Some game theory and financial contracting issues in corporate transactions

Applied Mathematics and Computation 186 (2007) 1018–1030 www.elsevier.com/locate/amc

Some game theory and financial contracting issues in corporate transactions Michael Nwogugu P.O. Box 170002, Brooklyn, NY 11217, USA

Abstract This article introduces new theories of financial contracting, and analyzes critical economic, and public policy issues either not raised or not analyzed fully in current academic and practitioner literature. A series of transactions by Encompass Services Inc. [M. Nwogugu, Corporate Governance, Legal Reasoning And Credit Risk: The Case of Encompass Services Inc., Managerial Auditing Journal 19(9) (2004)], is used to illustrate certain game theory, financial contracting theory and economic policy issues in the context of corporate transactions and financial distress.  2006 Elsevier Inc. All rights reserved. Keywords: Corporations law; Mergers and acquisitions; Game theory; Credit-risk; Bargaining; Financial contracting theory

1. Introduction Encompass Services Corp. (‘‘ESR’’), was formed in 2000 by the two-phase restructuring and merger of Building One Services Corp. (‘‘BOSS’’), and Group Maintenance America (‘‘GMAC’’) which was announced on November 3, 1999 and approved by shareholders of both companies on February 22, 2000. ESR provided maintenance and electrical/mechanical services and installation of building equipment at various types of facilities in many industries and residential buildings. Shortly after the merger, a confluence of events resulted in ESR’s financial distress. ESR, formerly a Fortune–500 company, was subsequently de-listed from the New York Stock Exchange and eventually traded on the NASDAQ Pink sheets (symbol ‘‘ESVN’’). On October 18, 2002, some of ESR’s creditors proposed a restructuring and a pre-packed bankruptcy filing, but there was no agreement among the creditors and ESR. On or around November 19, 2002, ESR filed for Chapter Eleven bankruptcy protection in the Federal Bankruptcy Court in Texas, USA. While under bankruptcy court protection, ESR’s 25,000 employees in 200+ offices, provide mechanical services, electrical services, cleaning systems/services and network technologies to commercial and residential buildings in the US. As of September 2002, ESR had about $1.2 billion of indebtedness ($589 million Secured Credit Facility; $339 million of unsecured bonds and note obligations; $309 million of outstanding mandatorily redeemable convertible preferred stock; and trade obligations). E-mail addresses: [email protected], [email protected] 0096-3003/$ - see front matter  2006 Elsevier Inc. All rights reserved. doi:10.1016/j.amc.2006.08.058

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2. Economic and policy issues 2.1. Contracting ESR became financial distressed due to substantial operating risks which were not managed properly: Use of sub-contractors: ESR’s dependence on sub-contractors to perform janitorial services reduced its ability to control the quality of work, and the time to complete projects, all of which may lead to cost increases. Note that the use of individual sub-contractors would have produced different results from (a) hiring full time employees and (b) strategic alliances with smaller companies that would have hired and supervised these independent contractors. It does not appear that the use of independent contractors had any material positive effect on ESR’s cost structure; and in the alternative any benefits would have been cancelled by ESR’s substantial interest payments. Financial contracting: The ESR transactions illustrates the impact of financial contracting on firm strategy, risk, information asymmetry, investor psychology and financial distress. Cornelli and Yosha [35]; Repullo and Suarez [78]; Rajan [77]; Smith and Warner [88]; Berger et al. [13]; Datta et al. [39]; Bolton and Scharfstein [22]. ESR became financially distressed partly due to the nature of its contracts, and or its failure/ omission to contract • A substantial number of ESR’s service contracts were relatively short-term contracts, which could be terminated by clients upon 30–90 days notice. Unfortunately, ESR’s post-merger size and capabilities (technical and geographical) did not change the nature of these contracts. • Many of ESR’s facilities services contracts were ‘‘fixed price contracts’’, in which ESR completed projects for a fixed price, and assumed the risk of cost increases and unforeseen contingencies. • ESR’s reliance on individual independent contractors for janitorial services was detrimental—in an industry were service quality is critical, these individual contractors probably did not have adequate incentives for optimal performance. • While ESR’s sources of revenues (service contracts) were short term and fixed price contracts, most of ESR’s liabilities were long-term liabilities. • ESR’s mandatorily redeemable convertible preferred stock effectively sent mixed signals to the investment community. This class of securities was not clearly debt or equity, and it worsened ESR’s risk profile, increased information asymmetry, increased moral hazard problems, and increased investors’ costs of analysis/monitoring. • In a labor-intensive industry, ESR did not have any formal/informal agreements with labor unions, trade associations or any group of employees. • ESR’s debt had relatively restrictive covenants and indentures. • ESR’s high leverage, the terms of its loans and securities, and uncertainties about post merger integration, made it more difficult for ESR to obtain new business from customers and to obtain necessary surety bonding for projects. • Issues pertaining to strategic alliances are analyzed in Nwogugu [76].

