Strategic vagueness in contract design: The case of corporate acquisitions

Yale Law Journal

Volumn 119, Issue 5, 2010, Pages 848-924

  Choi, Albert ^a   Triantis, George ^b  

^a UNIVERSITY OF VIRGINIA SCHOOL OF LAW   (United States)

^b HARVARD LAW SCHOOL   (United States)

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[No Author keywords available]

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EID: 77950159133     PISSN: 00440094     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (174)

1. For an excellent account, see Steven M. Davidoff, The Failure of Private Equity, 82 S. CAL. L. REV. 481 (2009). A sample of the failed deals is discussed in Part I, infra.
2. See Richard A. Posner, The Law and Economics of Contract Interpretation, 83 TEX. L. REV. 1581 (2005);
3. Robert E. Scott & George G. Triantis, Anticipating Litigation in Contract Design, 115 YALE L.J. 814 (2006);
4. Steven Shavell, On the Writing and the Interpretation of Contracts, 22 J.L. ECON. & ORG. 289 (2006).
5. Albert Choi & George Triantis, Completing Contracts in the Shadow of Costly Verification, 37 J. LEGAL STUD. 503 (2008).
6. When a proxy is noisy, it does not perfectly correlate with the true state of the world. For instance, quarterly accounting net income of a corporation is positively but not perfectly correlated with the long-term profitability of the corporation. Less noise means that the degree of correlation is higher and that the proxy is more accurate in representing the true state of the world.
7. The same benefit would follow from a precise rule that calls for extensive fact finding and evidence that is both costly and subject to judicial error.
8. Litigation costs can arise either from the task of interpreting a vague provision or from the presentation and weighing of evidence proving whether a contingency occurred or a promisor performed as promised. To illustrate the difference, consider that a confidentiality promise can be phrased precisely, but verifying the disclosure of confidential information may be very costly, in terms both of evidence costs and the risk of error.
9. Antonio J. Macias, Risk Allocation and Flexibility in Acquisitions: The Economic Impact of Material-Adverse-Change (MACs) Clauses (Apr. 17, 2009) (unpublished manuscript, on file with author).
10. The effect of the credit crunch is particularly significant with respect to private equity purchasers, as opposed to strategic purchases by other corporations. See Nixon Peabody Survey Examines M&A Activity During the Credit Crunch, Apr. 21, 2008, http://www.nixonpeabody.com/services_pubdetail.asp?ID=2266&SID=57 (summarizing a survey of senior Fortune 500 executives and private equity practitioners by Nixon Peabody LLP).
11. See infra text accompanying note 89-94.
12. See infra text accompanying note 89-94.
13. These requirements are explained infra Section II.E.
14. For a general discussion of how warranties can function as a signal of quality, see Sanford J. Grossman, The Informational Role of Warranties and Private Disclosure About Product Quality, 24 J.L. & ECON. 461 (1981);
15. George L. Priest, A Theory of the Consumer Product Warranty, 90 YALE L.J. 1297 (1981).
16. Contract theory distinguishes cooperative from "selfish" investment, where the latter refers to the seller's specific investment that reduces the future cost of producing the widget. Consider, for example, that the seller may need to adjust its manufacturing process to prepare to serve the buyer's needs. Once the seller makes this investment, the buyer may engage in a "hold-up" strategy to lower the price of the widget. By committing the buyer to a specified price that compensates the seller for this specific investment, the contract addresses the hold-up problem. However, the contract impedes the flexibility of the parties to adjust their deal to changes in the environment. Selfish specific investment does not play an important role in our analysis of corporate acquisition contracts in this Article.
17. See Yeon-Koo Che & Donald B. Hausch, Cooperative Investments and the Value of Contracting, 89 AM. ECON. REV. 125 (1991). When investment is cooperative, it has a direct effect on the trading partner's willingness (valuation) to trade. Under theoretical analysis, cooperative investments are problematic when valuations are nonverifiable because the conventional solutions, such as unconditional option contracts, function poorly in providing the requisite investment incentive.
18. We assume in this example that the parties cannot subsequently renegotiate the terms of their contract, but consider the impact of contract design on renegotiation later in the Article. See infra Sections II.H., III.C.
19. When the parties are symmetrically informed, ex post efficiency by renegotiation can be achieved regardless of the optionality or ex post allocation of contractual rights and obligations. Our claim is that when the parties are asymmetrically informed, option contracts that rely on vague clauses, such as material adverse change clauses, are more effective in promoting ex post efficiency. This claim is presented in more detail infra Sections II.H., III.C.
20. Shareholder ratification is usually required by state law in cases of statutory mergers and assets sales. See, e.g., DEL. CODE ANN. tit. 8, §§ 251, 271 (2001). Ratification is not required in the case of a stock sale, since in those cases the target shareholders are "voting" by submitting their shares to the tender offer. In negotiated stock acquisitions, however, stock acquisition agreements play an important function comparable to asset acquisition or merger agreements.
21. In the case of a publicly traded target with dispersed shareholders, the delay can be significant due to the fact that the target board must arrange a (special) shareholders' meeting to vote on the merger/acquisition proposal. If the target is privately held, on the other hand, the delay can be much shorter. In this Article, we focus more on publicly traded targets.
22. See Srikant Datar et al., Earnouts: The Effects of Adverse Selection and Agency Costs on Acquisition Techniques, 17 J.L. ECON. & ORG. 201, 216 (2001) (finding that 4.1% of transactions in its sample involved earnouts).
23. In a recent letter outlining important issues in merger and acquisition deals, a partner at a leading firm wrote that the key pitfalls of earnouts include: lack of alignment of goals post deal... employee morale issues if earn out not paid... hard to anticipate all interpretation issues that will arise later... slows deal negotiations and drafting... payment milestones can become outdated... revenue milestone may cease to be achievable due to cost cuts... milestones can be impacted by employee attrition. milestones can be impacted by consolidation or sale of buyer's divisions... difficult to anticipate all ways in which buyer can "game" the milestone, e.g., [in the case of a] revenue milestone. change in revenue recognition methodology. earnings milestone- change in reserves or effective tax rate.
