The Merger Agreement Myth

The following post comes to us from Jeffrey Manns, Associate Professor of Law at The George Washington University Law School, and Robert Anderson IV, Associate Professor of Law at Pepperdine University School of Law.

Practitioners and academics have long assumed that markets value the deal-specific legal terms of merger agreements yet have failed to subject this premise to empirical scrutiny. Mergers are high-stakes events, so it is unsurprising that the conventional wisdom posits that value is at stake in drafting acquisition agreements and negotiating conditions, “fiduciary out” clauses, and deal protection provisions. The question is whether financial markets price the highly negotiated legal terms of acquisition agreements or only value the financial terms forged by management and bankers. The challenge in answering this question is the difficulty in separating the market impact of the merger announcement (and disclosure of financial terms) from the disclosure of the legal terms, since these events occur in close proximity.

We conduct an empirical study that shows that markets do not respond in an economically significant way to the deal-specific legal terms of M&A agreements. We collected a data set of public company cash mergers spanning the decade from 2002 to 2011 and applied a modified event study to test statistically whether the market reacted to the disclosure of merger agreements. We analyze market reactions by exploiting the (small) temporal gap between the announcement of pending mergers (which lays out their financial terms) and the disclosure of acquisition agreements (which delineate the legal terms) typically one to four trading days later. We find that markets react almost exclusively to the initial merger announcement, and there is no economically consequential market reaction to the disclosure of the acquisition agreement. This finding implies that the extensive negotiations over deal-specific legal terms are not priced into financial market valuation.

This article considers a range of potential explanations for the lack of market response to the legal terms of acquisition agreements, such as market expectations about the deal terms and the slowness of markets to understand the implications of merger terms. However, we argue that the most compelling logic for markets’ dismissing the legal terms of merger agreements is found not in the merger agreements themselves, but in the strength of the motivations of corporate participants to complete publicly announced deals. Markets understand that the decision to merge appears driven by the hope (or often the hubris) of the greater potential returns for the combined company following the merger and the target company shareholders’ desire for the takeover premium. As a result, even though M&A lawyers carefully craft “walk-away” rights for the prospective acquirer, markets know the acquirer is highly unlikely to realize or exercise these rights. Markets recognize that both parties are strongly inclined to make whatever adjustments it takes to go through with the transaction in a friendly merger, and therefore dismiss any agreement provisions to the contrary to the point that the legal terms have little to no material impact on the target company’s price.

The conclusion that the legal terms of merger agreements do not move financial markets has the potential to result in a sea change in the assumptions about the workings of M&A law. We argue that the unwillingness to walk away from a negotiated transaction ex post, which is manifested by the market’s non-response to walk-away rights, causes acquirers to over-invest in due diligence ex ante. This fact, in turn, results in a suboptimal number of deals being signed, as well as lower returns for the target and acquirer alike.

We suggest that lawyers should take into account the market’s assessment of merger motivations to take innovation in legal drafting in a new direction. If M&A lawyers embrace the markets’ view that their clients’ priority is successfully closing the merger and not calling it off, they should focus less on closing conditions, break-up fees, and MAC/MAE provisions that empower clients to call off deals. Instead, lawyers should innovate by designing “contingent compensation” provisions that compensate clients for closing deals that are less advantageous than expected. Tailoring the deal to make part of target company shareholders’ compensation contingent, such as through event-based contingent value rights, would mitigate the potential for over- or under-estimation of uncertainties after closing.

This approach would offer a more nuanced alternative to the blunt instrument of closing conditions by giving incentives for parties to adjust compensation, rather than to play an all or nothing game over whether events constitute “material adverse changes.” Unlike the “contingent closing” paradigm that dominates public company acquisition agreements, a “contingent consideration” paradigm would make the accuracy of representations and warranties matter after the closing. This, in turn, would allow targets to make credible representations about quality, reducing the need for costly and wasteful investigations of the target in due diligence.

We argue that this focus on contingent consideration, rather than contingent closings, could enable clients to sign more deals, reduce both the stakes of the pre-closing period and the need for due diligence, and produce higher returns for targets and acquirers alike by better aligning the incentives of the parties. Accounting and tax complexities and deal-structuring issues have held back the use of contingent compensation in public company deals, but deal lawyers should seek to be creative in overcoming these regulatory barriers if they want to live up to their role as “transaction-cost engineers” in public company M&A transactions.

The full article is available for download here.

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