Berkeley Program in Law and Economics

Abstract The standard contract that governs friendly mergers contains a material adverse change clause (a “MAC”) and a material adverse effect clause (a “MAE”); these clauses permit a buyer costlessly to cancel the deal if such a change or effect occurs. In recent years, the application of the traditional standard-like MAC and MAE term has been restricted by a detailed set of exceptions that curtails the buyer’s ability to exit. The term today engenders substantial litigation and occupies center stage in the negotiation of merger agreements. This paper asks what functions the MAC and MAE term serve, what function the exceptions serve and why the exceptions have arisen only recently. It answers that the term encourages the target to make otherwise noncontractable synergy investments that would reduce the likelihood of low value realizations, because the term permits the buyer to exit in the event the proposed corporate combination comes to have a low value. The exceptions to the MAC and MAE term impose exogenous risk on the buyer; the parties cannot affect this risk and the buyer is a relatively superior risk bearer. The exceptions have arisen recently because the changing nature of modern deals make the materialization of exogenous risk a more serious danger than it had been. The modern MAC and MAE term thus responds to the threat of moral hazard by both parties in the sometimes lengthy interim between executing a merger agreement and closing it. The paper’s empirical part examines actual merger contracts and reports results that are consistent with the analysis.