The Value of M&A Drafting

Adam Badawi is a Professor of Law at UC Berkeley, Elisabeth de Fontenay is a Professor of Law at Duke University, and Julian Nyarko is an Associate Professor of Law at Stanford University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Are M&A Contract Clauses Value Relevant to Bidder and Target Shareholders? (discussed on the Forum here) by John C. Coates, Darius Palia and Ge Wu; Allocating Risk Through Contract: Evidence from M&A and Policy Implications (discussed on the Forum here) by John C. Coates; and The New Look of Deal Protection (discussed on the Forum here) by Fernan Restrepo and Guhan Subramanian.

What terms matter in merger agreements? M&A lawyers share a strong sense that merger agreement terms matter for deal outcomes and for the parties’ payoffs. In theory, the specific deal terms reached by the parties affect the likelihood of closing and the various deal risks borne by each party, which should in turn translate to real dollars. Scholars have made little progress mapping specific deal terms to expected payoffs, however. Empirical challenges abound, such as the difficulty of isolating the impact on deal outcomes of deal terms versus deal characteristics. Similarly, scholars have not been able to resolve the debate over whether lawyers tend to draft merger agreements optimally, or whether they tailor deal terms either too much or too little.

In The Value of M&A Drafting, we approach these questions indirectly, by asking what terms M&A lawyers themselves deem most important during the drafting process.  Specifically, we use textual analysis tools to measure how much lawyers choose to tailor different deal terms, when they are under severe time pressure versus when they are not.  We do this by comparing the degree of tailoring in “leaked” deals—those where information about the deal negotiations became public prior to signing—to the degree of tailoring in all other deals. Leaks typically motivate parties to sign the merger agreement as quickly as possible, which puts the lawyers drafting the merger agreement under significant time pressure.  Using a sample of 2,141 public-company M&A agreements signed between 2000 and 2020, we find evidence that time pressure leads lawyers to prioritize negotiating and tailoring certain terms over others, which suggests which deal terms the lawyers believe are most important.

First, we estimate which M&A agreements in our sample were derived from a common template and group them accordingly. Rather than drafting from scratch, lawyers draft M&A agreements starting from a template (typically, an agreement for a prior deal), so their effort is limited to choosing which terms to edit and tailor (and how much). Second, for each deal term of interest, we measure the average textual similarity among the leaked deals in the cluster compared to the deals that were not leaked.  We find strong evidence that agreements for leaked deals are edited less than those for other deals based on the same template, suggesting that time constraints can and do alter the final contract signed by M&A parties. We also show that lawyers prioritize certain clauses over others when under time pressure, and identify which clauses are prioritized. Overall, the findings help to validate some theoretical models of contract drafting and suggest which terms in M&A agreements the drafters themselves view as the most important.

The article addresses two significant challenges to empirical research into the value of M&A drafting. The first is developing a method to analyze the text of M&A agreements in a way that accounts for the ways deal lawyers draft their agreements. Much of the existing text analysis research in law and finance relies on simple word counts in disclosures and contracts (see, e.g., Cohen et al. 2020; Hoberg and Phillips 2016; Paulus et al. 2021). While this approach is popular for identifying clusters of documents that have the same content, its neglect of word order makes the approach ill-suited to understanding the text borrowing that lies at the heart of the template-driven drafting practices in M&A. In this paper, we shift the focus from content similarity to textual similarity. In doing so, we develop a method that identifies collections of merger agreements that stem from the same template and quantifies the amount of edits that were made in order to alter the template into its final form.

The second challenge stems from the endogeneity and selection effects in many of the decisions that deal makers and deal lawyers make over the course of a transaction. Differences across documents may be due to features of deals that researchers cannot observe and thus cannot control for. To overcome these limitations, we identify deals that are (likely) subject to a leak or other public release of information about the deal shortly before its signing and official public announcement. We treat this as a plausibly exogenous shock to the amount of time lawyers have to draft M&A agreements. We hypothesize that, when a deal leaks, time pressure will cause the drafting lawyers to lean more heavily on templates rather than tailoring text to the deal at hand. We use abnormal returns in the ten-day period prior to deal announcement to identify deals where leaks were likely to create time pressure, yielding a balanced sample of leaked and non-leaked deals. We then group deals according to the common merger agreement template from which they are derived. Within each common-template group we conduct a clause-level comparison of leaked deals to non-leaked deals. To do so we devise a novel approach that allows for statistical inference that overcomes several known problems with comparisons using computational text analysis.

Overall, we find that the text in leaked deals is systematically closer to the text of the agreement template than the text of non-leaked deals—that is, there is less tailoring of the merger agreement when lawyers face unexpected time pressure to finalize the draft. But our finding that lawyers edit leaked deal agreements less than non-leaked deal agreements does not hold for all deal clauses. We show that, for some provisions, lawyers engage in a similar amount of tailoring in both leaked and non-leaked deals. We infer that these clauses are among the most important in a deal because, even when pressed for time, lawyers still ensure that these provisions are negotiated to roughly the same degree that they would be without time constraints. The clauses that fall into this category are broadly consistent with practitioners’ intuitions about which deal terms are most important. They include, among others, the material adverse effect (MAE) clause, which allocates the risk of changes in business conditions between signing and closing, and the ordinary course of business covenant, which governs the operation of the business until the merger is ultimately completed. In contrast, more mundane clauses such as the choice of law and the requirement to comply with covenants are only tailored when there is ample time, but are left relatively untouched under pressure.

Beyond identifying which deal terms M&A lawyers themselves view as most important, these findings suggest that deal lawyers are in fact selective in their approach to tailoring M&A agreements: when pressed for time, they focus their efforts on specific terms deemed to affect the parties’ bargain the most.

The full paper is available for download here.

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