Allocating Risk Through Contract: Evidence from M&A and Policy Implications

John Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School.

Risk allocation provisions (RAPs) are an important part of M&A contracts. In a new research paper, Allocating Risk Through Contract: Evidence from M&A and Policy Implications, I analyze those provisions in the contracts for a representative sample of deals for US targets, and find both wide variation but also clear patterns in when they are used and how they are designed. The patterns I observe reflect multiple economic theories: they show that RAPs are used and designed in light of the information different parties to a deal are likely to have, their incentives during and after the deal, and also transaction costs, especially the costs of enforcing contracts. Despite these patterns, the contracts also show enormous variation in how risk is allocated — and some of this residual variation correlates with the experience of deal lawyers — suggesting that some choices are better than others. Practitioners can benefit from better understanding economic theories, and academics can benefit from better understanding how varied and complex real-world contracts are.

Among the basic patterns I find are the following:

  • Indemnities are the most common means to share risk, and are most frequently used if the current liabilities fluctuate over time in the target’s industry and/or if the bidder and target are in different industries.
  • However, targets rarely retain all risk, even with respect to the pre-deal period — most contracts cap indemnification below bid value; most indemnities die a year after the deal closes; and almost all include baskets or deductibles and thresholds that eliminate small claims.
  • Earn-outs — which are the most studied type of RAP among academics — are the least common method of sharing risk, and are concentrated in high-tech industry deals.
  • RAPs are much less common (but do occur) in deals for SEC-registered targets, and also become less common as the number of target owners increases, even past the point that the owners are unlikely to have meaningful information about the target.
  • Escrows, which make it easier for bidders to enforce RAPs while addressing the risk that a bidder may be tempted to overreach, are common, while pure holdbacks (which do not address the latter risk) are less common.

These patterns are all consistent with economic theory, which suggests that risk are best borne by the party with more information and by the party with control over whether the risk is realized, but also that transaction costs – particularly enforcement costs, which grow as the number of target-owners increases — are a crucial factor limiting the net benefit of allocating risk through contract.

After accounting for these factors, however, RAPs still exhibit wide variation, and some of that variation correlates with the experience of the law firms involved in the deals. RAPs are generally less common, less extensive, less complex, and vary less, when more experienced lawyers are involved, and when lawyers on one side are matched with similarly experienced lawyers on the other side of the deal. Specifically, survival periods are shorter, caps are lower, baskets/deductibles are larger, and price adjustments rely on fewer metrics. These findings suggest that experienced lawyers recognize that while RAPs can be valuable, they also have significant costs (disputes, enforcement, inefficient risk-bearing through mistaken design). In other words, less can be more: given enforcement costs, M&A participants can achieve much benefit with simple, modest RAPs, while complex and extensive RAPs generate more costs than they are worth.

The paper ends with several normative recommendations that flow from the data. First, legislators might consider limiting statutes of limitation for M&A contracts — the default of three to six years common in most states is much longer than what the parties to such contracts typically impose as a deadline for bringing claims. Second, consistent with the dominant choices of deal participants, legislators might also wish to impose amounts-in-controversy requirements for M&A-related disputes, to limit claims to those that individually and in the aggregate are meaningful, to reduce the risk of opportunistic and costly lawsuits. Third, lawyers might wish (either voluntarily or through self-regulation) to begin making formal disclosures of two kinds of information to their clients: how much deal experience they have (broken down into deals involving SEC-registered and non-SEC-registered targets), and what the typical or average outcomes of RAPs have been for past clients (e.g., how often claims have been made or earn-outs paid, how the claims and/or payments compare to the deal size, whether disputes have arisen, and if disputes did arise, what the outcomes of the disputes were). Such disclosures would inform client choices and improve the deal-making process.

The full paper is available for download here.

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  1. JStapleton
    Posted Thursday, September 20, 2012 at 10:49 am | Permalink

    This is an article in search of a real purpose. The data is, no surprise, “noisy”, yet this professor steams ahead to the conclusion that simplified deal protection measures are an indicia of top firms, as opposed to the use of needlessly complex measures which are used by rube firms because of their insecurities. All of this is of course supported by fancy multivariate regression analysis of deal documents.
    This Wachtell shill was previously responsible for an article in which he attributed the absence of shark repellants in West Coast issuer organic IPO documents not to the prevailing venture capital culture, but rather to the alleged lack of sophistication of West Coast law firms. Hmmm, a little inconsistent, no?
    But let’s not stop there. This professor’s colleague, Guhan Subramaniam, published a paper suggesting that Siliconix tender structures resulted in cheaper bids and they were predominantly used by clients represented by elite law firms; lesser firms weren’t aware of the structure. Again, this is allegedly supported by the mumbo jumbo regression analysis.
    If HLS’s corporate law professors are dealing with this kind of nonsense–attempting to scientifically validate use of Wall Street law firms by analyzing deal structures and documents–I’d suggest the law school get some better funding sources to promote scholarship which at least attempts to be serious.

  2. John Coates
    Posted Monday, October 29, 2012 at 10:06 am | Permalink

    I will let readers decide for themselves if the article lacks purpose; if “deal protection” is what I study here; if articles focusing on private target deals or IPOs [available here: – note the finding that Silicon Valley firms started advising clients to add takeover defenses during the 1990s, despite the power of VC culture); if multivariate regression – a staple of undergraduate education for at least 30 years – is “fancy” “mumbo jumbo”; if detailed analysis of a representative sample of M&A contracts is “serious”; and if contract terms agreed to by experienced lawyers (including many based outside NY) are likely to reflect their experience, and worth understanding. But let me correct the record on one point: my colleague’s surname is Subramanian, not Subramaniam.

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