Wanna Keep This Economic Mess to a Minimum? Honor Contracts.

Thom Lambert —  9 February 2009

New York Times business columnist Joe Nocera insists that current economic conditions call for courts to ignore carefully negotiated contracts between sophisticated business entities. Arguing that Dow Chemical Company should be free to walk away from its agreement to buy specialty chemical manufacturer Rohm & Haas, Mr. Nocera contends that “maybe, just maybe, deals that stop making sense ought to be called off, especially in the middle of a once-in-a-lifetime financial crisis.” He says he can’t understand why so many people don’t agree with him on that point. Perhaps I can explain their position.

First, though, some background. Last summer, Dow won a hard fought bidding war for Rohm & Haas. Beating out rival BASF, Dow agreed to buy Rohm & Haas for $78 per share — a 74% premium. To persuade Rohm & Haas to accept its offer over BASF’s, Dow agreed to a number of pro-seller terms: the deal was not contingent on Dow’s obtaining financing; there was no provision permitting Dow to back out if the deal threatened Dow’s investment-grade credit rating; the deal was not dependent on either company’s stock price; and, most importantly, the deal would be subject to specific performance by Rohm & Haas if Dow tried to back out. (For non-lawyers out there, specific performance is a court order that the breaching party actually perform its contractual obligation; paying money damages for non-performance will not suffice.)

Dow had planned to finance the Rohm & Haas deal with $9 billion in proceeds from another transaction it was to enter with the Kuwaiti government. When the Kuwaitis found themselves financially strapped because of falling oil prices, they first renegotiated the deal with Dow and ultimately backed out altogether. That meant that Dow could complete the Rohm & Haas aquisition only by taking a short-term bridge loan that would lower Dow’s credit rating to junk bond status.

Dow is now trying to get out of its deal with Rohm & Haas, which is insisting that Dow proceed with the deal. Mr. Nocera argues that the court should side with Dow. Citing the difficulties the deal will create for the combined entity, he writes:

[S]houldn’t somebody be worrying about those problems? Dow Chemical employs around 45,000 people; Rohm & Haas employs more than 15,000. The American chemical industry — which was suffering even before the financial crisis because of the rise of commodity chemical companies in China and elsewhere — is going to be in a bad place for the foreseeable future. At a time when every job matters, and when the economy is holding on for dear life, does it really make sense that “shareholder value” should be the only value that counts? Many of the current shareholders are merger arbitrageurs, who dive into pending deals and bet on their outcome.

In other words, given that this deal may cause job losses and would benefit only unsympathetic stock gamblers who create little real value for society, wouldn’t society as a whole be better off if the court were to allow Dow to walk away from this deal?

No, it wouldn’t. Putting aside the fact that arbitrageurs play a vital information-producing role in our economy and should be rewarded for their efforts, giving Dow a mulligan on this deal would have systematic, wealth-destructive effects.

Contracts (i.e., voluntary exchanges) create wealth, for each party perceives itself to be better off because of the exchange. Thus, a key to economic growth — that thing we so desperately need right now — is contracting behavior. As people exchange goods and services, thereby moving them from lower to higher valued uses, our economy will grow out of the mess it’s in. To facilitate contracting, the rules of the game have to be clear. Parties must be able to predict when they execute a deal how things will ultimately play out. If they can’t be assured of outcomes, they’ll be less inclined to enter into contracts in the first place, and wealth will be squandered. A legal precedent permitting a sophisticated business entity to walk away from a clear deal when a well-known risk materializes would create a tremendous amount of uncertainty, thereby discouraging wealth-creating trades.

Mr. Nocera undoubtedly understands the importance of legal certainty. But mustn’t there be some exceptions? “Sometimes,” he writes, “the climate really does demand that the rules of the game be changed, at least temporarily.”

In fact, contract law does incorporate some flexibility for changed circumstances. Several contract doctrines — most notably the “impracticability” and “frustration of purpose” defenses — permit parties to get out of improvident deals when risks materialize. The problem for Dow is that the law permits parties to create greater predictability by effectively contracting around these doctrines. Thus, if the contract allocates a risk to one of the parties, that party can’t avail itself of one of these defenses if the risk materializes. That is essentially what happened here.

Presumably in order to minimize the price it would have to pay, Dow agreed to several terms that would insure Rohm & Haas against the risk that the deal wouldn’t materialize. Dow agreed to forego a number of standard contractual outs, such as a financing contingency, and it went so far as to guarantee that a court could force it to proceed with the deal, rather than just order it to pay monetary damages, if it tried to back out. Dow’s a big boy, and it knew precisely what it was doing: it was giving Rohm & Haas an insurance policy in exchange for a lower share price.

If a court were now to hold that Dow could walk away from this deal, the court would effectively destroy the ability of contracting parties to trade assurance (“Don’t worry, this deal will happen!”) for money (a lower price). By thus cutting back on the freedom of contract, the court would reduce the possibility of creating value through trade. Many deals, those in which assurance of performance is very important to one of the parties, would be squelched altogether.

This is assuredly not the way to bring our economy out of its current straits. We need to encourage wealth-creating trades by strengthening, not weakening, the institution of contract.

Thom Lambert

Posts

I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

3 responses to Wanna Keep This Economic Mess to a Minimum? Honor Contracts.

  1. 

    Is any of this even in question in light of the Delaware Chancery’s recent opinion in Hexion v. Huntsman? Vice Chancellor Lamb could copy and paste from that opinion….. Otherwise I completely agree. Forget relative bargaining power here, these are two sophisticated chem companies who can (and did) afford the best i-bankers and lawyers around. Freedom to contract also means freedom from contracting. Don’t include all the pro-seller provisions if you aren’t willing to assume the risk allocation and follow through, because courts should and will make you follow through or pay through the nose.

  2. 

    I agree with your minor premise, but might be less unequivocal about your major premise. In this particular instance, Dow is a sophisticated company that presumably could’ve properly weighed the risks, and should bear the consequences of its agreement.

    But for people saddled with onerous payday loans, or who have been manipulated by unscrupulous mortgage brokers, I think the courts would do well to cast a skeptical eye towards the agreements.

    Relative bargaining power matters.

  3. 

    Do you really believe arbitrageurs provide much information in these days? They seem to be speculators to me, betting one way on a deal and carefully crafting hedge strategies in case it goes the other. That’s just clever scenario-playing, not creation of much useful information. They can certainly hedge so that they have no real economic stake in the deal, through borrowed shares and empty voting.

    And I think it’s better to say wealth remains frozen in hard assets when a contract goes south, not necessarily that the wealth is squandered. Dow could conceivably go on to bright prospects even without the R&H deal. Shareholders would be stuck holding the stock for a longer period to reap those benefits, but at least theoretically those benefits may be out there. Semantics, I know, but language often wins the argument.