24. DAVID W. HEALY, M&A DEALS: KEY ISSUES, TIPS AND TACTICS 5-6 (2005).
25. In a study of acquisitions by strategic buyers of public companies in 2008, an ABA subcommittee found that over seventy-five percent provided that the seller was entitled to seek specific performance. MERGERS & ACQUISITIONS MARKET TRENDS SUBCOMM., ABA BUS. LAW SECTION, 2009 STRATEGIC BUYER/PUBLIC TARGET MERGERS & ACQUISITIONS DEAL POINTS STUDY (FOR TRANSACTIONS ANNOUNCED IN 2008) 85-88 (2009), available at http://blogs.law.harvard.edu/corpgov/files/2009/10/Deal-Point-Study-9-10-09.pdf [hereinafter ABA 2009 STRATEGIC BUYER STUDY].
26. Agreement and Plan of Merger Among Pfizer Inc., Wagner Acquisition Corp., and Wyeth (Jan. 25, 2009), available at http://www.sec.gov/Archives/edgar/data/5187/000119312509014288/dex21.htm [hereinafter Pfizer-Wyeth Agreement].
27. See Julie MacIntosh, Merger Terms Reveal New Ways To Spread Risk, FIN. TIMES, Jan. 27, 2009, at 21, available at http://www.ft.com/cms/s/0/1b289cfa-ec13-11dd-8838-0000779fd2ac.html?. The fee fueled some speculation of a general upward trend. Id.
28. Reverse break-up fees were usually set at the same level as break-up fees (fee payable by the seller to terminate), typically between two and four percent of the deal price. Steven Davidoff remarks that the option created by reverse termination fees "was not calculated according to any option pricing method. Nor did it appear to be calculated by reference to the damage incurred by an acquiree in the event that it was exercised by the [acquirer]." Davidoff, supra note 1, at 515. Davidoff later suggests that the typical amounts appeared to undercompensate acquirees for the losses [from the exercise of the option]. Evidence of this came from the post-termination share trading prices of acquirees against whom these provisions were invoked. In the months after the exercise of this provision, the share prices of these companies traded significantly below the pre-offer price. Id. at 516 (citation omitted).
29. Pfizer-Wyeth Agreement, supra note 22, § 9.10. The provision begins by stating that "[t]he parties hereto agree that irreparable damage would occur if any provision of this Agreement were not performed in accordance with the terms hereof" in order to support the case for specific performance. Id.
30. Id. § 7.2(a).
31. Id. § 3.6(b).
32. Id. § 7.2(a); see also id. § 8.1.
33. Id. § 7.2(c). This clause provides that Pfizer's obligation to effect the merger is conditioned on the nonoccurrence of this contingency.
34. See ABA 2009 STRATEGIC BUYER STUDY, supra note 21, at 45 (stating that all agreements had such bring-down clauses).
35. Pfizer-Wyeth Agreement, supra note 22, § 3.7, 3.9, 3.10, 3.14. Wyeth also represents and warrants that it "ha[s] taken reasonable steps to protect the confidentiality and value of all trade secrets and any other confidential information." Id. § 3.14(b).
36. Id.
37. Id. § 9.13(f).
38. See ABA 2009 STRATEGIC BUYER STUDY, supra note 21, at 28 (finding that ninety-seven percent include a MAC "walk right"); NIXON PEABODY, SEVENTH ANNUAL MAC SURVEY (2008), http://www.nixonpeabody.com/linked_media/publications/MAC_survey_2008.pdf [hereinafter NIXON PEABODY'S SEVENTH MAC SURVEY].
39. Pfizer-Wyeth Agreement, supra note 22, § 3.6.
40. See supra note 33 and accompanying text.
41. See sources cited supra note 34. For a summary of variations in the MAC elements, see NIXON PEABODY'S SEVENTH MAC SURVEY, supra note 34, at 4. See generally Kenneth A. Adams, A Legal-Usage Analysis of "Material Adverse Change" Provisions, 10 FORDHAM J. CORP. & FIN. L. 9 (2004) (reviewing and recommending variations in MAC/MAE language).
42. Frontier Oil Corp. v. Holly Corp., No. Civ. A. 20502, 2005 WL 1039027 (Del. Ch. 2005) (applying in Delaware court New York law chosen in a contract); IBP, Inc. v. Tyson Foods, Inc. (In re IBP), 789 A.2d 14, 68 (Del. Ch. 2001) (establishing the IBP test under Delaware law).
43. In re IBP, 789 A.2d at 68 (citation omitted). The second Delaware Chancery opinion, Frontier Oil v. Holly, was decided in 2005, and concerned a strategic merger between two petroleum refiners. The interpretation of what constitutes material and adverse came up in the context of a MAE exception. The seller, Frontier, represented in the contract that there was no pending or threatened litigation against it "'other than those that would not have [or reasonably be expected to have], individually or in the aggregate, a Frontier Material Adverse Effect.'" Frontier Oil, 2005 WL 1039027, at *10. The purchaser claimed that an environmental action lawsuit violated this representation but, consistent with In re IBP, the court held that the litigation was insufficiently material from the longer-term perspective of a reasonable acquirer. Id. at *41. The Delaware Chancery Court applied the IBP test again recently in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008). The court placed the burden of proving the occurrence of a MAC on the buyer, despite the fact that the absence of a MAC was a condition precedent to closing under the agreement. The court held that "absent clear language to the contrary, the burden of proof with respect to a material adverse effect rests on the party seeking to excuse its performance under the contract," particularly because Hexion was also the plaintiff seeking declaratory judgment that the MAE had occurred. Id. at 739.
44. 965 A.2d 715.
45. EBITDA is earnings before interest, taxes, depreciation, and amortization.
46. 965 A.2d at 742. The court also rejected Hexion's attempt to avoid the deal by paying the reverse termination fee. See text accompanying note 73-74 infra.
47. See Ronald J. Gilson & Alan Schwartz, Understanding MACs: Moral Hazard in Acquisitions, 21 J.L. ECON. & ORG. 330, 337-40 (2005) (arguing that carve outs support the investment theory of MAC clauses).
48. The carve out in the MAE definition of section 9.13(f) of the Pfizer-Wyeth agreement is representative: [A] Company Material Adverse Effect shall not be deemed to include effects, events, developments, changes, states of facts, conditions, circumstances or occurrences arising out of, relating to or resulting from: (A) changes generally affecting the economy, financial or securities markets or political or regulatory conditions, to the extent such changes do not adversely affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the pharmaceutical or biotechnology industry; (B) changes in the pharmaceutical or biotechnology industry, to the extent such changes do not adversely affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in such industry... Pfizer-Wyeth Agreement, supra note 22, § 9.13(f).
