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LBO: Break Up Fees

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


[1]—How Break Up Fees Work

Facing overpayment risk due to excessive competition among potential financial partners, the LBO funds have adopted a variety of strategies to counteract this problem, including searching outside the borders of the United States for opportunities. It is an article of faith that any deal that is auctioned, with professional advisors in charge, is inherently risky because potential buyers are stuck with the probability they will be paying top price for the merchandise. Given the aggressive promises made by the managers of buyout funds (20 percent plus compounded rates of return, net of significant fees), one has to be good and/or lucky to hit the IRR bogey if a premium price has been paid. Accordingly, the buyout funds assiduously look for opportunities to "sole source" a deal, to negotiate on some sort of exclusive basis with the seller(s) of the target.

A "no shop/no solicit" clause in the letter of intent protects the fund while the transaction is being negotiated. The second protection arises after the contract has been signed between the buyer and the seller(s). Although the seller(s)' promises to sell/merge may purport to be facially unconditional, a contract with the board of a public company is vulnerable (i) to a shareholder vote (although major shareholders may occasionally sign on); (ii) to a fiduciary out in case an unsolicited counter bid appears; and, in today's environment, (3) the likely necessity of a "go shop" burden on the target's board  actively to solicit competing bids if there is any indication that current insiders will be advantaged by the trade.

Accordingly, universe the financial partners and their advisors have borrowed from the culture of M&A generally and bargain hard for "break-up" or "topping fees." The breakup or topping fee is now an accepted element of corporate finance in a variety of contexts, including M&A, buyouts, and, in fact, bankruptcy auctions, when the debtor, a going concern, is put up for sale. Frequency of occurrence and a fair amount of litigation has resulted in some norms for the acceptable amount of break-up/topping fees, ranging from 2 to 5 percent of the total price or investment proposed by the initial suitor. The case law has, in effect, capped at those percentages the damages a disappointed suitor can exact from the target (and, de facto, from the winning bidder), on the theory that more aggressive fees would amount in effect to forestalling a valid auction and thereby penalizing the minority shareholders of the target. Much of the litigation on this point (and much of the litigation in this general area) arose from the universe of contested and hostile takeovers, the intervention of the judiciary spurred in party by the suspicion that the managers in control of the target were feathering their own nests by accepting bids that benefited them personally (for example, in the form of employment contracts and stock options) at the expense of the powerless minority shareholders.

The break-up/topping fee modality is, in effect a form of liquidated damages if the overbid is the winner, because it is now conventional wisdom that the directors of a public target have a "fiduciary duty" to the minority shareholders to accept high bids even after a purchase agreement has been reached; thus, the board of public target will insist on a "fiduciary out." The fiduciary out means that specific performance, or Draconian damages that are the equivalent of specific performance, are not available to the initial suitor. Hence, liquidated damages (the break-up fee) are the only remedy in the case of an overbid, the convention being that those damages cover the initial suitor's out-of-pocket costs plus an override, the total capped at a number within the realm of possibility for the over-bidder to pick up. If the initial suitor's bid is equal to a base line of, say, 100, it seems fair to require the over-bidder to come in somewhere higher than 102 or 105 to qualify, but not 150.

[2]—Sample Break Up Fee Provisions

1.  In the event that (i) this Agreement is terminated (A) by Parent or the Company pursuant to {Section} and, at any time after the date of this Agreement and prior to the Stockholders Meeting, an Acquisition Proposal shall have been publicly disclosed or otherwise communicated to the senior management or Board of Directors of the Company and shall not have been irrevocably withdrawn prior to the Stockholders Meeting, (B) by Parent pursuant to {Section} and, at any time after the date of this Agreement and prior to the breach giving rise to Parent's right to terminate under {Section}, an Acquisition Proposal shall have been publicly disclosed or otherwise communicated to the senior management or Board of Directors of the Company and shall not have been irrevocably withdrawn prior to the breach giving rise to Parent's right to terminate under {Section}, or {Section} by Parent or the Company pursuant to {Section} and at any time after the date of this Agreement and prior to the termination of this Agreement, an Acquisition Proposal shall have been publicly disclosed or otherwise communicated to the senior management or Board of Directors of the Company and shall not have been irrevocably withdrawn prior to the termination of this Agreement, and (ii) within twelve months after this termination, the Company enters into an agreement in respect of any Acquisition Proposal or a transaction pursuant to which any Acquisition Proposal is consummated, then the Company shall pay the Termination Fee (minus the amount, if any, previously paid pursuant to {Section}) to Parent, by wire transfer of same day funds, on the date of the agreement in respect of the Acquisition Proposal or, if earlier, consummation of the transaction in respect of the Acquisition Proposal, as may be applicable; provided that, for purpose of this {Section}, the term "Acquisition Proposal" shall have the meaning assigned to such term in {Section}, except that the references to "20% or greater" and "20% or more" shall be deemed to be references to "50% or greater" and "50% or more", respectively).

