Strategic vagueness in contract design: the case of corporate acquisitions.

Author:Choi, Albert

ARTICLE CONTENTS INTRODUCTION I. CONTRACT DESIGN AND VAGUENESS A. Contract Goals and Optionality B. Contingent Optionality in Corporate Acquisitions 1. Closing Conditions a. Representations and Warranties b. MAC Conditions c. Covenants d. Exogenous Conditions 2. Termination Fees C. Vagueness II. THE EFFICIENCY OF CONTRACT VAGUENESS A. Front-end Transaction Cost Savings B. Agency Conflicts C. Adverse Signaling D. Ex Post Renegotiation E. The Upside of Litigation Cost: An Information Screen F. Efficient Investment G. Ex Ante Signaling Revisited H. Ex Post Renegotiation Revisited III. NUMERICAL EXAMPLE OF STRATEGIC VAGUENESS A. Efficient Investment 1. The Unconditional Contract 2. The Precise Contract 3. The Vague Contract B. Using a MAC Clause To Signal Value Ex Ante 1. The Unconditional Contract 2. The Precise Contract 3. The Vague Contract C. Ex Post Renegotiation 1. The Unconditional Contract 2. The Precise Contract 3. The Vague Contract 4. Relative Efficiency IV. CONTROLLING LITIGATION STAKES AND COSTS BY CONTRACT CONCLUSION INTRODUCTION

The unprecedented and unanticipated economic and financial shocks of the past couple of years have profoundly altered expected payoffs from executory contracts. Credit markets have frozen, common stock prices have plummeted, and commodities prices have swung wildly. A variety of excuse, or walk-away, provisions such as closing conditions, force majeure clauses, and termination or cancellation rights are being triggered to cancel deals either at fees set by liquidated damages or at no cost. The current economic conditions provide plausible grounds for excuse in a wide range of contracts, so these provisions are currently being actively tested, in court and in renegotiations. The invocation of material adverse event (MAE) or material adverse change (MAC) clauses in corporate acquisition agreements and lending commitments have been particularly noteworthy, as a number of multibillion dollar deals have fallen through. (1) The parties in these deals have been engaged in litigation over the interpretation of these terms and in renegotiation of their agreements. The outcomes should be of great interest to contract scholars and are likely to lead to significant revision or redrafting of these provisions in the next generation of contracts.

Although the interpretation of these provisions has a significant financial effect on the parties to these broken deals, it has an even greater ex ante impact on the contract design of future deals. The contractual allocation of risks plays a role well beyond the simple transfer of risk to the superior risk bearer. It is an essential tool in addressing the goals of contract in a world of asymmetric information. First, it provides incentives for a party to take measures to minimize the risk (efficient investment). Second, a party's agreement to assume a risk signals private information about the probability and severity of the risk, and thereby promotes efficient decisions to contract (efficient decision to contract). Third, the parties may be asymmetrically informed as to whether the risk in fact materialized, and that information can be elicited through the assignment of risk to the party who is likely to be better informed ex post. This promotes efficient decisions whether to execute the transaction (efficient trade). Thus, much more is at stake in the design of contract terms that allocate risks than simply exploiting differential risk preferences.

The optimal allocation of risks is complicated further by the presence of transaction costs, both at the drafting and enforcement stages of the contractual relationship. Transaction costs explain why contracts are incomplete and fail to specify fully the optimal obligations in each possible future state of the world. One cause of incompleteness is the cost of litigating and enforcing contracts. Contract theorists focus on the cost of verifying facts and typically posit that parties avoid terms that are costly to verify. Vague contract provisions fall in this category because of the cost and uncertainty of judicial interpretation. Yet, drawing on the line of scholarship that analyzes the rules-standards dichotomy in the design of legal rules, recent work frames the choice between vague and precise contract terms as a tradeoff in information costs: precise contract provisions raise contracting costs on the front end, but reduce enforcement costs at the back end. (2) If a provision matters only in remote contingencies, for instance, then the back-end costs should be discounted by that remote probability, and it may be correspondingly efficient to save front-end costs by using a standard (or a vague term) rather than a rule. In some cases, however, this benefit can be outweighed by the cost of protracted adversarial litigation, even if discounted by the low probabilities of the remote contingencies. The choice of precise rules over standards may also be driven by the fact that courts (the back-end decisionmakers) are usually less informed than the parties themselves (the front-end deciders). This raises the prospect of costly judicial error on the back end.

In a recent article, we departed from this tradeoff between drafting and enforcement costs, and focused on the effect of differing litigation costs on performance incentives under precise and vague contractual obligations. (3) In the analysis, the prospect of verification or litigation costs may be beneficial to contracting, in addition to the front-end contracting cost savings. We thereby offered a distinct explanation for the use of vague terms and a different approach to incomplete contracting. A contract will very rarely be able to include terms that invoke perfect and costless signals of desired performance. A challenge of contract design is to choose among signals that vary in their information content and litigation costs. We suggested that parties may choose a vague standard (such as "best efforts") that invites costly and error-prone judicial proceedings over a precise proxy that is both less noisy (4) and less costly to litigate. (5) We demonstrated that litigation costs may be beneficial as a screen on the promisee's incentive to sue and as an effective sanction against the breaching promisor. (6) Without the benefit of this screen, a noisy proxy that is costless to verify raises the possibilities of false positives and false negatives, which, in turn, undermine incentives. So long as the court's judgment is correlated with the promisor's actual behavior, the parties can combine a vague term, such as best efforts, with a set of prices (including liquidated damages), so as to provide additional incentive to the promisor through an off-the-equilibrium, credible litigation threat. Indeed, litigation costs may in fact never be incurred when either they encourage settlement or they are harnessed through appropriate contract design to assure contractual performance.

This Article applies and extends significantly our analysis of litigation costs to show that they contribute broadly to the three contracting goals listed above: efficient investment, efficient decisions to contract, and efficient trade under conditions of imperfect information. In other words, we look at problems of adverse selection as well as the moral hazard analyzed in our previous work. Our analysis applies to a wide range of commercial contracts and contexts, but we adopt as our application the design of corporate acquisition agreements for several reasons. First, these contracts involve sophisticated parties and large financial stakes. Vague clauses, such as MAC conditions, are among the most heavily negotiated nonprice terms and appear to have a significant effect on the level of acquisition premiums. (7) Second, signaling and efficient investment incentives are likely to be important in these transactions because the seller has significant private information. Third, the collapse of financial markets and of corporate earnings over the past two years has put considerable stress on acquisitions: deals are breaking up and buyers (and their lenders) are invoking termination rights and contract conditions, particularly MACs, as the basis for walking away. (8)

MAC conditions permit the buyer to avoid the closing of the deal if a material change has occurred in the financial condition, assets, liabilities, business, or operations of the target firm. We choose to focus on MACs in particular because, at least since the economic shock following 9/11, commentators have urged greater precision in the language of MACs, including the use of quantitative thresholds. (9) Yet, the typical MAC provision is not quantitative and remains remarkably vague. Vague contract terms invite self-interested and conflicting interpretations. As a result, they fuel disputes, as well as costly and uncertain litigation. Even where MAC provisions have some precision, they nevertheless give rise to substantial litigation costs if the pertinent factors are costly to verify. The uncertainty in MAC application, as well as the considerable resources that are invested in these disputes, prompts commentators to predict that future MAC provisions will be much more precise and simple. In particular, they suggest that future MAC clauses will adopt thresholds in readily proven quantitative measures (which we call "proxies"), such as revenues, customer or employee retention, earnings, and stock price. (10)

These sentiments are understandable as ex post reactions to the dissolution of deals in the current environment. We argue, however, that the ex ante case for vague provisions is underappreciated and parties should be cautious in substituting precise quantitative thresholds. The conventional analysis posits that vague terms are justified only when the expected larger litigation costs are outweighed by savings on the front end, in lower drafting costs. In acquisition agreements, this would suggest that...

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