It is common wisdom among transactional lawyers that good teamwork results in smoother deals and better service for their clients. Perhaps for this reason, capital-markets practices frequently tout their teamwork skills as a source of value for clients, especially in securities offerings where lawyers acting for issuing companies work closely with underwriters and their lawyers in a team-like fashion, all pulling for the success of the issuing company.
However, teamwork holds a potential pitfall for transactional lawyers, because their desire to work collaboratively with other parties in a deal can blunt their ability to advocate effectively on behalf of their clients. A prime example of this can be found in securities offerings, where teamwork often magnifies agency costs between issuing companies and the lawyers that serve them. This occurs for at least two reasons. First, teamwork, as it is frequently executed, can discourage dissent by team members at times when well-handled disagreement is critical. Disagreement is at the core of advocacy, and research on teams reports that dissenting voices are necessary for optimal outcomes in any kind of group work. Second, since all members of the deal team ostensibly serve the issuing company, a sense of team cohesion can mask the subtle but significant ways in which the interests of the lawyers and the underwriters diverge from those of the issuers. In short, while teamwork is essential for capital markets lawyers to run a smooth deal, it may paradoxically be a threat to lawyers’ effectiveness as an advocate in certain situations.
In a recent article posted here, I provide a theoretical and empirical analysis of the agency costs that arise from lawyers’ teamwork in capital markets transactions. I find both quantitative and qualitative evidence of little-noticed but significant agency costs that arise in certain circumstances that offset the benefits that come from familiarity between parties working together on a transaction. The analysis draws on interviews with practitioners and analyzes a unique dataset of information from 2,265 initial public offerings. In particular, I look at collaboration between lawyers on both sides of each deal and the investment banks that frequently take companies public. The analysis reveals that, while familiarity between the lawyers and bankers in a deal may promote teamwork and lead to faster deal completion, it is also systematically associated with negative consequences for the issuing companies, such as higher levels of underpricing and a greater likelihood of securities litigation.
Although collaboration and teamwork cannot be directly observed ex post in the data, a reasonable proxy is the repeated interaction between the parties involved in the deal: the investment bank underwriters, the issuing company’s management, and the lawyers for each side. I analyze the interactions between the law firms and underwriters at the organizational level and then, using names of counsel drawn from SEC filings, I analyze the repeated interactions among individual lawyers. The analysis yields two broad conclusions: (1) that repeated interaction between lawyers and the investment banks is linked to some benefits one would expect to find with better teamwork from repeated collaboration on the same kind of task; and (2) that repeated interaction is also linked to evidence of significant agency costs between the issuer and its counsel and underwriters.
The analysis demonstrates that agency costs between issuing companies and their legal counsel are especially pronounced just when the conditions for team cohesion are at their best. For example, an important pattern emerges with respect to the opening day price performance of an issuing company’s stock, revealing positive and negative implications. Opening day price performance – the opening day “bounce” – is considered to be essential to a successful deal. Underwriters and issuers often aim to intentionally underprice a deal by around 15 percent of what they believe the fully distributed trading value will be to encourage a bounce. However, an excessively high bounce is detrimental to the issuing company, because it means the company sold the stock at too low a price (i.e., underpriced by too much) and gave up more value from the deal than necessary. When the underwriter’s counsel has represented an underwriter repeatedly within the past year, the first-day bounce of the security they create is 3–5 percent higher on average than the first-day bounce for the security created in each past interaction, when controlling for other factors that might have an impact on first-day performance (including market conditions and time periods during which the first day bounce tended to be unusually high). This can be interpreted as a relatively modest indication of good deal performance, because it indicates stronger demand in the issuance without exceeding a reasonable amount of underpricing.
However, where the issuer’s counsel and underwriter have been on the same deal team frequently in the past year, the average first day bounce is much higher: 9 percent more on average than the first day bounce for the security created in each past interaction, controlling for other relevant factors. When the issuer’s counsel has represented the underwriter in an IPO in the past year, the bounce is 12–16 percent higher than average, again holding other factors constant. Although a moderate level of price jump is to be expected in an IPO, the excessive first-day jump when the issuer’s counsel has worked repeatedly with the underwriter is troubling, because it suggests that the issuer loses more money in the deal when its counsel is more familiar with the underwriter. Underwriters, for their part, have less reason to be troubled by money left on the table, because that money is captured by the underwriters’ institutional clients who in turn generate future business and favorable relationships with the underwriters, all at the issuer’s expense.
In addition to money left on the table, a troubling pattern emerges when litigation outcomes are analyzed. When the issuer’s counsel has represented the underwriter in the preceding year, the probability that the issuing company will be subject to a securities class action lawsuit nearly doubles. These results are robust to numerous controls and tests to rule out selection bias.
The results are also consistent with accounts of practitioners and research on teams that suggest that teamwork can both exacerbate and conceal conflicts between the interests of agents (the lawyers and investment bankers) and their clients (the issuing companies). While teamwork may improve efficiency and yield better results in a transaction, the group’s pursuit of a common goal can blur the boundaries of a lawyer’s agency role and create confusion as to whether the lawyers should pay deference to the issuer or the underwriter—a confusion that is intensified when the lawyers have an incentive to ingratiate themselves with the investment banks who are repeat players in the IPO market. At the same time, teamwork can make such conflicts difficult to deal with, because parties either fail to recognize the conflicts or shy away from raising objections for fear of damaging the collaborative team ethos. Over time, team members’ desire for cohesion and aversion to disagreement may also lead to groupthink, thus making it more difficult for lawyers to perceive how their clients’ interests diverge from the goals that the group is pursuing. In short, teamwork may paradoxically be both the key to a successful deal and a threat to the lawyer’s effectiveness as an advocate.
These results, along with those described in more detail in the article, provide evidence that, while teamwork might improve a deal’s outcome, the familiarity and collaboration that go hand-in-hand with teamwork have the potential to enhance the costs of agents’ misaligned incentives. Put simply, frequent interaction is a core component of teamwork, and groups who work together form better teams. However, teamwork in a context where adversarial interests exist may pose dangers with respect to the lawyer’s fundamental duties as an agent. This conclusion has implications for the law of fiduciary duty, the rules governing lawyers’ ethics, and the practical norms by which securities deals are executed, all of which are discussed in the article.
The most obvious solution to this problem is to prevent lawyers who represent underwriters from representing issuers within a certain time frame, as is done with audit partners in accounting firms as a result of the Sarbanes Oxley Act. However, that solution, while attractive for its simplicity, precludes the possibility that the benefits of teamwork can be harnessed while minimizing agency costs. A more satisfying solution starts with greater recognition of the importance of dissent in team dynamics. Researchers in the field of psychology have found that group tasks result in better outcomes when some members of the group are permitted, or even encouraged, to raise objections. This can be done without damaging the positive aspects of a team dynamic or straining the relationships among team members. In fact, lawyers are especially well suited to providing an advocacy role within a collaborative setting, although doing so effectively requires them to establish early in any deal an agreed process through which dissent can be raised.
This post comes to us from Professor Jeremy McClane at the University of Connecticut School of Law. It is based on his recent article, “The Agency Costs of Teamwork,” available here.