49. The carve out for changes in general economic conditions was found in well over ninety percent of the agreements in the ABA studies. ABA 2009 STRATEGIC BUYER STUDY, supra note 21, at 31;
50. MERGERS & ACQUISITIONS MARKET TRENDS SUBCOMM., ABA BUS. LAW SECTION, 2007 PRIVATE EQUITY BUYER/PUBLIC TARGET MERGERS & AQUISITIONS DEAL POINTS STUDY 20 (2007) [hereinafter PRIVATE EQUITY BUYER STUDY]. The exclusion for disproportionate effect was found in over ninety percent of those carve outs. The Nixon Peabody study found a slightly lower incidence, eighty-nine of the one hundred largest deals in their sample. NIXON PEABODY'S SEVENTH MAC SURVEY, supra note 34, at 7. In all three studies, the carve outs for changes in the industry were slightly less common than the general economic conditions, but the exclusion for disproportionate effects on the target was more likely in this category. See supra note 34. Much less frequent carve outs are: change in securities markets; change in trading price or trading volume of the target's stock; change in exchange rates; and change in interest rates. Id.
51. The Pfizer-Wyeth agreement provides for the following carve out: "acts of war, armed hostility or terrorism to the extent such changes do not adversely affect the Company and its Subsidiaries in a disproportionate manner relative to other participants in the pharmaceuticals or biotechnology industry." Pfizer-Wyeth Agreement, supra note 22, § 9.13(f)(D). Carve outs for terrorism and/or war are common and appear to have increased in frequency from 2005 to 2008. ABA 2009 STRATEGIC BUYER STUDY, supra note 21, at 21.
52. See Pfizer-Wyeth Agreement, supra note 22, § 9.13(f)(C) (excluding legal changes to the extent such changes do not adversely affect Wyeth in a disproportionate manner). The frequency of carve outs for changes in law runs similar to that for terrorism and/or war. See sources cited supra note 34.
53. A "Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from... (b) changes in Applicable Law (provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K, or interpretations thereof by any Governmental Authority. Agreement and Plan of Merger Among SLM Corp., Mustang Holding Co. Inc. and Mustang Merger Sub, Inc. (Apr. 15, 2007), available at http://www.sec.gov/Archives/edgar/data/ 1032033/000095010307000954/dp05308_ex0201.htm. When Sallie Mae brought suit against the consortium of private equity firms to enforce the $900 million reverse termination fee, the parties disagreed as to whether this carve out also determined the threshold for materiality in the MAC: Sallie Mae read the provision as requiring that the effect of the legislation must be in fact materially more adverse than the effect of the anticipated legislation (not the status quo). In a scheduling conference on October 22, 2007, the court found SLM's interpretation to be intuitive, but commented that the parties could have easily provided for this materiality threshold expressly in the MAC definition. The parties then reached a settlement under which the buyers and their banks agreed to refinance $30 billion of Sallie Mae debt. Andrew Ross Sorkin & Michel J. de la Merced, Sallie Mae Settles Suit over Buyout That Fizzled, N.Y. TIMES, Jan. 28, 2008, at C1.
54. Nixon Peabody's report on the agreements dated June 1, 2007 to June 1, 2008 stated: "[W]hile the MAC definitional elements were slightly narrower than in the prior year, we noted a decrease in the number of MAC exceptions... indicating the advancement of buyers' bargaining power during this period... due at least in part to a lack of credit available to finance transactions." NIXON PEABODY'S SEVENTH MAC SURVEY, supra note 34, at 4.
55. Professor Davidoff lists several renegotiated transactions in the appendix of his article, The Failure of Private Equity. Davidoff, supra note 1, at 544.
56. See Steven M. Davidoff & Kristen Baiardi, Accredited Home Lenders v. Lone Star Funds: A MAC Case Study 11 (Wayne State Univ. L. Sch. Legal Studies Research Paper Series, No. 08-116, 2008), http://ssrn.com/abstract=1092115.
57. Andrew Farrell, Lone Star Buys Accredited, Finally, FORBES.COM, Sept. 19, 2007, http://www.forbes.com/2007/09/19/accredited-lone-closer-markets-equity-cx_af_ml_0919markets39.html.
58. Pfizer-Wyeth Agreement, supra note 22, § 5.1 (emphasis added).
59. Id.
60. Id. § 5.1(c).
61. Id. § 5.1(d) (capped at $50 million individually and $200 million in aggregate).
62. Id. § 5.1(c) (capped at $120 million).
63. Id. § 5.1(j) (capped at $0.30 per share of common stock, or $0.50 per share of convertible preferred stock).
64. Id. § 5.1(m) (capped at $50 million in the aggregate, other than cash management or investment portfolio activities in the ordinary course of business or permitted elsewhere in the section).
65. Id. § 5.1(n) (capped at $1.2 billion in the aggregate, and with covenants requiring Wyeth not to engage in any new capital projects in excess of $50 million individually and $100 million in the aggregate).
66. Id. § 5.1(p)(ii) (stating that there would be no new employment relationship with "any Person who earns an annual rate of base salary of more than or equal to $215,000"). Wyeth also agreed not to waive, release, assign, settle, or compromise any claim, other than product or tax claim, if the resolution would be material to the company and subsidiaries taken as a whole or would involve payment in excess of $25 million individually and $100 million in the aggregate. Id. § 5.1(u).
67. The ABA 2009 Strategic Buyer Study found a financing condition in only twelve percent of the sample, see ABA 2009 STRATEGIC BUYER STUDY, supra note 21, while the ABA Private Equity Buyer Study found it in twenty-three percent in the 2006 sample, down from fortyeight percent in the 2005 sample. See PRIVATE EQUITY BUYER STUDY, supra note 45.
68. Pfizer-Wyeth Agreement, supra note 22, § 6.13 (emphasis added).
69. Id. § 6.3(a) (emphasis added).
70. Empirical investigation found reverse break-up fees in only one percent of deals in 1989, but thirteen percent in 1998. Thomas W. Bates & Michael L. Lemmon, Breaking Up Is Hard To Do? An Analysis of Termination Fee Provisions and Merger Outcomes, 69 J. FIN. ECON. 469, 470 (2003);
71. Micah S. Officer, Termination Fees in Mergers and Acquisitions, 69 J. FIN. ECON. 431, 442 tbl.1 (2003). From 2005 to 2006, over sixty percent of all private equity buy-outs had RBFs.
