Termination Fees and Efficient Merger Contracts

We present a model in which mutual gains from trade motivate the use of termination provisions in merger contracts. The inclusion of a termination provision in the contract permits Pareto efficient merger contracts and results in strictly higher payoffs for both bidder and target compared to contracts without termination fees. The fees are revealed not to be primarily a form of bidder insurance, although they do increase the probability that a merger is consummated. The model provides a rich collection of predictions, all of which are consistent with the empirical regularities reported to date