Legal Financial Arbitrage: Merger Arbitrage and Beyond

This class will focus on an increasingly important (yet academically underdeveloped) area of intersection in law and finance: Legal-Financial Arbitrage (LFA). This field is a subset of financial arbitrage, a well-known practice of spotting hard-to-justify price differences among two (or more) identical (or highly correlated) investments and then capitalizing on those differences in a riskless (or nearly riskless) way. LFA is a subset of financial arbitrage, but LFA focuses on pricing differences occasioned by legal/regulatory uncertainties or anomalies (e.g., contract interpretation and enforceability, regulatory status and enforcement, etc.), capitalizing on those differences using the tools of arbitrage trading. LFA is a true cross-profession enterprise. Although financial arbitrage is nothing new in financial markets, and assessing legal risks is the stock-in-trade for attorneys, the two skill sets have started to intersect meaningfully in LFA, as so-called “strategic situation” and “merger arbitrage” traders have increasingly focused their attention on legal matters that may not be fully appreciated by other market participants, either because they are less attentive to legal and regulatory situations or because the trade rests on unique judgments about how legal matters will unfold. The most commonly employed LFA trading strategies concern announced M&A transactions (which provide a natural setting where the value of an M&A target’s stock should home in on a known value at a future time if a deal closes). We will focus much of our attention on M&A transactions.  But like LFA trading generally, we will not be so limited.  LFA opportunities exist in many other law-relevant domains, such as corporate governance and board control fights, bankruptcies, commercial/IP litigation, and mass tort claims. What will link all the situations we study, however, is the central importance of combining sound legal assessments to generate (probabilistic) forecasts of the outcomes of these situations, to assess how these outcomes will affect prices of the firms’ traded securities.  We will discuss how biased beliefs and the risks faced by market participants can lead to investment opportunities.  Finally, we will discuss the implementation of optimal arbitrage positions. Accordingly, we hope to facilitate dialogues and innovative idea generation between JD and MBA students (working in teams).