Are Merger Clauses Value Relevant to Target and Bidder Shareholders?

John C. Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School; Darius Palia is Professor of Finance at Rutgers University; and Ge Wu is a Ph.D. candidate in finance at Rutgers Business School. This post is based on their recent paper.

Related research from the Program on Corporate Governance includes Why Have M&A Contracts Grown? Evidence from Twenty Years of Deals, by John C. Coates, IV; M&A Contracts: Purposes, Types, Regulation, and Patterns of Practice, by John C. Coates, IV; and The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

A large financial economics literature has found that shareholders earn significant abnormal returns over the market on announcement of a merger and acquisition transaction. These studies have found that target shareholders earn positive abnormal returns of between 20 percent and 35 percent, whereas bidder shareholders earn zero to small negative abnormal returns. However, every merger and acquisition deal is governed by a set of contracts terms that are described in detail in the merger agreement filed with the SEC. These contract terms often called “merger clauses” are negotiated between the bidder and target in order to communicate deal terms, specify risk sharing between the parties, and describes dispute management provisions in case of litigation.

We examine the impact of merger clauses on the abnormal returns earned by target and bidder firms, respectively. There are two opposing a priori views on the expected relationship between merger clauses and the abnormal returns earned by target and bidder firms. One the one hand, merger clauses might not have any significant effect on the abnormal returns as they are “boilerplate” agreements charged by overpaid lawyers (see Manns and Anderson (2012), and Anderson and Manns (2016)). On the other hand, merger clauses might have a significant effect because they are drafted by expert lawyers that modify to fit each individual deal. Such contract language modifications evolve either in reaction to new case law or statutes or financial risks, or by learning from the ‘best practices’ of other deal lawyers (see Cain, Macias, and Davidoff Solomon (2014), and Coates (2016)).

We find the following results. First, we find that bidder protective merger clauses increase the bidder’s abnormal returns. Second, we find that target protective clauses increases the target’s abnormal returns. Third, we find that pro-competition merger clauses result in higher abnormal returns for targets, but have no significant effect for bidders. These results show that merger clauses have a significant impact on the abnormal returns of bidder and target firms which is consistent with the expert drafting view of Cain, Macias, and Davidoff Solomon (2014) and Coates (2016), and against the boilerplate view of Manns and Anderson (2012), and Anderson and Manns (2016). Fourth, we find that buyer protective clauses decrease the probability of deal completion, whereas the target protective and pro-competition clauses have an insignificant impact on the probability of deal completion. Fifth, we examine if the impact is different for “good” versus “bad” deals. We use an ex-ante definition of “good” and “bad” deals, wherein we define a “good” deal when the transaction involves the use of cash only as the medium of exchange, and all other transactions as “bad” deals. We find that the bidder and target protective indices to be more positively related to abnormal returns for “bad’ deals than for “good” deals. Additionally, we find that the effect of pro-competition indices on target abnormal returns is on average larger for “good’ deals than for “bad” deals but the difference is not statistically significant.

The complete article is available here.

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