Is “intermediary influence” all that unique? Can it be isolated? And how much harm really results? These are among the questions Professor Lawrence Cunningham poses in his thoughtful essay and recent post responding to my work on how intermediaries alter institutional arrangements in self-serving and socially costly ways. In the essay, Professor Cunningham also examines the acquisition market to provide additional evidence of intermediary influence while simultaneously introducing the question of how competition limits intermediary influence and the welfare losses that emanate from it.
Professor Cunningham concludes that “far from constituting criticism of Judge’s work, [the] questions [he raises] warrant further research precisely because her work is so important and fruitful.” I share his instinct that Intermediary Influence is better viewed as a conversation starter than an ender and his response helps to further that conversation. I welcome this dialogue and I hope others take up his invitation to further examine of these challenging issues. The rise of intermediaries as fixtures in finance and many other industries has inspired a rich body of literature seeking to explain their rise. Quite naturally, this literature focused on the myriad ways that reliance on intermediaries can create value. Yet, as Intermediary Influence and its companion piece, Fee Effects, demonstrate, institutional arrangements that rely on specialized intermediaries—like most institutional arrangements—are a mixed bag: there are some significant and often overlooked costs along with the many benefits they provide. Only by identifying these drawbacks can we develop the full picture required to understand how best to ensure that the benefits that arise from the use of intermediaries continue to exceed the associated, and sometimes hidden, costs.
I view Cunningham’s concerns as falling into two broad categories—some are focused on whether intermediary influence is sufficiently problematic to merit significant academic and regulatory attention and others are focused on trying to disaggregate intermediary influence from other phenomena. I will structure my response accordingly.
My focus in Intermediary Influence is on the way that the very same informational and positional advantages that enable intermediaries to be so useful simultaneously enable intermediaries to play an outsized role in the processes through which the institutions giving rise to their influence evolve. To understand why this influence is so troubling, it is necessary to return to my first article on the topic, Fee Effects. The core insight in Fee Effects is that in a static environment where consumers have the choice between a number of transactions, each of which creates value in excess of the associated costs, consumers’ reliance on specialized intermediaries alters the mix of transactions ultimately consummated. Influenced by intermediaries’ self-serving recommendations, consumers will opt for the high-fee transaction more often than they otherwise would. More important than the wealth transfer from clients to intermediaries that predictably results is the loss of the greater gains that might have been realized had intermediary influence not biased the decision.
These foregone gains remain important when we shift to the dynamic environment at issue in Intermediary Influence because one of the primary ways that intermediaries maximize their long-term profitability is by entrenching institutional arrangements that require consumers to rely on intermediaries whenever they consummate a particular type of transaction.
To make all of this more concrete, the traditional structure of the New York Stock Exchange (NYSE) is a prime example of an institution that allowed the member-intermediaries who controlled the NYSE to provide real value to clients while simultaneously enabling them to exercise significant influence over the processes through which its rules and other dimensions of the environment evolved. The long life of the NYSE’s rule mandating fixed brokerage fees, revealed to be far longer than was socially optimal by the rapid decline in the average fees charged when the rule was finally abolished, attests to the capacity of intermediaries to entrench inefficient arrangements. Going further, and highlighting the connection between the pieces, the fees that the broker-dealers who belonged to the NYSE could charge for trading individual stocks appears to have had altered the types of financial products that individual investors held. When brokers could earn supracompetitive profits each time a client traded individual stocks there were high levels of individual ownership. After brokers could no longer earn those excessive fees in connection with individual stocks, there was a significant decline in the level of individual ownership of common stock and a rapid increase in the proportion of individuals who instead invested in mutual funds. This well-documented shift is consistent with the notion that brokers recommendations were biased by their own incentives and that the biased recommendations meaningfully altered the type of transactions consummated.
