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Do lawyers create value in M&A?
Finance / 24 October, 2015
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Professor of Finance, Head of Finance Department
Zacharias Sautner is Professor of Finance and Head of the Finance Department at Frankfurt School of Finance & Management. His research was published in leading international journals such as the Journal of Finance, Review of Financial Studies, or Review of Finance. He teaches corporate finance, valuation, and corporate governance. He has won various awards for his research and teaching.

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Are lawyers worth the high hourly fees they often charge? Where do they produce value for their clients? These are questions that quickly come up whenever corporate managers pursue an M&A opportunity that requires advice from a corporate lawyer. However, answering these questions is very difficult. A new paper by me and my co-authors Christel Karsten and Ulrike Malmendier provides some new insights into these questions. The paper is available here.

In a nutshell, we show that hiring good lawyers pays off, as more expertise comes with more favorable M&A contracts and with better target prices. We document these effects by studying contracts signed between buyers and sellers in 151 acquisitions of privately-held targets. These unique and proprietary data were made available by one of the largest law firms in The Netherlands. Our sample includes contracts negotiated by many leading international law firms, including eight top-10 firms.

We first analyze the effects of lawyer expertise on key contract clauses that represent the diverging interests of buyers and sellers. We focus on provisions that have been identified by legal literature as being crucial in negotiations, in particular, provisions that allocate risk. For a given price, the buyer prefers to allocate a maximum level of risk to the seller, while the seller prefers the opposite.

One crucial channel of risk allocation are warranties, which are guarantee statements by the seller about the quality of the target. While warranties themselves are not necessarily used to allocate risk (but rather as a signaling tool to overcome asymmetric information), risk allocation is negotiated through clauses attached to warranties, which affect their scope and enforceability. This is very the details matter.
First, warranties may come with the statement “so far as the seller is aware,” which renders them unenforceable unless the buyer proves that the seller had knowledge of a warranty violation. The buyer, therefore, prefers the inclusion of few knowledge qualifiers, whereas the seller prefers many. A second clause is an overarching qualifier that states that any warranty needs to be violated in “a material respect.” This clause also reduces enforceability by the buyer who prefers that warranty breaches do not need to be material; the seller prefers the opposite.

We find that more relative legal expertise on the buyer side is associated with more risks allocated to the seller. Specifically, more buyer lawyer expertise comes with more warranties without knowledge qualifiers and a higher probability that warranty breaches do not need to be material. Seemingly, seller lawyers that face buyer lawyers with high expertise fail to follow the advice in Miller (2008, p.240): “Add materiality and knowledge qualifiers wherever possible.”
Another important risk in acquisitions arises from adverse events between signing and closing dates. As a default, this risk lies with the buyer, who contractually agrees to purchase the target at a given price. Contracts can shift this risk to the seller by including a MAC clause, which allows the buyer to cancel the deal if the target suffers a material adverse change (MAC). While the buyer prefers the inclusion of such a clause, the seller favors not to carry this risk. We again find that more relative expertise of the buyer lawyer increases the probability that a MAC clause is added.

We then look into the underlying bargaining dynamics to understand the channels that high-expertise lawyers use to influence negotiations in their clients’ favor. In particular, we assess which party is allowed to provide the first contract draft. This is a crucial element, as it creates a first-mover advantage by setting an anchor or reference point for the upcoming negotiations. Law firms usually have buyer- and seller-friendly model contracts, which they try to use as starting points when drafting contracts. Freund (1975, p.26) writes “in negotiating acquisitions, the axiom is: If you have an opportunity to draft the documents, do so; you will jump into the lead, and your opponent will never catch up completely.” Consistent with this advice, we find that more expertise is associated with a higher probability that a party can deliver the first draft.

To evaluate the value implications of lawyer expertise, we analyze the prices paid for the targets. While lawyers are generally not the primary parties bargaining over prices, they may nevertheless directly affect prices through their efforts during the legal due diligence and contract drafting process. We find that expertise also pays off here: more relative legal expertise on the buyer side is associated with lower prices paid for targets.

We then analyze whether the fees of lawyer justify the documented benefits. Surprisingly, we show that more legal expertise does not come with higher fees. The driver of this result is that expertise helps to shorten negotiation times, resulting in a lower legal bill. SO the bottom line of our paper is that high-expertise lawyers negotiate beneficial M&A contracts and economize on transaction costs.

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