Adriano Ferraz Fernanda Dolabella Marcelo Matos April 19 2023 Break-up fee clauses and their use in cross-border M&A transactions Freitas Ferraz Advogados | Corporate Finance/M&A - Brazil Adriano Ferraz, Fernanda Dolabella, Marcelo Matos Corporate Finance/M&A IntroductionBreak-up fee clauseWhen can a break-up fee clause be used?Break-up fee clauses and antitrust riskDefining value of break-up feeCommentIntroductionA contract is essentially a way of allocating risks between the involved parties. The Brazilian legislature expressly recognises this in the Civil Code.(1) M&A transactions are no different. They depend on the correct assessment of the risks inherent to the transaction, observed during negotiations and/or identified during due diligence, and the consequent allocation of these risks in the agreement. This activity is undoubtedly one of lawyers' and legal consultants' most essential functions in this practice.In M&A transactions with signing and closing, in which there is an interval between signing the agreement and closing the deal, extra attention is required in allocating the risks. In this allocation exercise, one of the main concerns will be the risk of not closing the deal. This may occur, for example, if any of the stipulated conditions precedent are not met.This concern is even more relevant when dealing with cross-border transactions, in which the parties' negotiation takes place in the context of different jurisdictions and different legal and practical realities. In these transactions, in addition to the correct allocation of business risks, the parties need to be concerned with the effects of certain mechanisms used on the jurisdiction applicable to the contract.Break-up fee clauseAmong the various mechanisms that may be used for the correct and efficient allocation of contractual risks is the break-up fee clause,(2) one of the many institutes imported from foreign law into Brazilian practice. It is a common clause in the practice of cross-border transactions and may be used in M&A contracts involving a foreign party and a Brazilian party. Thus, it is important to know how this mechanism is treated under Brazilian law.In Brazil, the break-up fee clause may be qualified as a penitential fine. It establishes that a specific monetary amount must be paid if the planned transaction is not consummated for reasons foreseen in the contract, which are not related to the notion of fault or default by the parties. Its penitential nature derives from the fact that the clause's primary function is to establish the price to be paid for the free withdrawal of the parties. It is, therefore, a valid and effective mechanism for contractually allocating the risk of not closing a deal.When can a break-up fee clause be used?A break-up fee clause helps to price the risk of withdrawal by one of the parties when there is a provision in the agreement to that effect. On the one hand, it can be useful to define a seller's "withdrawal price", since the party interested in acquiring a company spends much money to make the first acquisition proposal, especially in the case of cross-border transactions. On the other hand, it may also represent a way to price the "buyer's regret". In M&A transactions, especially in the due diligence phase, the target company and the sellers spend time and share crucial information with the buyer, even knowing that eventually the transaction may not close.Therefore, a break-up fee clause can be used to:overcome the buyer's obstacle of bearing the costs and expenses relating to the transaction, which may not close; orguarantee a remuneration to the seller for the time spent, assumption of exclusivity periods and/or sharing of information during the negotiations.The reason is that, through a break-up fee clause, the parties define an amount to be paid if one or both parties "back off" from the deal, establishing how much it will cost if the deal does not close.Break-up fee clauses and antitrust riskA break-up fee clause is also an efficient mechanism for allocating the regulatory risks inherent to M&A transactions, such as antitrust risk. This is relevant in transactions subject to the prior approval of the Administrative Council for Economic Defence (CADE). In this scenario, a break-up fee clause assumes the nature of a conditional obligation of guarantee, as a promise of financial compensation in case the deal cannot occur. It ensures a certain compensation and/or refund of expenses and costs incurred by one of the parties during the negotiations.(3)ExamplesA break-up fee clause was used in the acquisition of Linx by Stone, which took place in 2020. In that case, the parties established that if the CADE did not approve the transaction, Stone would have to pay approximately US$120 million to Linx as a break-up fee. Thus, by inserting a break-up fee clause in the contract, Stone assumed the risk of paying that amount to Linx if the transaction did not occur due to a negative response from the CADE.In the sale of the pulp manufacturer Fibria to Suzano in 2018, it was stipulated that if the CADE's approval was conditional on changes in the business that were not accepted by Suzano, it would be subject to the payment of a break-up fee of approximately US$150 million, which would not occur if the CADE rejected the transaction. In other words, the break-up fee clause was stipulated not because of the risk of a rejection by the CADE, but rather to allocate the risk of the CADE's requirements that Suzano would bear.In both cases, the CADE approved the transactions and the break-up fee clause was not enforced.CADE's perspectiveThe CADE recognises break-up fee clauses as a valid mechanism, and expressly excludes them from the definition of previous consummation of economic concentration acts (known as "gun jumping").(4) This reinforces the possibility of using break-up fees to allocate risks in transactions subject to the prior approval of regulatory agencies.Defining amount of break-up feeIn the Brazilian context, parties must be careful when defining the amountof a break-up fee clause. The amount used in previous transactions is usually considered as a reference (obviously, only when these are disclosed). The stipulation of a break-up fee with an amount higher than that used in practice by the market may represent an inefficient allocation of risk. This situation may raise questions about the eventual liability of the managers of the affected company, who may be accused of acting contrary to the interests of the company and/or its partners.(5) Therefore, defining the amount of the break-up fee clause demands caution from the administrators, lawyers and legal professionals involved.CommentThere is great potential for the use of break-up fee clauses in cross-border deals and it is possible to establish them in deals that are subject to Brazilian jurisdiction. When this occurs, it is fundamental that the function of the clause is well understood by the parties involved in the transaction and that its amount is within market standards.For further information on this topic please contact Adriano Ferraz, Fernanda Dolabella or Marcelo Matos at Freitas Ferraz Advogados by telephone (+55 31 4141 0308) or email ([email protected], [email protected] or [email protected]). The Freitas Ferraz Advogados website can be accessed at www.freitasferraz.br.Endnotes(1) See the recent reform established by the Law of Economic Liberty (No. 13,874/2019), which introduced article 421A in the Civil Code as follows (unofficial translation):Civil and business contracts are presumed to be parity and symmetrical until the presence of concrete elements that justify the removal of such presumption, except for the legal regimes provided for in special laws, also guaranteeing that . . . the allocation of risks defined by the parties must be respected and complied with.(2) Also known as the "termination fee clause" or the "failure fee clause".(3) Judith Martins-Costa, "A cláusula break up fee: qualificação perante o direito brasileiro", Revista de Direito Societário e M&A, volume 1, year 1, São Paulo: Ed RT, January-June 2022.(4) See "Guia para Análise da Consumação Prévia de Atos de Concentração Econômica".(5) This question was raised in the transaction between Linx and Stone, in which the break-up fee was established at 10% of the transaction. For further information, see "Multa elevada da operação entre Linx e Stone pode restringir liberdade de voto de acionista".