Key Takeaways

  • A breakage fee (or breakage cost) is a financial penalty imposed when a contract, loan, or financial arrangement ends earlier than agreed.
  • These fees compensate lenders or counterparties for lost interest, administrative costs, or unfavorable market conditions caused by early termination.
  • In master repurchase agreements, breakage costs cover losses from unwinding funding positions or failing to meet interest obligations.
  • In M&A transactions, break fees act as deterrents against walking away from a deal and can range from millions to billions depending on the deal size.
  • LIBOR-based loans are especially sensitive to breakage costs because advances tied to the Eurodollar market cannot be repaid before expiration without penalty.
  • Breakage fees are also common in leases, equipment rentals, and energy contracts where early termination disrupts expected returns.

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.

Breakage Costs and Liquidation Fees in Contracts

Breakage costs often appear in contracts as “breakage costs and liquidation fees” clauses. These provisions define the obligations a party must meet if a financial arrangement is cut short or assets are liquidated early. For lenders and counterparties, these fees ensure they are compensated for:

  • The loss of anticipated interest or income.
  • Transaction costs and administrative expenses tied to unwinding positions.
  • Losses caused by liquidating deposits or investments earlier than expected.

For borrowers or contracting parties, these clauses underscore the importance of understanding the potential financial impact of early termination. Negotiating how these fees are calculated—whether as a flat amount, percentage of outstanding principal, or based on market indices—can significantly affect overall liability.

Break Fee

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.

Breakage Fee in Mergers and Acquisitions

In mergers and acquisitions (M&A), breakage fees—commonly called termination fees or reverse break fees—are standard contractual tools. These are negotiated amounts paid by one party if the deal collapses under certain conditions, such as:

  • A target company accepting a competing bid.
  • Regulatory authorities blocking the transaction.
  • Shareholders rejecting the merger.

Break fees in M&A can serve as:

  1. Compensation – covering sunk costs of due diligence, advisory fees, and management time.
  2. Incentives – encouraging both parties to complete the deal rather than walk away.
  3. Risk allocation – ensuring one party bears responsibility if the deal fails for reasons within their control.

Notably, reverse break fees—where the buyer pays if they cannot complete the acquisition (often due to financing failure or regulatory obstacles)—are becoming more common in large transactions.

LIBOR Breakage

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.

Breakage Costs Beyond LIBOR

While LIBOR-based advances are classic examples of breakage fees, similar penalties apply in other industries and financing contexts:

  • Fixed-rate loans: Borrowers who refinance before maturity often face breakage costs calculated as the lender’s lost interest spread.
  • Leases and rentals: Lessees who terminate early may pay a breakage fee to cover lost rental income and asset depreciation.
  • Energy contracts: Utilities and suppliers may impose breakage costs if customers end supply agreements early, particularly when energy was purchased in advance.

These examples highlight that breakage costs are not limited to sophisticated financial markets. They function broadly as a contractual safeguard to ensure parties are compensated when long-term commitments are disrupted.

Frequently Asked Questions

  1. What is a breakage fee in simple terms?
    A breakage fee is a penalty paid when a loan, lease, or contract ends earlier than agreed, compensating the other party for lost income or costs.
  2. How are breakage costs calculated?
    They are often based on the lender’s lost interest, a set percentage of outstanding principal, or administrative and market-related costs detailed in the agreement.
  3. Are breakage fees the same as prepayment penalties?
    Yes, in many loan agreements they function similarly, though breakage fees may also apply in non-loan contexts such as leases or M&A deals.
  4. Can breakage fees be negotiated?
    Yes. Parties can negotiate the size, triggers, and calculation method of breakage costs before signing a contract.
  5. Why are breakage fees important in M&A transactions?
    They discourage parties from abandoning deals and ensure compensation for wasted costs if a merger fails due to actions within one party’s control.

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