The legal advisory market for major corporate transactions is dominated by a relatively small number of elite law firms. What value do these law firms provide? Regulatory expertise, innovative drafting, speed of execution, and reputational cachet have all been offered as likely candidates. In Market Information and the Elite Law Firm, I argue that a considerable share of the profits earned by these firms also derives from selling their information about current “market” transaction terms.
Indeed, corporate transactions such as mergers and acquisitions or financings are characterized by several salient facts that lack a complete theoretical account. First, they are almost universally negotiated through agents. Transactional lawyers do not simply translate the parties’ bargain into legally enforceable language; rather, they are actively involved in proposing and bargaining over the transaction terms. Second, they are negotiated in stages, often with the price terms set first by the parties, followed by negotiations primarily among lawyers over the remaining non-price terms. Third, while the transaction terms tend to be tailored to the individual parties, in negotiations the parties frequently resort to claims that specific terms are (or are not) “market.” Fourth, the legal advisory market for such transactions is highly concentrated, with a half-dozen firms holding a majority of the market share.
The article provides a theoretical account of negotiations over corporate transactions consistent with these facts, centered on specific information problems faced by the parties. The claim is that, for complex transactions experiencing either sustained innovation in terms or rapidly changing market conditions, (1) the parties will maximize their expected surplus by investing in market information about transaction terms, even under relatively competitive conditions, and (2) such market information can effectively be purchased by hiring law firms that hold a significant market share for a particular type of transaction.
Why is market information useful? The considerable complexity of corporate transaction terms creates an information problem: One or both parties may simply be unaware of the complete set of surplus-increasing terms for the transaction, and of their respective outside options should negotiations break down. This problem is distinct from the classic problem of valuation uncertainty. Rather than unawareness of facts that may affect the value of the capital asset to be transferred between the parties, the problem identified here is unawareness of the possibilities for contracting with respect to that asset. The difference can be illustrated using the well-worn example of a used-car sale. The buyer may be uncertain as to the value of the car itself, given unawareness of certain facts such as whether it was well maintained by the seller. This source of valuation uncertainty can be mitigated in part by a seller-provided warranty. A different problem is presented, however, if the parties are entirely unaware of the concept of a warranty.
Though unrealistic in the context of used-car sales, both unawareness of value-increasing terms and uncertainty over outside options are not only plausible, but likely for certain corporate transactions. The non-price terms of transactional agreements and their associated payoffs may change rapidly as a result of contractual innovation and market conditions, such that parties without current market information may have difficulty determining their expected surplus from transacting. This is particularly so for corporate transactions involving private companies or private securities offerings, because the transaction terms will remain private for at least some period of time. In such cases, law firms with a high market share of that particular advisory work are likely to have the best real-time access to the full range of transaction terms, given their role in negotiations and control of the transaction agreements.
The parties to such transactions are therefore in a strategic game: They must decide whether to invest in acquiring market information about transaction terms and how much of this information to reveal to their counterparty. The article provides a formal bilateral bargaining model showing that, under plausible assumptions, there is a unique Nash equilibrium to the parties’ game in which both sides will engage an informed law firm to advise them on the transaction. This joint investment in market information ensures that the parties will get the benefit of all value-increasing transaction terms, while avoiding costly signals to an uninformed counterparty.
The implication is that aggregating and selling market information can be important roles for law firms with leading transactional practices, as distinguished from their traditional roles as reputational intermediaries, regulatory experts, and draftsmen. Such law firms should therefore have a self-perpetuating volume advantage for transactions in which a material share of the information about transaction terms is private.
The paper has broad implications for contract theory. The dominant view is that the non-price terms of voluntary bargains will tend to be economically efficient—that is, they will maximize the parties’ joint surplus, regardless of their relative bargaining power. The paper shows that institutional differences in how transactional agreements are negotiated can lead the parties to deviate from the efficient set of terms simply by being unaware of the surplus-maximizing set, for example. Moreover, because transactional lawyers typically drive negotiations over the non-price terms, they ultimately play a far greater role in valuing transaction terms than is commonly understood.
 Coates IV, John C. 2001. “Explaining Variation in Takeover Defenses: Blame the Lawyers,” 89 California Law Review 1301-1421.
 Choi, Albert, and George Triantis. 2012. “The Effect of Bargaining Power on Contract Design,” 98 Virginia Law Review 1665-1743.
 Choi, Albert, and George Triantis. 2013. “Market Conditions and Contract Design: Variations in Debt Contracting,” 88 New York University Law Review 51-82.
This post comes to us from Associate Professor Elisabeth de Fontenay at Duke University School of Law. It is based on her recent article, “Market Information and the Elite Law Firm,” available here.