Is There a First-Drafter Advantage in M&A?

Adam Badawi is a Professor at UC Berkeley School of Law and Elisabeth de Fontenay is an Associate Professor at Duke University School of Law. This post is based on their recent article, forthcoming in the California Law Review. Related research from the Program on Corporate Governance includes M&A Contracts: Purposes, Types, Regulation, and Patterns of Practice and Allocating Risk Through Contract: Evidence from M&A and Policy Implications (discussed on the Forum here), both by John C. Coates, IV.

Does the party that provides the first draft of a merger agreement get better terms as a result? There is considerable lore among transactional lawyers on this question, yet it has never been examined empirically. In a recent article, Is There a First-Drafter Advantage in M&A?, we develop a novel dataset of drafting practices in large M&A transactions involving U.S. public-company targets. We find that there is little or no advantage to providing the first draft with respect to the most monetizable merger agreement terms, such as merger breakup fees. Notwithstanding, we do find an association between drafting first and a more favorable outcome for terms that are harder to monetize, more complex, and that tend to be negotiated exclusively by counsel, such as the material adverse change (MAC) clause. These findings are consistent with the view that the negotiation process generates frictions and agency costs, which can affect the final deal terms and result in a limited first-drafter advantage.

For major corporate transactions such as mergers and acquisitions, lawyers themselves view the task of preparing the first draft of the transaction agreement as a critical component of the value that they provide, and they devote considerable time and effort to it. Indeed, it is an article of faith among lawyers that the first draft can influence the final deal: an advantage in the first stage leads to an advantage for one’s client in the end. But is this deeply held belief correct?

Many contract theorists would find it implausible. For several decades now, a dominant view in the field of law and economics has been that parties to any voluntary arrangement choose final terms—other than the “price” term—that maximize their collective interests. Further, the parties will arrive at these “efficient” terms regardless of their relative bargaining power or the specifics of the negotiation process. One implication is that which party provides the first draft and even what that first draft contains should be entirely irrelevant to the final contractual outcome. In this view, the first draft of a transaction agreement is simply a default starting point for the parties’ negotiations: if the terms included in the first draft happen to be the efficient ones, they will be retained; otherwise, they will be modified, because both parties have an interest in arriving at the efficient terms.

Although claims about a first-drafter advantage on corporate transaction terms are ubiquitous among practitioners, they have not been explored empirically to date. In fact, although M&A transactions figure prominently in both the finance and corporate law literatures, to our knowledge no data exists even on the question of which party (the acquirer or seller) is chosen to provide the first draft of the merger agreement and under what circumstances. The conventional wisdom is that drafting responsibility is overwhelmingly awarded to the acquirer. Using a sample of 867 merger agreements involving U.S. public-company targets signed between 2007 and 2016, we show that this view is simply incorrect. For each deal, we examine the proxy statement to determine which party provided the first draft of the agreement and how competitive the sale process was. Contrary to the conventional wisdom, we find that initial drafting responsibility for our sample was split almost perfectly evenly between acquirer’s counsel and seller’s counsel. Further, we find that the strongest predictor of which party drafts first is whether the target company is sold in an auction process. If so, the seller is overwhelmingly likely to draft; if not, then drafting responsibility tends to rest with the acquirer.

We then turn to the task of identifying whether drafting first is associated with more favorable deal terms for that party. We find that this is indeed the case for some terms in the merger agreement, but not for the most monetizable ones. Specifically, we examine the association between the party that provided the first draft of the merger agreement and four material provisions in public-company deals: the termination fee, the reverse termination fee, the “go-shop” period, and the “material adverse change” (or “MAC”) clause. Separately for auction deals and non-auction deals, we construct matched samples of buyer- and seller-drafted merger transactions based on propensity scores. We then analyze the association between each of the four deal provisions that we selected and various deal characteristics, including which party provided the first draft. We find that, on average, the go-shop and MAC clause in the final (executed) merger agreement are relatively more favorable to acquirers when the acquirer provides the first draft, and relatively more favorable to sellers when the seller provides the first draft. We find little or no evidence of such an association for the termination fee and reverse termination fee.

We then examine various hypotheses that would explain this limited first-drafter advantage, including bargaining power, anchoring, lawyer experience or agency costs, and the negotiation process. We conclude that the most likely explanation has to do with the transaction costs associated with the M&A negotiation process and lawyer agency costs. The termination fee and reverse termination fee are highly salient, specified numerically, and easily translated into (expected) dollar amounts, making them obvious points of negotiation for the parties themselves. By contrast, the MAC clause is a complex, non-numerical term that tends to be negotiated exclusively by counsel. The go-shop period falls in between: although specified numerically (in days), it is not readily converted into dollars and cents by the parties, and is far less salient to the parties than the termination fee and reverse termination fee. Thus, the fact that we find evidence of a first-drafter advantage for the go-shop and MAC, but not for the termination fee and reverse termination fee, is consistent with the negotiation process itself affecting final terms. A party’s impatience to get the deal done may cause it to concede to the drafting party on terms that require lawyer time and expertise to negotiate and are difficult to value, but not on the most fundamental economic terms.

Our results cast doubt on both the classical prediction that parties always agree to efficient terms and the view that drafting first provides a clear advantage. The answer lies somewhere in between. We provide evidence that there is a first-mover advantage even in major transactions among highly sophisticated, informed parties, but that this advantage dissipates for terms that are easy to monetize.

The full article is available for download here.

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