A break fee (or inducement fee) generally refers to a fee payable by a target to a bidder if a specified event occurs that prevents an offer from completing, although mutual break fees are appropriate in certain deal structures. A target usually agrees to pay such a fee because it needs to persuade (or induce) the bidder to make the offer, for the perceived good of the target and its shareholders. Break fees can be agreed between major shareholders of targets and bidders: in those circumstances most of the problems considered below are avoided.
Break fees developed as a form of deal protection in the US, where the legal and regulatory approach to deal protection mechanisms has been traditionally less restrictive in comparison to Europe. This is not least because of widely differing approaches to the principle of a company's maintenance of its own share capital. Since the late 1990s, break fees have become increasingly popular in the UK and are now an established feature in many takeover offers, although still most relevant for private equity or other financial bidders or in merger situations where mutual break fees are appropriate. Break fees have also been adopted in certain jurisdictions in continental Europe.
There are still differences between the US and UK approaches, both in terms of the size of break fees (which in the US are commonly around 3% of deal size but have risen as high as 5%) and in terms of degree of comfort with the legal position. They are now common, but it is wrong to assume that break fees are regarded as invariably legal in the UK. In legal terms they need to be treated with caution and each case must be looked at on its own merits.
The statutory prohibition on a company giving financial assistance for the purchase of its own shares and directors' fiduciary duties are the two main issues. Other law and regulation also needs to be considered, including the Takeover Code (where the party paying the break fee is a public company), the Listing Rules (where the party paying the break fee is listed on the London Stock Exchange), and common law rules regarding the unenforceability of penalty clauses.
Financial assistance
A UK company must not give financial assistance directly or indirectly for the purpose of the acquisition of its own shares, unless a relevant exemption applies. It is a criminal offence for it to do so. Directors may be personally liable to repay a break fee that is paid but subsequently deemed to constitute unlawful financial assistance and the related transaction may be rendered void and unenforceable.
The relevant financial assistance can take a number of forms, including being given by way of a gift or indemnity, or any other assistance that reduces the net assets of the company to a material extent.
Steps can be taken to minimize the risk of a break fee constituting unlawful financial assistance. In particular, the break fee must not constitute an indemnity, which would, for example, typically be the case in an arrangement to reimburse advisory costs incurred by a bidder. Any break fee arrangement should instead be a commercially agreed fixed fee, being a permitted amount required to induce the bidder to proceed with its offer.
Two issues arise on meeting the test that the break fee should not reduce the net assets of the company to a material extent:
Net assets: it is generally accepted that the net asset test should be based on market value and not book value of the target. Views differ on how to determine market value for these purposes. One view is to take the value of the offer, but the bid price could be affected by external factors, such as the commercial objectives of a particular bidder whose bid may turn out to be unsuccessful. Others regard the right test to be market capitalization (possibly before the existence of the offer is reflected in the price, as the break fee will only be paid if the original offer does not proceed). A more cautious view is to take the value realizable on sale of the assets, after tax charges, as the relevant value for creditors (for whose benefit the rule exists). These sorts of uncertainties still make it safer to try and agree a figure of less than 1% of the more conservative of these tests.
Material reduction: the term material has been generally interpreted as being any figure in excess of 1% of the company's net asset value, although this threshold is not derived from any court decision and a cautious view would be that between ?-1% is likely to be safe. Nor is a rigid application of a figure always appropriate; materiality must be judged from the viewpoint of the creditors and shareholders of the target (as those intended to be protected by these provisions). An appropriate percentage could arguably be lower than 1% where the absolute sum involved could of itself be regarded by a court as material, but the better view is probably that materiality should always be relative to net assets. Other factors should be considered, including the relative stability or volatility of net asset values, to avoid a payment being judged as material in hindsight.
The UK courts have considered financial assistance in two recent cases - Chaston v SWP Group plc (CA) and MT Realisations Ltd v Digital Equipment Co Ltd. Neither directly concerned break fees, but the attitude of the courts has reinforced caution on this area of law. In particular, Chaston confirmed that financial assistance can take place even if there is only a proposal to acquire shares; accordingly, the payment of a break fee on a bid failing or not being made could still constitute financial assistance.
