Faux Contracts

Posted: 11 Jul 2019

See all articles by Cathy Hwang

Cathy Hwang

Stanford Law School; University of Utah - S.J. Quinney College of Law

Date Written: February 8, 2018

Abstract

In deals, parties sometimes enter into agreements that look like contracts but lack the legal bite of formal contracts. What value can these agreements add that formal contracts cannot? This Article shows how parties use these agreements to mitigate so-called mundane transaction costs and to build a small relational ecosystem for future steps in the same transaction.

Parties use non-binding agreements in a variety of unsurprising contexts, like when binding agreements are too expensive or illegal, or when informal enforcement suffices. Use of non-binding agreements is puzzling, however, when parties are sophisticated—that is, when parties have the financial means and technical sophistication to enter into real, binding legal contracts, but choose to use non-binding ones instead. Early-stage mergers and acquisitions (“M&A”) is one such situation: parties enter into non-binding term sheets, which often look like contracts, but intentionally opt out of formal enforcement. Informal enforcement is also unlikely, because many M&A parties are not repeat players in the market. Yet, despite lack of enforcement, parties abide by the terms of the non-binding term sheet.

This Article makes two contributions to the literature. First, it shows that sometimes, enforcement is not necessary or even preferred: rather, parties prefer to decouple ex ante contracting from ex post enforcement through “faux contracts” like M&A term sheets. In doing so, parties can leverage the benefits of engaging in a contracting exercise, without actually subjecting themselves to enforcement. Because complex business deals are highly collaborative design processes, using a contract-like tool, even (or especially) without enforcement, helps parties organize, clarify, and understand the metes and bounds of their deals and obligations, whether or not they plan to, or can, enforce them. Second, through original interviews, this Article shows how parties use these early agreements and other activities to build a small relational ecosystem in which they feel enough trust to make further investments. Ultimately, parties’ reputation still matters to them—not on the broader M&A market, but within the individual deal. Parties also bundle binding and non-binding provisions in one document to encourage adherence and engage lawyers who, in an effort to preserve their own reputations, change term sheet practice on the margins.

Suggested Citation

Hwang, Cathy, Faux Contracts (February 8, 2018). Virginia Law Review, 2019. Available at SSRN: https://ssrn.com/abstract=3416929

Cathy Hwang (Contact Author)

Stanford Law School ( email )

Crown Quadrangle
559 Nathan Abbott Way
Stanford, CA 94305-8610
United States

University of Utah - S.J. Quinney College of Law ( email )

383 S. University Street
Salt Lake City, UT 84112-0730
United States

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