Strategic Vagueness in Contract Design: the Case of Corporate Acquisitions

The unprecedented and unanticipated economic and financial shocks of the past couple of years have led parties to look for contractual escapes from deals. Some parties exercise options embedded in their contracts by paying liquidated damages or cancellation fees. Others invoke excuse provisions such as force majeure, material adverse change or market-out clauses, to terminate at no cost. Under either set of circumstances, disputes arise, are litigated and typically settled either by a termination of the deals or adjustments to their terms. The increased attention paid to these provisions has illuminated the vague language with which these options and excuses are framed, and their uncertain interpretation. One instance in which this has been noted is the common use of material adverse event or change (MAE/MAC) conditions in corporate acquisition contracts. As the current crisis works its way through our economic system, attention will be shifted from the collapsed deals to the design of future transactions. The vague language of past agreements has fueled disputes and threatened costly and uncertain litigation. Should future parties, in corporate acquisition deals and other commercial contracts, inject greater precision in their agreements? There are many proponents of this advice. However, we lack a theoretical framework for setting out the costs and benefits of vague and precise provisions. In this paper, we provide such a framework in order to improve awareness of the strategic use of vagueness in contracting. The conventional rules-standards analysis suggests that vague terms are justified when the expected larger litigation costs in enforcing standards are outweighed by the lower costs of drafting. In acquisition agreements, this would suggest that vague MAC clauses yield benefits only by reducing front-end drafting costs. Yet, some proxies for material adverse change, such as quantitative thresholds in stock price, revenues or accounting earnings, are easy to draft and can be verified at low cost. They are usually noisy proxies, however, and therefore are not perfect. * Last revised on April 3, 2009. We thank Henry Hansmann, Roberta Romano, Alan Schwartz, and Eric Talley for very helpful discussions. Earlier versions of this paper were presented in workshops at Virginia and Yale. Triantis thanks the John M. Olin Center for Law, Economics and Business at Harvard for research support. ∗∗ Professor of Law, University of Virginia School of Law. Visiting Professor, Yale Law School. ∗∗∗ Eli Goldston Professor of Law, Harvard Law School. Strategic Vagueness in Contract Design Version: April 3, 2009