Tuesday, November 20, 2012
Article Spotlight: The Merger Agreement Myth
So I wouldn't describe myself as a corporate law enthusiast, but I wanted to highlight a recent and provocative article authored by my Pepperdine colleague Robert Anderson and his co-author Jeffrey Manns, titled The Merger Agreement Myth, 98 Cornell L. Rev. (forthcoming 2013). The article has gotten quite a lot attention and has been written up by Reuters, the ABA Journal, and Dealbreaker (full disclosure: some of the write-ups push the envelope on the somewhat more modest - and thoughtful - claims in the article). In any event, here's the abstract for the piece. Enjoy!
Practitioners and academics have long assumed that financial markets value the deal-specific legal terms of public company acquisition agreements, yet legal scholarship has failed to subject this premise to empirical scrutiny. The conventional wisdom is that markets must value the tremendous amount of time and money invested in negotiating and tailoring the legal provisions of acquisition agreements to address the distinctive risks facing each merger. But the empirical question remains of whether markets actually price the legal terms of acquisition agreements or whether they solely value the financial terms of mergers. To investigate this question, we designed a modified event study to test whether markets respond to the details of the legal terms of acquisition agreements. Our approach leverages the fact that merger announcements (which lay out the financial terms) are generally disclosed one to four trading days before the disclosure of acquisition agreements (which delineate the legal terms). We focused on a data set of cash-only public company mergers spanning the decade from 2002 to 2011 to ensure that the primary influence on target company stock prices is the expected value of whether a legal condition will prevent the deal from closing. Our analysis shows that there is no economically consequential market reaction to the disclosure of the details of the acquisition agreement. Markets appear to recognize that parties publicly committed to a merger have strong incentives to complete the deal regardless of what legal contingencies are triggered. We argue that the results suggest that dealmakers and lawyers focus too much on negotiating “contingent closings” that allow clients to call off a deal, rather than on “contingent consideration” that compensates clients for closing deals that are less advantageous than expected. Our analysis suggests drafting recommendations that could enable counsel to protect clients against the effects of the clients’ own managerial hubris in pursuing mergers that may (and often do) fall short of expectations.
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Interesting, since agreement terms do seem to have a significant impact on the regulatory approval process. The mere existence of language allocating antitrust risk, for instance, makes a deal significantly more likely to be investigated by the FTC or DOJ Antitrust Division and for divestitures to result before approval is obtained (see the research by John Harkrider on this subject, such as http://www.avhlaw.com/media/article/58_Risk-Shifting%20Provisions.pdf). That said, I am not at all surprised that the markets do not take these deal terms into account in pricing the companies, since they tend to price for antitrust risk very generally.
Posted by: Charles Paul Hoffman | Nov 20, 2012 9:33:01 PM
Interesting indeed. But I wonder a bit about their empirical strategy. It relies on the assumption that the merger agreement contains material information not set forth in the press release. In my experience, in addition to disclosing the materials financial terms of the transaction, the press release also discloses the material legal terms, including any deal-specific or non-standard closing conditions, break-up fees, and the like.
Posted by: Joshua Teitelbaum | Nov 22, 2012 10:22:06 AM
Having contingent consideration in a public company deal is an interesting idea, and a nice way to conclude the article, but there would be significant transaction costs.
First, earn-out provisions are complicated even when there's a single seller or limited number of sellers on the other side. Depending on how granular you want to get, the earn-out provision needs to specify accounting elections, etc.
Second, it's unlikely a public company acquirer wants to be bound to keeping the acquired company in a form that permits segregation of the target's assets, revenues, etc.
Third, the usual coin between negotiated in the deal is who gets the benefit of the synergies (i.e. assuming there's a surplus in the transaction, who gets it, the buyer or the seller?). The earn-out is a very complicated way of slicing that pie.
Fourth, who or what acts as the monitor for the selling shareholders? One would have to appoint a trustee akin to what you have in a bond deal to act for the selling shareholders.
Finally, most deal lawyers know that simpler and quicker is better at least in terms of getting the deal to the finish line. And I'm pretty sure we'd never be able to study the benefits of contingent consideration on public company deals that didn't get done because of the wrenches thrown in by the complications of negotiating one of these exceedingly complex provisions. Since the contingent compensation provision benefits the buyer, and since delay generally benefits nobody (neither the buyer nor the seller wants the disruption, employee morale issues, customer uncertainty, etc.), I don't see buyers opting for this. Indeed, one would think if the market were calling for this, and there were no better method of policing acquisition overpayment, we'd have seen it already.
Posted by: Jeff Lipshaw | Nov 23, 2012 10:30:30 AM
We are very grateful for the comments on our article. I have included a few of my own responses below, with apologies for not giving these comments the detailed treatment they deserve.
In response to Charles Paul Hoffman's comments, if the language itself does have a causal effect on the probability of investigation by antitrust authorities, then the lack of market response would indeed be surprising. Without having read the article you reference, my guess is that the market is able to relatively accurately assess the antitrust risk without looking at contractual language, even if that language correlates with the ultimate level of antitrust scrutiny.
In response to Joshua Teitelbaum's comment, we agree that to the extent the legal terms are contained in the press release, we will not be able to determine the market reaction to them. In our survey of the press releases, however, we have found that they are usually quite cursory, containing little legal information. We rarely saw press releases that included much information about closing conditions or other legal details Indeed, the break-up fee is often not even disclosed, and many cases, the boilerplate legends at the end constituted the bulk of the press release. So although we agree that we cannot ascertain the value of what is already disclosed in the press release (or otherwise anticipated by the market), we think that the majority of the agreement's text does not fall in this category.
In response to Jeff Lipshaw's comments, I agree that for a variety of reasons there might be reluctance to adopt contingent consideration arrangements as a matter of course. If there were already widespread adoption of these provisions then our evidence would perhaps be more solid, but also less relevant as a normative recommendation. In response to point one, I agree that the contingent consideration provisions could be more complex to negotiate and draft, but there are relatively simple versions to address many of the problems of unknowns. In response to point two, I also agree that some forms of congingent consideration (such as a percentage of profits of the acquired company) could restrict the acquirer's ability to integrate the businesses. However, other forms, such as a payment on issuance of a patent or contingent on sales from a particular product, pose fewer obstacles to integration of the companies, and are in fact more common. In response to the third point, we believe that the extra surplus will be shared by both parties, although one might expect the target would get the majority as it tends to do in the existing structure anyway. In response to the fourth point, I believe that a common structure is to have a bank or trustee serve as an agent for the public shareholders. In response to the fifth point, I certainly agree that speed in closing the transaction is among the foremost priorities in public company mergers. Some of that is for the good reasons you state. However, I would argue that some of that is also is a symptom of the "will to close" that we have identified in the article. I would also argue that our approach could actually make closing quicker as less due diligence would be required. I agree that these are all debatable points, however, and your comments are definitly fair and well-taken.
Posted by: Robert Anderson | Nov 23, 2012 8:24:55 PM
Interesting piece. One thing that would make your results even more surprising would be if you could show that the legal language actually affects the outcome of the merger. For example, maybe certain language increases success probability (I think the SDC database includes mergers that do not go through - run a logit of completion against whatever legal language flags you have). If it does, and it is still not priced when released, you could narrow down the causes of your results to either (1) leakage before your event window, (2) irrationality, or (3) smoe weird endogenity affecting legal language, deal pricing and completion rates (this seems unlikely to me, but you can't rule it out).
Posted by: Finance Academic | Nov 25, 2012 9:24:54 PM
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