[Varshini Sunder is a student at Hidayatullah National Law University.]
It is essential for M&A agreements to be exhaustive and even account for a situation where the transaction falls apart. With the ever-growing volume of M&A transactions in India, a look into the clauses which contemplate the possibility of the deal going south becomes necessary.
Consider a situation wherein, after significant deliberation, Company A makes an offer to acquire Company B and they enter into an agreement stipulating the same. However, acquisitions, especially for listed entities, cannot take effect immediately. There may be some hurdles detected by the regulators which cannot be overcome; or, Company B may simply be on a lookout for better deals. In such situations, the efforts put in by Company A could be rendered fruitless.
Therefore, in order to induce an acquirer to make an offer and to compensate it for the loss it may have to bear if the deal goes south, break fee clauses are introduced. Sellers also insist on including reverse break fee clauses, through which the seller is compensated if the acquirer is unable to consummate the transaction.
Both, break and reverse break fee, are deal protection devices. Prof. Coates and Prof. Subramaniam, in their seminal work published in the Stanford Law Review defined deal protection as ‘a term in an agreement related to an M&A transaction involving a public company target that provides value to the bidder in the event that the transaction is not consummated due to specified conditions’. This article aims at providing an overview of break fee clauses and related trends in some other security markets.
A break fee (termination fee or break-up fee) is a sum paid by the seller to the buyer in the event that the proposed transaction is not completed. The object of a break fee clause is to compensate the bidder for out-of-pocket expenses. Chesire & Fitfoot’s Law of Contract states that break fee should be upheld if it is a reasonable forecast of the loss incurred by the frustrated bidder.
Capping the break fee
In the United Kingdom, Rule 21.2 of the City Code on Takeovers and Mergers requires all inducement fees to be approved by the Takeover Panel. Additionally, such fee must be ‘de minimus’ and normally ‘no more than 1% of the value of the offeree company calculated by reference to the price of the competing offer’.
Rule 13 of the Singapore Code on Takeovers and Mergers also states that the fee must be minimal and ‘no more than 1% of the value of the offeree company calculated by reference to the offer price’. It is also mandatory for the offeree company to provide (in writing), to the Securities Industry Council, a confirmation that the break fee arrangements were agreed as a result of normal commercial negotiations, that it was in the best interest of the shareholders, etc.
South Africa, vide Guidance 1/2012, regulates break fees and limits it to 1% of the offer value. Its rationale can be found in Section 119(1)(c) of the Companies Act 2008, which seeks to ‘prevent actions by a regulated company designed to impede, frustrate, or defeat an offer, or the making of fair and informed decisions by the holders of that company’s securities.’
The ‘range of reasonableness’ test
Quite to the contrary, the State of Delaware (the United States of America) has not introduced any straightjacket formula to ascertain the validity of a break fee. The courts have deemed this to be a ‘nuanced fact intensive inquiry’.
The Delaware courts also offer some jurisprudence on defensive tactics adopted by the Board of Directors (Board). In the celebrated case of Revlon Inc v Macandrews & Forbes Holdings, the court stated that the defensive measures adopted by the Board to defend against undesired bidders must be ‘reasonable’, with a result to foster bidding, not destroy it. Subsequently, Unitrin, Inc. et al v American General Corp., stated that the Board’s defensive response, in exercise of their fiduciary duties, must not be preclusive or coercive. Therefore, a break fee, often used as a defensive tactic, must act as an inducement to one bidder, without coercing the shareholders or deterring competing bids.
Putting this principle to test, the Delaware Court of Chancery decided the validity of break fees in re Comverge, Inc. In the said case, the termination fee, coupled with the reimbursement expenses, amounted to 5.55% and 7% of the deal value if the company entered into superior transaction during the go-shop period and after the go-shop period respectively. These percentages themselves tested the limits of what has been previously considered reasonable by this court (3-4% of deal value). Further, the notes conversion privilege held by the acquirer, amounting to USD 3 million, could also be viewed as a break fee by potential bidders. Therefore, the court considered the possibility of the break fee, in effect, amounting to 11.6% (during the go-shop period) and 13.1% (after the go-shop period) of the deal value which could have had an unreasonably preclusive effect on potential bidders. The court also imputed bad faith on the part of the directors who, in breach of their fiduciary duties, had agreed to such a potentially preclusive agreement.
