Author: Nandini Shenai
Year: 4th year BBA.LLB (Hons)
Institution: NMIMS School of Law, Mumbai
While the financial sector is still reeling from the Pandemic’s ramifications, parties are being extra vigilant when it comes to M&A Transactions. As a result, it is imperative that steps be taken to increase the certainty of the agreements. A “break fee” is a payment which is to be made by the company that wishes to be acquired to the prospective buyers for events that are pre-determined and agreed-upon factors that may cause the agreement to be terminated or situations that may arise between signing and closing of the deal that do not allow it to get completed.
While dealing with the aspect of Break Fee, it is necessary to understand the method in which it is incorporated into M&A transactions. Considering the lack of mechanisms available to regulate the monetary value of the break fee clause, the author analyses the reasonability test that is followed in the United States as a measuring tool. This article seeks to evaluate the jurisprudence behind the “break fee” clause in light of M&A transactions in India and compare its application in similar jurisdictions.
Keywords Transactions, risk, target company, regulation.
A break fee clause will encourage competition between potential buyers, which is good for companies that want to be acquired by other companies. If potential buyers are promised that they would be compensated for any additional expense that is caused to them in course of the transaction, they would be keen to invest more on such transactions.
Furthermore, when companies are set to combine in some form, and the transaction is confirmed but not completed, it may have unintended consequences for the parties involved. Due to this, parties find it safer to enter into a sealed arrangement that prevents one party from “walking away” without repercussions, leaving the other side to pick up the pieces of a failed transaction, especially when they have incurred significant expenses and costs.
INCORPORATION INTO AGREEMENTS AND USES
These Clauses safeguard the transaction and have the ability to ensure that parties honour the terms of the contract. If the target company fails to uphold its end of their bargain, it would be liable to pay the break fee, making it difficult for the target company to attract potential buyers in the future. As decided by The Delaware Supreme Court in Brazen v. Bell Atlantic Corp, simple acknowledgement that a vote opposing the merger will lead to the invoking of the break fee clause but would not imply shareholder intimidation. Furthermore, the deal cannot be rendered coercive because shareholder’s vote opposing the merger would only come into light if the target company is offered a better deal by another prospective buyer.
Presently, no Indian law specifically recognises the break fee clause, hence, it would be regulated by the provisions of the agreement signed by the parties. Nevertheless, considering that minority shareholders stay back in the firm due to the invoking of the break fee, this logic might not be valid in India.
INSTANCES WHERE BREAK FEE CLAUSE CAN BE INSTITUTED IN M&A TRANSACTIONS
For instance, Company A presents Company B with a proposal to acquire it, and the two companies sign a contract stating that they will undergo an acquisition transaction. Acquisitions, particularly for publicly traded companies, cannot, however, happen instantly. it may happen that the legal team at Company B comes across obstacles that cannot be resolved, or a bottleneck situation arises, or Company B is still open to better offers from other prospective buyers. In such circumstances, Company A’s endeavours may be made futile. At such times it is advised to include a “break fee” clause in contracts to avoid loss to the prospective acquirer.
Other reasons why the “break fee” clause must be included in M&A transactions are:
- Competitive bidding: The bidder is well placed to demand a break fee if the target company terminates the agreement and chooses to undergo acquisition with another bidder.
- If the shareholders of the target company vote against the acquisition after the agreement has been formed.
- If the target company does not honour material terms of the contract.
- If the target company misrepresents itself to the prospective buyer.
According to the decree passed in Revlon, Inc. v. MacAndrews & Forbes Holdings, the court held that the Board’s protective measures against unwelcome bidders must be “fair,” with the aim of encouraging rather than discouraging bidding. Following that, in Unitrin, Inc. et al v American General Corp., the court dictated that the Board’s protective approach should not be hinting towards intrusion or coercion while discharging their duties.
In Re Comverge, Inc., the Court ruled on the fairness of break fees/termination fees, bringing this theory to the test. If the firm decided to enter into superior transactions before and after the bidding period, the termination charge, along with repayment costs, accrued to 5.55 percent and 7% of the valuation of the contract, respectively. These numbers pushed the boundaries beyond what was previously thought to be reasonable under the “break fee” clause.
If acquisition agreements of listed companies in India include the “break free” clause, it automatically falls in under the purview of the Securities Exchange Board of India (SEBI) once the Draft Letter of Offer is filed. As a result, it is easy for the market regulator to cancel the “break fee” clause on the grounds of it being too high or unreasonable. Furthermore, a disproportionately high break fee could be considered “financial assistance” under Section 67 of the Companies Act 2013. Any public corporation that provides financial aid in relation to the purchase of securities is in violation of this clause.
REGULATION OF BREAK FEE
There is no legislation in India that specifies the maximum amount of break fee that can be charged, nor have courts passed decrees that set a cap on maximum “break fee” that can be charged. However, despite the apparent grey area, businesses have continued to include certain provisions in their contracts. They are, in effect, an essential component of acquisition deals.
India adheres to a stringent “no frustration” or “board neutrality” policy pertaining to defence strategies. This provision aims to render the target company’s Board of Directors helpless in the event of a hostile takeover bid giving shareholders exclusive authority to make decisions. That being said, as per Section 166(2) of the Companies Act 2013, directors have a fiduciary responsibility to the firm’s shareholders. Directors, in discharge of this responsibility, can include break fee provisions in the acquisition deal in order to attract other investors to propose a better offer.
To decide the legitimacy of a break fee, an equilibrium must be reached between the “board neutrality principle” and a director’s fiduciary responsibility. Furthermore, the regulation of break fee clauses can differ based on the circumstances of the transaction and the kinds of businesses associated. Due to the contractual structure of the agreement, it would fall under the ambit the Indian Contract Act, 1872. When the agreement is breached by the target company, Section 74 comes into play and as a result the break fee clause of the agreement is invoked. As per this clause, the courts have the authority to award fair damages which must be decided on the basis of the facts of the matter.
BREAK FEE CLAUSES IN OTHER JURISDICTIONS
- USA: The scattered essence of shareholding in the United States is a distinguishing feature. As a result of this function, the board of directors serve as representatives for the stakeholders, with the authority to make a variety of decisions that affect the result of a bid. They must make those judgments in the best interests of the corporation, and they owe the stakeholders a fiduciary duty. However, a stringent regulation is not yet devised in the US.
- UK: In order to comply with the UK’s board neutrality clause, break fees are subject to a de minimis threshold. A de minimis threshold is a proportion of total cost of the deal that all break fees are measured by (1 percent in the case of UK). This theory is drawn from the United Kingdom by the majority of Commonwealth countries.
As per the analysis and other existing literature, there seem to be questions about both theoretical and practical regulatory methods concerning the implementation of break fee clauses. They can be used more often as an enticement and defence tool, thus mitigating the frustration of uncertainty when they are present.
Adding to the absence of standardisation and continuity in the use of such clauses in India, there is no sum that can be considered regular. Drawing a lead from established regimes where these terms are more commonly used, the estimated “break fee” number will be between 1% and 3% of the contract valuation.
To avoid any ambiguity, it would be prudent to provide specific regulations for publicly traded companies wanting to include break fee clauses in their contracts. The Delaware court’s “reasonability test” is undoubtedly a decent place to begin. SEBI could also consider incorporating guidelines, which would help to regulate similar clauses in M&A transactions.