26 August, 2016
Summary
The latest High Court decision in the ANZ Bank fees class action gives more comfort as to whether a break fee or reverse break could be susceptible to challenge as a penalty.
The High Court said a range of factors could be used to view a payment obligation as not being an impermissible penalty.
Background
The latest High Court case in the ANZ Bank fees class action deciding that late fees imposed by banks were not unenforceable under the law of penalties provides some comfort that a break fee or reverse break fee is less susceptible to challenge.
In the case, Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, a class action was brought claiming that late payment fees of up to $35 was an impermissible penalty as the actual cost to the bank was much less.
The High Court, by a majority, adopted a very commercial approach to the issue. The majority judges said that a payment obligation that arises on breach will only be unenforceable as a penalty if it is penal in nature, that is if it is in nature of a punishment for non-performance.
In this regard, the High Court said that the test is not whether the amount reflects a ‘genuine pre-estimate of damages’. It need not. It will only be a penalty if it is ‘extravagant and unconscionable’ and ‘out of all proportion to the interests of the party of whom it is to be paid.’
In this regard, a court will not be confined in assessing the direct costs of the breach. In the ANZ Bank case, the bank suffered the loss of its money and various indirect costs such as following up the customer seeking payment and having to provide additional regulatory capital. Those costs were said to be ‘very difficult’ to quantify, but ,despite that, regard could still be had to them. The court emphasised that departure from the general principle of freedom of contract requires exceptional circumstances.
Application to break fees
In Australia, break fees are generally limited to 1% of the equity value of the target company, in accordance with the guideline issued from the Takeovers Panel many years ago. The Panel has not prescribed an equivalent general position in respect of reserve break fees.
Except in extraordinary circumstances, a payment limited to this amount is most unlikely to be ‘out of all proportion’ to the losses suffered by the bidder or regarded as ‘being extravagant and unconscionable.’ Therefore, absent special circumstances, it is most unlikely that a standard break fee could be successfully challenged under the law of penalties.
Application to reverse break fees
The case of reverse break fees is more difficult given that the fee is paid to the target company which, in the case of a failed deal, will have suffered costs and expenses incurred in promoting the transaction, which would rarely approach 1% of equity value.
However, apart from those costs, the target company has an interest in getting a return for all the promises given to the bidder under the transaction agreement and also for the diversion of management time in pursuing the transaction. This would include the undertaking to take all steps necessary to give effect to the transaction, but it would usually give other valuable promises, such as restricting its freedom to carry on its business as it decides in the interest of its shareholders pending the outcome of the transaction and granting exclusivity restrictions which would limit its ability to engage with the rival bidders. Those are very valuable freedoms that the target gives up as part of the bargain. Under the High Court decision, they should be taken into account in determining if a reverse break fee could be regarded as a penalty.
In addition, it is arguable that a target has a legitimate interest in protecting the interests of its shareholders, who may suffer a serious loss if the bidder terminates the proposed transaction.
All of those arguments support a conclusion that, absent special circumstances, it is most unlikely that a reverse break fee could be struck down as a penalty, certainly fees of the size we have seen in the Australian market.
Commentary
It is worth noting that the US law has a similar legal principle which outlaws ‘penalties’. The High Court decision mentions that bank fee litigation was run and lost by claimants in 1996 when the courts decided that there was no penalty.
Since then, break fees and reverse break fees in the US of 5% or more of the equity value of the target company have regularly been agreed and, as we have seen in recent times, frequently paid on a broken deal. That history may provide some further comfort to Australian bidder and target companies that the common practice and extent of break fees and reverse break fees in Australia is well within the limits of the law.
For further information, please contact:
Rodd Levy, Partner, Herbert Smith Freehills
rodd.levy@hsf.com
