An Empirical Critique of the Myth that Markets Value Merger Agreements

Abstract

Practitioners and academics have long assumed that financial markets value the deal-specific legal terms of public company acquisition agreements, yet legal scholarship has failed to subject this premise to empirical scrutiny. The conventional wisdom is that markets must value the tremendous amount of time and money invested in negotiating and tailoring the legal provisions of acquisition agreements to address the distinctive risks facing each merger. But the empirical question remains of whether markets actually price the legal terms of acquisition agreements or whether they solely value the financial terms of mergers. To investigate this question, we designed a modified event study to test whether markets respond to the details of the legal terms of acquisition agreements. Our approach leverages the fact that merger announcements (which lay out the financial terms) are generally disclosed one to four trading days before the disclosure of acquisition agreements (which delineate the legal terms). We focused on a data set of cash-only public company mergers spanning the decade from 2002 to 2011 to ensure that the primary influence on target company stock prices is the expected value of whether a legal condition will prevent the deal from closing. Our analysis shows that there is no economically consequential market reaction to the disclosure of the details of the acquisition agreement. Markets appear to recognize that parties publicly committed to a merger have strong incentives to complete the deal regardless of what legal contingencies are triggered. We argue that the results suggest that dealmakers and lawyers focus too much on negotiating “contingent closings” that allow clients to call off a deal, rather than on “contingent consideration” that compensates clients for closing deals that are less advantageous than expected. Our analysis suggests drafting recommendations that could enable counsel to protect clients against the effects of the clients’ own managerial hubris in pursuing mergers that may (and often do) fall short of expectations.