In recent years, the legal profession in the UK and the US have been working with economists in order to unravel the complex structure of commercial transactions. One of the fruits of this exercise is the development of an economic framework for analysing transactions (the “Economic Framework”). The Economic Framework provides insights into the economics of commercial transactions by distilling the complexities of the economic relationship between contracting parties into four categories of commercial risks. It thereby provides a systematic structure for understanding and designing complex transactions. This article outlines the Economic Framework and examines how it operates in practice.
The Economic Framework
At the heart of any commercial transaction is the economic relationship between the contracting parties. The complexities of this relationship shape the structure and terms of the deal. The Economic Framework disentangles these complexities by classifying them into the following four categories of risk, which are known in economics as:
- adverse selection;
- moral hazard;
- asset specificity; and
- exogenous factors.
The above classifications identify the commercial risks inherent in the complex economic relationship between the contracting parties and, more importantly, the cause of such risks. By understanding the cause, the practitioner is in a better position to evaluate the likelihood of the risk and to devise a targeted response.
This article examines each commercial risk category and the contractual responses typical to each risk, illustrating how the Economic Framework works in practice.
Put simply, adverse selection is the risk of overpaying for an asset (from a buyer’s perspective) and underselling an asset (from a seller’s perspective). It arises as a result of pre-contractual information asymmetry between the parties regarding the value and quality of the target asset, with the seller usually possessing more information than the buyer. This information asymmetry could potentially break the deal: the buyer may undervalue the target asset simply because it lacks the data to make an informed assessment, and the seller, having a higher valuation of the asset because it has more information, may be unwilling to sell at a lower price.
Typical solutions to adverse selection can be divided into two groups. The first group consists of solutions that bridge the information gap through information exchange. Due diligence is representative of solutions in this category. Through the due diligence exercise, the seller communicates information about the target asset to the buyer.
However, due diligence has its limitations. The seller may flood the buyer with information regardless of its relevance and materiality. Given cost and time restraints, the buyer’s review of the information provided will necessarily be limited.
To some extent, the failings of due diligence can be addressed by well-structured disclosure mechanisms. A disclosure mechanism that absolves the seller’s liability in respect of disclosed matters could encourage the seller to volunteer material information in a focused manner.
The second group of solutions involves the seller providing some sort of “guarantee” regarding the value of the target asset. Typical examples include the seller providing representations and warranties regarding the condition of the target asset. These “guarantees” will usually be subject to time and monetary limits, which are heavily negotiated.
On the one hand, “guarantees” address the risk of adverse selection. On the other hand, they create credit and security risks: the “guarantees” will be worthless if the seller becomes impecunious or is difficult to locate. Such risks are often addressed by the buyer retaining part of the purchase price for a certain period of time.
Warranty and indemnity insurance is also gaining popularity amongst contracting parties as an alternative, or in addition, to the retention mechanism described above. The insurance ensures a clean exit for the seller and gives the buyer the ability to recover warranty and indemnity claims from a financially viable insurer.
In many cases, the quality of a party’s performance of its contractual obligations may not be immediately apparent due to the difficulties in monitoring and measuring its performance. The greater the difficulty in determining the quality of performance, the greater the risk of opportunistic behaviours such as shirking from responsibilities and diverting value for personal gains. “Moral hazard” is the term used to describe the risk of opportunistic behaviour in these situations.
Typical solutions to moral hazard can be divided into two groups. The first group consists of solutions that improve access to information. For example, an investor who holds a minority stake in a company may, under the investment documents, require the company to provide it with regular financial information and to notify it upon the occurrence of certain events material to the value or operation of the company. A minority investor with particularly strong bargaining power may also secure a right to audit the company’s accounts.
The second group of solutions involves some kind of alignment of interest, usually by way of financial incentives. Take for example a sale of the entire equity interest in a company where the sellers are retained post-completion to manage the company. An earn-out structure that increases the purchase price with reference to the company’s performance post-completion can incentivise the sellers to maximise the company’s profits, thereby aligning the interests of the buyer and sellers.
If the parties’ interests are perfectly aligned, the problem of moral hazard will disappear altogether. Whilst perfect alignment is rare (if indeed possible), a well-structured mechanism will align the parties’ interests as closely as possible by using performance indicators that are:
- easy to measure;
- most likely to accurately reflect the sellers’ actual efforts;
- least likely to be distorted by external factors such as the general economic climate; and
- least likely to create perverse incentives such as over-cautiousness or excessive risk-taking.
Where a party makes a substantial investment that is (1) specific to one transaction and (2) difficult to transfer to a third party, then there is a risk that the non-investing party will exploit the investing party because it knows that the investing party is “locked-in”. “Asset specificity” is the term used to describe this situation.
In the context of a sale of a corporate group by way of a share deal, asset specificity may occur if the buyer requires the seller to re-organise the target group before completing the transaction. If the re-organisation makes sense only for the buyer because of its own unique tax or corporate structure, then there is a large hold-up risk for the seller because other potential buyers may not be interested in the re-organised target group.
Typical responses to asset specificity seek to increase the non-investing party’s exit cost and cost of opportunistic behaviour. So for example, in the re-organisation scenario mentioned above, the seller may require the buyer to bear all or some of the re-organisation cost. Other examples of solutions in this group include taking deposits, break fees and put or call options.
The term “exogenous factors” refers to circumstances that are beyond the control of the parties, such as merger clearance, inflation and the stability of the financial system. Exogenous factors disrupt the intended course of performance of contractual obligations by, for example, making it more costly for one party to perform its obligations or reducing the value of the target asset.
Typical solutions for dealing with exogenous factors fall into three groups. The first group simply allocates the risk of exogenous factors between the parties. For example, if completion of a transaction is conditional upon the absence of material adverse change, then the seller bears the risk of the occurrence of exogenous factors that trigger a material adverse change.
The second group of solutions involves the parties settling on “standards” of performance (such as “reasonableness” and “due care”) instead of detailed “rules” of performance. Since “standards” are more flexible than “rules”, it permits the parties to adjust performance in light of changing circumstances, without amending the contract. However, the flexibility of “standards” also creates ambiguity, which makes “standards” more prone to litigation and disputes than “rules”.
Whether “standards” or “rules” should be adopted in a particular case depends on a number of factors, including the extent to which an obligation can be precisely delineated, the complexity of the obligation, the cost of setting out and agreeing upon precise terms of performance, and the cost of enforcement through legal proceedings.
The third group of solutions involves some sort of mechanism for re-adjusting the affected contractual obligation. For example, instead of expressing the price as a fixed figure, it can be expressed as a formula consisting of variable components to be ascertained at a future date. Parties may also design a mechanism for negotiating changes to the contract upon the occurrence of exogenous factors, or simply appoint an independent third party to determine potential areas of dispute such as the fair value of an asset.
The Economic Framework provides a structure for understanding and thinking about commercial transactions from an economic perspective. By structuring the analytical process in terms of commercial risks, the Economic Framework helps practitioners to discern the financial dynamics that drive transactions and to develop targeted responses.