Policy Implications of the Common Ownership Debate

Intervene or Wait for More Research?

In arguing for legal intervention now, Elhauge trenchantly invokes tobacco regulation, noting that tobacco companies staved off life-saving regulation of tobacco products by insisting that scientists supplement the well-understood correlations between tobacco use and lung cancer with scientific “proof” of causal mechanisms. ⁷ Today’s example is resistance to climate regulation by skeptics who claim that causation has not yet been established. As Schmalz points out, science cannot prove causation but can only infer it by ruling out increasingly remote alternative theoretical hypotheses. This process has no logical end, which means an overly rigorous insistence on scientific proof would shut down all forms of regulation.

We have no choice but to evaluate the existing studies and make a judgment. While not everyone has been persuaded by the AST paper, ⁸ there are several facts that are mostly undisputed. First, there is an incentive—a very large one, from the standpoint of theory, given that the law blocks off other forms of collusion—for someone to buy up large stakes in competitors and discourage them from competing with each other. Second, stakes large enough to give influence have already been obtained by major institutional investors and large activist investors as well. Third, there is substantial evidence that common ownership has some effect on the behavior of portfolio firms—with the major discussion about whether this effect is negative or positive, systemic or sector-specific, and large or small. ⁹ Fourth, the spectacular growth of common ownership over the last few decades confronts us with a novel financial structure that concentrates economic power in a handful of firms, creating, at the least, significant potential for great harm. This trend will not end anytime soon. Bebchuk and Hirst predict that the Big Three institutional investors will cast 40% of votes at S&P 500 firms by 2039, up from 25% today. ¹⁰

Finally, the traditional skeptical view of antitrust law associated with the Chicago school, whose echoes can be heard in the argument of the critics, is not looking so good these days. Chicago Schoolists believed that market incentives undermined collusion and monopoly, and antitrust intervention cannot handle the complexity of market behavior outside obvious cases. In taking a hammer to the more restrictive antitrust doctrine that prevailed before the 1970s, they promised that relaxation of antitrust law would not accelerate consolidation. And yet just the opposite happened. ¹¹ All of these developments taken together would normally be considered ample justification for a policy response—at a minimum, investigation, information-gathering, and readiness to intervene, but potentially much more.

The Nature of the Mechanism

The mechanism debate addresses the causal pathway that connects common ownership with higher prices being charged by portfolio firms. The debate initially arose when skeptics asked why they should believe the AST results when it was possible that the correlations between ticket prices and common ownership might reflect an innocent omitted variable. But the debate is important for a second reason. If AST’s empirical results are correct, we need to understand the mechanism, so that we can design a policy response that is suited to the source of the anticompetitive outcomes. Various authors, including AST and Elhauge, ¹² discuss a variety of possible mechanisms. For simplicity, and at the risk of ignoring important complications and variations, I will group them into two categories.

These two types of mechanisms can be understood in a crosscutting way in terms of activity or passivity on the part of the common owner. This distinction gets to the heart of the skepticism of the critics who doubt that common owners have the incentive to design an optimal incentive contract that would cause managers to soften competition, especially given the risk that an incentive contract that discouraged competition by blunting incentives would also discourage managers from engaging in effort to cut costs and innovate. ¹⁶ AEGS point out that blunter incentives both reduce incentives to cut cost and to compete, and from the common owner’s standpoint, the gain from less competition may exceed the cost from less effort—especially as the underlying product market becomes more concentrated. Thus, even a relatively passive common owner—one who more or less deferred to management in all respects, normally voting with them when they proposed self-interested blunt incentives in their compensation packages—would produce the common ownership effect of less competition in product markets. But because managers will tend to propose incentives that are too blunt, common owners may, on the margin, intervene with more active measures—like threats to fire managers or attempts to negotiate compensation packages directly. ¹⁷

If either of these mechanisms are in play, what is the right policy response? There are a number of possibilities.

But there are reasons for thinking that traditional antitrust enforcement will not be adequate to the problem. One is the novelty of the factual setting. Courts have not adjudicated a claim that a firm has caused anticompetitive harm to a market by gradually acquiring a large minority ownership stake in multiple competing firms over decades. And while an anticompetitive purpose is not strictly required, courts may be reluctant to recognize liability on the part of firms that obtained their large stakes by offering index funds, which are widely regarded as socially beneficial. The growth of institutional investors, and their possibly anticompetitive influence on portfolio firms, have the feel of a systemic problem with how markets work rather than the kind of one-off antitrust violation that courts are accustomed to handle.