2.2. Securities law liability and top management changes and incentive compensation In May 2000, shortly after the shareholder approval of the merger (February 2000) and the actual ESR, ESR’s stock price declined substantially even as the trading volume increased—such sudden and sharp post-transaction declines in share prices are sufficient basis for liability for misconduct under US securities laws. A review of the SEC disclosure statements filed in 2000 in the ESR transactions shows that BOSS and GMAC anticipated substantial value creation from the combination which never materialized—under US laws, the nature and type of disclosures made by GMAC and BOSS effectively created civil and criminal liability for them based on inappropriate forward-looking statements, that could be reasonably construed as

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full or partial assurances as to future performance by ESR, upon which investors could have reasonably relied on for financial and investment decisions. 3. Company performance and stock price performance in M and As and LBOs The sudden and quick decline in ESR’s stock price immediately after the 2000 merger had substantial information content because: (a) it occurred almost immediately after the ESR merger, (b) it occurred despite increased trading volume of ESR’s shares, (c) the decline was permanent, (d) it did not have any material impact on stock prices of other companies in the sector. Furthermore, the sharp and sudden decline in ESR’s stock price was: (a) evidence of substantial divergence of opinions between banks that financed the mergers, and stock market investors, and hence substantial information asymmetry despite many disclosures by ESR; (b) evidence of major differences in information processing capabilities among ESR’s shareholder (who received substantial disclosure), ESR’s advisors, stock market investors, banks/lenders and Apollo; (c) evidence of the stock market’s valuation of ESR’s Goodwill—and further evidence of the opacity of Goodwill and the need to change Goodwill accounting rules; (d) evidence of the stock market’s estimates of ESR’s post-merger integration success, and post-merger ability to get new contracts under the new organizational structure (presumably after investors had conducted due diligence and talked to ESR’s current and prospective customers), (e) evidence of the stock market’s opinions about Apollo’s role in the BOSS and GMAC transactions, and the valuations of the securities used in the ESR transactions (including investor estimates of potential dilution caused by the use of convertible securities in the ESR transaction). More specifically, the ESR transactions and the aftermath (financial distress, bankruptcy, declines in stock prices, changes in management, etc.) completely contravenes most, if not all of the financial theories developed in Dennis and Dennis [42]; Wruck and Weiss [95]; Wruck [96]; Wruck (1990); Wruck [98], Wruck and Baker (1989); Wruck (1989); Wruck et al. [94,97] and Dann [38]. Also see: Niaz (2005); Sargent (2004); Granger et al. [52]; Trafimow [91]. ESR became financially distressed partly because of its failure to change its organizational structure sufficiently before and after the February 2000 merger between BOSS and GMAC. The issue of appropriate organization structure was critical given that BOSS and GMAC had a history of substantial acquisitions in a fragmented labor-intensive service industry. ESR’s dependence on sub-contractors to perform janitorial services reduced its ability to control the quality of work, and the time to complete projects, all of which may have lead to cost increases and client dissatisfaction. The change in ESR’s organizational structure (which occurred simultaneously with the BOSS/GMAC merger) reduced emphasis on cross-selling services and cross-training employees: The post-merger ESR organizational structure focused on regional management of distinct service lines, while the emphasis should have been on regional management of all of ESR’s service lines (and one ‘‘national team’’ to handle ‘‘national accounts’’), which would have enhanced cross-selling of services and encouraged cross-training of employees and managers in various aspects of ESR’s business. Hence, the lack of appropriate organizational structure: (a) weakened contractual relationships with customers, (b) weakened internal implied contractual relationships among departments. The following are some testable hypothesis of company performance and stock price performance. Hypothesis 1. During the immediately preceding five years before the February 2000 merger, BOSS and GMAC each acquired more than fifty companies—and there were substantial management changes at BOSS and GMAC after each of these acquisitions. Traditional finance literature and finance theory will have postulated that ESR’s stock price would have increased substantially immediately after the 2000 merger (that created ESR) because: • The series of prior acquisitions by BOSS increased its stock price even though these acquisitions involved fraudulent conveyance, and the number of shares outstanding increased. • The series of prior acquisitions by GMAC increased its stock price even though these acquisitions involved fraudulent conveyance, and the number of shares outstanding increased. • The ESR combination was supposed to, and could reasonably have been believed to increase ESR’s market share and geographical coverage, while reducing operating expenses.

