S. 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).