Friday, November 16, 2012

Netflix and Some Personal History with the Poison Pill

It will be interesting to follow the battle for Netflix.  The company recently adopted a 'poison pill' in response to Carl Icahn's acquisition of a 10% interest in the company.  Some recent details are contained in this link from MSN Money.

Poison pills are so named because they are designed to make a company indigestible to a hostile bidder.  Typically, a poison pill is a 'springing right' giving shareholders the option of either buying shares in their own firm at a bargain price or buying shares in the bidding firm at a bargain price.  (More on this latter option in a moment.)  Conceptually, this seems like a stock split or a stock dividend where under idealized conditions, the wealth of a shareholder isn't affected.  In the case of the poison pill, however, the 'acquiring or bidding party' is excluded from using the pill.  Hence other shareholders gain at the loss of the potential bidder.

The first poison pill was issued by Enstar in 1982.  By early 1985, there were 12 in existence.  I know, because I was a young assistant professor at the time, visiting at the University of Washington in Seattle.  My colleague, Paul Malatesta and I were intrigued by a Wall Street Journal article describing the pill and we conducted the first empirical examination of their characteristics.  (The original article that came out of this is now dated but for those interested it was published in the Journal of Financial Economics.  It can be viewed here and downloaded at the top left of the page).

Of particular interest to us was the concept that you could 'buy stock in the acquiring party's firm at a reduced rate'.  The last time I checked, I couldn't give you the right to buy someone else's car at a bargain rate.  We wondered how this could work with stock and decided to investigate.  We called Marty Lipton, regarded as the father of the poison pill and he informed us that, yes, the article was correct and that there were now 14 such pills - he had done them all.  So we began our analysis with that small sample.  Soon the sample grew to 30.  By that time, the legality of the pill was being decided in the Delaware Courts.   The courts upheld the legality of the Household International pill in November 1985 and our sample quickly grew to over 120.  By the end of 1986 there were over 300 in existence.

Our main findings at the time:

  • Firms that issued pills had been less profitable than their peers
  • Shareholders of Firms that issued pills suffered wealth losses
  • Executives of these firms owned smaller amounts of shares and hence, were more insulated from the losses

The announcement of a pill can send two messages.  First - wow, the firm's in play!  This would boost stock prices.  Second, is the deterrent effect of the pill itself.  For the very earliest pills, we found the wealth losses to be negative.  In fact the wealth losses were 1% for firms not in play, but if we restricted our analysis to those already in play at the time the pill was announced, (so the positive 'in play' hit was already in the price) the wealth losses were 4%.

The impact and efficacy of the pill has continued to be debated over the past 30 years.  Throughout the rest of the 1980s and 1990s thousands of companies adopted them.  As they became more anticipated, the price reaction was muted.  Advocates argued that they effectively prevented so called 'raiders' from stealing the company.  The pills, it is argued, increase bargaining power.  Detractors counter that the pills can be used to entrench mangement at the expense of shareholders.   It is still felt that the combination of a poison pill with a staggered board (i.e., electing say a third of the directors each year) is a powerful deterrent to acquisition.  The combination is important because pills can be rescinded by the board, so a proxy fight resulting in a takeover of the board would remove the pill.  However, few acquiring firms would be so patient as to wait two or more years to get control of the entire board.  Over the past decade there has been a movement by activists to remove poison pills and staggered boards. Many boards have agreed.

The specific details of Netflix's pill can be found here.  Note: Netflix has a staggered board.  It will be interesting to see how the directors react and whether the pill is used to negotiate or thwart Icahn's bid.

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