72. Francis J. Blassberg & Kyle A. Pasewark, Trendwatch: 2005 Deal Terms, in DEBEVOISE & PLIMPTON PRIVATE EQUITY REP. 11 (2006);
73. DOUG WARNER & ALISON HAMPTON, WEIL GOTSHAL SURVEY OF SPONSOR-BACKED GOING PRIVATE TRANSACTIONS 15 (2006); Afra Afsharipour, Paying To Break Up: The Metamorphosis of Reverse Termination Fees (UC Davis Legal Studies Research Paper No. 191, 2009), http://ssrn.com/abstract=1443613 (demonstrating empirically the increase in use from the period 2003-2004 to 2008-2009).
74. The ABA 2009 Strategic Buyer Study found that over half of the sample provided for reverse break-up fees as the seller's exclusive remedy. ABA 2009 STRATEGIC BUYER STUDY, supra note 21, at 97. A further thirty-five percent set the break-up fee as a cap on liability only if there was a failure in buyer financing. Id. at 99. In the ABA 2007 Private Equity Buyer Study, about thirty-five percent provided for a reverse break-up fee as an unconditional cap. PRIVATE EQUITY BUYER STUDY, supra note 45.
75. For instance, in April 2008, Mars, Incorporated agreed to acquire the William Wrigley Jr. Company for Gilson & Schwartz, supra note 43, at 337-40. billion under an agreement that surprisingly allowed Mars to walk away for any reason upon payment of the reverse break-up fee and explicitly barred specific performance. Wm. Wrigley Jr. Com. (Form 8-K) (Apr. 28, 2008), available at http://www.sec.gov/Archives/edgar/data/108601/000134100408000796/form8-k.htm.
76. A Weil Gotshal report found that seventy-nine percent of transactions linked RBFs to failure to obtain financing, particularly in private equity transactions, and twenty-four percent to failure to obtain regulatory approval (especially antitrust approval in strategic mergers). WARNER & HAMPTON, supra note 65;
77. see also Francis J. Blassberg & Joshua J.G. Berick, Are Private Equity and Strategic Deal Terms Converging?, in DEBEVOISE & PLIMPTON PRIVATE EQUITY REP. 13 (2005) (indicating that in 2004 a majority of the sample of twenty-five going-private transactions had financing conditions);
78. Paul S. Bird & Jonathan E. Levitsky, Acquisition Agreements After the Credit Crunch: What's Next?, in DEBEVOISE & PLIMPTON PRIVATE EQUITY REP. 3-4 (2007) (observing that "the SunGard, Neiman Marcus and Hertz buyouts in 2005 ushered in a new market practice" replacing the financing condition with a reverse break-up fee of one to three percent of the transaction value and that "the disappearance of the financing condition and the reverse termination fee went hand-inhand").
79. United Rentals, Inc. v. RAM Holdings, Inc., 937 A.2d 810 (Del. Ch. 2007). Cerberus did not attempt to avoid the termination fee by pleading a MAC under the contract. Id. at 845 n.202. United Rentals challenged the acquirer's (a subsidiary of Cerberus) right to pay a $100 million termination fee. The contract was ambiguous as to remedies and there was no clear evidence of a common understanding between the parties. Nevertheless, the Delaware Chancery Court applied the forthright negotiator principle and found that the target knew or should have known that acquirer believed that its only obligation on termination would be the payment of the fee.
80. This pattern of a two-tier structure appears to have emerged around 2005, with the Neiman Marcus buyout. See Neiman Marcus Group Inc. Definitive Proxy Statement (Schedule 14A), at 66-68 (July 18, 2005), available at http://www.sec.gov/Archives/edgar/data/819539/000119312505143823/ddefm14a.htm; see also Bird & Levitsky, supra note 67, at 3;
81. Paul D. Ginsberg et al., Shifting the Risk: An Evolving Approach to Financing Contingencies in LBO Acquisitions, M&A LAW., Mar. 2006, at 8, 11.
82. Pfizer-Wyeth Agreement, supra note 22, § 7.2(c).
83. Id. § 6.3.
84. Id. §§ 8.1(b), 8.2(e).
85. For an account of Hexion's failed litigation strategy, see Amy Kolz, The Big Fall, AM. LAW., Apr. 1, 2009, available at http://www.law.com/jsp/tal/PubArticleTAL.jsp?id=1202429420534.
86. Hexion Specialty Chems. v. Huntsman Corp., 965 A.2d 715, 724 (Del. Ch. 2008). The parties subsequently settled. Hexion and its affiliates agreed to pay Huntsman $425 million to purchase $250 million of its senior convertible notes. See Press Release, Hexion (Dec. 14, 2008), http://www.hexion.com/news_article.aspx?id=6814.
87. Steven Davidoff suggests that invoking a MAC gives the buyer cover against reputational harm from backing out, even if the buyer paid the termination fee. Davidoff also suggests that invoking a MAC may play a role in negotiations, where the contract fee in fact sets a maximum. Given the continued use of the reverse termination fee structure in private equity deals, the inclusion of a MAC clause provides the private equity firm cover to invoke the MAC clause to "completely" walk from the transaction. Given the damage a MAC claim inflicts on a company, the company will be heavily incentivized in such circumstances to settle out at a lower figure, setting the reverse termination fee as an upper bound of payment.
88. Steven M. Davidoff, The Big MAC, Dealbook Blog, Mar. 10, 2008, http://dealbook.blogs.nytimes.com/2008/03/10/the-big-mac.
89. Transcript of Scheduling Conference at 8, SLM Corp. v. J.C. Flowers LLP, C.A. No. 3279- VCS (Del. Ch. Oct. 22, 2007).
90. Michael J. de la Merced, Canceling Harman Deal, Suitors Buy Bonds Instead, N.Y. TIMES, Oct. 23, 2007, at C8.
91. See, e.g., Great Lakes Chem. Corp. v. Pharmacia Corp., 788 A.2d 544, 557 (Del. Ch. 2001) (finding that a reasonable inference from the broad words "business of the Company" in a MAC includes "price cutting in the market, patent infringement by a competitor, diminished sales that resulted from these events, and the loss of a major customer due to market forces").
92. IBP, Inc. v. Tyson Foods, Inc. (In re IBP), 789 A.2d 14, 68 (Del. Ch. 2001).
93. The parties in Hexion disagreed on whether the better measure of material adverse effect should be the change in EBITDA or earnings per share, whether the change should be measured between quarters or year-to-year, and whether the target's failure to meet projections is relevant. Hexion Specialty Chems. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008).
