Allocating Risk Through Contract: Evidence from M&A and Policy Implications

Abstract

In a hand-coded sample of M&A contracts from 2007-08, risk allocation provisions exhibit wide variation. Earn-outs are the least common means to allocate risk, indemnities are most common, followed by price adjustment clauses. Techniques for mitigating enforcement costs - escrows, holdbacks, and seller financing - are common. Target SEC registration and ownership dispersion correlate negatively with the use and extent of risk sharing. Target-owners retain risk more frequently, but not universally or exclusively, in industries in which current liabilities vary more, and when buyers and targets are in different industries. Bidder and target law firm agents match on bid value and prior deal experience, but law firm mismatches are common, and both law firm experience and experienced-based mismatches correlate with the use, variance, and design of risk allocation provisions. While asymmetric information and incentives are important, so are transaction and agency costs, implying roles for lawyers to serve as transaction-cost engineers and for policy-makers to set binding default rules of property, tort and contract law. Specific policy implications include: contract statutes of limitations should be shorter; default law should require minimum amounts in controversy and caps on post-closing contract liability; and lawyers should disclose to clients their M&A experience and typical outcomes of specific risk-allocation provisions.