Break Fee Agreements in M&A: Regulatory Challenges

[By Aniket Singh and Pranav Mihir Kandada]

The authors are students at NALSAR University of Law, Hyderabad.

Introduction

In M&A transactions, a “break fee” agreement is an arrangement between the target company and the potential acquirer. In this arrangement, the target company promises to pay a certain fee to the potential acquirer in case the offer from the acquirer does not go through for any given reason. Such agreements are often looked upon favorably as beneficial deal-protection devices.  However, the quantum of the break fee is regulated in several jurisdictions through varying approaches. This article seeks to explain the concerns associated with break fee arrangements and examine how various jurisdictions regulate it.

Uses and Concerns

For target companies and stockholders, a break fee arrangement can induce competition between the bidders. By assuring potential acquirers that they will be compensated for various costs undertaken prior to effectuating a transaction (identification and assessment of the target, fees for due diligence, etc.), a break fee would encourage bidders to spend on such assessments and make better bids. As potential acquirers are now assured of compensation for their efforts, more of them can enter the fray thereby increasing competition and providing better options to the shareholders. In this manner, break fees facilitate M&A transactions.

However, break fees are deal protection devices that invariably function by preferring one bidder over the other. Although a break fee’s impact on the net asset base of the company is negligible, it could potentially wipe out the annual revenue of the target. This would make the target less attractive to subsequent bidders. Hence, a high break fee could serve to reduce competition.

Further, a high break fee amount could constrain shareholder choices. Shareholders are coerced when they are forced to vote for transactions backed by the management. A vote would be structurally coercive when the directors “have created a situation where a vote may be said to be in avoidance of a detriment created by the structure of the transaction … rather than a free choice to accept or reject the proposition voted on.”

When a high break fee amount assured by the management is disclosed to the shareholders, the shareholders get to know the exact cost to be borne if the merger does not go through. Voting against such a proposition becomes unviable and costly for the shareholder. Thus, a higher break fee empowers the company’s management to influence voting.

Despite this influence, it is contentious whether a break fee arrangement is structurally coercive. In Brazen v. Bell Atlantic Corp., the Delaware Supreme Court stated that mere knowledge that voting against the merger would result in activation of the fee does not by itself constitute shareholder coercion. Further, the arrangement would not be coercive, as the shareholders would only vote against the merger in favour of a better price from another bidder. In the Indian context, however, this reasoning may not be applicable given the minority shareholders who would remain in the company with diminished value due to activation of the break fee.

How US Deals With Break Fees

A characteristic feature of the shareholding in US is its dispersed nature. Due to this feature, the board and management act as agents for the shareholders and are empowered to take various decisions, which determine the outcome of an offer. They have to make these decisions in light of the interest of the company and owe duties of care and loyalty to the shareholders. The Delaware jurisdiction has especially favoured the exercise of such powers by the management. Further regulation has also been developed in such a manner.

The various standards of review in the US should not be readily applied in other jurisdictions because the nature shareholding in many jurisdictions is concentrated and not dispersed (e.g., the jurisdictions of India, Japan, Korea, Singapore, and China). These jurisdictions have adopted the rule of Board Neutrality, which finds its origin in the UK. The Board Neutrality Rule makes the shareholders and not the management of the primary decision-makers regarding an offer. The management has little to no leeway to enter into deal protection devices once an offer is made. Only with prior approval of the shareholders, can the management undertake any such act. A judgment rule, which is predicated on management’s freedom and power to take decisions without shareholder approval, would hardly make sense in these jurisdictions.

How the UK and Most Asian Countries deal with Break Fee

The UK in furtherance of its board neutrality rule provides for a de minimis limit to deal with break fees. A de minimis limit is the standard percentage value of transaction value against which all break fees are adjudged (1% in the case of UK). Apart from the UK, de minimis limits are now an accepted standard in jurisdictions of Australia, Hong Kong, etc.

However, de minimis limits have multiple issues. Firstly, they favor rigidity and certainty over flexibility. Even though certainty leads to a more predictable market, flexibility allows managers to structure the fee to custom-fit the specific conditions their companies face.  Secondly, given the dual nature of break fees as inductive as well as anti-competitive, the quantitative standard of a de minimis limit would not be ideal to distinguish and adjudge the permissibility of such arrangement.

These concerns have been raised in multiple jurisdictions. The Australian Business Community has argued that a target might have to go beyond a de minimis limit considering the various specific circumstances an enterprise might face. The reason for not using a de minimis limit in the US was held to be along the same lines. The Delaware Chancery Court in In re IXC Communications, Inc. Shareholders Litigation held that a break fee arrangement must be judged by evaluation of the entire agreement and the terms of negotiation that brought it about.

Regulation in Asia

Importing de minimis limits to Asia would be contrary to the purpose for which they were introduced in the UK.  The de minimis limit is part of the larger Board Neutrality rule. This rule was introduced in the dispersed shareholding context of the UK. In such context due to agency problems between managers and minority shareholders, it becomes pertinent to take away powers of decision-making from the boards and hand over the same to the shareholders.  In the Asian context, where shareholding is concentrated, this rule causes concerns between the controlling shareholders and the minority shareholders. In jurisdictions with concentrated shareholding, the managers and the controlling shareholders are the same interest group as such shareholders influence the managers. Arguably, this interest group runs contrary to the demands of minority shareholders.

Thus, the board neutrality rule, which was introduced in UK for the protection of shareholders, has the effect of further entrenching the controlling shareholders’ decision-making power at the expense of minority shareholders.

Conclusion

From the foregoing discussion, there seem to be concerns associated with both the qualitative as well as quantitative regulatory approaches regarding break fee agreements. There is a need to further the use of break fee agreements as an inducement and protection mechanism while minimizing the frustration of competition in their presence. Rather than importing a brightline test or a de minimis limit in order to determine the permissibility of a break fee, different jurisdictions need to evolve regulations that are tailored to the specific vernacular of their markets. While undertaking a qualitative analysis to determine the permissibility of a particular quantum, the concerns of minority shareholders must be addressed. Further, regulatory or judicial authorities must ensure that the arrangement does not bring about a coercive situation for the shareholders when choosing one bid over the other.

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