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E-MailEdward B. Rock is Professor of Law at New York University School of Law; and Daniel L. Rubinfeld is Professor of Law at NYU School of Law and Robert L. Bridges Professor of Law Emeritus and Professor of Economics Emeritus at the University of California, Berkeley. This post is based on recent paper by Professor Rock and Professor Rubinfeld.
For the past thirty years, regulatory reform efforts have focused on encouraging diversified institutional investor involvement in corporate governance. Now, some recent economic research threatens to chill these developments. In Azar, Schmalz and Tecu (working paper 2015) and Azar, Raina and Schmalz (working paper 2016), the authors argue that concentration among shareholdings by institutional investors has led to higher prices in two relatively concentrated industries: airlines and banking. Based on this research, Einer Elhauge (2016) has argued that current ownership patterns by diversified institutional investors violate Section 7 of the Clayton Act. Following on Elhauge’s piece, Posner, Scott Morton and Weyl (working paper 2016) propose a “solution” in which diversified investors would be limited to acquiring one firm in any oligopolistic industry.
In this paper, we critique the economic evidence, focusing on the airline industry. We then challenge Elhauge’s legal analysis and critically examine the proposals of Posner et al. Although we are unconvinced by the provocative claims of this new literature, we agree that an open discussion of the antitrust implications of common ownership by large institutional investors is appropriate and timely. We meet this challenge by sketching out and defending proposed “Antitrust Guidelines,” including a safe harbor, in an effort to prevent possible anticompetitive effects, while continuing to encourage institutional investor involvement in corporate governance.
The economic analyses are implausible theoretically and unconvincing empirically. The core claim is that managers of airlines, in choosing their business strategies, take into account the effect of those strategies on the value of the stock portfolios held by their investors. Because, as we show, the airlines’ shareholders have very different portfolios—some own all the major airlines, others only some, and some only one—we do not see how managers could do this. Other than maximizing the value of their own company, no other strategy could command the approval of investors with heterogeneous and often changing portfolios. Although “soft competition” might be in the economic interests of some of their shareholders, it will be against the economic interest of others. We also find implausible the claim that shareholders would be able to influence managers to “soften” competition so as to maximize portfolio value. How would they do so when directors do not run on a “competition” platform, and when shareholders vote on few other issues of importance?
Turning to the empirical analysis, we raise a variety of questions, focusing primarily on the claim that the modified Herfindahl-Hirschman index or HHI (the MHHI) is commensurate with the familiar HHI. Moreover, we are unconvinced by the efforts of Azar et al to control for the endogeneity of both the HHI and the MHHI. With regard to the claimed channel of influence—executive compensation—we are likewise unconvinced. Azar et al rely on a related paper that argues that the channel of influence is the (relative) absence of “Relative Performance Evaluation” in management compensation in concentrated industries. The idea is that without RPE, managers will care more about the profits of other firms in the same industry. Examining airlines, we show that contrary to the Azar et al assumption, RPE is pervasive in the airline industry, as one would expect given the pressure from leading shareholders and Institutional Shareholder Services (“ISS”) to utilize relative performance measures in structuring compensation.
We then provide a comprehensive analysis of the legal framework, starting with Clayton Act Section 7 and the 1957 Supreme Court case of U.S. v. DuPont (GM). The key legal issues are (a) whether there is evidence that the holdings are anti-competitive and (b) the scope of the “solely for investment” exemption. Contra Elhauge’s analysis, we conclude that existing ownership patterns do not violate Section 7, a position that is consistent with decades of DOJ/FTC enforcement policy.
Turning to Posner et al, we reject their proposal that index funds should be forced to abandon their highly successful business model and limit themselves to buying one firm in any concentrated industry. A much more likely response to antitrust risk, we argue, would be for funds to become entirely passive in governance matters, essentially “putting their shares in a drawer.” Although this strategy would satisfy the “solely for investment” exemption, the cost to corporate governance would be high, and any theory of antitrust liability that would induce this conduct should be viewed skeptically.
The final section takes seriously the core issue raised by this provocative line of research raises, namely, the intersection between the increased concentration of shareholdings and antitrust. Although we reject the claims that existing ownership patterns have anti-competitive effects, we agree that common ownership can be anti-competitive. We sketch out and defend proposed “Antitrust Guidelines,” including a safe harbor for investment below 15%, with no board representation and only “normal” corporate governance activities. This, we argue, complies with current law and will preserve institutional investors’ involvement in corporate governance. We also explore scenarios that would raise serious issues under Clayton Act Section 7 and Sherman Act Section 1, including the acquisition of large (30%+) holdings in competing airlines, and portfolio managers who act as “Cartel Ringmasters.”
The key takeaway is clear: although the current structure of institutional investor ownership does not violate the antitrust laws, institutional investors, like industrial companies, must be conscious of antitrust risk and should train their professionals accordingly.
The complete paper is available for download here.
