Break fees – a case for exceeding the 1% guideline

In brief

• 24 years on, the 1% break fee guideline set by the Takeovers Panel still remains standard practice.
• In this article, we discuss two recent court decisions and what circumstances may justify departure from the 1% guideline.
• In our view, a departure is justified where the break fee’s quantum, structure and effect do not undermine the underlying policy justifications for the guideline, being the prevention of anti-competitive or coercive break fees.

Overview of the 1% guideline

In a public M&A transaction, a break fee is the negotiated amount paid by the target to the bidder if certain specified events occur. Most notably, the break fee is usually payable if the target receives a competing proposal or the target materially breaches the implementation agreement. 

Break fees are primarily designed to compensate the bidder, where appropriate, for the costs and risks associated with pursuing a transaction that ultimately does not proceed. However, they can also serve as a deal protection mechanism to hold the target to the agreed deal and potentially dissuade a rival bidder (who indirectly bears the economic cost of paying this amount). 

The 1% break fee was a ‘guideline’ set by the Takeovers Panel in 2001, over 24 years ago.¹  This guideline was created for two key policy reasons, to ensure that break fees: 

1. anti-competitive: were not of a quantum that had a significant anti-competitive effect on existing or potential rival bidders; and
2. coercive: did not have a significant coercive effect on target shareholders by unduly influencing their voting decision.

The Takeovers Panel and courts have generally considered that a break fee not exceeding 1% of the equity value of the target is acceptable.

The market has generally complied with this guideline, notwithstanding the reality that costs to pursue a transaction have risen and in a number of transactions such costs are not adequately covered by 1% of the equity value.

There have been calls to revisit whether 1% of equity value continues to be the appropriate measure (see our article here suggesting that it may need to be revisited).

Exceptions to the guideline 

The Takeovers Panel’s position is that a break fee exceeding 1% of the deal value is generally considered ‘prima facie excessive’.²  However, the Takeovers Panel’s guidance acknowledges that, in limited cases, it may be appropriate for the 1% guideline to apply to enterprise value rather than equity value, for example, where the target is highly geared. 

A pragmatic commercial approach has been adopted by courts assessing schemes of arrangement where break fees in excess of 1% have not been challenged where the equity value of the target is relatively low.³  

In those schemes, parties were able to demonstrate that the break fee is a genuine estimate of the costs incurred by the bidder if the transaction were to fall through. Accordingly, adhering to the 1% guideline would lead to a negligible break fee that would not make commercial sense. 

Cap on damages

There is often a debate between bidder and target as to whether the break fee should be the cap on damages. The market practice on this point is mixed.

Like many other contracts, parties may agree a reasonable pre-estimate of loss as liquidated damages, but leave open the ability to recover damages, particularly where the loss arises from a party’s breach.

Capping the recoverable loss at the liquidated damages amount is a concession by the bidder in favour of the target, as it limits the target’s exposure should it not perform the contract (noting that specific performance and other recourse may be available to a bidder, depending on the circumstances and terms of the agreement).

The position on whether a break fee is a cap is therefore relevant to the quantum of the break fee agreed.

Interestingly, in the private M&A context, damages for breach are rarely capped (other than by reference to the aggregate purchase price) – the argument goes, why should the seller have an option over the deal with an immaterial and capped exposure for not performing the contract it committed to.

Circumstances where more nuance may be warranted

For good reason, the 1% guideline is guidance not a rule – situations may warrant more nuance. For example:

1. What if the actual costs of a bidder exceed 1% and the target is medium sized (not small)?
2. What if the structure of the break fee is not inconsistent with the policy objectives it serves?

We believe that the Takeovers Panel and the courts should acknowledge the need for nuance in how break fees are regulated, provided the core policy objectives of the guidance are not undermined.

For example, consider the following scenario:

1. The bidder’s actual costs are reasonably expected to exceed 1% of the target’s equity value.
2. The bidder and target agree a two-tier break fee with the following features:
   • 1% payable if the bidder terminates because of a competing proposal;
   • 3% payable if the bidder terminates because of the target’s material breach; and
   • no break fee is payable if target shareholders simply vote against the scheme.

The construct above is a concession secured by the target Board to avoid having uncapped liability to the bidder (i.e. the Board convinced the bidder to cap the target’s exposure to the break fee). In our view, it elegantly avoids the break fee being anti-competitive or coercive, and is a fair compromise to allow target shareholders to access the benefits of the bidder’s proposal.

Recent NSW Supreme Court consideration of a two-tiered break fee

These precise facts above were put before the Supreme Court of New South Wales in a recent scheme. 

However, the Court was uneasy with the novelty of the construct.

The Court did not determine that the break fee was unacceptable. However, it did flag at the first Court hearing that it would need to hear more evidence to assess the merits of the break fee structure, which would likely delay granting the orders to convene the scheme meeting. The parties to the transaction did not want to delay their transaction timetable and agreed on the ‘Court room steps’ to amend the break fee to align with the 1% guideline.