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• ESR’s earning power was projected/expected to increase substantially due to grater geographical and product coverage. • The variability in ESR’s earning power (generation of cash flow) was historically low, and it could have been reasonably assumed that this state would continue in future periods. However, the exact opposite occurred—contracting, financing, corporate governance and knowledge-management issues dampened ESR’s stock price performance. Hypothesis 2. The principles that can be derived from the ESR transactions are that in technology companies, service companies, and in industries with substantial reputation-effects and network- effects, rapid and frequent changes in top management: • • • •

Significantly reduces the pace at which effective merger/combination integration can occur. Reduces employee focus and morale. Reduces customer loyalty and propensity to commit to long term projects. Affects the company’s capital budgeting processes and ability to commit to potentially beneficial long term projects. • Creates uncertainty about strategic direction. • Send the wrong signals to investors and capital markets participants. These principles remain valid regardless of whether or not the merger/combination increases the resulting company’s geographical or product coverage. Hypothesis 3. The ESR, BOSS and GMAC transactions illustrate the negative effects of improper incentive compensation, particularly in the context of high leverage. Shortly after the ESR transaction in 2000, the price of ESR’s common stock declined substantially and ESR became insolvent. 4. Information content of bank loans Given the pre and post-transaction events in the ESR case, and in particular, the sudden decline of the market values of ESR’s debt and shares, several theories can be deduced: Hypothesis 1. The market reacted negatively to the fact that most of the debt used in the ESR transactions were private debt. This exercabated the information asymmetry created by the substantial Goodwill on GMAC’s and BOSS’s balance sheets. Hypothesis 2. The banks that provided the loans for the ESR merger presumably did extensive due diligence before the transaction closed. The sudden post-transaction decline in the market values of ESR’s public and private debt, is evidence of reputational effects in perceived information content of debt. (both underwriter and issuer reputation). See: Fang [49]; Chemmanur and Fulgru’eri [32]; Glaeser et al. [50]; Dentchev and Heene [43]; Dasgupta (2005). The events in the ESR/BOSS/GMAC transactions invalidated theories introduced in the following articles: Hart [56]; Hart and Moore [57]; Diamond [45]; Rajan [77]; Almazan and Suarez [3]; Lummer and McConnell [72]; Slovin et al. [86]; Smith and Warner [88]; Bayless and Chaplinsky [10]; Best and Zhang [17]; Berger et al. [13]; Datta et al. [39]; Detragiache [44]; Krishnaswani et al. [68]; Suazrez and Sussman [90]; Hellman and Murdock [60]. Datta & Iskandar-Datta & Patel [39]—(a) documented negative stock price responses to debt IPO announcements consistent with debt maturity and debt ownership structure theories, (b) documented that the equity wealth effect is negatively related to the offer’s maturity and positively related to the degree of bank monitoring, (c) documented that firms with less information asymmetry and firms with higher growth opportunities have less adverse stock price responses in debt IPOs. On the contrary in the series of transactions by BOSS and GMAC, and just before ESR was formed by the merger, the stock prices of these entities initially

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increased upon announcement of issuance of public debt. On the contrary the equity wealth effect is not positively related to the degree of bank monitoring, because shortly after the ESR transaction which involved substantial bank loans and hence, significant bank monitoring, ESR’s stock price declined significantly. Thirdly, and on the contrary, ESR had relatively low information asymmetry (because it had substantial public disclosures) and also had perceived strong growth prospects as evidenced by use of debt financing, but yet the equity wealth effect was very adverse and much more than that experienced by firms that provided less public disclosure. Bayless and Chaplinsky [10]: (a) documented at positive and significant 1% announcement-day return for debt issues made by firms that would normally be expected to issue equity; (b) documented that the stock market reacts negatively when firms that are expected to issue debt issue equity instead; (c) documented that the informational content of public security offerings is conditioned by investors’ prior beliefs, (d) that debt issues convey good news relative to equity issues. The ESR transactions rendered all these theories inaccurate. The market prices of BOSS’s and GMAC’s shares initially reacted positively when it was announced that debt would be used in the ESR transaction. The informational content of ESR transactions were not conditioned by investor’s prior beliefs—investors reacted very differently immediately after the ESR transaction closed, than they did before the transaction closed. The same investors that voted to accept the ESR transactions and associated debt apparently bid down ESR’s shares. Debt issues do not necessarily convey good new relative to equity issues and it depends on the circumstances - in the case of ESR, immediately after the 2000 merger, the use of substantial amounts of debt was all of a sudden perceived by investors as a bad omen when the expected service contracts didnt seem to be likely to materialize, and when post-merger integration remained difficult. Investors’ post-merger reaction was based on development of new assumptions about ESR’s prospected as opposed to their prior beliefs.

