Reverse break fees – which are fees paid by the buyer to the seller on the failure of an agreed transaction – are becoming an increasingly standard contractual tool, along with break fees payable by the seller, for allocating the risk of non-consummation of the deal. We expect this trend to continue with reverse break fees being used in strategic transactions as well as in private equity transactions, where they first made their appearance. We further expect to see increasing nuance in the crafting of reverse break fees, with more differentiation in fee amounts between reverse break fees and the break fees prescribed for sellers; and also differentiation, depending on the event that triggers the reverse break fee, in both the amount of the fee and the exclusivity of the fee as a remedy for the seller.
Break fees, whether payable by the buyer or the seller, are all about the allocation of the risk of the deal not closing. They serve as compensation, in whole or in part, for the payee's out-of-pocket and other costs associated with the failure of the deal. If the amount of the fee exceeds the benefits to the payor of not closing, the fee is an incentive to consummate the deal. However, if a payor would be better off paying the fee and walking away from the deal with the payee's enforceable rights limited to the break fee, then the fee is effectively the strike price for an option and an incentive for non-consummation.
Break fees payable by the seller have long been a feature of the M&A landscape. Delaware law requires the seller’s obligation to close to be subject to a "fiduciary out" in the event of a superior proposal from a third party; this has become a standard term in all U.S. and Canadian M&A deals. Equally standard is provision for the seller to pay a break fee to the buyer in the event of the seller’s exercise of the fiduciary out. Delaware courts, relying on fiduciary principles, regulate the permissible amount of break fees payable by the buyer in order to protect against fees that, by their size, would effectively preclude a superior proposal, defeating the purpose of the fiduciary out. This Delaware fiduciary limitation has also become market practice in the United States and Canada.
Reverse break fees first appeared in the private equity context. In the usual private equity deal, the buyer is a shell that, while sponsored by a private equity firm, is not backstopped by the firm; the buyer’s ability to close and its legal obligation to do so typically used to be conditional on financing being available. This left sellers exposed to all of the costs of a failed deal if the buyer could not close, or even if the buyer simply would not close in breach of its contractual obligations (since the usual contractual remedies for breach – specific performance and damages – are unlikely to be meaningful against a buyer that is a shell).
In the absence of meaningful legal recourse for the seller against the buyer, there was inherent optionality to the private equity deal structure. Reverse break fees effectively put a price on the buyer's option. However, perversely, the pricing of the option did not utilize any normal option pricing technique. Rather, the reverse break fee typically simply matched the break fee stipulated for the seller. This was so despite the fact that costs to the seller of a failed deal (which could include business disruption, potential loss of senior management and valuation backlash in the market) likely exceeded the costs of a failed deal faced by the buyer – and despite the fact that the fiduciary limitations on a seller's break fee are not applicable to a reverse break fee (since the size of a reverse break fee is generally irrelevant to the prospects of a superior proposal being made for the seller).
The lack of thought given to the pricing of reverse break fees resulted in the mispricing of what amounted to a buyer’s option and led to many "option exercises" on transactions struck before the credit crisis that ran into financing difficulties or became unattractive to buyers after the onset of the crisis. This experience has led, since the credit crisis, to more careful thought in the pricing and structuring of reverse break fees.
What Are the Trends in Reverse Break Fees?
- Increasing use of reverse break fees in strategic deals. The factors that led to the use of reverse break fees in the private equity context to compensate for financing risk do not normally apply in the context of strategic deals, or at least not to the same degree. The strategic buyer normally has substantial assets backstopping its obligations, making the seller’s usual contractual remedies against the buyer for non-performance meaningful; and the buyer’s obligations in a strategic deal are normally not subject to a financing condition. However, there can be other conditions to closing a strategic deal that create risk of failure that a seller could want protection against by way of a reverse break fee – for example, the need for regulatory approval or shareholder approval. And a seller in a strategic deal may prefer, because of ease of enforcement, at least the option of a reverse break fee rather than facing the vagaries of litigation if the deal is not consummated. These kinds of factors have led to the migration of reverse break fees from their original private equity context to strategic deals. We expect this to continue.
- Less symmetry between reverse break fees and seller break fees. The symmetry between the reverse break fee amount and the amount of the seller’s break fee, which was the typical pattern, has broken down. The symmetry lacked business logic since the risks and costs of deal failure for seller and buyer are not symmetrical; and the symmetry was not compelled by any legal logic. We expect to see increasing differentiation between reverse break fees and seller break fees.
- More nuance in the structure of reverse break fees. We are seeing more nuance in reverse break fees, with the structure varying from deal to deal depending on deal-specific circumstances. Key variables include the following:
- Triggers for the fee. Parties, through negotiation, can specify one or more triggers, not limited to breach by the buyer of its contractual obligations, depending on the degree of optionality the seller is prepared to live with and the buyer is prepared to pay for.
- Amount of the fee. The amount of the reverse break fee as a percentage of deal value is trending upward as reverse break fees cease to be in lockstep with seller break fees. In addition, the amount of the reverse break fee payable in any given deal can be made variable depending on what triggered it, with a higher fee payable when the buyer chooses to walk away than the fee payable when a condition that is outside the buyer’s control fails, such as a regulatory approval.
- Exclusivity of the reverse break fee as a remedy. The reverse break fee can be made the seller’s exclusive remedy if the deal does not close, or it can be an alternative to specific performance and damages; it could also be a hybrid, with the exclusivity of the fee as a remedy varying according to the trigger for the fee.
The continuing evolution of reverse break fees illustrates the ability of contract, through innovation, to refine the allocation of deal risk. Given the increasing use and utility of reverse break fees as a protection of seller interests, a seller must give careful consideration to reverse break fees as a component of any M&A deal.