Breakage Costs: Everything You Need to Know
Breakage costs refer to a prepayment penalty on a fixed-rate loan or a fee that a lender charges to keep the borrower from refinancing shortly after closing.3 min read
Breakage costs may refer to either a prepayment penalty on a fixed-rate loan or a fee that a lender charges to keep the borrower from refinancing a loan shortly after closing. These charges allow the lender to recoup the cost of the interest rate associated with fixed-rate funding. They are often calculated on a sliding scale, such as a percentage of the outstanding principal at the time the loan is refinanced. Breakage costs are spelled out in the original contract.
Breakage Costs in Master Repurchase Agreement
Breakage costs consist of all the losses and expenses that the lender incurs when employing or liquidating third-party deposits. These costs may result from a loan prepayment on any date but the last day of the interest period when interest is accrued at the LIBO rate (London Interbank Offered), or from the borrower's failure to pay accruing interest by a specified date or amount.
Loans funded at the LIBO rate are subject to a matching deposit in the Eurodollar market for a comparable amount for the purpose of figuring breakage costs. The lender will provide a certificate detailing how its losses are calculated.
When a deal or contract fails, a break fee is paid as compensation. This is common if:
- A contract is ended before its expiration date.
- A mergers and acquisitions deal is terminated for specific reasons indicated in the contract.
In the latter situation, the break fee is negotiated ahead of time as an incentive for the company to complete the deal and to provide security if the deal is not completed. It is calculated by estimating the time that managers and directors spent negotiating the deal, along with the cost of due diligence.
If a no-shop clause is breached, or the target company goes with another company, the break fee will apply. External factors can also trigger the break fee, such as regulatory approval.
Form S-4 is filed with the Securities and Exchange Commission (SEC) as a disclosure of break fees.
Break fees can also be charged to lessees who return equipment or for rented premises vacated before the lease has expired. Some business contracts incorporate a break fee to prevent nonperformance.
For example, in a 2017 proxy filing, Rockwell Collins Inc. filed a Form S-4 regarding its takeover of United Technologies Corporation (UTC). It stipulated a break fee of $695 million if:
- UTC terminated the merger because of a breach of contract.
- Either party terminated the agreement before the end date.
- Rockwell Collins did not obtain shareholder approval.
- Rockwell Collins instead entered an alternative acquisition proposal.
One of the most common types of interest rates, as noted by Bankrate.com, is the London Interbank Offered Rate (LIBOR). It often serves as a benchmark for loans that have an adjustable interest rate. If the borrower prepays a LIBOR rate advance before it expires, this is what the lender considers a breakage.
Large companies can opt for the LIBOR rate when requesting an advance from a bank or a lender. LIBOR advances cannot be repaid before their expiration like other interest rates can. They carry:
- A fee
- A repayment amount
- Advance notice requirements.
Because breakage is undesirable for the lender, fees are charged to borrowers who prepay.
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