5. Bankruptcy laws, contracting and the business cycle and financial distress This section analyzes the real and perceived effects of US bankruptcy laws on financial contracting and on the financial distress process. The relevant literature includes: Detragiache [44]; Berger et al. [13]; Hellman and Murdock [60]; Dam [37]; Jacoby [64]; Jacoby [65]; Morrison and Riegl [73]; Vychodil and Ondrej [93]; Berkovitch et al. [16]; Bigus [18]; Berckovitch [14]; Goertz and Mahoney [45]; Goertz and Mahoney [45]; Berkovitch [14]. Claessens and Klapper [33]; Berkovitch et al. (1998); Mayer and Sussman; Hogfeldt and Hogholm [62]; Brown; Durnev and Kim [46]; Chatterjee et al. [30]; Hope [63]; Langevoort [71]; Munck [74]. Several hypothesis can be deduced from ESR (Nwogugu [75]): Hypothesis 1. That ESR, BOSS and GMAC transactions were financed with so much debt, relatively small tangible assets, short term service contracts, is evidence of significant reliance on bankruptcy laws (by company management, and financial sponsors) for protection. In most jurisdictions, such knowing and detrimental reliance is not penalized under any laws, even though such conduct is improper, and causes substantial transaction costs, and loss of equity value. Hypothesis 2. That banks agreed to provide so much debt for acquisitions where there was not adequate tangible collateral is evidence of reliance on the threat of bankruptcy as motivation for better managerial decisions and performance. Its also evidence on reliance on bankruptcy laws as a monitoring device. Hypothesis 3. Bankruptcy laws are essentially part of every financial contract (implicitly and explicitly), because they define processes and remedies upon default, conditioned on several events. Schwartz [84]; Berkovitch and Isreal [15]; Bebchuk and Picker [11]; Claessens and Klapper [33]. Hence, this implicit incorporation of bankruptcy laws in contracts, (a) creates contingent/non-contingent economic value and social capital in the right to invoke bankruptcy laws; (b) creates contingent/non-contingent economic value and social capital in the probability of obtaining a stay of bankruptcy proceedings; (c) creates contingent/non-contingent economic value and social capital in the debtor’s right to reject otherwise valid contracts (in bankruptcy proceedings).