Neither is there any law in India prescribing the limit up to which break fee is permissible nor have the courts had the opportunity to lay down the law with respect to such fee. But this seemingly grey area has not prevented companies from including such clauses in their agreements. In fact, they form a crucial part of marquee deals. Reports suggest that one of the reasons the merger negotiations between Swiggy and UberEats failed is because the parties could not agree on the break fee. An attempted acquisition of the US-based Cooper Tire and Rubber Co. by India-based Apollo Tyres Ltd. involved a break fee and a reverse break fee amounting to $50 million and $112.5 million respectively.
When it comes to defensive tactics, India follows a strict ‘no frustration’ or ‘board neutrality rule’. This rule intends to leave the target’s Board powerless in the wake of a hostile takeover offer, and instead confers the sole decision making power upon the shareholders. However, directors owe a fiduciary duty towards the stakeholders of the company under Section 166(2) of the Companies Act 2013. It is in this capacity that directors may introduce break fee clauses in the acquisition agreement and induce the white knight (friendly investor) to make a higher bid. But this fee should not, in effect, divest the shareholders of their decision-making power by nudging them towards the white knight bid. Therefore, a balance needs to be struck between the ‘board neutrality rule’ and a director’s fiduciary duties to determine the validity of a break fee.
Additionally, the treatment of break fee clauses may vary depending on the nature of the deal and the types of companies involved therein. In case of a transaction between private companies, the nature of deal, being contractual, would be governed by the Indian Contract Act 1872 (Contract Act). Since break fee is only payable when a contract is essentially ‘breached’, Section 74 of the Contract Act is attracted. According to this provision, the courts are vested with the power to grant a reasonable compensation, which shall be determined based on the facts of the case.
More hurdles arise when listed entities include break fee clauses in their acquisition agreements. Such agreements would come under the radar of the Securities and Exchange Board of India (SEBI) through the Draft Letter of Offer (DLOF) filed. It is therefore perfectly possible for the market regulator to strike down such a fee, vide the comments offered on the DLOF, on the account of it being unreasonably high and devoid of any rational nexus with the transaction.
Moreover, unreasonably high break fee could also constitute ‘financial assistance’ as per Section 67 of the Companies Act 2013. According to this provision it is unlawful for any public company to give financial assistance in connection with the acquisition of shares. In a case concerning Section 151 of the English Companies Act 1985, that is similarly worded, the High Court of England and Wales in Paros Plc v. Worldlink Group Plc, held that the break fee did constitute financial assistance as the fee was smoothing the path to the acquisition of the shares.
While a lack of regulation of break fee is not seemingly deterring companies from including these clauses in India, it would still be prudent to establish some guidelines on the same. This is especially important in the current times with the Covid-19 outbreak looming over ongoing M&A transactions. The matter of open offer by M/s Jyoti Limited has sealed the fate of Material Adverse Change (MAC) clauses as far as withdrawal of an open offer under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulation, 2011 (Takeover Code) is concerned. The SEBI, in the above matter, tested the MAC clause with the yardstick of impossibility. Given the scant jurisprudence on MAC clauses in India, the courts may be persuaded by this yardstick while interpreting such a clause even outside the scope of the Takeover Code. There is a high likelihood that this outbreak would not qualify to meet the threshold of impossibility. This would mean that bidders, who nevertheless choose to walk out of deals, would be liable to pay the break/reverse break fees as a consequence.
In order to prevent any uncertainty that may arise, it will be judicious to lay down some guidelines for listed companies wishing to introduce break fee clauses in their agreements. The ‘range of reasonableness’ test adopted by the Delaware courts is definitely a good starting point. Additionally, SEBI may consider introducing safeguards as mentioned in the Singapore Code as this would further aid in regulating such clauses in M&A transactions.