and/or against public order.
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People's Republic of China
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There are no specific regulations relating to break fees.
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There are no specific rules relating to break fees.
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Generally permitted.
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Directors must faithfully perform their duties and protect the interests of the company.
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Parties may agree a penalty for breach of contract. However, if the agreed penalty significantly exceeds the loss actually suffered, a Court may reduce the amount payable.
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Portugal
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There are no specific regulations relating to break fees. However, the board of a target company cannot take any action that is capable of affecting the company's financial situation.
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There are no specific rules relating to break fees.
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Generally permitted.
Parties must act in good faith.
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Directors must faithfully perform their duties and protect the interests of the company.
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Penalty clauses are enforceable as long as they are not excessive.
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Spain
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From the filing of the bid until its result is announced, the board of a target company cannot enter into any transaction to disrupt the offer (Article 14, Royal Decree 1197/1991, 26 July on public takeovers (Regulation)).
Disclosure obligations should be considered (for example, disclosure of break fees would be required in any offering circular (Article 15.1, Regulation).
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There are no specific rules relating to break fees. General disclosure obligations should be considered.
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A public limited company (sociedad anonima) may not provide financial assistance for the acquisition of shares in it or those of any controlling company (Article 81.1, Corporations Law). There is a similar provision for a private limited company (Sociedad Limitada) (Article 40.5, Limited Companies Law).
Break fee arrangements between a target company and a bidder may breach these provisions, particularly if the size of the fee is instrumental in ensuring that the acquisition occurs.
There is no case law on break fees. It is likely that they would only be permitted in exceptional circumstances.
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Directors must act with due care and diligence (being that of a fair businessperson and a loyal representative), and in the best interests of the company.
Directors must not fetter their discretion and must act in accordance with the company's constitution.
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Penalty clauses are not enforceable against a target company.
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The Netherlands
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The Financial Markets Authority has not issued any policy statements on break fees.
Such arrangements would need to be disclosed in any offering circular (Section 9I, Decree on the Supervision of Trading of Securities (Besluit toezicht effetenverkeer)).
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Prohibition on certain types of frustrating action (Annex X sub D, Euronext Amsterdam Stock Exchange Listing Rules). This could include certain break fee arrangements.
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On its face, the general prohibition on financial assistance in relation to the issuance and acquisition of shares is unlikely to catch break fees (Section 2:98c, Dutch Civil Code). However, some commentators argue that financial assistance is given when a conditional commitment to pay is entered into.
Therefore the cautious view is that such arrangements might be caught if not carefully drafted. There is no case law on break fees however.
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Directors must act in the best interests of the company.
Need to review the company's constitutional documents.
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If a break fee arrangement is of too long a duration, or is disproportionate in the circumstances, it may be held by a Court to be void.
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UK
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Regulated by the City Code on Takeovers and Mergers (City Code), The Rules Governing Substantial Acquisitions of Shares (SARs) and the Companies Act 1985.
Permitted, if it does not constitute frustrating action, although de minimis limit of 1% of value of target company (calculated by reference to the offer price) imposed (General Principle 7 and Rules 21.1 and 21.2, City Code).
Target company and its financial adviser required to give comfort letter to Takeover Panel (Rules 3 and 21.2, City Code).
Need to disclose break fee arrangement (Rules 21.2 and 26(m), City Code).
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In the absence of shareholder approval, fee limited to 25% of the average of the target company's profits over the preceding three financial years (paragraph 10.24, Listing Rules).
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General prohibition on financial assistance (Section 151 – 158 Companies Act 1985). Provisions should be analyzed carefully. The relevant arrangement should not be worded as an indemnity and must not give rise to a material reduction in the target company's net assets. Market practice is that more than 1% is material for these purposes.
Criminal sanctions for breach by company and/or by directors.
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Directors must act in good faith in the best interests of the company and must not fetter their discretion.
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Penalty clauses are unenforceable.
Care required in drafting trigger events. Need to be wary if the arrangement relates to breach of a non-solicitation or exclusivity undertaking.
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US
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Takeover regulation is a matter of state, not federal, law. Rules vary from state to state.
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NYSE and other exchanges do not impose specific restrictions on break fees.
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Permissible, but acceptable level varies from state to state.
No concept of financial assistance (or of maintenance of capital) in the US.
In Delaware, fees between 1% and 4% are generally acceptable. Courts have indicated that fees of 6% or more are excessive.
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Directors must act in accordance with their fiduciary duties.
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Penalty clauses are generally unenforceable.
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Disclaimer
The information in this article is for general guidance only. It does not contain definitive advice.
This article is based on an earlier article, produced for publication in PLC Mergers and Acquisitions Handbook 2004/05.
Author biography
Richard May
Simmons & Simmons
Richard May specializes in advising financial institutions (including retail banks, investment funds, and asset managers) and their advisers on public and private mergers and acquisitions, joint ventures and securities offerings. May also regularly advises on a wide range of securities and financial services regulatory issues, including issues relating to the Financial Services Action Plan (FSAP).
His recent transactions include:
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advising Barclaycard on its joint venture with House of Fraser relating to the management by Barclaycard of House of Fraser's existing and new store card accounts;
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advising the Financial Services Authority on the establishment in the UK of the Committee of European Banking Supervisors. CEBS advises the Commission on legislative proposals relating to the supervision of banks and facilitates cooperation between member states in relation to such supervision;
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acting for The British Land Company PLC on its participation in the Morgan Stanley consortium that acquired Canary Wharf Group plc for £1.8 billion ($3.4 billion); and
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advising Anker Plc on the virtual acquisition of Anker BV, the pan-European IT business, and on its AIM IPO.
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