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Hypothesis 4. ESR was relying on bankruptcy laws as a protection against labor problems. That bankruptcy laws can be used for strategic purposes (non-distress purposes) represents a major weakness, that create substantial information asymmetry, corporate governance and management problems. Hypothesis 5. The existence and possible application of bankruptcy laws provide motivation or demotivation in terms of company and employee performance. Under US laws, firms can file for bankruptcy for several reasons—financial distress, strategy, to avoid labor problems, etc. This represents major weaknesses of BR laws which can be exploited unfairly to stymie competition—in fact BR laws can be use for conduct that is anticompetitive. Hypothesis 6. US Bankruptcy laws can greatly enhance or reduce the value of distressed companies depending on: (a) capital structure, (b) type of bankruptcy (liquidation versus reorganization versus merger/combination), (c) company’s negotiating position, (d) availability of prepackaged bankruptcy and or pre-bankruptcy reorganization, (e) the bankruptcy judge’s experience and predisposition, (f) distressed company’s access to capital, (g) industry’s reliance on credit, (h) debt-market and equity-market perceptions of the distressed company’s strategy, management, capital structure and prospects. Hence, the sensitivity of distressed-firm values to interest rates, labor, information held by creditors, etc., increases due to the existence and implication of Bankruptcy laws. Hypothesis 7. Bankruptcy laws are contractually waivable, although this is rarely done. Schwartz [84]; Berkovitch and Isreal [15]; Bebchuk and Picker [11]; Claessens and Klapper [33]. Hence, Bankruptcy laws have an expectations-value to debtors and creditors. This Expectations-Value depends on: (a) nature of the debt contract; (b) remedies for default other than bankruptcy. Hypothesis 8. Most bankruptcy laws are not proactive—nothing happens unless a creditor or the distressed company files for bankruptcy. This causes various problems: (a) substantial transaction costs, (b) inefficient continuance, (c) information asymmetry. Hypothesis 9. The existing thresholds for initiating bankruptcy under US laws, are grossly inadequate and inappropriate. Hypothesis 10. Given the history and performance of ESR, more regulatory agencies (eg. SEC, FTC, FCC, FDA, etc.) should implement mandatory solvency tests of companies that they supervise/examine, and should have the mandate to initiate bankruptcy proceedings for companies deemed unsuitable for continued operations. Hypothesis 11. In most jurisdictions, the magnitude of control granted (over operations of filing companies) to bankruptcy judges in bankruptcy proceedings is excessive and detrimental. Many bankruptcy judges do not have any formal business education and or have not worked in companies in operations/managerial positions. Many of the issues and technologies are highly complex, and require the use of an independent highly skilled jury-type committee to accurately analyze the issues (technological, sociological, psychological, financial, strategic, etc.). The results of the existing processes and judicial discretion include inefficient–continuance, inefficient–liquidation, longer duration of bankruptcy proceedings, inappropriate stays, greater transactions costs, inappropriate interference with business relations (between the distressed company and its creditor’s, suppliers, employees, etc.). 6. Game theory and financial distress The ESR, BOSS and GMAC transactions: (a) effectively invalidate all theories developed in Aumann and Peleg [5], Aumann and Maschler [6], Aumann and Shapley [7]; Aumann [8]; Wilks and Zimbelman (2004); Bruner and Eades [26]; Berkovitch and Khanna (1991); Bechara and Damasio (2005), Lambert [70];

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Munck [74]; Roberts and Pashler [80]; Saloner [83]; (b) illustrate and prove that game theory does not work in real life, or is applicable only to a much smaller set of situations than was previously proposed, c) illustrates some critical issues involved in game theoretic analysis of financial distress, corporate transactions and bankruptcy—Fisher (1989) criticizes the use of game-theory for antitrust analysis. Also see: Li (1997). In this instance, before April 2000, all parties involved choose to continue (instead of reorganizing BOSS and GMAC or filing for bankruptcy) and to fund BOSS, GMAC and ESR even though all three entities were bankrupt at all times between 1997 and April 2000, and had violated US antitrust laws. In February 2000, various banks agreed to provide loans to fund the ESR transactions, and in October 2002, ESR’s creditors rejected its proposed prepackaged bankruptcy plan. These transactions were even more suprising given that as of February 2000, more than 40% of ESR’s, BOSS’s and GMAC’s assets consisted of goodwill, and all three entities were financed mostly with debt—there was not adequate collateral for these loans. Thus, the banks must have placed substantial value on the goodwill owned by these three companies—in this instance ‘‘expectations’’ of future good financial performance based on consolidation. Barnden (2002); Allen and Lueck (1995); Bergstrom et al. [12]; Bliss [19]. Traditional game theory analysis would have postulated that the banks, creditors, external auditors and government regulators would have acted differently than they did in the ESR instance. Song and Panayides (2002); Friedman (1998); Green [53]. In this instance, strategic alliances would have provided a more efficient way of achieving the same or similar objectives as M and A transactions. BOSS and GMAC’s insolvency was obvious. Rationality did not prevail. In this instance, N-player and one-player coalitions were definitely possible, feasible, potentially profitable and could have significantly changed the outcome and value of the game(s) at each stage. The absence of government intervention in the preceding roll-up acquisitions/mergers by BOSS and GMAC significantly altered the game (series of games), and was not justified even on the basis of national security considerations. Filing for bankruptcy or requesting for a restructuring were rational moves. Nash equilibria solutions were feasible. Bergstrim et al. [12]; Aiyagari and Williamson [2]; Song and Panayides (2002); Smit et al. [87]; Ahmed et al. [1]; Chen and Daley [31]. On or around October 18, 2002, ESR proposed a prepackaged plan of reorganization (under Chapter 11) to the holders of its 10.5% senior subordinated notes and its secured credit facilities. The main terms of the proposed plan were as follows: (1) ESR would secure a $100 million debtor-in-possession financing and a $100 million Exit Facility. (2) ESR would sell some non-strategic and under-performing businesses, and deliver $50 million of net proceeds from such sales (including related tax refunds) to the senior bank lenders by December 31, 2003. (3) Any trade claims owed to vendors would be paid as usual, consistent with ESR’s normal business practices and current credit terms. (4) Any amounts outstanding under ESR’s primary bank credit facility would be exchanged for a new $200 million term loan and 80% of the shares of new common stock in Reorganized ESR. (5) ESR’s 101/2% Senior Subordinated Notes would be exchanged for 20% of the shares of new common stock in the Reorganized ESR. (6) ESR’s junior subordinated notes of $4.1 million, its Convertible Preferred Stock, its common stock and all outstanding stock options and warrants would be canceled without consideration. (7) The reorganized ESR would adopt a stock option plan and assume substantially all employee agreements and contractual arrangements. (8) ESR would secure adequate surety bonding capacity. Traditional principles of game-theory are as follows: • A game is strictly determined if it has at least one saddle point. In strictly determined games, all saddle points in a game have the same payoff value. In strictly determined games, choosing the row and column through any saddle point gives optimal strategies for both players. • In a strictly determined game, the optimal mixed strategies are pure strategies, and are the optimal pure strategies. • Every game has optimal mixed strategies for both players. Every finite, zero-sum, two-person game has optimal mixed strategies. If there is more than one optimal mixed strategy, then there are infinitely many.

