Compliance, Detection, and Mergers and Acquisitions

Abstract

Firms operate under a wide range of rules and regulations. These include, for example, environmental regulations (in which some industries have increased regulatory exposure) and finance and accounting (where all industries have reporting requirements). In other areas, such as antitrust cartels, enforcement is unregulated and antitrust leaves the market as the default tool to police against anti-competitive behavior. In all of these areas, detection of non-compliance by a firm can result in significant penalties. This issue of non-compliance has implications in the merger and acquisitions (M&A) context. In a transaction between an acquiring firm (buyer) and a target firm (seller), there is asymmetric information about the target’s quality. In our framework, we link a target’s quality directly to the strength of its regulatory compliance. In an M&A transaction, an acquirer seeks information about the target’s compliance, as a compliance failure may result in substantial penalties and sanctions, post-acquisition. In the presence of quality (compliance) uncertainty about target firms, low quality targets can masquerade as high quality. This would tend to give rise to a M&A market with Lemons-like characteristics, resulting in low transactions prices and dampening of M&A activity. We examine how M&A transactions in such regulatory areas – environmental, finance and accounting, and antitrust compliance problems – might function to alleviate quality uncertainty.

Keywords: corporate compliance, corporate strategy, Lemons markets, mergers and acquisitions, environmental regulations, securities regulations, accounting, antitrust, cartels, white collar crime

JEL Classification: G34, K21, K22, K32, L40, M21