Reverse Break-Up Fee

What is a reverse break-up fee?

Reverse break-up fee (also reverse termination fee) is a contractually agreed payment by the buyer to the seller side if the transaction fails for reasons within the buyer's area of risk. The recipients are the sellers or the target company. Contract language calls the buyer's area of responsibility and risk its sphere. Typical triggers are a failure to finance the purchase price, a refused regulatory approval, for example by the competition authority, and breach of the buyer's obligations.

It is the counterpart to the seller side's break-up fee. It is regulated in the company purchase agreement and concerns the period between signing and closing. It is common above all in large transactions in the US market, for example in leveraged acquisitions by financial investors or with strategic buyers facing considerable antitrust risk. In the German Mittelstand (medium-sized businesses) and in venture transactions it is rarely agreed.

The risk between signing and closing

If signing and closing are separated in time, the sellers bear a risk of their own during that period. The purchase agreement usually obliges them to run the company only within the ordinary course of business (ordinary course of business). Larger investments, new financings or strategic changes of course require the buyer's consent. Employees, customers and competitors learn of the transaction, and other bidders have withdrawn.

If closing fails, the sellers return to the market with a company whose intention to sell is known and whose development has been restricted for months. The reverse break-up fee is meant to compensate for this disadvantage to the extent that it stems from the buyer's sphere. A prerequisite is that the closing conditions and the triggers of the payment are precisely aligned with one another.

The triggers in detail

Failure of financing

German company purchase agreements do not usually contain a financing condition. Under German law, a debtor is in principle responsible for its ability to pay. Buyers with debt financing therefore present binding financing commitments at signing, the conditions for drawdown of which are limited to a few points that the buyer can control (certain funds).

Acquisitions through specially formed acquisition vehicles, which have no assets other than the purchase agreement, are critical. A claim against such a company is worth only as much as the commitments behind it, such as an equity commitment from the fund or a guarantee from the parent company. In the US market, financial investors often limit their liability to the reverse break-up fee. Economically, this gives them a right to withdraw from the transaction against payment of the amount.

Refused or delayed regulatory approval

Merger control is the term for the review of corporate mergers by the competition authorities. If a merger reaches their thresholds, it may not be completed before clearance (Section 41(1) of the German Act against Restraints of Competition, GWB). A comparable prohibition on completion applies to acquisitions subject to notification in the investment screening under the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz) and the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung), which concerns above all acquirers from states outside the EU in sensitive technology sectors. If clearance is refused without the buyer having breached an obligation, the sellers generally have no claim without a contractual provision. The reverse break-up fee shifts this risk to the buyer.

In addition or alternatively, buyers undertake in a hell-or-high-water clause to accept all reasonable or even all conditions imposed by the authorities, up to the disposal of parts of the business. An agreed end date (drop-dead date) limits the waiting period. The payment often falls due if this date passes without clearance.

Breaches of obligations by the buyer

Further triggers are breaches of duties to cooperate, such as a late or incomplete filing with the authorities, and a refusal to close even though the closing conditions have been met. If the buyer lacks required consents from its own bodies or shareholders, this too falls within its sphere.

Legal classification in Germany

Under a valid purchase agreement, the sellers have a claim to payment of the purchase price under German law (Section 433(2) of the German Civil Code, BGB). For the purchase of shares this applies correspondingly via Section 453(1) BGB. The claim to performance is the statutory default, unlike in US law, where judicial enforcement of closing (specific performance) is at the court's discretion. This starting point determines the effect of the reverse break-up fee.

If the payment is agreed as an additional minimum amount, it strengthens the sellers' position. If it is agreed as the exclusive remedy, it replaces the claim to performance and further damages. It then acts as a limitation of the buyer's liability. Under German law, such a limitation does not cover intentional breaches of duty, because liability for intent cannot be waived in advance (Section 276(3) BGB).

The legal classification depends on the trigger. If the payment is tied to a breach of duty by the buyer, it is, depending on the wording, a contractual penalty (Sections 339 et seq. BGB) or liquidated damages. If it is tied to a refused clearance for which neither party is responsible, it is rather an independent promise of payment by which the buyer assumes this risk. A judicial reduction of an excessive contractual penalty (Section 343 BGB) is excluded if a merchant promised it in the course of its commercial business (Section 348 of the German Commercial Code, HGB). This regularly applies to acquisition vehicles in the legal form of a GmbH (German limited liability company) or AG (German stock corporation).

In the sale of GmbH shares, the provision is part of the notarised purchase agreement and covered by its notarial form. How the sellers are taxed on the payment depends on whether they hold their shares privately or through a holding company.