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• If there is more than one optimal mixed strategy for one or both players, then that player may select any one mixed strategy. The expected value of the game does not depend on which optimal mixed strategy is used. • The value of a game is its expected value if optimal mixed strategies are used. • An equilibrium point in game theory is a set of strategies {xi . . . xn}, such that the ith payoff function Ki(x) is larger or equal for any other ith strategy. That is K i ðxi ; . . . ; xn Þ > K i ðx1 ; . . . ; xi1 ; xi ; xiþ1 ; . . . ; xn Þ: • In a Nash equilibrium, no player has an incentive to deviate from the strategy chosen, since no player can choose a better strategy given the choices of the other players. A Nash equilibrium of a strategic game is a profile of strategies ðs1 ; . . . ; sn Þ, where si 2 S i (Si is the strategy set of player i), such that for each player i, "si 2 Si, ui ðsi ; si Þ > ðsi ; si Þ, where si = (s)j2Nn{i} and ui : S  xj2N S j ! R. However, the conduct of many participants in the ESR (BOSS, GMAC, ESR) transactions violated, and did not conform to all these principles of game theory. See: Smit et al. [87]; Abarbanell and Meyendorff (1997); Joosten et al. (2004); Brusco et al. [27]; Young (1987); Baird and Picker [9]; Bliss [19]; Postrel (1991); Zhao (2000); Papayoanou (2001); Deman [41]; Braun [24]; Wilks and Zimbelman (2004); Weir et al. (2002); Gorton and Schmid (2000); Gorton and Schmid (1999); Van Witteloostuijn (2003); Presman and Sethi (1996); Young (1987); Joosten et al. (2004); Bliss [19]; Durnev and Kirn [46]; Claessens and Klapper [33]; Hogfeldt and Hogholm [62]; Yilmaz [99]; Shubik [85]; Boland [21]; Erev and Roth [48]; Colman [34]; Banner and Abbott [55]; Roth et al. [82]; Cox [36]; Laffont [69]; Arthur [4]. Such non-conformance and irrationality is typical in many real-life ‘‘games’’, and can be attributed to: • • • • • • • • • • • • • • • • • • • • • • • • • • •

Expectations—pertaining to profits, liabilities, final states of wealth, etc. Absence of government intervention. Lack of clarity of the financial structure. Information processing capabilities of the players, indirect participants and regulators. Differences in availability of information. Economic conditions. Types of contracts (financial and non-financial) used. Human relationships and business relationships, and the need to preserve such relationships, all of which can result in violations of principles of game theory. Governmental influences and national security concerns sometime result in violations of game theory principles. The nature of players in any game is a major determinant of the characteristics and outcome of the game. The types of ownership of interests that at stake in the game(s) Dentchev and Heene [43]; Dumev and Kirn [46]; Roth et al. [82]. Reputation effects. Abreau and Sethi (2003); Dentchev and Heene [43]; Durnev and Kirn [46]. Reliance on bankruptcy laws and judicial intervention. Willingness-To-Accept-Losses, Regret minimization, and irrationality in decision making. Reciprocity. Type of capital (most of ESR’s capital was human capital). Capital constraints for two or more players. Significant opportunity costs for two or more players. Sunk cost effects. Sudden adverse changes in conditions. Availability of credit, or conversely, excess credit. Belief revisions, and rates of revisions. Perceived unfairness. Negative social capital or perceived excess social capital. Low Trust. Magnitude of ‘common knowledge’. Group think and herd behavior.

