The Strategies of Anticompetitive Common Ownership.

• Author: Hemphill, C. Scott

INTRODUCTION

Institutional investors often hold shares of competing firms. Recent scholarship has considered whether such common ownership has anticompetitive effects. Antitrust theorists have long suggested that the interests of a common concentrated owner (CCO) differ from those of an owner of a single firm and that a CCO might be able to induce firms in which it holds a stake to further these interests. (1) Recent empirical evidence, finding that CCOs are associated with higher prices and lower output, seems to support this theory. (2)

This new evidence, along with the dramatic growth in institutional investors' holdings over the last several decades, has stimulated a major rethinking of antitrust enforcement. The Department of Justice has acknowledged concerns about the anticompetitive effects of common ownership and investigated common ownership of competing airlines. (3) In 2018, the Federal Trade Commission took these concerns a step further, conducting an all-day hearing on the subject. (4) In Europe, antitrust enforcers have taken a more aggressive approach: in addition to announcing a potentially wide-ranging inquiry into the effects of common ownership, (5) the European Commission actually relied on theory and evidence about the anticompetitive effects of common ownership in a 2017 decision analyzing a major merger. (6)

Academic commentators have advocated more extreme measures. They urge policies that would require funds to cease their ownership of competing firms, shrink to a fraction of their current size, or lose the right to vote their shares in portfolio firms. (7) This line of scholarship makes the startling suggestion that large index funds and many large, actively managed mutual funds contravene antitrust law. These proposals, if adopted, would fundamentally transform the landscape of institutional investing.

The new empirical evidence also poses a challenge to corporate governance scholarship. This literature has long viewed most institutional investors--and mutual funds in particular--as largely benign actors that seldom exercise their substantial powers. (8) Institutional investors--due to their large shareholdings, access to sophisticated advice, and economies of scope--have the capacity to help overcome the collective action problems that plague corporate America. Alas, in the view of corporate governance scholars, institutional investors have not been active enough. (9) In particular, mutual funds are mostly reactive and generally refrain from openly pushing for the removal of ineffective management. (10) Thus, an important goal of corporate governance reformers has been to increase the activity level of institutional investors. (11)

From the traditional corporate governance perspective, evidence that CCOs have an anticompetitive effect is therefore disconcerting. Many corporate governance scholars harbor doubts that this conclusion, so different from their long-held notions, can be correct. Moreover, even talk of potential antitrust liability or additional regulation of institutional-investor voting might discourage these already-reluctant shareholders from becoming more assertive. Such threats could play into the hands of supporters of managerial primacy who, for their own reasons, have been skeptical about the influence of institutional shareholders.

The most important piece of empirical evidence so far, and the trigger for an outpouring of related work, is a study of the airline industry by Jose Azar, Martin Schmalz, and Isabel Tecu (AST). (12) AST concludes that common ownership of competing airlines, evaluated at the route level, is associated with higher prices on that route. (13) Critics have subjected AST to sustained scrutiny, contesting its methodology and conclusions. (14) At the same time, commentators have offered AST and related studies as the empirical basis for sweeping reforms. (15)

Missing from the debate thus far has been a systematic explication and assessment of the causal mechanisms that might link common ownership to higher prices. This inquiry is important for several reasons. First, the absence of a plausible mechanism would raise doubts about proponents' preferred interpretation of the statistical relationship between common ownership and market outcomes. Second, a finding that only certain types of investors can plausibly avail themselves of the mechanism would suggest the need for narrower, more targeted reform proposals and enforcement actions, as well as targeted investigations to uncover direct evidence of CCOs influencing corporate policy.

This Article is an effort to fill this gap. We identify a wide range of potential mechanisms linking common ownership to anticompetitive effects. As to each mechanism, we evaluate, first, whether the current empirical literature tests the mechanism--that is, whether its use would generate the observed empirical results. Second, we assess whether the mechanism is plausible, in the sense that it is feasible, effective, and in a CCO's interest.

As we explain, potential mechanisms differ along three main dimensions. First, some mechanisms produce conflict, rather than consensus, between the CCO and other firm shareholders, by inducing a firm to take actions that raise CCO portfolio value at the expense of that firm's value. Second, certain mechanisms target specific firm actions, while others affect the firm's actions across the board. Finally, some mechanisms are active--the CCO speaks with management, votes on a proposal, or otherwise takes some positive step to further its strategy--rather than passive.

Our evaluation yields three main results. First, some widely discussed mechanisms are, in fact, not tested through the methodology employed in the empirical literature. Specifically, AST and many other studies are limited to targeted conflict mechanisms and apply neither to consensus mechanisms (16) nor to passive across-the-board mechanisms. (17)

Second, some mechanisms face major challenges as to feasibility and effectiveness. To be feasible, a CCO must have the power and ability to employ the mechanism. Yet institutional investors are poorly structured to generate, transmit, induce, and monitor compliance with targeted active strategies or otherwise lack the capacity to pursue them. (18) To be effective, the use of the mechanism must generate benefits to the CCO by raising the value of companies held by the CCO net of any collateral value reductions caused by the mechanism. Yet most across-the-board strategies, such as reducing the degree to which compensation depends on firm performance, dilute incentives to maximize firm value, resulting in harm that may exceed the benefits associated with the strategy. (19)

Third, some mechanisms are implausible because they do not serve the interests of institutional-investor CCOs. To be in a CCO's interest, the profits that the CCO obtains from any net increase in portfolio value must exceed the costs to the CCO from employing a mechanism. Yet institutional CCOs generally have only weak incentives--much weaker than the common-ownership literature presumes--to maximize the aggregate value of their portfolio securities. (20) Furthermore, some mechanisms entail significant legal and reputational risk to CCOs, making their employment by institutional investors implausible. (21)

Our main conclusion is that, for most mechanisms, there is either no strong theoretical basis for believing that institutional CCOs could or would want to employ them, no significant evidence suggesting that they do employ them, or both. (22) Our findings, however, are not uniformly negative. A mechanism that we call "selective omission" is consistent with both theory and empirical evidence. (23) A CCO engaged in selective omission presses for firm actions that increase both firm value and portfolio value, while remaining silent as to actions where the two conflict. Aside from selective omission, some across-the-board mechanisms may plausibly be employed, but substantial empirical evidence of their use is currently lacking.

Our analysis has several important implications. First, the empirical literature has paid insufficient attention to systematic differences in the incentives of different investor types. For example, in any analysis of anticompetitive effects, advisors that mostly manage index funds should be distinguished from other CCOs. (24) Index funds are, at first blush, the most plausible culprits because they tend to own similar stakes across multiple competitors and maintain stable holdings over time, which, as we show, facilitates the use of certain mechanisms. Index funds, however, have the weakest incentives and the least ability to employ targeted mechanisms. Our analysis therefore suggests that index funds either play no significant role in generating anticompetitive effects or systematically employ different mechanisms than other types of CCOs.

Second, the welfare effects of CCOs are ambiguous even if common concentrated ownership is associated with anticompetitive effects. (25) If CCOs do induce anticompetitive outcomes, they can also be expected to induce actions that improve a firm's efficiency and, in turn, its profits--for example, by eliminating redundant expenditures.

Third, our analysis reveals top priorities for further research. (26) The current empirical literature raises concerns that deserve significant attention but that are neither sufficient to establish that CCOs engage in selective omission nor well designed to test certain other plausible causal mechanisms. We suggest studies to fill these gaps and emphasize the importance of seeking direct evidence of the steps CCOs take, and the steps firms take in response, that produce anticompetitive results. The studies should include examinations of internal communications among officials of an investment advisor and external communications between officials of an investment advisor and executives of portfolio...