94. There remains a question as to whether the IBP test would apply in situations where the buyer was a financial (short-term) investor (for instance, a private equity firm) rather than a strategic buyer like Tyson in this case. A Tennessee opinion concerning a This is the minimum reverse break-up fee the low-type seller has to offer, since closing the deal allows her a profit of $40. The maximum reverse break-up fee the buyer would be willing to pay is $90. As the fee gets higher, the high-type seller's incentive to mimic the low-type becomes even stronger..5 billion financial acquisition of a hat and footwear company, Genesco, suggested that the MAC ought to be interpreted in light of the purposes and goals of the merger. Memorandum and Order at 34, Genesco, Inc. v. Finish Line, No. 07-2137-II(III) (Tenn. Ch. Dec. 27, 2008), available at http://www.genesco.com/images/litigation_library/genesco-pdf.pdf. In this case, the court noted that the buyer expected that its debt service costs and working capital would come from Genesco's operations earnings, and the drop in earnings would have jeopardized its ability to effectuate that plan. Id. at 37.
95. In In re IBP, the target argued that their earnings drop was caused by a general economic slowdown. However, the Delaware Chancery Court declined to read an exclusion for such general change into the MAC provision. It required that the parties provide so explicitly. 789 A.2d at 66. In that contract, the MAC had no carve out. Id. at 14; Agreement and Plan of Merger Among IBP, Inc., Tyson Foods, Inc. and Lasso Acquisition Corp. (Jan. 1, 2001), available at http://www.sec/gov/Archives/edgar/data/52477/000095013001000056/0000950130-01-000056-0006.txt. In a footnote, the court suggested somewhat confusingly that a "contrary rule will encourage the negotiation of extremely detailed 'MAC' clauses with numerous carve outs or qualifiers." 789 A.2d at 68 n.155.
96. Nip v. Checkpoint Sys. Inc., 154 S.W.3d 767, 770 (Tex. App. 2004) (finding, in one of the few cases in which a court held that a MAC had occurred, that the MAC definition had a monetary threshold for the adverse effect (equal to or greater than $50,000), and the court found that the loss of future income from cancellation of a lost customer was at least that amount).
97. The private equity acquisition of Goodman Global for $2.65 billion had a condition requiring the target to have a minimum EBITDA of $255 million for the fiscal year ending December 31, 2007. Proxy Statement of Goodman Global, Inc. (Schedule 14A), § 6.3(d), at A-37 (Dec. 7, 2007), available at http://www.sec.gov/Archives/edgar/data/1314655/000119312507261343/ddefm14a.htm#toc33884_16.
98. In re IBP, 789 A.2d 14.
99. Genesco, Inc. v. The Finish Line, Inc., No. 07-2137-II(III), slip op. at 31-33 (Tenn. Ch. Dec. 27, 2008). As a consequence of the court's ruling, Finish Line agreed to pay $136 million to Genesco to terminate the deal. Press Release, Finish Line, Finish Line Inc. Announces Settlement of Litigation (Mar. 4, 2008), http://phx.corporate-ir.net/phoenix.zhtml?c=81647&p=irol-newsArticle&ID=1115110. Chancellor Hobbs held that the material adverse change, if any, was caught by the carve out. In contrast, the Delaware Chancery in Hexion Special Chemicals v. Huntsman did not need to apply a similar carve out for changes in general industry conditions because it found that insufficiently material change had occurred to trigger the general MAC condition. 965 A.2d 715 (Del. Ch. 2008).
100. In the Sallie Mae litigation, the purchasers argued, inter alia, that the tightening of credit markets had a disproportionate impact on Sallie Mae because of its size and the corresponding magnitude of its credit needs each year. For more on the Sallie Mae case, see supra note 48.
101. See, e.g., Kenneth A. Adams, Understanding 'Best Efforts' and Its Variants (Including Drafting Recommendations), 50 PRAC. LAW. 11, 13-14 (2004) (reviewing case law interpreting variants of best efforts); Choi & Triantis, supra note 3 (explaining screening and signaling benefits from use of best efforts clauses); Scott & Triantis, supra note 2 (explaining use of best efforts clauses).
102. In their paper, Davidoff and Baiardi note that "MAC clauses are typically defined in qualitative terms and do not describe a MAC in quantitative terms." Davidoff & Baiardi, supra note 51, at 17; see also Adams, supra note 37, at 23-24 (noting the vagueness of the materiality standard in MAC definitions).
103. David Sands, Gabriel Matu & Taylor Dasher, The Global Credit Crunch: A MAC?, THEDEAL.COM, Nov. 14, 2007, http://www.thedeal.com/servlet/ContentServer?pagename=webreprint&c=TDDArticle&cid=1193281688005.
104. Jeffrey D. Litle & Kurt C. Donnell, Material Adverse Change Clauses: Don't Be Chicken Little, MONDAQ.COM, Sept. 10, 2009, http://www.mondaq.com/unitedstates/article.asp?articleid=85830.
105. See, e.g., David Marcus, Material Change Clauses Scrutinized After Sept. 11, N.Y. L.J., Jan. 3, 2002, at 5.
106. See, e.g., David Marcus, Desperately Seeking Certainty, DEAL MAG., July 18, 2008, http://www.thedeal.com/newsweekly/features/desperately-seeking-certainty.php ("The run of collapsed deal has led some observers to predict that sellers would demand greater contractual certainty from PE shops in merger agreements, but so far that hasn't happened.").
107. Peter S. Golden, Arthur Fleischer Jr. & David N. Shine, Negotiated Cash Acquisitions of Public Companies in Uncertain Times, 13 M&A LAW. 1, 7, at 2009.
108. The Seventh Annual Nixon Peabody Survey did observe, however, that the MAC language "would reasonably be expected to have a Material Adverse Effect" did become less frequent. "Although we saw the pendulum swing back to the buyer, interestingly, the 'would reasonably be expected to' formulation showed up in only 15% of the agreements as compared to 52% in the prior year. One possible reason for this result is sellers' desire for increased deal certainty by eliminating this forward-looking language." NIXON PEABODY'S SEVENTH MAC SURVEY, supra note 34, at 5. In contrast, however, the survey found a slight increase in the proportion of deals that left "material adverse change" undefined: from one percent to seven percent. Id. at 6.
109. Although almost all merger or acquisition agreements are fully or partially integrated, see, e.g., Pfizer-Wyeth Agreement, supra note 22, at § 9.5(a), courts will often refer to extrinsic evidence to clarify unclear, vague, or ambiguous provisions. The use of both an integration clause and vague language may seem inconsistent. Our analysis suggests that this combination may be deliberate.
110. Hexion Specialty Chems. v. Huntsman Corp., 965 A.2d 715, 726, 731 (Del. Ch. 2008). Judge Lamb reprimanded Hexion for opportunistically selecting and influencing its experts in order to produce a solvency opinion that would provide grounds for termination. Id. at 730. Whether vague or precise contract terms are more likely to encourage wasteful expenditures in anticipation of litigation is a complicated question.
111. See George G. Triantis, The Efficiency of Vague Contract Terms: A Response to the Schwartz-Scott Theory of U.C.C. Article 2, 62 LA. L. REV. 1065 (2002) (suggesting that precise terms may increase incentives to invest in evidence production).
112. See, e.g., Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of Contract Law, 113 YALE L.J. 541, 602-03 (2003) (arguing that moral hazard is more likely when parties have broader scope for opportunistic interpretation of vague standards such as "impractical" and "unreasonable").
113. See sources cited supra note 2, which address the tradeoff between front-end and back-end costs. In the context of corporate acquisitions, see, for example, Golden et al., supra note 94, at 7, which notes that the parties "tacitly understood that the benefit of having a nontraditional and, perhaps, less ambiguous standard was outweighed by the prospect of a difficult and, perhaps, unsuccessful effort to agree on an appropriate standard, such as a 15% drop in quarterly earnings." 100.
114. See, e.g., Isaac Ehrlich & Richard A. Posner, An Economic Analysis of Legal Rulemaking, 3 J. LEGAL STUD. 257 (1974);
115. Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 DUKE L.J. 557 (1992).
116. Scott & Triantis, supra note 2;
117. see Henry S. Noyes, If You (Re)Build It, They Will Come: Contracts To Remake the Rules of Litigation in Arbitration's Image, 30 HARV. J.L. & PUB. POL'Y 579 (2007).
118. Claire Hill observes that: [I]f the money-saving explanation was correct, we might expect that the more likely contingencies would be those addressed in complex business contracts. To the contrary, the set of contingencies we see addressed do not seem to correspond linearly to the set of more likely contingencies. Remote contingencies are often addressed; what seem like more likely contingencies are left unaddressed.
119. Claire A. Hill, Bargaining in the Shadow of the Lawsuit: A Social Norms Theory of Incomplete Contracts, 34 DEL. J. CORP. L. 191, 205-06 (2009) (internal citations omitted).
120. See Posner, supra note 2, at 1583 ("[D]eliberate ambiguity may be a necessary condition of making the contract; the parties may be unable to agree on certain points yet be content to take their chances on being able to resolve them, with or without judicial intervention, should the need arise."). A similar phenomenon has been noted to explain vagueness in the language of legislation or regulation. See, e.g., Colin S. Diver, The Optimal Precision of Administrative Rules, 93 YALE L.J. 65, 73 (1983) (arguing that the costs of securing agreement among the participants in the rulemaking process usually rise when a rule's transparency "sharpens the focus of value conflicts").
121. See, e.g., Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate Contracting (or "The Economics of Boilerplate"), 83 VA. L. REV. 713 (1997). The lawyer who proposes more precise language, in a departure from convention, might face an adverse signaling problem, as outlined infra at Section II.C.
122. The signal of litigiousness is suggested in different contexts (for example, prenuptial agreements) by Kathryn Spier.
123. Kathryn E. Spier, Incomplete Contracts and Signalling, 23 RAND J. ECON. 432 (1992). Professor Claire Hill proposes two related explanations for why parties deliberately leave MAC clauses incomplete.
124. Hill, supra note 102. First, she suggests that parties may want imprecision "to retain a litigation position, when they concluded that negotiations would have yielded a worse result, a definitive rejection of their position(s) (something also known as 'leaving a strategic handle')." Id. at 198. Second, she argues that increases in contractual precision may undermine the policing of behavior through communal and relationship norms: "[I]f parties negotiate such contingencies beyond what is standard in the community, they may crowd out some of the community's relationship-preserving norms, making litigation (and general cost increasing wariness) more likely." Id. at 214. Hill argues that the appropriate role of litigation is thereby limited to extreme cases of opportunism. Id. at 210, 212-13.
125. See Eric A. Posner, A Theory of Contract Law Under Conditions of Radical Judicial Error, 94 NW. U. L. REV. 749, 762 (2000) (arguing that nonlegal sanctions deter low-value opportunism, while contract enforcement deters high-value opportunism).
126. This claim runs counter to a conventional theoretical claim that bargaining or market power does not manifest itself in nonprice terms.
127. See, e.g., Richard A. Posner, Natural Monopoly and Its Regulation, 21 STAN. L. REV. 548, 548-85 (1969); Priest, supra note 12, at 1320-21;
128. Alan Schwartz, A Reexamination of Nonsubstantive Unconscionability, 63 VA. L. REV. 1053, 1071-76 (1977).
129. See Jessica Hall, Scuttling Deals? More a Threat Than Reality, REUTERS, Sept. 18, 2007, http://www.reuters.com/article/reutersEdge/idUSN1845894020070918.
130. Davidoff, supra note 75.
131. Davidoff & Baiardi, supra note 51 (citing Jeffrey Thomas Cicarella, Wake of Death: How the Current MAC Standard Circumvents the Purpose of the MAC Clause, 57 CASE W. RES. L. REV. 423, 430 (2007)).
132. They may improve ex ante investment incentives, however, if the bargaining power is given to the party, for instance through assignment of property rights, who must make the investment.
133. See Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986).
134. Scott & Triantis, supra note 2.
135. See supra text accompanying notes 82-87.
136. See infra Part IV.
137. Gilson & Schwartz, supra note 43, at 337-40.
138. This is due to the fact that (1) the parties need to renegotiate around an existing contract as opposed to no contract in the ex ante signaling situation; and (2) the bad-type seller, with whom closing the deal is inefficient, has nothing to lose from mimicking the good type. See infra Section III.C.
