The 1% break fee rule – a comment

Increasing costs of conducting a takeover bid or scheme of arrangement will often mean that the costs of a bidder will exceed 1% of the equity value of the target company. To accommodate that, the Takeovers Panel may need to re-visit its guidance.

In brief

• The 1% break fee rule of thumb was set by the Takeovers Panel in 2001.
• In many bids these days, it will be insufficient to cover a bidder’s costs.
• The Takeovers Panel may need to review its guidance.

The 1% break fee rule – a comment

The Takeovers Panel adopted the 1% break fee rule of thumb in 2001. 

At the time, the rule was controversial (believe it or not). That was not due to debate about the percentage that should be set, but because many people saw break fees as an unnecessary US import that should have no place in the Australian M&A market.

I remember being told by the Chairman of a very prominent ASX listed company as we embarked on a potential transaction that under no circumstances would he agree to the company agreeing a break fee with a bidder because ‘he did not believe in break fees’. Needless to say, after the company ran an extensive process fielding various offers for the company, we readily gave a break fee to the highest bidder. 

The 1% rule of thumb was modelled on the UK’s rule at the time. It was designed to be an amount which, consistent with the general principles under Chapter 6, would not be anti-competitive nor coercive for shareholders, but would still give some cost protection for a disappointed bidder. It was a toe in the water intended to placate both sides of the debate about break fees.

(Interestingly, the UK changed its rules in 2011 following Kraft’s bid for Cadbury to generally outlaw traditional break fees and all other forms of deal protection which impose obligations on a target. In essence, those arrangements are permitted only with the consent of the UK Takeover Panel or in very limited circumstances, such as when a target is seeking to encourage a competing offer, following receipt of a hostile bid or in a formal sale process.) 

The rule nowadays

The Panel’s 1% rule of thumb has largely stood the test of time. While it is strictly a “guideline” rather than a mandatory rule, it does not appear to create much controversy in practice and parties to recommended transactions (which, after all, is the only situation in which a break fee is agreed) readily agree to a break fee equal to 1% of the equity value of the target company. So much so that it is barely worth spending any time negotiating the amount of the fee. It is unusual to find any deviation from 1% of equity value.

However, I believe that the Panel needs to consider issuing some further market guidance. The 1% break fee guideline was set 23 years ago. Since then, there has been enormous increases in costs and expenses of conducting a takeover bid or scheme of arrangement. 

There is no comprehensive source that shows how public company M&A costs have increased since 2001, but, according to the Reserve Bank of Australia’s inflation calculator (available at https://www.rba.gov.au/calculator/financialYearDecimal.html), a basket of goods and services valued at $100 in FY2001 would cost $186.01 in FY2024. That represents a total increase in costs of 86% and an average inflation rate of 2.7% over 23 years. 

My sense is that the costs of undertaking a public company transaction have increased by at least these percentages. That is the result of greater regulatory complexity (for example, arising from FIRB and competition law aspects) and a far greater amount of due diligence and preparation being typically undertaken for each transaction, not to mention higher charges and fees for advisers and lenders. 

The result is that 1% of implied equity value will not be sufficient to cover the costs of a bidder in many transactions. It is hard to be definitive, but, in my experience, a bid with any complexity often involves costs that are a multiple of 1% of deal value (unless the deal value happens to be particularly large).

One solution would be to simply change the guidance to give a higher percentage, say 2% or 3%. That would get our market practice closer to the US practice, where break fees of up to 5% are not uncommon. 

Another solution would be for the Panel to state clearly that, in low-value bids, a break fee in excess of 1% would not necessarily be unacceptable. When issued in 2001, the Panel’s original Guidance Note 7 (then called Lock-up Devices) contemplated precisely this point: see paragraph 15. That approach was followed by the Panel in Ausdoc Group Ltd [2002] ATP 9, where a break fee equivalent to 1.87% of implied value was not regarded as unacceptable in a bid worth $187 million, given the complexity of the business conducted by the target company. 

The Panel’s current guidance note was issued in 2023. It does not expressly contemplate any deviation from the 1% guideline for lower value bids. I think that element could be reintroduced without any controversy. It was a useful feature previously. A debate about higher percentages for all bids (say, 2% or 3%) can wait for another day.