Parties to a takeover transaction often negotiate the payment of a fee by the target to the potential acquirer, in the event that the target elects to walk-away from the transaction, usually because it has decided to accept a more attractive offer.
Break fees are a common feature of public market transactions in South Africa. The rationale for a break fee arrangement is:
(1) to compensate the potential acquirer for the cost of the time and resources expended in conducting a due diligence, raising funding and negotiating the takeover and related agreements; and
(2) to inhibit interlopers from making competing offers, as such offers would have to cover the cost of the break fee.
To date, break fees have not been challenged in South Africa provided that, in the case of public market transactions, the Guideline of the Takeover Regulation Panel (“Panel”) on break fees is complied with. In terms of Guideline 1/2012, which sets out the Panel’s interpretation of section 119(1)(c) of the Companies Act 71 of 2008 (“Companies Act”), the Panel will allow payment of a break fee if it does not exceed 1% of the value of the offer, and the details of the break fee must be disclosed in the circular to be sent to shareholders.
However, the legal position in South Africa regarding break fees is in fact more complicated than may first appear.
One important issue is whether a typical break fee arrangement would constitute “financial assistance” as contemplated in s44 of the Companies Act. Take, for example, a typical public market takeover transaction where the offeror requires the target to pay a break fee if the target board were to recommend an alternative offer and following that the initial offeror withdraws or its offer is not accepted. Whilst the break fee would only become payable if the takeover did not occur, it does impoverish the target and is agreed for the purpose of facilitating the takeover (ie an acquisition of shares).
Unlike in the United States of America, both England and South Africa have a long history of legal proscription against providing financial assistance in relation to the acquisition by a company of its own shares.
Until recently break fee arrangements were commonplace in the United Kingdom. In September 2011, the City Code on Takeovers & Mergers introduced a general prohibition on “inducement fee arrangements” between an offeror and target on takeovers of UK companies subject to the Code. In addition, the English courts ruled in Paros Plc v World Link Group Plc (2012 WL 608542) that a break fee constituted prohibited financial assistance as contemplated in s151 of the English Companies Act of 1985 (“English Companies Act”).
The question, then, is whether the South African courts would, faced with similar facts, adopt a similar approach. Whilst it may be tempting to rely on the Paros case, the provisions of s151 of the English Companies Act and s44 of the Companies Act are sufficiently different to sustain the argument that the decision of the English court in the Paros case is of limited assistance. This means that one should rather rely on the South African case law regarding financial assistance.
The South African courts have held the rationale for the prohibition against financial assistance to be “. . . the protection of creditors of the company, who have a right to look to its paid-up capital as the fund out of which their debts are to be discharged . . . The purpose of the Legislature was to avoid that fund being employed or depleted or exposed to possible risk in consequence of transactions concluded for the purpose of or in connection with the purchase of its shares . . .” (Lewis V Oneanate (Pty) Ltd and Another 1992 (4) SA 811 (A) 818A-B).
A break fee becomes payable only if the proposed transaction to which it relates has failed. That being so, it cannot be said that the break fee constitutes the provision of financial assistance by the company for the purpose of the subscription of shares, issued or to be issued, as contemplated in s44(2) of the Companies Act. However, the payment of a break fee may well constitute the provision of financial assistance by the company in connection with the subscription of shares, issued or to be issued, as contemplated in s44(2) of the Companies Act.
In Lipschitz NO v UDC Bank Limited 1979 (1) SA 789 (A) 797H, the court stated that “[t]he words ‘in connection with’ appear to have been inserted in order to cover a situation where, although the actual purpose of the company in giving financial assistance might not have been established, its conduct nevertheless stood in such close relationship to the purchase of its shares that, substantially if not precisely, its conduct was similar to that of a company which gave the forbidden assistance with the purpose described in the section”. This would certainly be the case where a break fee is a sine qua non of the offeror to make an offer. It may also be the case where it has the effect of “smoothing the way” for consummation of the transaction.
In the typical case, a break fee arrangement would constitute financial assistance. Whether it constitutes financial assistance prohibited by s44(2) of the Companies Act will depend on whether such financial assistance was “for the purpose of or in connection with” the purchase of shares.
In my view, there is a distinct risk that a typical break fee arrangement will be held by the South African courts to contravene s44(2) of the Companies Act for the simple reason that it has the effect of exposing the creditor’s fund to the risk of impoverishment in connection with the purchase by a company of its shares. It matters not that the proposed transaction in respect of which it has become payable has failed, in that the object of agreeing to pay the break fee is the provision by the company of financial assistance in connection with the purchase of its shares.
The consequence of concluding a transaction which is the subject of a break fee arrangement which contravenes s44(2) of the Companies Act is serious – the transaction is void.
There are alternative mechanisms which may be employed that achieve many of the deal protection objectives sought through a break fee, but which avoid the risk of a contravention of s44(2) of the Companies Act.
*Cadman is a director with Read Hope Phillips
(This article first appeared in DealMakers quarterly magazine)