Notably, a two-tiered break fee structure has been adopted in various schemes, including more recently in Midway Limited / River Capital (2024) and Schrole Group Ltd / TES Aus Global Pty Limited (2024).

The Court in this case noted that the 1% “working guideline” was commonly accepted and that courts tend not to require significant proof of costs incurred and significant disclosure to shareholders as to such break fee arrangements. Once parties depart from this norm, the Court noted that issues will arise as to whether solemn contractual recitals of arm’s length negotiations and assertions of costs will be sufficient to justify the quantum of the break fee.

It was noted by the Court that while there is nothing wrong with innovation in break fees, parties should be aware that novel constructs may be more heavily scrutinised. Parties seeking to pursue the construct again, should come well-armed to justify them.

We agree that more substantive evidence on costs should be required in these circumstances, but the innovative construct itself has merit as being legitimate, given:

1. Quantum: the relatively low equity value of the target, and the significant costs the bidder had incurred on the transaction to date, leading to the conclusion that the break fee here was not excessive.
2. Structure and effect: The break fee was carefully structured to navigate the policy considerations noted above. It appropriately straddled the core concerns of anti-competitiveness and coercion that underpin the 1% guideline set by the Takeovers Panel. The break fee was not:
   • Anti-competitive – The break fee here had been carefully formulated so as not to deter rival bidders. If the break fee was triggered because of a competing proposal then 1% would be paid; or
   • Coercive – it was not a “naked no vote” fee (i.e. payable on target shareholders voting down the scheme).
3.  Cap on damages: The target board traded the two-tier structure in return for having the break fee as the cap on damages. The construct was a reasonable conclusion reached in arms’ length negotiations. This is a legitimate trade-off that is ultimately beneficial for the target, delivering certainty on potential exposure under the implementation agreement

Recent WA Supreme Court consideration of a two-tiered break fee

By comparison, in a recent judgment of the WA Supreme Court, Justice Strk commented on a two-tiered break free structure. In that case, the break fee was structured such that:

1. A break fee of 1% (~$180k) was payable if the bidder (TES Aus Global) terminated the scheme implementation deed following a material breach by the target (Schrole Group).
2. A higher break fee of 2.3% (~$400k) was payable if there was a change in Schrole Group’s board recommendation or completion of a competing proposal.

This is a more challenging construct to accept than the scenario considered by the NSW Supreme Court described above in light of the policy objectives. A higher break fee (above 1%) would be activated if a rival bidder emerged, potentially undermining competition for the target.

Justice Strk accepted that a break fee over 1% was acceptable where a competing proposal emerges as the new bidder would be required to absorb the expense, which was not considered excessive. Presumably, the target’s relatively small equity value informed the Court’s decision to allow the construct.

The role of the courts

There is a foundational question in schemes of arrangements. What is the role of the courts in policing agreed break fees? 

Stated simply:

1. At the first court hearing, the court must determine if the scheme is of a kind that if the requisite majorities are reached then the court would be likely to approve it.
2. At the second court hearing, the court must determine that the scheme is fair, which is a broad and multi-faceted consideration.

On its face, an assessment of the appropriateness of the break fee is not central to either test. Nevertheless, the courts have tended to assess the appropriateness of break fees at the first court hearing. There is a question as to whether this is necessary, and more specifically whether it is necessary for the court to police the enforcement of the Takeovers Panel guidance, absent a live dispute. 

If a break fee is coercive (e.g. a large fee payable on shareholders vote against the scheme), one can envisage that the court may have fairness concerns.

However, if a break fee of larger than the 1% guideline is agreed by sophisticated parties, why should the court intervene and stop the scheme process in its tracks. It is open to a rival bidder or even a shareholder to challenge the legitimacy of such a break fee, at which time the court could turn its attention to the enforceability of the break fee (for example is it a penalty or has it interfered with the fairness of the scheme). 

The challenge, which was faced in the NSW Supreme Court matter above was that, while the parties negotiated a reasonable compromise that balanced the competing priorities of bidder and target, their scheme process and timetable was put at risk in circumstances where no live dispute or challenge existed. This can leave transactors boxing at shadows during reasonable, arms’ length negotiations.

Commentary

While departure from the 1% guideline is relatively untested outside of small value deals, we consider that a departure may be warranted where the following criteria are met:

• Considerable costs: Where considerable costs and expenses have been incurred by the bidder (including opportunity costs).
• Formulation of break fee: Where the break fee has been formulated in a manner that is not anti-competitive, such that it does not deter rival bidders.
• Break fee is not coercive: Where the break fee triggers do not depart from the usual triggering events (e.g. by not including a “naked no vote” fee which may be regarded as effectively coercing shareholders into voting in favour of a scheme).

Overall, we welcome more nuance in the application of the Takeovers Panel’s guidance on break fees in a manner that appropriately navigates the core objectives of ensuring break fees are not anti-competitive or coercive while recognising that there are circumstances which justify departure from the 1% guideline.