In 1963, the Supreme Court recognized that courts may block, and break up, mergers that threatened excessive concentration. ¹⁹ The logic straightforwardly applies to common ownership, as Elhauge observes. ²⁰ But there is little enthusiasm for this approach among courts today. This seems to be less about doctrine than the attitudes of judges, who are friendlier to big business than they used to be. While there may be good cases against hedge funds, private equity firms, and other activist financial institutions that have clearly bought up large stakes in competing firms in order to soften competition, creative and ambitious claims against the big institutional investors whose impact on markets through the largely passive accumulation of shares for indexing purpose may be a hard sell.

Finally, there are a range of logistical complexities and problems that may deter antitrust lawsuits. The empirical analysis that litigators would need to undertake in order to prevail is difficult and expensive; there remain a range of methodological disputes that heighten the risk of litigation; judges may regard remedies like divestiture as disruptive; and they also may simply not be able to understand the theory. While, as Elhauge notes, acquisition and even retention of stock may qualify as an anticompetitive act under blackletter antitrust law, ²¹ I suspect that some judges will be bothered by the mechanism issue, just like AST’s critics. They may worry that institutional investors can become liable under the AST theory as a result of actions that they may not even be aware of (say, the sale of stock to the dispersed market by a large undiversified shareholder ²² ). They will not believe that institutional investors order portfolio firms to soften competition unless there is proof of communications; they may not regard voting for a management compensation package that provides management with incentives that are more blunt than socially optimal as sufficiently clear; and they will likely regard the AEGS crowding-out mechanism as a problem for the legislature rather than the courts.

AEGS suggests that the ultimate problem for competition is not so much the rise of common ownership as the decline of the large undiversified investor. In AEGS’s model, competition is retarded even in a Berle-Means word of dispersed shareholders if large blocks are not held by undiversified owners. That seems more like a regulation-of-capital-markets problem than a problem for which traditional antitrust legal principles are suited. And a regulatory approach may seem more appropriate because courts might worry that if they recognize antitrust liability in one case, thereafter potential defendants will not know whether a range of possibly reasonable measures—like mirror-voting, or transferring voting authority from fund families to funds, or limiting their acquisitions to a relatively small percentage of a firm’s stock—will suffice to avoid liability. To be sure, creative and ambitious courts may rule otherwise, but in the meantime, these risks seem likely to deter litigation and certainly large-scale litigation that would provide optimal incentives to minimize the common ownership effect where harmful.

We can cut the Gordian knot with a regulatory approach that forbids large common owners to communicate with, or exert control over, managers in any way. The rule would provide that only undiversified owners may communicate with managers. Common owners must remain mum and either not vote or mirror-vote. The effect of this rule would be to create a kind of dual-class ownership structure. Undiversified shareholders would retain voting and communication rights; diversified shareholders would be passive, protected only by their right to dividends and liquidation value.

One virtue of this approach is that it is consistent with one of the original stated justifications of index investing: to minimize expenses. Index funds distinguished themselves from active funds in just this way: because they did not pick stocks, they could refrain from monitoring firms, and of course knowing nothing about the firms, they had little reason to vote. Unfortunately, this justification was in tension with their fiduciary duty to their clients. The reform would require redefinition of the fiduciary duty as requiring the common owner to advance the interests of clients in an administrative capacity only.

A problem with this approach is that it casts its net too large, depriving diversified owners of their control rights even if they are too small to reduce competition. In aggregate, this might leave shareholders at the mercy of managers who do not have to face adverse votes from the bulk of their shareholders. Moreover, in the AEGS model, a common owner may push management of a portfolio firm to compete more rather than less vigorously. If the company has a large undiversified shareholder, AEGS predicts that the common owner will push management to compete less vigorously. But if the company has no large undiversified shareholder and only small shareholders, then the common owner could push management to compete more vigorously. Blocking communication by common owners may on net be unwise.

There are other possible corporate governance reforms, for example, strengthened enforcement of restrictions on interlocking directorates, as it appears that common owners place directors on the boards of competing firms, and may exercise influence through those directors. ²³ However, this reform would leave numerous other pathways of influence.

The standard for judging performance-sensitivity would be based on the compensation practices of firms in other sectors that are more competitive (either because common ownership is less or the product market contains more firms) or firms in the same sector that do not have significant common owners. While government regulation of the terms of employment agreements is generally frowned upon, it may well be justified in this context. It could be modeled on actions against investment advisors for excessive fees under section 36(b) of the Investment Company Act of 1940, which regulates compensation of investment advisors for managing investment funds.

The advantage of this approach is that it is unlikely that diversification exhibits the scale economies that, say, a complex manufacturing operation does. The stock prices of firms within a single sector are highly correlated. The diversification gains from owning all airlines rather than one are small. And because individuals would remain free to buy shares in the minnows, or to buy shares in multiple large funds, those who insisted on maximum diversification would remain free to obtain it at low cost through some trouble.