139. The reason that the ex ante signaling story produced separation, even when the seller was using only the price, was that closing the deal was efficient for both types of seller. If the bad-type seller, for instance, attempts to mimic to be the high-type and offers a high price, when the buyer rejects that offer, she incurs an opportunity cost of being able to close the deal (for certain) at a lower price, which is still higher than how much she values the assets. If the bad type seller's value is higher than the buyer's, as in the ex post renegotiation scenario, the bad type seller no longer incurs any opportunity cost from the buyer's rejection. Similar reasoning applies to the good type when the bad type attempts to renegotiate to drop the deal, which we show infra Section III.B.
140. The probability of a successful renegotiation cannot be one, however, since otherwise, the bad-type will mimic the good-type by also filing the suit. Even though the suit has a negative expected return, the bad-type knows that, before judgment, it will close the deal with the buyer. Therefore, some inefficiency will remain. This is demonstrated more precisely in Subsection III.C.3. infra.
141. The numbers indicate that even after an adverse shock, there still is a $10 million surplus from executing the deal. This assumption is not necessary. We could have changed the numbers so as to make the deal unattractive after an adverse shock. When there is a chance that the deal becomes unattractive for both parties, the main challenge the parties face is the design of the renegotiation mechanism so as to close the deal only when there is a positive surplus from closing the deal. We deal with this problem in Section III.C. infra.
142. Although the assumption that the seller's investment can reduce the probability of an adverse shock from one to zero is clearly unrealistic, the assumption keeps the exposition as simple as possible. We can relax this assumption to accommodate more realistic scenarios. The zero-one assumption renders the "shock" to be completely under the seller's control. In reality, the seller's preclosing behavior will have a causal relationship to the shock while the balance of the risk would come from factors that are beyond the seller's control.
143. Unlike the parties' information over valuation, we can be more flexible on whether or not the buyer observes the seller's investment behavior. If the buyer does not observe the seller's investment behavior, this becomes a classic moral hazard problem, where the investment incentive should be based on a contingent pricing scheme. Even if the buyer does observe the seller's behavior, we can assume that it may be prohibitively costly for the buyer to prove the seller's misbehavior to the court.
144. This is a simple application of the Coase Theorem. We implicitly assume that the parties are rational and that the "transaction costs," such as the cost of writing and redrafting a contract, are fairly small compared to the size of the deal so that the parties will always bargain around the initial terms to achieve the efficient result ex post. In the next two Sections, we deal explicitly with the problem of information asymmetry that can impede the parties from reaching the efficient outcome.
145. As we noted in Part II, the Delaware courts have demonstrated a willingness to specifically enforce acquisition agreements. Although many acquisition agreements provide for liquidated damages (in the name of a reverse break-up fee), this assumption will greatly simplify the analysis and the main argument will not be lost by relaxing it. Indeed, under certain circumstances, the parties might rely on a reverse break-up fee, rather than specific performance, to control their ex post litigation incentive. For instance, when the remedy of specific performance is too attractive, the seller may bring a lawsuit against the buyer even when the buyer's exercise of her option is not unjustified, and this can destroy the seller's ex ante investment incentive. To eliminate such indiscriminate litigation, the parties would want to reduce the potential payoff to the seller by stipulating a reverse break-up fee. Thus, a contract might give the buyer two break-up options: the buyer can not close the deal by either paying the break-up fee or by paying nothing if she can successfully show a material adverse change. We discuss the effect of incorporating a reverse break-up fee in more detail infra Part IV.
146. Assuming such a stylistic and unrealistic bargaining/renegotiation protocol will greatly simplify the analysis and make the examples consistent throughout this Article without sacrificing generality. The assumptions can be relaxed to accommodate other types of bargaining scenarios. In a more general bargaining game, the parties can make offers and counter-offers until (or even after) one exercises an outside option by filing a lawsuit.
147. The maximum value of the assets to the buyer is $100, so she would not agree to a higher price. A price lower than $50 will leave the seller with no incentive to invest because the buyer would want to close the deal even if the adverse shock reduces the value of the assets (to $50). For now, we will remain agnostic about the price and come back to this issue later.
148. We will see shortly that the amount of investment incentive given to the seller under the proxy contract is insufficient, so that the initial price of the agreement will only be $50. Hence, by triggering renegotiation, the buyer is giving the seller the opportunity to raise the acquisition price.
149. The assumption that the litigation cost is completely insensitive to the merits of the claim is not necessary, but we do need it to be "sufficiently" insensitive. Costly verification comes with an implicit assumption that such verification cost is insensitive to who is in the right. See supra Section II.E.
150. For instance, the seller's assets might be subject to future product liability, and given that the seller has produced and sold the (allegedly) defective products in the past, the seller will generally have better knowledge about the degree and extent of the liability than the buyer.
151. See Albert H. Choi, Successor Liability and Asymmetric Information, 9 AM. L. & ECON. REV. 408 (2007), for how such asymmetric information can undermine transactional and deterrence efficiency in successor liability cases.
152. We can relax this assumption by assuming, instead, that the buyer finds out the seller's true type before closing but only probabilistically. This would not change the main result.
153. If the low-type seller offers $60, the offer will be accepted for sure. If she mimics a high-type seller and offers $100, suppose the offer will be accepted with probability β. For her to prefer offering $60 rather than mimicking the high-type, $60 should be at least as large as her profit from making the $100 offer with the condition. In other words, we need $60 to be larger than or equal to β × $100 + (1 - β) × $50. By solving for the maximum β that satisfies the inequality, we get β = 1/5. That is, the buyer must reject the $100 offer with probability of at least four-fifths. This type of equilibrium is known as the Perfect Bayesian Equilibrium where the buyer's belief about the seller type, in equilibrium, is consistent with the actual seller type.
154. Given that the buyer still places a higher value on the low-type seller's assets, even if the index realization is low, the buyer and the seller can renegotiate the price downward and close the deal. The proxy-index, then, will dictate the relative bargaining positions in this renegotiation stage, like in the previous example. We ignore this possibility in this example to keep the analysis simple, but inclusion of renegotiation will not change the results.
155. The one-fifth probability can be found as follows. If the low-type seller offers $60 with or without the proxy condition, the offer will be accepted for sure. If she mimics a high-type and offers $100 with a proxy condition, suppose the offer will be accepted with probability β. For her to prefer offering $60 rather than mimicking the high-type seller, $60 should be at least as large as her return from making the $100 offer with the condition, which is β × (3/4 × $50 + 1/4 × $100) + (1 - β) × $50. By solving for β, we get β = 4/5. In other words, the buyer must reject the $100 offer with probability of at least one-fifth.
