Break-Up Fee: A Comparative Analysis of Its Application In Brazil and the United States

Considering the inherent risks and the substantial investments involved in M&A transactions, it’s advisable to incorporate mechanisms in the project’s structure to safeguard the parties if the deal fails. The importance of these tools is usually higher when the deal involves a listed company and when the parties expect a long gap between signing and closing. This article will focus on one of those mechanisms: the break-up fee.

The break-up fee or termination fee clause is a risk allocation mechanism establishing a disengagement price for the deal to be paid by one of the parties if they do not complete it. It is usually triggered by (i) breach of any obligation leading to contract termination, (ii) failure to secure approval from the shareholders and/or board or directors, or (iii) lack of approval of the transaction from governmental authorities.

When the risk to be protected is the commitment of the selling party to complete the deal, the selling party bears the break-up fee to protect the buyer from the possibility of the seller accepting a new proposal during the transaction, between signing and closing. If, however, parties wish to protect the risk of the purchaser losing interest in the deal due to causes not directly related to the negotiation, we may have a reverse break-up fee, providing the seller with the assurance that the purchaser remains motivated to complete the transaction, and compensating the seller's involvement in the failed transaction. If the risk to be protected is the potential non-approval of the transaction by a governmental authority, the buyer usually bears the break-up fee.

Brazilian market numbers show an increasing use of the break-up fee. According to a survey conducted by the consulting firm Dealogic, between 2003 and 2015, only 10 out of 2,000 M&A transactions in Brazil encompassed the break-up fee. However, since 2016, this trend has escalated, with at least six contracts incorporating the termination fee clause in a single year. In 2018, the average break-up fee was 8.2% of the transaction price. By 2020, this average dropped to 7.4%, based on 13 transactions. Even with this decrease, the Brazilian percentage remains above the international market average.

An increasingly common practice in Brazil is the application of break-up fee clauses in transactions that require governmental authority approval – especially from Brazil’s Central Bank (“BACEN”) and the Administrative Council for Economic Defense (“CADE"), the Brazilian antitrust authority. This practice is more frequent in large-scale transactions due to market concentration risk since CADE must approve the transaction as a condition precedent to closing the deal. As parties mainly use the break-up fee to compensate for the transactional costs incurred for the transaction to be successful, the greater the risk of a veto by CADE, the higher the break-up fee tends to be.

The intriguing aspect of this event lies in the fact that the party responsible for indemnification assumes a high risk since the transaction's completion depends exclusively on a decision by an external regulatory body. This differs from the break-up fee motivated by a failure attributable to one of the parties.

There has been a significant increase in the use of break-up fees in the U.S. as well. In April 2023, the investment banking firm Houlihan Lokey released the "2022 Transaction Termination Fee Study" a comparative analysis of transactions announced in 2022 valued at over $50 million involving U.S. public companies, based on data from Refinitiv and S&P Capital IQ. The study, encompassing 140 transactions, revealed that: “In the 2022 Study, termination fees as a percentage of transaction value ranged from 0.3% to 6.2%, with a mean of 2.7% and a median of 2.6%”.

Along these lines, in November 2023, an article published by Paul, Weiss, Rifkind, Wharton & Garrison LLP indicated that the average break fee percentage amount stood at 3.1%, slightly below the preceding twelve months' average of 3.5%. Also, the average reverse break fees were 5.8%, in line with the last twelve months' average of 5.7%.

When comparing the average percentage rate in Brazil and the U.S., the available data indicates that break-up fees adopted in M&A transactions in Brazil are higher (in terms of percentage of the transaction price). This difference may be associated with different risk perceptions in both countries. However, the fact is that the break-up fee has been assuming a growing presence as a risk management tool in M&A transactions in both jurisdictions. As the break-up fees evolve and gain broader application, their strategic deployment remains pivotal for parties to manage risks in complex M&A transactions properly.