December 04, 2005
Pricing Legal Risk
Posted by Victor Fleischer

I've been working on a case study of the MasterCard IPO.  MasterCard is going public early next year.  The structure is fascinating.  A dual class common stock structure allows the member banks to give up voting rights but retain economic rights.  The company will also give 15% of the shares to a charitable foundation, which will make takeovers more difficult.  It's a masterpiece of regulatory cost engineering.

The 3 Billion pound gorilla in the corner is antitrust liability.  No one really knows how much pre-IPO liability MasterCard has.  And while the new structure probably means that the actions of the member banks aren't per se illegal post-IPO, going forward there's still risk of a finding of anti-competitive behavior by MasterCard itself.  Most of the IPO proceeds are going to redeem some of the member banks' shares, but 650MM is being held back from the US banks to cover legal and regulatory costs.  Is that enough?  The rating agencies aren't sure, and have downgraded MasterCard.  (In the IPO, MasterCard is giving up the right to make special litigation assessments against the member banks, and it's unlikely that creditors would be able to pierce the veil for post-IPO liability.)

My question is this:  how does the market price this legal risk?  We often assume that the market is really good at sorting out and pricing risks accurately.  But how exactly does this happen?  Bankers have to price this thing.  Most of them probably think Herfindahl-Hirschman is a new beer by Hefeweizen.  How do they do it?  Does Fidelity go out and hire antitrust counsel to make a prediction?  Do they just pick a number out of thin air? 

More generally, does anyone know how Wall Street deals with pricing legal risk?  When RIM did a follow-on offering last year, how did Wall Street estimate the odds that Blackberries could go dark over the NTP patent dispute?   

I wonder if there are consulting firms out there who help out with this.   Maybe I should start one.  Hmm.  Or maybe I should start a hedge fund targeting mispriced legal risk.  That way I could make my "2 and 20." 

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