This article is part of our M&A Tips series, focusing on various matters in the evolving world of M&A. Stay tuned for regular updates and commentary on topical issues across the sector.
Pre-signing deal protection measures are increasingly important to protect the interests of both buyers and sellers in a transaction. This article takes a dive-in on provisions in term sheets relating to good faith negotiations and break fees and discusses how these can be used favourably in a transaction.
Term sheets are useful for focusing the energy of the parties on the major issues early in the process, saving time and expense in drafting the formal agreements later. While generally non-binding on the parties, there are exceptions to make certain provisions legally binding to protect parties’ interests before the deal is sealed.
In volatile markets, it is especially useful for parties to set out expectations of each other in the event the deal does not complete. Having binding agreement on break fees and good faith negotiations is important to protect the parties’ interests in the event the term sheet does not lead to a definitive agreement.
Cost underwrites for work fees and break fees in the simplest sense, are fees that one side agrees to pay the other if the deal does not proceed. Such payment is conditional upon, for example, the vendor withdrawing from a potential deal notwithstanding a valid term sheet. The break fee aims to achieve the outcome such that any costs incurred by the non-defaulting party in reliance on the other party completing the transaction is covered by the party that has decided to walk away. As such, break fees will typically be a sum that will cover an estimate of legal, financial and tax due diligence costs and term sheet negotiation fees. Accordingly break fee provisions that are legally binding also have the effect of encouraging parties to honour the exclusivity of the term sheet for that particular matter and pursue the same transaction with third parties only after the term sheet expires. In common law jurisdictions, it is important for these fees to be a genuine pre-estimate of the fees incurred to avoid such provisions from being deemed to be unenforceable on the basis that they are penalties imposed for the non-consummation of the transaction.
On another note, some term sheets may contain a legally binding agreement for parties to negotiate in “good faith”. That is to say, parties are to refrain from engaging in conduct that is uncommercial, unreasonable or otherwise in bad faith while the term sheet is valid. These provisions seek to overcome behaviours such as backtracking, unjustifiable positions and failure to share material developments. While admittedly challenging to enforce (and unenforceable in certain jurisdictions), good faith provisions may create useful resistance and even moral or reputational pressure on parties to keep the deal on track.
As set out above, where bargaining positions permit, it is useful to consider including good faith negotiation and break fee provisions in term sheets to focus the parties’ minds prior to the signing of a definitive agreement. That said, parties should seek legal counsel on the suitability of the use of such provisions as there are inherent challenges in negotiating and enforcing these provisions.