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Game theory is inaccurate for various reasons, some of which are explained as follows. Game Theory erroneously assumes one party’s complete or partial knowledge of the opposing party’s position, intent and options. On the contrary, in real life, there is often substantial information asymmetry, differences in knowledge, differences in information processing capabilities, and divergencies between an individual’s expressed intent and actual conduct. The information asymmetry that is inherent in most bargaining situations is not captured in game theoretic analysis. This is because a) there are substantial differences in information processing capabilities, b) substantial differences in biological/neural processes in each person, c) substantial differences in each person’s belief system (Nwogugu (2005a), Roth and Malouf [81]). In any game, when the number of players is large, the estimated results are very likely to be inaccurate. Hence, game theory, if applicable at all, applies to games involving very few people (typically two-person games). Game theory often assumes constant combinations of players, resources and restrictions—which often does not occur in real life. Almost all game theoretic analysis does not consider Opportunity Costs, Regret and Willingness-To-Accept-Losses (WTAL). In game theoretic analysis, risk is expressed almost exclusively in terms of variances, means, standard deviations. It has been shown that WTAL, transferability/deferral/application of losses, and total wealth, are valid and relevant risk measures Nwogugu (2005a,b). Regret and regretminimization are not incorporated into game theoretic analysis and the related literature. Regret and regret minimization are critical elements of bargaining, because they affect risk aversion, perceptions, bargaining objectives, utilities and states Nwogugu (2005d). Regret minimization is inter-twined with, and an inseparable element of decision making and bargaining. Abreu and Sethi (2003) found that the game theory literature does not explain the presence of behavioral players and the specific forms of irrationality assumed in games, and the population shares of various types of irrationality. Hauk and Hurkens [58] found that none of the known strategic stability concepts capture forward induction as its defined in Van Damme (1989). Goeree and Holt [51] analyze various contradictions in game theory. Game Theory is a generalization and approximation of Expected Utility Theory (‘‘EUT’’). Game theory is based on analysis of expectations and utilities, given assumptions of the player’s knowledge and other player’s knowledge. Hence, game theory is simply groupings and manipulations of expected utilities, Hey and Orme [61]. Game Theory does not incorporate the effects of Social Capital and belief systems. Game Theory erroneously assumes that player’s/subject’s utility payoffs are the same as their monetary payoffs. Game Theory does not sufficiently discriminate between cash and non-cash transfers. Game theory does not incorporate all elements of Reciprocity, Fairness and Trust in bargaining—game theoretic models assume constant profit-maximizing rationality based on utilities—but omit often-occurring elements of relationship-building, Trust, Fairness and reciprocity. Bargaining is essentially a social exchange which varies among cultures, over time, by age and location. Game theory over-generalizes the elements of the social exchanges inherent in bargaining, Kiyonari et al. [67]. Rationality is a critical element of Game Theory. Rationality often equates to profit maximization. Fairness is also a critical element in bargaining and decision making. In the bargaining context, Rationality conflicts with fairness, such that both cannot co-exist in any one frame of analysis. To the extent that game theory does not incorporate the trade-offs between rationality and fairness, or does not incorporate fairness, then game theory is inaccurate, Rabin [79]. Corradi and Sarin (2000) found that different ways of taking the continuous limit of the same model may result in either an ODE (ordinary differential equation) or a SDE (stochastic differential equation), each of which is typically used in modeling properties of discrete stochastic processes in game theoretic analysis. Corradi and Sarin (2000) also show that continuous models and discrete models in game theory yield substantially different results/approximations—but if the theories/states/processes/characterizations in game theory are correct, then both methods should produce the same results (or in the worst case scenario, the discrete models should be shown to be special cases of continuous models), but since this is never the case, game theory is wrong. To evaluate this contention, note the most important characteristics of game theory that matter for both continuous and discrete models are: a) the resources are the same—the compounding of money in continuous time is not relevant because financial institutions generally use one method to calculate interest payments, b) the number of players are the same, c) time restrictions are the same, d) the information available to each party remains the same.

