Is it time to lift the limit on break fees?

THE cap on break fees imposed by the Takeovers Panel runs the risk of some companies failing unnecessarily.

BREAK fees limited to 1 per cent of the equity value of a company that is a takeover target may be putting businesses at risk of not being able to access rescue funding — for example, from the US high-yield debt market.

Where a board of directors of an ASX-listed company has conducted a lengthy and transparent process in circumstances where their company’s financial position is deteriorating, and the lender requires a market break fee to secure the proposal, the question should be whether the board’s business judgment should be second guessed by limits on break fees imposed by the Takeovers Panel?

In our minds there is a serious question as to whether the 1 per cent cap on break fees is appropriate in a distressed loan transaction. A lender assumes a fundamentally different risk in this kind of transaction compared with the typical control transaction, because the lender advances the loan funds to the distressed borrower months before shareholder approval can be sought. Whereas in a typical control transaction the bidder does not pay the bid price until after it is sure the conditions precedent are satisfied and its bid is successful.

So we believe there are circumstances where a larger fee would be justified and indeed deserved by a party who is providing benefits to the company and its shareholders. A good example is the recent battle to provide a rescue funding package to Billabong.

For more than 12 months, Billabong conducted a public sale and refinancing process. Several proposals were announced but subsequently withdrawn. Billabong’s financial position deteriorated markedly over this period. It announced a series of earnings downgrades and was under financial pressure. Eventually, it secured a concrete refinancing proposal with offshore investors able to provide much-needed capital as well as strategic and operational expertise.

To win this long awaited “rescue” deal which involved the immediate provision of a bridge facility for several hundred million dollars, the board agreed to substantial break fees on terms consistent with those found in the US high-yield debt market. That is, substantially in excess of 1 per cent.

The break fee was to be payable if Billabong shareholders did not approve an equity convertibility feature for the riskiest tranche of the loan. Due to the urgency, all of the loan funds were advanced to Billabong well before there was an opportunity to seek shareholder approval. This funding package flushed out a rival proposal, and the break fees were challenged before the panel for being anti-competitive and coercive. It was said that the potential acquisition of a substantial interest in Billabong shares by way of the convertible debt was not taking place in an efficient, competitive and informed market. The offshore investors agreed to restructure their proposal and to reduce the break fees to 1 per cent of enterprise value. As a result, the rival proposal was ultimately successful and the reduced break fee was paid to the original bridge lenders.

At first glance, this seems like a good outcome — the system worked. Taking a longer term view, however, have we got the balance right? Will this outcome prove to be a deterrent for future lenders in similar circumstances?

The returns to lenders in the US distressed debt market are calibrated to compensate lenders for the significant risks they take with financially stressed borrowers. Australian companies seeking to borrow funds in this market compete with other borrowers for those funds and must be prepared to accept market terms.

The panel, in imposing non-market limits on what Australian borrowers may agree to, is potentially denying stressed targets access to this important market. Will US distressed debt financiers still be prepared to provide rescue financing to a distressed target when standard commercial terms can be rejected by the panel?

Will shareholders in distressed companies be deprived of the rapid and dramatic increase in share price, which was enjoyed by Billabong shareholders when the bridge funding was provided, because funders cannot be assured of receiving a commercial return on their funds and appropriate reward for their risk?

A 1 per cent break fee may well be sufficient to compensate an unsuccessful bidder for its advisory and opportunity costs because it has not outlaid any of the purchase price. However, a lender to a distressed borrower risks losing not only its advisory costs but also some or possibly all of the loan funds it has advanced, without any certainty that it can be compensated for that risk by way of equity upside on its loan.

The need to guard against lock-up devices that prevent competition for control of a company is not challenged. But the relatively rigid application of a 1 per cent cap on break fees runs the risk of some companies failing unnecessarily, as lenders lose confidence in receiving what they consider to be a market return for their efforts. Isn’t the maintenance of a competitive market for control of a target secondary to its survival?

Australia’s policy on break fees does not strike the right balance in all circumstances. It over-emphasises the value of competition to shareholders and does not give enough weight to the risks assumed by the lender and the benefits enjoyed by shareholders from a rescue package.

Steven Glanz and Guy Sanderson are partners at global law firm Baker & McKenzie.