- The High Court has altered the law relating to agreed payments that are ‘penalties’. Penalties are unenforceable against the party required to make the payment.
- The change to the law has the potential to raise questions about the enforceability of break fee commitments in corporate control transactions. This may prompt bidders to adopt strategies to mitigate the risk of break fees being challenged.
Last month, the High Court of Australia handed down its decision in Andrews v Australia and New Zealand Banking Group Limited. The Andrews Case is part of an ongoing class action brought by a group of ANZ customers. They claim that certain provisions in customer contracts are ‘penalties’ and therefore void or unenforceable. In its ruling, the High Court determined that a payment obligation that arises otherwise than upon breach of contract may be a ‘penalty’. Other aspects of the class action continue.
The Andrews Case has the potential to impact on break fee arrangements in takeovers and schemes of arrangement, including their drafting, timing and quantification.
Very broadly, an agreed sum that person A is contractually required to pay to person B may be a penalty if:
- the trigger for the payment is where there is a failure to satisfy or meet a provision which operates in favour of B, and
- the agreed sum exceeds what can be regarded as a genuine pre-estimate of the damage likely to be suffered by person B as a result of that failure.
The penalties doctrine provides that if the agreed sum is a penalty, it will not be enforceable.
Until the Andrews Case, it was understood that the doctrine only applied where the trigger for the payment of the agreed sum was a breach by B of a contract between it and A. However, the High Court has determined that the doctrine may apply in a broader range of circumstances.
The Andrews Case
In the Andrews Case, the High Court ruled that it was possible that fees charged by the bank otherwise than upon a breach of contract by the customer (or otherwise than upon the occurrence of an event that the customer was responsible to ensure did not occur) may be penalties. It ruled that the distinction between payment obligations that may and may not be penalties is more nuanced than simply determining whether they are or are not triggered by a breach of contract.
The High Court ruled that the distinction that needs to be drawn is between:
- payments in return for a service or other benefit, which cannot be a penalty even if the payment exceeds the value of the service or benefit, and
- payments that are security for the fulfilment of some condition (even when the party liable to pay the amount did not promise that the condition would be fulfilled), which may be a penalty if the payment exceeds the loss that could be suffered as a result of non-fulfilment of the condition.
This is a question of construction of the relevant contract, based on substance rather than form. This position represents a departure from what had previously been understood to be the law in Australia and, at a practical level, the distinction that is required to be drawn is unlikely to be clear cut in many cases.
Potential impact of Andrews Case on break fees
The practical upshot of the Andrews Case on break fees is that there is now greater scope for a break fee to be challenged, either by the target or a competing bidder that successfully acquires the target. This could occur despite the break fee being within the Takeovers Panel’s threshold of 1% of equity value.
In some transactions, a breach of the implementation agreement is not included as a break fee trigger. Although this is typically to make it clear that the bidder’s recovery for breach of contract is separate from the break fee (and therefore not limited to the 1% threshold), this approach has until now also had the advantage of making it clear that there is no scope for the target to attack the break fee on the basis that it is a penalty.
Following the Andrews Case one or more approaches may be adopted in an effort to mitigate the risk that a break fee may be argued to be a penalty.
The 2008 decision in the Re Hostworks Group Limited scheme of arrangement resulted in some scheme implementation agreements outlining the nature of the bidder’s key costs that the break fee is intended to reimburse. In that case, Justice Mansfield remarked that scheme break fees should be linked to a pre-estimate of the costs to the party receiving the break fee (as opposed to a percentage of equity value) and that parties should consider providing a breakdown of those costs. The Andrews Case may well see a greater number of implementation agreements (for both takeovers and schemes) providing an outline and itemisation of the costs intended be covered by the break fee, in an effort to make it clear that it is a reasonable pre-estimate of the bidder’s likely costs. At several points in its judgment, the High Court emphasised that the penalties doctrine does not apply where the loss suffered as a result of non-fulfilment of the condition could not be compensated by damages. Accordingly, where appropriate, implementation agreements may also note any costs that the break fee is intended to reimburse but that are impossible to quantify with any degree of accuracy at the time that the break fee is agreed.
The Andrews Case may also result in greater scrutiny of the drafting of break fee triggers in the negotiation phase of control transactions. While the focus of the High Court’s test is principally on the substance of the contract rather than its form, the wording of the relevant contractual provisions may be influential on the outcome of a close case. At first blush, the High Court’s reasoning does not appear to leave much room for drafting work-arounds. Most break fee triggers usually relate to an action by the target, or event, that does not result in or follow from any additional service or benefit to the target (at least not one emanating from the bidder), leaving the break fee open to challenge. However, break fee drafting may develop in an effort to support an argument that in certain instances a break fee is a payment in the first, safe limb of the High Court’s characterisation. For example, a competing transaction trigger might be drafted to make it clear that the benefit being enjoyed by the target is the capacity to exercise its ‘fiduciary out’ rights from the deal protection provisions, allowing it to engage with a rival bidder in search of a better deal.
In addition to drafting approaches, bidders may look to the commercial substance of their arrangements with the target in an effort to mitigate the risks created by Andrews Case. For example, bidders may seek that break fees attaching to a change of director recommendation or a successful competing transaction are triggered and paid before the successful counter-bidder acquires control of the target. Targets may resist this, concerned to ensure that a rival transaction is ‘locked in’ before becoming liable for the break fee. Even if the trigger time can be accelerated, relations between the original bidder and the target may already have deteriorated as a result of the emergence of a rival transaction, elevating the risk that the break fee will be challenged. Bidders may therefore start seeking third party security for break fees (such as bonds, like in the Normandy Mining Limited 03 Takeovers Panel application).
At a conceptual level the Andrews Case is likely to draw parties’ focus back onto a bidder’s costs and their relativity with the quantum of the break fee, as well as structural steps that can reduce the risk of non-payment of break fees. This is despite the trend following the Takeovers Panel’s 2005 rewrite of Guidance Note 7: Lock-Up Devices (including through the deletion of its Annexure setting out recoverable bidder costs) being to devote less attention to costs and more attention to the competitive effect of a break fee.
Other outstanding break fee issues
The uncertainty created by the Andrews Case comes at a time when it remains to be seen whether Australian Courts will give any weight to the decision in Paros plc v Worldlink Group plc, handed down by the High Court of England and Wales in March. In that case, a break fee was held to constitute unlawful financial assistance in the context of a reverse takeover. Despite the differences between the Australian and English financial assistance prohibitions, and the financial circumstances of the parties in that case which was relevant to the outcome, the Paros Case potentially undercuts the grounds on which it is commonly accepted that Australian break fees cannot constitute financial assistance.
In the case of break fees, it is a case of watch this space…