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Butler [28] explains many instances where game theory has been shown not to be accurate. Unique phenomena such as Parrondo’s Paradox are further evidence that Game Theory is inaccurate. Harmer and Abbott [55] and Edlins [47] identified specific situations in which Game Theory was inaccurate and could not explain the dynamics of bargaining. Many studies have identified numerous deficiencies in Game Theory; and or have disproved critical assumptions of Game Theory such as utility maximization, knowledge of other party’s strategies, expectations, etc.. These studies include: Durnev and Kim [46]; Shubik [85]; Boland [21]; Hechter [59]; Blount and Larrick [20]; Bromiley and Papenhausen [25]; Edlins [47]; Erev and Roth [48]; Colman [34]; Harmer and Abbott [55]; Dellnitz and Junge [40]; Johnson et al. [67]. Roth et al. [82]; Cox [36]; Laffont [69]; Miller (April 2005); Hart et al. (2001); Arthur [4]. Several empirical and theoretical studies have questioned and disproved the relevance and applicability of Rationality and Equilibrium, which are critical assumptions underlying Game Theory - the studies include Hechter [59]; Bromiley and Papenhausen [25]; Erev and Roth [48]; Colman [34]; Roth et al. [82]; Laffont [69]. Green [54] empirically demonstrated that game theory is not effective in prediction decisions. Chatterjee [29] presents several criticisms of game theory. Troger [92] found that although sunk costs are relevant, almost all game theoretic analysis omits sunk costs in bargaining outcomes. Similarly, Backward Induction is a critical mathematical technique used in game theoretical analysis, but Johnson et al. [66] have shown that backward induction is often incorrect. Brams [23] states that backward induction is sometimes omitted in game theoretic analysis. Brams [23] also introduces several problems inherent in applying game theory to international relations. However, Stone [89] compared Game Theory and Theory Of Moves, and found that game theory was more effective. Thus, traditional game theory principles are applicable only under a much more limited set of conditions than was previously established. The differences, if any, between the outcomes of long-term games and shortterm games is highly dependent on the capitalization of the players, the degree of regulation applicable to the game, the propensity to commit crimes, and the possible penalties that could result from any such crimes. 7. Conclusion Many large corporate transactions raise key economic, accounting and policy issues that have certainly not been considered at all or fully analyzed in existing literature. The ESR transaction illustrates that most principles of Game Theory don’t function in the real world (or function in a much fewer types of circumstances than were previously theorized). The quality and scope of financial contracting by firms has become critical not only to firm value but also for determination of liability, the design of sanctions, and establishment of evidentiary standards and laws. References [1] A. Ahmed, C. Takeda, S. Thomas, Bank loan provisions: a reexamination of capital management, earnings management and signalling effects, Journal of Accounting and Economics 28 (1) (1999) 1–25. [2] R. Aiyagari, S. Williamson, Credit in a random matching model with private information, Review of Economic Dynamics 2 (1) (1999) 36–64. [3] A. Almazan, J. Suarez, Managerial compensation and the market reaction to bank loans, Review of Fiancial Studies (2002). [4] B. Arthur, Complexity and the economy, Science 284 (2) (1999) 107–109. [5] R. Aumann, B. Peleg, A method of computing the kernel of n-person games, Mathematics of Computation (1965). [6] R. Aumann, M. Maschler, Game theoretic analysis of a bankruptcy problem from the Talmud, Journal of Economic Theory (1985). [7] R. Aumann, L.S. Shapley, Long-term competition: a game-theoretic analysis, in: Gale et al. (Eds.), Essays in Game Theory, 1994. [8] R. Aumann, Backward induction and common knowledge of rationality, Games and Economics Behavior (1995). [9] D. Baird, R. Picker, A simple non-cooperative bargaining model of corporate reorganization, Journal of Legal Studies (1991). [10] M. Bayless, S. Chaplinsky, Expectations of security types and the information content of debt and equity offers, Journal of Financial Intermediation 1 (1991) 195–214. [11] L. Bebchuk, R. Picker, Bankruptcy rules, managerial entrenchment and firm specific human capital, Working Paper, 1992. [12] C. Bergstrom, T. Eisenberg, S. Sundgren, Secured debt and the likelihood of reorganization, International Review of Law and Economics 22 (4) (2001) 421–442. [13] P. Berger, E. Ofek, D. Yermack, Managerial entrenchment and capital structure decisions, Journal of Finance 52 (1997) 1411–1438.

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Further reading [1] K. Hopt, Labor representation on corporate boards: Impacts and problems for corporate governance and economic integration in Europe, International Review Of Law And Economics 14 (2) (1994) 203–214.