The new wave of financial economics empirical scholarship has revitalized what had been theoretical discussions about the effects of common ownership in both economics and law. Common ownership within the same industry by mutual funds may create incentives for those funds to maximize the returns of their portfolio through collusion rather than to maximize the value of any particular company within its portfolio. An institutional investor that has stakes in firms A, B, and C, for example, enjoys a greater total profit from its entire portfolio if there is coordination across the firms and hence less competition. A common owner across firms in the same industry will want to maximize its entire portfolio of investments rather than maximize its investment in one particular firm in its portfolio. This means that a common owner finds a way to influence the profitability and conduct of its portfolio company rivals when it makes strategic decisions in each of its portfolio firms.
In a new paper, Debt, Control, and Collusion, I shift the debate from a focus on common ownership to a focus on common control. Debt-control-based governance is a critical part of the corporate landscape. I note that various creditors can exert control over more than one company in the same industry without any ownership. I suggest that a change in antitrust policy is necessary to police against debt-control-based collusion and that the focus should be on coordinated effects and indicia of control rather than ownership for purposes of antitrust merger control.
Unlike common ownership, which focuses on the upside value of potential collusion, common debt focuses on mitigating downside risk. This behavior is collusive and may harm consumers, but traditional antitrust law (particularly merger law) leaves an enforcement gap. The traditional view in antitrust economics is that debt weakens rather than strengthens collusion. Further, price wars are often viewed in the literature as a punishment mechanism. The traditional thinking on debt and competition has made its way into antitrust law. The current antitrust law merger framework, a fundamental part of antitrust thinking since the 1970s, with the passage of the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR), misses all pure-debt (as opposed to convertible-debt) transactions.
My work turns the traditional antitrust thinking about debt on its head and suggests that under certain circumstances debt will strengthen rather than weaken collusion. The incentives for collusion work differently in debt than in equity. At the firm level, in the typical setting of collusion, shareholders have an incentive to cause their firms to engage in anti-competitive conduct (because the shareholders are the residual claimants), as they benefit from higher prices via collusion through increased stock value due to higher revenues. Creditors typically lack this incentive because they do not have an equity stake. Because creditors do not have the same influence over firm managers that shareholders typically have, their incentive to partake in debt-based collusion is different from that specific to managers.
A necessary condition for this is for the capital structure to matter. Typically, this is occurs when a firm does not have a ready market for additional equity investment because it is in distress and the default risk is high, or when a firm is in bankruptcy, where the equity of interest is subordinate to that of the creditors.
There are several factors that make debt-based control and collusion more likely. The expected payoff of debt and equity for all the firms in an industry almost always gets bigger with collusion, and the variance of each firm’s value is probably also lower with collusion (no one is trying to dominate the industry, which is likely to reduce the variance). This is more likely in industries that are in distress. In an ex ante sense, if debt can help lead to tacit collusion, each firm involved should want to figure out a way to make it work. Ex post, debt holders have a continuing incentive to make it work.
Successful collusion by creditors requires an understanding of the type of control that matters for antitrust purposes. While it may be that creditors exercise control over debtor corporations, it seems that the relevant antitrust question is whether they have the incentive and ability to cause corporations to violate antitrust law. The types of control that some creditors have include the ability to: 1. set the price, 2. decide whether to acquire companies, 3. reduce the capital expenditures, and 4. replace the top management. Firms with control regularly exercise it through contracts even when the pricing terms are not explicit and when control is merely understood but does not qualify as “control” for purposes of agency law. Antitrust is replete with such examples in other contractual areas.
In my paper, I identify the incentives to collude and offer several possible mechanisms: 1. multimarket contact, 2. signaling through disclosure, 3. signaling through bankruptcy filings, 4. learning by doing, and 5. executive compensation contracts.
I conclude the paper with some targeted reforms of the HSR pre-merger notification system to add debt-based control as a factor that may produce an anti-competitive effect. Such an outcome recognizes the economic-based spirit of the existing HSR rules but applies that spirit to a different form of transaction that has the same effect of influencing business decisions and substantially lessening competition.
This post comes to us from Professor D. Daniel Sokol, the Huber C. Hurst Eminent Scholar Chair in Law at the University of Florida Levin College of Law. It is based on his recent article, “Debt, Control, and Collusion,” available here.