To be sure, a growing appreciation of the benefits of diversification and other developments during this period may have further facilitated this shift. The example thus brings to the fore Cunningham’s quite legitimate concerns about the challenge of disaggregating intermediary influence. Yet, looking beyond the overall trend of growing institutional ownership to the types of funds that individual investors initially acquired—which were typically actively managed funds with fees that were significantly higher and performance typically below index funds—further supports the notion that the shift was at least in part a byproduct of intermediaries using their influence to maximize fees. More generally, disaggregating is difficult. Fee effects and intermediary influence are deeply embedded phenomena that cannot be disentangled from the complex ecosystems in which intermediaries operate. Moreover, there is meaningful overlap between intermediary influence and other—understood even if not eliminated—challenges, such as agency costs and collusion.
Attempting to further develop the role of intermediary influence in distorting markets and abet these distortions is thus one of the challenges ahead and should inform discussions of the resources that should be devoting to mitigating intermediary influence and the ways that we can use insights developed in other fields in furtherance of that project. At the same time, the correlation between the types of financial claims that individual investors hold and intermediary incentives is precisely the type of correlation that Intermediary Influence suggests ought to be taken seriously. The world is too messy for us to wait until a phenomenon can be isolated before acknowledging its power, particularly when there is so much evidence that is consistent even if overdetermined.
That the fixed brokerage fee model eventually broke down and fees fell accordingly also supports Cunningham’s claim competition is an important and powerful force limiting the capacity of intermediaries to indefinitely put their interests above their clients. On this front, it is important to distinguish the specific example Cunningham uses in support of his claim and the claim itself. In his essay, Cunningham persuasively shows that Berkshire Hathaway’s refusal to pay the excessive intermediary fees that drain value from so many other deals has contributed to its success and that, along with other advantages, enables Berkshire Hathaway to prevail at times in the competition for acquisitions. Yet, the example does more to convince me that all companies would be better run and all investors would be better off if Berkshire Hathaway represented the norm rather than the exception in its operations. While Cunningham persuasively argues in his recent book, “Berkshire Beyond Buffett,” that there are dozens of Berkshire executives running its vast network of subsidiaries who successfully apply the Buffett’s strategy (many both before and after joining Berkshire), we are not yet at the point where we can reliably clone more investors like Warren Buffett. Shifting to the more general point, competition, the value of a good reputation, and other market forces do play important roles limiting intermediaries’ tendency to use their influence in self-serving ways. This not only limits the costs of intermediary influence, it also informs the type of mechanisms that are most likely to be effective in efforts to further reign in those costs. In particular, altering the type of transparency requirements imposed and otherwise bolstering the capacity of competition and reputation to counteract intermediaries’ self-serving tendencies will often be the most important and productive ways to address intermediary influence. The reason that these market forces need an extra boost are myriad but many flow from the same challenges—the informational and positional advantages that intermediaries regularly enjoy coupled with the pervasiveness of industry structures conducive to collusion and other forms of cooperation—that give rise to intermediary influence and fee effects. Moreover, as I highlight in Fee Effects, there are specific reasons to suspect that reputation in particular will be a far less effective constraint than commonly believed. As a starting point, bad behavior must be identified as such to result in any harm to an actor’s reputation and the subsequent performance of any financial asset is a very noisy indicator of the quality of initial recommendations to acquire that asset. Additionally, parties who rely on intermediaries that themselves depend on maintaining a reputation for being sophisticated and adept are unlikely to broadcast an intermediary’s bad behavior for they will not want to publicize that they have been duped.
While there is much more to say on all of these topics, I hope this back and forth has been half as much fun for our readers as it has been for me. I look forward to continuing the conversation and to hearing other voices chime in on these important issues.
 Lawrence A. Cunningham, Intermediary Influence and Competition: Berkshire versus KKR, 82 U Chi L Rev Dialogue 177, 180 (2015).
The preceding post comes to us from Kathryn Judge, Associate Professor of Law and Milton Handler Fellow at Columbia Law School.