In a conventional merger or acquisition, the merging companies become a single legal entity, with one business buying the outstanding shares of the other.
However, when a DLC is created, the two companies continue to exist, and to have separate bodies of shareholders, but they agree to share all the risks and rewards of the ownership of all their operating businesses in a fixed proportion, laid out in a contract called an "equalization agreement".
There are often tax reasons for companies from different jurisdictions to adopt a DLC structure instead of a regular merger where a single share is created.
A third motive is the reduction of investor flow-back, which would depress the price of the stock of one of the firms in their own market if the merger route were used instead.
In the academic finance literature, Rosenthal and Young (1990) and Froot and Dabora (1999) show that significant mispricing in three DLCs (Royal Dutch Shell, Unilever, and Smithkline Beecham) has existed over a long period of time.
[7][8] Both studies conclude that fundamental factors (such as currency risk, governance structures, legal contracts, liquidity, and taxation) are not sufficient to explain the magnitude of the price deviations.
A potential explanation is that local investor expectations affect the relative prices of the shares of the DLC parent companies.
[9] Because of the absence of "fundamental reasons" for the mispricing, DLCs have become known as a textbook example of arbitrage opportunities, see for example Brealey, Myers, and Allen (2006, chapter 13).
LTCM established an arbitrage position in this DLC in the summer of 1997, when Royal Dutch traded at an eight to ten percent premium.
[12] In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions.
Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss.
In these situations, arbitrageurs receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss.