“The prisoner’s dilemma is a canonical example of a game analyzed in game theory that shows why two purely “rational” individuals might not cooperate, even if it appears that it is in their best interests to do so.” – Wikipedia
Two people are arrested and placed in solitary confinement with no means of speaking to or exchanging messages with the other. The police admit they don’t have enough evidence to convict the pair on the principal charge. They plan to sentence both to a year in prison on a lesser charge.
Simultaneously, the police offer each prisoner a Faustian bargain. Each prisoner is given the opportunity either to betray the other, by testifying that the other committed the crime, or to cooperate with the other by remaining silent.
Here’s how it goes:
- If A and B both betray the other, each of them serves 2 years in prison
- If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison (and vice versa)
- If A and B both remain silent, both of them will only serve 1 year in prison (on the lesser charge)
Because betraying a partner offers a greater reward than cooperating with them, all purely rational self-interested prisoners would betray the other, and so the only possible outcome for two purely rational prisoners is for them to betray each other.
The interesting part of this result is that pursuing individual reward logically leads both of the prisoners to betray, when they would get a better reward if they both cooperated.
However, in reality, humans display a systematic bias towards cooperative behavior in this and similar games, much more so than predicted by simple models of “rational” self-interested action.
I hope this is the case with Fiat (F:IM $FIATY) shareholders and arbitrageurs. On August 1st Fiat shareholders had a vote and approved the merger – of the already purchased - Chrysler.
Because Fiat’s registered office will be transferred outside of Italy, it’s stock delisted from the Italian exchange, and the company reorganized in another country, the Italian Civil Code states that certain cash exit rights are provided to those shareholders who voted against the merger. In Fiat’s case there were 100.1M (~8%) shares who voted against.
These shareholder receive a put option which can force the company to buy their share at the average price of the last 6 months. In the case of Fiat, the 6 month average price is €7.727 per share (or $10.33 per ADR).
However, if 64.7M or more of those shareholders exercise their put option, crossing over a €500M liability to Fiat, the entire merger falls apart, and importantly, those put options can not get exercised.
First off, it is imperative to understand that Fiat already bought Chrysler, that isn’t changing. This is all about combining both subsidiaries into a new – Netherlands based – entity to be called FCA. It is important for a new tax structure, a new listing here on the NYSE, and for issuing new convertible bonds to help fund expansion.
While it is an important step, many in the media have portrayed the consequences of the “deal falling apart” as Fiat not being able to purchase Chrysler. There is nothing further from the truth. From an operational perspective, the companies have already merged, and nothing will change that.
Having said that, it still would be a setback, and it will delay several important steps of Marchionne’s 5 year plan.
Back to the game theory, if all of the 100.1M shares decide to put their stock to Fiat – and play the role of a rational prisoner – the merger gets delayed and nobody gets to put their shares or get the €7.727. With the stock trading today at €7.17, and it’ll probably fall further on news of a delay, I sure hope at least 35.4M choose a cooperative behavior and remain silent.
PS. This post could have been a bit more timely if I posted it last week alongside this tweet
— Elliot Turner (@ElliotTurn) August 7, 2014
as $FIATY was a full point lower at that point.
It is still a good 25% off it highs from a few months ago, and while there is plenty of risk in the name, I do think that this is an attractive price for long-term oriented investors.