156. This is the minimum reverse break-up fee the low-type seller has to offer, since closing the deal allows her a profit of $40. The maximum reverse break-up fee the buyer would be willing to pay is $90. As the fee gets higher, the high-type seller's incentive to mimic the low-type becomes even stronger.
157. More generally, suppose the high-type seller values the assets at VH and the low-type at VL. Suppose also that the initial price of the agreement is P0 and the low-type seller offers a reverse break-up fee of P1 after observing an adverse shock. For separation, we need P0 ≥ P1 + VH for the high-type and P1 + VL ≥ P0 for the low-type. Combining the two inequalities, we get VL ≥ P0 - P1 ≥ VH which is not feasible so long as VH > VL.
158. This result is in stark contrast to that of the previous Section. See supra Section III.B. When the parties were engaged in ex ante bargaining, even if the seller could signal using only the price without any other conditions, the seller could achieve separation (at cost) so long as the buyer's rejection of the high-price offer was sufficiently high. The reason separation was possible was that not closing the deal was costly even for the low-type seller since there is some surplus that can be captured from closing the deal. In this case, however, such a surplus does not exist. That is, since the efficient outcome for the low-type seller is no contract or no deal, the low-type seller is not afraid of getting her offer rejected by the buyer with any probability. The low-type seller has nothing to lose by mimicking the high-type.
159. See supra Section II.E.
160. See supra Sections III.A., B.
161. The story is similar to Michael Spence's education model, in which the high-ability workers signal their quality by obtaining a costly education. See Michael Spence, Job Market Signaling, 87 Q.J. ECON. 355 (1973). There is a slight twist, however. In our renegotiation model, the parties need to renegotiate after the separation in order to be able to realize surplus from the transaction.
162. It is fairly straightforward, albeit involved, to show that $84 is the optimal price that the seller will offer the buyer. The analysis is involved partly because the initial price determines the litigation stakes and plays an important role in screening the litigants and also in the renegotiation process. Briefly, if the price were (much) higher than $84, both types of seller will always file suit against the buyer (for specific performance) and the buyer's willingness to pay for the assets will be much lower than the price, making the initial agreement unsustainable. If, on the other hand, the price is (much) lower than $84, neither party files suit and, when the buyer always exercises the option, the contract is worthless. Hence, even when the seller has all the ex ante bargaining power, the $84 price is optimal for the seller.
163. To trigger the option, the buyer may be relying on either publicly observable information, such as stock price or reported earnings, or unobservable, subjective information.
164. The assumption that the seller makes the renegotiation demand right before the judgment is not necessary. We can move the renegotiation demand to either after the judgment or, even better, before the entire $15 cost of litigation has been spent. In order to achieve separation, however, the seller must incur some litigation costs before making the renegotiation offer: renegotiation cannot take place before the seller files suit. The reason is that the low-type seller can mimic a prefiling renegotiation offer at no cost, thereby destroying signaling and separation.
165. This equilibrium belief, as we will show, is consistent with the seller's actual behavior. In equilibrium, only the high-type seller files suit, validating the buyer's belief.
166. If the seller were to make a different renegotiation demand, the buyer would know that the seller was not the high-type seller and the buyer would reject the offer. By filing suit and making the same renegotiation demand as the high-type seller, the low-type seller mimics the high-type.
167. The acceptance probability here is fairly low for two reasons. First, because the remedy is specific performance and only the high-type seller files a lawsuit against the buyer, the litigation cost already keeps the bad claims out of court, making the additional efficiency gain smaller. Second, because the renegotiation demand ($90.4) is even higher than the initial price (due to the fact that the buyer is facing the high-type seller in litigation), this provides more incentive to the low-type to mimic the high-type. To discourage the low-type seller from filing the lawsuit, the acceptance probability needs to be low. If, for instance, the parties had used a reverse break-up fee instead, where carrying out the court's judgment does not have any efficiency benefits (since the break-up fee constitutes a transfer), the acceptance probability will be higher.
168. Note that the high-type seller would not have a credible litigation threat if there were no renegotiation: (0.6)($84) + (0.4)($60) - $15 < 0. The fact that there is some renegotiation in equilibrium restores the high-type seller's incentive to sue. This also keeps the initial contract price and the renegotiation price low to reduce the low-type's incentive to file suit.
169. This is not an unrealistic assumption since, conditional on the realized proxy, the buyer's expected valuation of the seller's assets is either very high or very low, leading her to act based only on the realized proxy rather than on the renegotiation offer from the seller, if any.
170. Another advantage of using a (reverse) break-up fee is that when there is no adverse shock, the seller's litigation claim is more likely to be credible. In the investment example, without an adverse shock, the seller's assets were worth $80 to the seller and $100 to the buyer. With a $25 litigation cost, even if the buyer attempts to walk away from the deal (which is not credible), the seller also lacks a credible litigation threat. When the parties stipulate a break-up fee of $60, however, now, with a sixty percent chance of prevailing in court, the seller will have a credible litigation threat against the buyer who attempts to not close the deal.
171. One issue that might arise is whether the stipulated damages might be struck down as a penalty. Although there has not been much challenge against large (reverse) break-up fees in the mergers and acquisitions context, if this were a concern, the parties can attempt to reduce the litigation cost, for example, by relying on arbitration instead.
172. Although we frequently encounter fee-shifting clauses in acquisition agreements, burden of proof and arbitration clauses are (much) less common in deals with public targets. Arbitration provisions are much more common when privately held targets are involved. Given that most of the disputes of large acquisition deals are litigated in the specialized Delaware court system, one suspects whether a commercial arbitration panel would be (much) more competent than the Delaware judiciary.
173. The courts, in most cases, will impose the burden of proof on the buyer, who is attempting to exercise the MAC-based option, to prove that a material adverse change has occurred. The parties can contractually shift this burden to the seller if necessary. See generally Scott & Triantis, supra note 2.
174. If the parties renegotiate after the seller alone has borne litigation costs of $10, then the inefficiency falls from (0.25) × {$30 + (0.95) × (0.4) × ($40)} = $11.3 to (0.25) × {$10 + (0.95) × (0.4) × ($40)} = $6.3. Recall that the inefficiency that results from relying on a proxy does not depend on the litigation cost since that is assumed to be zero: the size of the inefficiency is fixed at $11.88.