Amount and security of the reverse break-up fee

In the US market, reverse break-up fees are often above the seller's break-up fee, commonly in the mid single-digit percentage range of the equity value. For the German market there is no reliable benchmark. An amount that is based on the disadvantages the sellers actually face if the deal fails is appropriate: transaction costs, loss of value of the company and forgone alternatives.

Besides the amount, enforceability counts. Usual security consists of guarantees from the parent company or the fund and bank guarantees. Deposit in an escrow account is possible but the exception in the Mittelstand.

Worked example: reverse break-up fee on a refused clearance

A strategic buyer based outside the EU acquires, through a German subsidiary, all shares in a software GmbH for an equity value of EUR 50 million. Closing requires clearance in merger control and in investment screening. A reverse break-up fee of 3% of the equity value has been agreed for the case that the clearances are not in place by the end date. It is agreed as the exclusive remedy and secured by a guarantee from the parent company. Nine months after signing, clearance is refused.

• Reverse break-up fee: 3% of EUR 50 million = EUR 1.5 million
• Sellers' transaction costs: EUR 0.8 million
• Later sale to another buyer: EUR 46.5 million, that is, 50 minus 46.5 = EUR 3.5 million less
• Sellers' disadvantages in total: 0.8 + 3.5 = EUR 4.3 million
• Coverage by the payment: 1.5 : 4.3 = about 35%
• Uncovered remainder: 4.3 minus 1.5 = EUR 2.8 million

Without the agreement, the sellers would have borne the entire EUR 4.3 million, because the buyer has breached no obligation. It would be different if the same exclusive payment were also agreed for a failed financing. Under German law the buyer is liable for its financing in any case, and the payment of EUR 1.5 million would limit this liability to about 35% of the disadvantage. The same clause can therefore mean protection or waiver, depending on the trigger.

Distinction: reverse break-up fee, hell-or-high-water and MAC

• Hell-or-high-water clause: obliges the buyer to accept regulatory conditions so that clearance is granted. It lowers the risk of failure, the reverse break-up fee compensates for it.
• Drop-dead date: the end date after which the parties can withdraw from the contract. It often determines when the payment falls due.
• Material adverse change: entitles the buyer to withdraw in the event of a material adverse change in the target company. If the buyer withdraws on this ground, no reverse break-up fee is usually payable.

Common mistakes

• Exclusive remedy without need. If the payment is agreed as the sole remedy, the sellers also give up their claim to performance in the event of a failed financing.
• Payer without assets. A commitment from the acquisition vehicle without a guarantee from the parent company or the fund cannot be enforced when it matters.
• Triggers not aligned. If triggers, closing conditions and end date do not fit together, gaps arise in which the contract ends without the payment falling due.
• Missing duties to cooperate. Without clear duties to file and cooperate in the clearance procedure, it is hard to prove that the buyer is responsible for the failure.
• Amount unrelated to the risk. A low amount gives the buyer a cheap right to walk away and compensates the sellers' disadvantages only in small part.

Frequently asked questions

What is the difference between a break-up fee and a reverse break-up fee?

The direction of payment and the trigger differ. The break-up fee is paid by the seller side to the prospective buyer, for example if it breaks off negotiations or accepts another offer. The reverse break-up fee is paid by the buyer to the seller side if the transaction fails because of circumstances in its sphere, above all financing or clearance.

Is a reverse break-up fee usual in the German Mittelstand?

No, it is the exception there. Sellers usually protect themselves through proof of financing, parent company guarantees and a careful allocation of clearance risk. A reverse break-up fee comes into consideration above all where there is a considerable antitrust or investment screening risk.

Does the reverse break-up fee replace the claim to payment of the purchase price?

Only if it is agreed as the exclusive remedy. Without such a provision, the sellers can continue to insist on closing and payment of the purchase price. If they terminate the contract instead, they are entitled to the fee. Whether it is credited against further damages should be expressly regulated in the contract.

When does a reverse break-up fee fall due?

When the agreed trigger occurs, often on termination of the contract after the end date has passed without clearance. The contract should provide for a payment period of a few days and interest in the event of default.

The Roemer Capital view

When comparing binding offers, Roemer Capital assesses not only the price but the certainty of closing of each bidder: origin of the funds, quality of the financing commitments, merger control risk and whether an investment screening is to be expected. A higher offer with open clearance risk can be worth less to the sellers than a lower one that closes with certainty.

Where such a risk exists, Roemer Capital works with the client to quantify the disadvantages that a failure after signing would trigger. From this it derives the negotiating position on the amount, security and end date of a reverse break-up fee. The contract wording for this is drafted by the client's law firm.