Fiduciary duties
Directors' duties to act in good faith and in the best interests of the company will come under scrutiny in the context of break fees. Directors need to consider their duties carefully. Relevant considerations may include:
whether the demand for a break fee has been tested. Is it needed to induce the bidder to make the offer? Is the bidder likely to withdraw from a good deal if the target does not agree to the break fee? Wasted costs are more likely to be of significance on a buy-out where financial backers are not prepared to bear such costs;
whether or not the break fee is payable only upon the success of a higher competing offer (that is, whether it is only payable if shareholders do receive the benefit of the higher offer);
whether the directors have already decided that it would be in the target's best interests to be taken over and if so whether there are reasons (such as synergies) for preferring a particular bidder.
The directors should also have careful regard to their duty not to fetter their discretion, for example, from discussing possible higher bids with a third party.
Directors should discuss at a board meeting, and reflect in the minutes, the board's reasons for believing that undertaking a break fee obligation is in the best interests of the company. A party relying on a break fee should check the memorandum of the company providing it and ask for a certified copy of relevant board minutes.
Other UK issues
The Takeover Code
Under the Takeover Code, where an offer is imminent or has been made to the shareholders of a UK public company (now including dual holding company transactions), the target board must not take any frustrating action or enter into contracts outside the ordinary course of business without the approval of shareholders.
The Takeover Panel permits break fees, provided that they amount to no more than 1% of the value of the target, measured by the bid value. The Panel should be consulted in advance, it must receive written confirmation from the target's board and its financial adviser that they believe the break fee is in the best interests of the target's shareholders, and full disclosure of the break fee arrangement is required (both in the offer documentation and by putting the break fee agreement on display).
The rules extend to any non-cash arrangement, to catch poison pills. Any favourable arrangements with a bidder that "have a similar or comparable financial or economic effect", such as put- and call-options, will be caught by the Code.
The Panel has recently issued a practice statement clarifying a number of issues on break fees, in particular stating that a target can agree break fees with two or more bidders. The 1% threshold applies to each individual break fee, rather than as an aggregate limit for the target, even if more than one such fee might become payable in certain circumstances. The compatibility of the latter position with the financial assistance rules would need to be looked at carefully and may well be questionable.
The Listing Rules
If a UK listed company agrees to a break fee under which maximum liability is equal to or exceeds 25% of the company's average profits for the previous three financial years, it will be treated as a Class 1 transaction, requiring shareholder approval. This is particularly important where the company is producing little or no profit.
The UK Listing Authority (the UKLA), as the relevant authority, has indicated that if a company is actually making a loss, it may disapply the test and the break fee will only be treated as a Class 1 transaction if it exceeds 1% of the value of the deal to which it relates. This appears to be the UKLA's approach generally, but specific clearance must be obtained from the UKLA in each case in which this issue arises.
Penalties under English law
Under English common law, any sum payable on a breach of contract that exceeds a genuine pre-estimate of loss may be deemed a penalty and be unenforceable as to the extent of the excess. There is a risk that a break fee may be found by a court to be a penalty where the trigger for payment is structured by reference to a breach of undertaking (for example, a no-shop clause), even where the fee payable is described as a pre-estimate of loss. Avoiding payment being linked to a breach is a preferable option.
Break fee obligation |
Amount (% of deal value) |
Trigger/Comment |
Selfridges 
|
1% |
Lapse or withdrawal of offer due to:
|
0.5% |
Withdrawal or adverse modification of directors' recommendation in circumstances other than in (c) above. |
|
Hamleys
|
1% |
Lapse or withdrawal of offer due to:
PizzaExpress entered into break fee arrangements with two bidders: |
PizzaExpress
|
1% |
Success of competing offer or withdrawal or adverse modification of directors' recommendation after announcement of possible offer. |
PizzaExpress
|
1% |
Success of revised Venice Bidder offer. Neither break fees payable if no offer successful. |
Debenhams
|
0.5% |
Non-satisfaction of offer acceptance condition. Originally fee agreed for continued due diligence with view to making bid, payable if CVC/TPG decided against making a bid above specified price or on success of competing offer after announcement of CVC/TPG bid. |
Debenhams
|
0.5% |
Success of competing offer. |
Canary Wharf
|
Up to 1% |
Three different inducement fees agreed:
|
Safeway
|
1% |
|
Typical/appropriate triggers
The relevant triggering events in relation to any particular break fee will depend on the negotiating positions of the parties and the particular situation.