2.  In the event that (i) this Agreement is terminated by the Company pursuant to {Section} as a result of a breach by Parent or Merger Sub of its respective obligation to effect the Closing pursuant to {Section} hereof and satisfy its obligations under Article II including depositing (or causing to be deposited) with the Paying Agent sufficient funds to make all payments pursuant to {Section} and (ii) Parent and Merger Sub fail to effect the Closing and satisfy such obligations because of a failure to receive the proceeds of one or more of the debt financings contemplated by the Debt Financing Commitments or because of their refusal to accept debt financing on terms materially less beneficial to Merger Sub than the terms set forth in one or more of the Debt Financing Commitments, then Merger Sub shall pay $XXX,XXX,XXX (the "Merger Sub Termination Fee) to the Company or as directed by the Company as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds.

3.  Each of the Company and Merger Sub acknowledges that the agreements contained in this {Section} are an integral part of the transactions contemplated by this Agreement. In the event that the Company shall fail to pay the Termination Fee or Parent's Expenses when due or Merger Sub shall fail to pay the Merger Sub Termination Fee when due, the Company or Merger Sub and Parent, as the case may be, shall reimburse the other party for all reasonable costs and expenses actually incurred or accrued by such other party (including reasonable fees and expenses of counsel) in connection with the collection under and enforcement of this {Section}.

4.  Notwithstanding anything to the contrary in this Agreement, (i) (A) in the event that Parent or Merger Sub breaches its respective obligation to effect the Closing pursuant to {Section} hereof and satisfy its obligations under Article II including depositing (or causing to be deposited) with the Paying Agent sufficient funds to make all payments pursuant to {Section}, (B) Parent and Merger Sub fail to effect the Closing and satisfy such obligations because of a failure to receive the proceeds of one or more of the debt financings contemplated by the Debt Financing Commitments (other than as a result of a reduction in such proceeds to be made available to Merger Sub pursuant to the terms of the Debt Financing Commitments, including for this purpose a failure to satisfy any condition relating to a leverage ratio or other financial test contained in such Debt Financing Commitments) that, together with the amount of equity financing committed pursuant to the Equity Financing Commitments, are sufficient to fund the transactions contemplated hereby or because of their refusal to accept debt financing on terms materially less beneficial to Merger Sub than the terms set forth in one or more of the Debt Financing Commitments, and (C) Parent and Merger Sub are not otherwise in breach of this Agreement (including their respective obligations pursuant to {Section}) except as contemplated by clauses {Section} and {Section} above such that the condition set forth in {Section} would not be satisfied, then the Company's right to terminate this Agreement pursuant to {Section} and receive payment of the Merger Sub Termination Fee pursuant to {Section} shall be the sole and exclusive remedy of the Company and its subsidiaries against Parent, Merger Sub and any of their respective affiliates, stockholders, partners, members, directors, officers or agents for any loss or damage suffered as a result of the breach of any representation, warranty, covenant or agreement contained in this Agreement by Parent or Merger Sub and the failure of the Merger to be consummated, and upon payment of the Merger Sub Termination Fee in accordance with {Section}, none of Parent, Merger Sub or any of their respective affiliates, stockholders, partners, members, directors, officers or agents shall have any further liability or obligation relating to or arising out of this Agreement or the transactions contemplated by this Agreement, and (ii) in no event shall Parent, Merger Sub and their affiliates, stockholders, partners, members, directors, officers and agents be subject to liability in excess of $XXX,XXX,XXX in the aggregate for all losses and damages arising from or in connection with breaches by Parent or Merger Sub of the representations, warranties, covenants and agreements contained in this Agreement.


Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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