“The Lannisters send their regards!" Remember when House Bolton reneged on their deal with House Stark on Game of Thrones? Well, while walking out on an agreement in a business scenario is not as violent as the “red wedding”, one could argue that the stakes are sometimes just as high.
With the global economy still grappling with the ripple effects of the COVID-19 pandemic, parties have now become extra cautious when it comes to merger and acquisition transactions. Therefore, steps to bolster deal certainty are the need of the hour.
In the West, deal protective devices like “break fee” and “reverse break fee” are commonly used. But they are not as common here in India. Now, these devices are likely to be more frequently included in M&A transaction documents in India going forward.
In fact, with the current atmosphere of uncertainty, there is a case to be made that these clauses must be used more often in Indian M&A deals.
First, let us understand the concepts of a break fee and a reverse break fee.
A break fee is an amount payable by the seller/target to the buyer, for pre-specified and contractually agreed events or circumstances, typically occurring between signing and closing, leading to termination of the contract before consummation of the transaction.
In contrast, in a reverse break fee construct, an amount is payable by the buyer to the seller/target, for similar pre-specified and contractually agreed events or circumstances, resulting in failure of consummation of the transaction.
Why use a break fee and a reverse break fee in M&As?
An M&A is not a run-of-the-mill transaction for most companies. In fact, for many companies, it is once-in-a-lifetime event.
Thus, understandably, in any M&A transaction, right from conceptualisation to execution of the term sheet, completion of the due diligence exercise and execution of the acquisition agreement, fulfilment of conditions precedent outlined in the acquisition agreement to closing, the parties involved (especially their senior management) spend a significant amount of time, energy and money.
In addition, a deal which is announced and not closed can have unwanted ramifications on the parties.
Given the above, it is but natural that players will want a watertight agreement which does not let any party “walk out” with impunity and leave the other party high and dry after having spent substantial efforts and expenses towards it.
It is principally to safeguard this interest that the concept of a break fee and a reverse break fee assumes significance. The possibility of paying a hefty termination fee can keep the parties on their toes and ensure that the terms of the contract are honoured.
When should a break fee be used in M&A transactions?
Every transaction is different. And a lot will depend on the facts and circumstances of each transaction and on the negotiating power of the parties. But some of the grounds on which the buyer should look to have a right to claim a break fee are;
- “Exclusivity” and “no-shop” restrictions (which prevent a seller from getting other offers): No buyer would want to be used as a “stalking horse”. Thus, if the seller/target terminates the acquisition agreement and elects to proceed with another buyer (in contravention of the exclusivity arrangement), the buyer is well positioned to seek a break fee.
- Failure to obtain the approval of the shareholders of the target company.
- Failure to fulfill material conditions precedent.
- Occurrence of an event resulting in a material adverse change.
- Material breach of interim covenants and restrictions of the seller/ target company.
- Material breach of representation and warranties of the seller/ target company.
When should a reverse break fee be used in M&As?
Some of the grounds on which the seller/target company should look to have a right to claim a reverse break fee are as follows.
- If the buyer is unable to arrange for financing to complete the acquisition.
- Failure to obtain the approval of the shareholders. This is more relevant in case of a transaction involving a share swap.
- Failure to obtain regulatory approvals required to complete the acquisition, such as from the antitrust regulator.
- Failure to close the transaction by the “long stop date”.
Quantum of break fee and reverse break fee
There is no amount which can be said to be standard, especially, in the Indian context given the lack of uniformity and consistency of usage of these deal protection devices. If one were to take a cue from mature jurisdictions where these concepts are more frequently used, a range of 1% to 3% of the deal consideration can be called the average ballpark number.
Also, at times, a two-tier break fee and reverse break fee structure is adopted by the parties. Here, a lower break fee may be payable upon occurrence of an event which is beyond the control of the parties. For example, rejection of a regulatory consent material to closing of the transaction despite the applicant party taking all steps required to obtain such approval.
In contrast, a heftier break fee may be payable if a party wilfully breaches the terms of the acquisition agreement. For instance, if it breaches the “no shop” or “exclusivity” provisions.
These are just broad indicators and parties would be well advised to look at all the relevant factors before proposing and finalising the break fee and reverse break fee amount. This includes aggregate deal consideration, the enterprise value, grounds of breach (for instance, wilful breach versus inadvertent breach), paying capacity of the parties, bargaining power of the parties, how “hot” is the target company and significance of the transaction.
In addition, parties must arrive at an amount which is a sufficient deterrent but does not become penal in nature.
Are the concepts of break fee, reverse break fee legally enforceable in India?
Currently, the concept of a break fee or a reverse break fee is not expressly recognised under any Indian statute and will, therefore, be governed by the terms of the contract entered into by the parties. Broadly, a break fee and a reverse break fee are enforceable in India subject to certain conditions. These include:
- If the quantum of the break fee or the reverse break fee is exorbitant and penal in nature, it is likely to be struck down by Indian courts. As a rule, the amount should be a genuine pre-estimate of losses suffered by the party claiming it and be reasonable. Thus, parties should cautiously tread this tightrope and try to strike a balance so that the amount of the break fee or the reverse break fee is high enough to act as a deterrent but not steep enough so as likely to be rejected by Indian courts.
- If the recipient of the fee is a non-resident, then prior approval of the Reserve Bank of India may be required.
- If the target company is listed, the Securities and Exchange Board of India may reject the reverse break fee construct where any fee is payable by the listed company to the buyer.
It is, however, important to note that none of these enforcement concerns and conditions are insurmountable and if proper expert legal advice is obtained during calibrating and drafting these constructs, parties can overcome these hurdles.
As the Indian business landscape continues to mature and adapt best practices from across the globe, it is extremely likely that more M&A players will use all available devices to minimise any risks and maximise deal certainty.
Hence, the concepts of the break fee and the reverse break fee are likely to gain more significance in future Indian M&A deals, especially, in the new normal of the post-COVID world where there is a crying need for deal protection devices to assuage parties’ concerns.
The pandemic has shifted the business sentiment from “Winter is coming” to “Winter has come”, and more players are looking to adopt all available reinforcements to shield them from the biting cold.
Prasenjit Chakravarti is a partner and Sushmita Sarin is a senior associate at law firm Khaitan & Co. Views are personal.