In an earlier paper, I and my coauthors argued that institutional investors should be given a choice between one option or the other—the minnow approach of complete diversification or the behemoth approach where they sacrifice some diversification but can be as large as they want. ²⁴ (They would also be permitted to be a fully diversified behemoth—with large shares in even competing firms—if they commit not to exert influence by word or vote, as in #3 above.) This regulatory approach would be a lot simpler than incremental remediation through litigation under the antitrust laws. Which is not to say that the regulatory approach would be simple. Regulators would have to define markets and figure out how to address cases where a single firm operates in multiple overlapping markets.

Moreover, market structure regulation is not as simple as converting behemoths into minnows. To take an extreme case, if ninety-nine common owners each owns a 1% stake in every firm in a sector, and (as in AEGS) they do nothing while managers have the remaining stake (or some combination of managers and undiversified funds), the common ownership effect will remain: executive compensation will be insufficiently performance-insensitive, so the firms will be both poorly run and uncompetitive. Market structure regulation must ensure that undiversified shareholders retain a sizable chunk of every firm. The rule allowing common owners to own stakes larger than 1% if they own no more than one firm in a sector would spur some institutional investors to become large owners that are undiversified within a sector, but it might not suffice. ²⁵

If we take the AEGS model as our guide, then policy should be oriented to ensuring that all firms have large undiversified shareholders. It is unclear what the right policy instrument for such a goal would be, but presumably a literal or effective Pigouvian tax on (within-sector) diversification and (in general) smallness could be appropriate. On the other hand, we might worry that extremely large common owners would collude with each other or engage in parallelism, and if this is a case then the expansion of common ownership as such should be the focus of policy.

This approach recognizes that the existing Merger Guidelines disregard a negative externality from mergers—that the incremental concentration of the market caused by a merger will increase the attractiveness of stakes in the firms in the industry for common owners, giving them an incentive to acquire stakes or increase their stakes, and then use their power to further limit competition between the merged firm and its remaining competitors. Or, to put the point differently: we should be willing to give up some scale economies in order to reduce the risk that competition will be excessively reduced in the future through the instrument of common ownership. Merger review currently recognizes that partial acquisitions (i.e., where one firm obtains a minority stake in its competitors) can reduce competition; ²⁸ this logic extends straightforwardly to cases where a third-party investor has partial stakes in the two competing firms.

The problem here is that U.S. product markets are already highly concentrated; it may be too late for an aggressive merger policy to make much of a different, at least in the short to medium term. And if economies of scale in the product market favor large firms, then a more aggressive merger policy may on net cause harm.

The Indirect Costs of Intervention

Several articles written after AST identify a possible benefit of common ownership aside from its facilitation of diversification: common owners may compel portfolio firms to cooperate in socially beneficial ways. We can identify two versions of this argument. First, imagine that Firm A and Firm B are independently developing COVID-19 vaccines. Each firm has proprietary information that it refuses to share with its competitor. A common owner is indifferent as to whether Firm A or B wins the race and so directs the two firms to share or disclose their trade secrets. Here, the common owner enables each firm to capture positive externalities from the behavior of other firms. ²⁹

Second, imagine now that Firm A and Firm B belong to different sectors. Firm A emits greenhouse gases or some other pollutant, and those emissions harm Firm B. A common owner of Firm A and Firm B will direct Firm A to mitigate its greenhouse gas emissions. Of course, the common owner will not direct socially optimal emissions but it will still benefit society. ³⁰ If either of these hypotheses is true, then restrictions on common ownership may be socially harmful.

From both an antitrust and regulatory perspective, however, there is less to these arguments than meet the eye. In antitrust cases, defendants can often argue that a business efficiency justifies behavior that would otherwise seem anticompetitive. Indeed, the research-sharing justification is not much different from the argument that common owners benefit their clients by giving them access to easy diversification. If research efficiencies arise, then in suitable cases, defendants may argue that common ownership (as well as mergers and other forms of cooperation) may be lawful.

The same point can be made about regulation. Simple regulations designed to limit common ownership or control by common owners of portfolio forms may (as so often happens) be required to yield to a more complex approach that creates safe harbors for socially beneficial cooperation across firms. Antitrust law and related regulations that encourage competition are already full of such exceptions.

Finally, regulators should be careful to distinguish diversification that involves common ownership within industries and diversification that involves common ownership (only) across industries. In the second example, a regulation that limits common ownership within sectors will still preserve at least a portion of the socially beneficial behavior: the common owner will restrict greenhouse gases in order to benefit the firms it owns outside the sector of the polluter, while it will have no incentive to reduce competition because it owns only one firm per sector. The first example is more difficult. A regulation that limits the common owner’s ability to own multiple firms in one sector will also prevent it from capturing the externality.