The typical trigger likely to be acceptable to a target would be that the fee is payable if the offer fails in the face of a successful competing offer. A target will typically wish to avoid paying a fee in circumstances where there is not a successful competing offer and shareholders would not receive any benefit from the process.
But the bidder is likely to seek further protection, such as where its offer fails after a withdrawal or modification of the target's directors' recommendation, whether or not in the face of a competing bid.
A break fee payable where an offer does not become or is not declared unconditional in all respects for any reason (except the bidder's own breach) may be objectionable to shareholders, because the bidder receives the fee even if they have simply turned down its offer.
A bidder could also seek to protect its offer:
from the target's shareholders failing to give any requisite approvals. As well as fiduciary duty considerations, such a provision is (understandably) not popular with institutional shareholders, but in appropriate cases it may be agreed;
from the target board shopping around for a competing bid, or even negotiating with a third party following an unsolicited approach. From the target's perspective it is important to preserve the directors' ability to consider a better offer, as well as to consider the risk that a court might determine that a break fee payable in such circumstances is a penalty;
from wasted costs where it decides not to make an offer after an unsatisfactory due diligence exercise. This concept was applied recently when Debenhams agreed to pay a commitment fee to CVC/TPG, accruing on a weekly basis while it carried out due diligence, if CVC/TPG decided not to make a higher offer than the offer made by the first bidder, Permira. This was seen by some as Debenhams paying CVC/TPG to look at it, but the arrangement did ultimately result in CVC/TPG making a higher offer for the company.
A bidder will want to ensure that alternative transactions not structured as an offer but which have a similar effect (for example, a disposal of a substantial part of the assets) are caught. A target should build in appropriate longstop dates, and other circumstances that may be appropriate for the fee to fall away.
There are examples in the UK in recent years of break fees that exceed 1% of deal value, but these involve circumstances where for structural reasons the above considerations do not apply. These include break fees payable on the disposal of a subsidiary, payable by the seller and therefore not financial assistance (Scottish & Newcastle/Spirit Amber - 2.4%) and under a dual headed structure transaction before the application of the Code and not involving the acquisition of shares (P&O Princess and Royal Caribbean - 2%).
1% not always acceptable
Break fees seem to have become, in just a few years, an accepted feature of the UK market. Bidders should always consider asking for them and will want to push for the maximum amount. A target should remember its duties to shareholders and creditors and not concede too easily. Most importantly from a target's perspective, it is an over-simplification of the legal issues to state that a break fee of 1% is always acceptable - each break fee request needs to be considered on its own facts.
Author biographies
Gavin Davies
Herbert Smith Partner, corporate division
Davies has broad experience in mergers and acquisitions, corporate finance and general corporate advisory work. He has acted on a range of takeovers and mergers, initial public offerings (IPOs), and public and private share and asset sales, and has particular experience in cross-border deals.
He has also represented clients in the formation of, and exit from, joint ventures, as well as a variety of business reorganizations. Gavin acts for corporate clients, from industries including media, banking and financial services and insurance, and for financial advisers.
Selected transactions include advising:
Enterprise Oil in relation to the £4.3 billion ($7.8 billion) recommended cash offer by Shell Resources plc;
Time Inc on its £1.15 billion acquisition of IPC Media;
De Beers on the recommended $19.6 billion offer proposals made by a consortium including Anglo American; and
TXU Europe Group on the £1.37 billion sale of its UK gas and power supply business to EON/Powergen and on the restructuring of its UK and European energy business.
James Palmer
Herbert Smith Partner, corporate division
Palmer specializes in mergers and acquisitions and corporate finance work, including takeovers (both hostile and agreed), schemes of agreement, joint ventures, demergers and other restructurings, IPOs and other securities offerings. He is chairman of the City of London Law Society's Company Law sub-committee.
Selected transactions include advising:
AOL Time Warner on various matters including the proposed combination of its Warner Music Division with the music business of EMI group plc and on the ultimate disposal of Warner Music;
British American Tobacco plc on the £15 billion merger with Rothmans International BV;
Groupe Danone SA on the £2 billion joint venture with Scottish & Newcastle plc in relation to Kronenbourg;
Freeserve plc on its £1.6 billion takeover by Wanadoo SA; and
the global coordinators and underwriters of the £4 billion privatization offering by HM Government in 1995 of its remaining shares in Powergen and National Power.
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