Unicorns, Guardians, and the Concentration of U.S. Equity Markets

Developments in private and public markets are changing the role equity plays in the United States, i.e., what “stock” means as a matter not only of investment and corporate governance, but also of political economy.  For several generations, a broad middle class invested directly in bureaucratically run corporations, disciplined by securities and other laws.  The governance of firms and therefore much of the economy was answerable to this broad middle class.  Perhaps most important, citizens understood such arrangements as “the free enterprise system” or even “the American way.”  We call this a “republican” imagination of equity markets.

There has recently been a decisive shift from broad-based to much more concentrated forms of ownership.  Ownership of U.S. firms, and so a great deal of the economy, has shifted into the hands of a small number of people.  Such concentration of ownership can be observed in both private and public equity markets.

Private equity markets are by definition concentrated, because few investors are legally qualified to participate in them.  Nonetheless, private equity is increasingly the preferred method of capital formation.  The rising importance of private equity markets is epitomized by now-common “unicorns,” privately owned start-up firms valued at over $1 billion.

Public equity markets are increasingly dominated by institutional investors with billions, or trillions, of dollars under management.  Such sums are unwieldy, and increasingly placed in passively managed index funds rather than actively managed.  By design, index funds require little human input and therefore have small staffs.  As a result, very few people control substantial portions of the public equity markets.

Looking backward can help bring the present into focus.  Berle and Means’ 1932 classic book, The Modern Corporation and Private Property, is often remembered for characterizing the modern corporation by its separation of ownership (shareholders) from control (managers). Shareholders were many, dispersed, and relatively powerless, while managers were few and powerful.  The challenge for the law, according to Berle and Means, was to prevent managers from taking advantage of shareholder investors without unduly compromising the ability of managers to use pooled capital to accomplish great things.  This view of the strengths and vulnerabilities of corporations as institutions, and law’s role in supporting the one and minimizing the other, dominated corporation and securities law throughout the 20th century.

Berle and Means were not, however, simply concerned with the governance of individual firms.  Berle and Means were worried that the few, managers of great firms, would collectively undermine the authority of the many, middle class shareholders from across the nation.  The corporation was crucial because it was the vehicle through which the republic could be undermined by princes of industry.

While Berle and Means were worried about the republican consequences of dispersed capital and concentrated management in the 1930s, in recent years, both capital and management have become concentrated.  In short, whether private or public, equity markets are less and less plausibly conceived of as the product of broad middle class participation in the economy.

Berle and Means were trying to promote a Progressive understanding of capital markets and corporate governance that was not very old.  Capitalism in the United States had changed character in the first few decades of the 20th century. The late 19th century was dominated by robber barons or titans — men like J.P. Morgan or Andrew Carnegie. Business was dramatic and exciting, maybe even dangerous.  By the middle of the century, we have The Man in the Gray Flannel Suit, the far blander culture of Dale Carnegie.

Law generally, and securities law in particular, played an important role in the shift from the capitalism of the robber barons to that of The Man in the Gray Flannel Suit.  Most important for present purposes, the Securities Act of 1933 and the Securities Exchange Act of 1934 and regulations thereunder established a mandatory disclosure regime for any company that offered stock to the public.  Such publicly traded firms simultaneously themselves became public in a number of ways.  Most directly, the companies had to disclose information about themselves and their operations to the public at large.  Business was integrated into the commercial republic through widespread investment. The stock market became the barometer of the nation’s economic health, its indices reported on the nightly news, despite the fact that other financial markets were larger.

Public companies also became public in a subtle sense.  The mandatory disclosure regime transformed the character of publicly traded firms and their managers, rendering barons into corporate officials, i.e., bureaucrats.  When transparency became the order of the day, firms needed to regulate their processes, hire accountants, and think like lawyers.  Compliance with securities law thus required a Weberian process of modernization and, indeed, disenchantment.  The excitement of the swashbuckling entrepreneur beloved by Schumpeter gave way to corporate policy and endless board meetings with minutes.  In this way, the vast power that corporations enjoy was made answerable to legal and political institutions.

Recently, however, public offerings have become less necessary.  New firms seem to require less capital, and more than enough money is in private hands.  The value of private placements now far outstrips that of public offerings. And, because their capital structure is private, such firms avoid the public disclosure regime and the process of bureaucratization, while adopting idiosyncratic governance arrangements.

Such fundamental shifts in the way business is financed have consequences for political economy. Executives of privately held companies need not comply with a mandatory disclosure regime and therefore need not be particularly answerable to the public.  For such companies, governance may be disciplined only by Facebook, as Uber’s recent embarrassment suggests. The capacity of securities law to foster republican U.S. equity markets has been undermined by the rise of private equity.

The public equity markets remain important; publicly traded corporations still dominate the economic landscape.  But how public are the so-called public markets?  The amount of money under management by institutional investors and rising inequality in the United States mean that few actors, nothing like the broad middle class, directly participate in the public stock market.  Indeed, the concentration of ownership under such guardians appears to be even greater than it was under the robber barons.

It is difficult to see this new regime in the ideological terms that animated stockholding, and law, throughout the 20th century.  This is not republican capitalism for the simple reason that power is too concentrated.  This is not democratic capitalism, because almost nobody has a vote.  The middle class, in any demographic sense, is only tangentially involved, so this is not middle class capitalism.

If stock ownership is so concentrated, then control of U.S. firms is now largely a matter of grace — we must hope that those owners who matter make good decisions about the allocation of capital, the governance of firms, and the preservation of portfolio value on which individuals and institutions rely.

In theory, the law could work to foster more broad-based forms of equity capitalism.  Breaking up concentrations of wealth might force businesses to make public offerings, and, in compliance with the securities laws, managers might have to become the (boring) sort of business people that we want running our utilities.  For another example, a tax on assets could be used to disaggregate private fortunes.  Similar things might be encouraged with a higher (or more broadly applicable) inheritance tax, perhaps with a hefty exemption for charitable giving.

Or the expansive notion of private offering enunciated in Regulation D could be revised, so that venture capital, private equity, and any number of inter-firm financings would have to be disclosed.  By the same token, the JOBS Act could be recalled or revised, so that firms with some relatively low number of shareholders (500 was the old number) would be forced to file company data with the SEC and, as a practical matter, would list publicly.  Or the law might require public disclosure for financings of, say, $500 million, regardless of the identity of the investors.

Turning to institutional investors, the law could cap the size of funds (or even banks). Or the law might limit horizontal shareholding within an industry, or require funds that held a certain percentage of interest in a given firm to devote significant resources to the management and oversight of that firm.

No doubt there are other approaches. But none of this is conceptually difficult, and would not even be particularly radical, at least in comparison with laws passed when what was once unblushingly called the free enterprise system was thought to be endangered.

This post comes to us from Amy Deen Westbrook, the Kurt M. Sager Distinguished Professor of International and Commercial Law and Co-Director of the Business and Transactional Law Center at Washburn University School of Law, and from David A. Westbrook, the Louis A. Del Cotto Professor of Law at the State University of New York’s University at Buffalo School of Law. It is based on their recent article, “Unicorns, Guardians and the Concentration of U.S. Equity Markets,” available here.