The Role of Transaction Costs in Common Ownership

“Common Ownership” arises when shareholders hold substantial stakes in different firms that impose externalities on each other, and it challenges the assumption that firms act to maximize their own profits. While firm decisions are ordinarily made by its board of directors and managers, most shareholders retain control over the appointment and dismissal of directors. Furthermore, corporate law requires managers to consider the interests of its shareholders when making decisions on behalf of the firm. Accordingly, if the interests of a firm’s shareholders include the profits of other firms, one might expect the firm to not only maximize its own profits, but also take those other firms’ profits into account when making decisions. This “common ownership hypothesis” predicts that, in maximizing its portfolio value, a common owner clearly has the prima facie incentive to internalize the pecuniary externalities between its competing portfolio firms by raising prices and lowering output at the expense of the firms’ consumers.

Although scholars have known about these potential anticompetitive effects for a long time, common ownership has attracted particular controversy in recent years. This rise in interest is commonly attributed to two key factors. First, capital markets have become increasingly concentrated. Today, the Big Three mutual funds (BlackRock, Vanguard, and State Street) hold almost 70 percent of U.S. public stocks and constitute the largest shareholder in 88 percent of the companies in the S&P 500.  Separately, new empirical evidence has illustrated how common ownership is associated with higher product prices and lower output in various (e.g., airline, banking, and pharmaceutical) industries. Nevertheless, scholars remain divided as to the precise mechanism through which common ownership can induce anti-competitive outcomes. Elhauge, for example, has contended that common owners have multiple avenues (e.g., executive compensation, exit rights, board elections, etc.) whereby they can raise equilibrium product prices relative to a counterfactual without common ownership. In contrast, scholars like Morley have disagreed, pointing out that securities regulations and corporate law discourage  institutional investors from interfering with product market decision-making in portfolio firms.

In a forthcoming article, I argue that all disagreements over the anticompetitive mechanisms of common ownership hinge on a central determinant: the transaction costs of internalizing pecuniary externalities between portfolio firms. I define two broad categories of transaction costs: information costs and coordination costs. Information costs arise when common owners have an incentive to raise prices on their own without inducing collusion among their portfolio firms. Coordination costs arise when common owners attempt to raise prices by increasing the probability of collusion among their portfolio firms.

Where the transaction costs of internalizing such externalities are positive, common owners will trade-off the gains from internalizing these externalities with the costs involved in doing so. While the anticompetitive effects of common ownership arise from the potential for common owners to internalize the pecuniary externalities that each portfolio firm imposes on other rival firms within the common owners’ portfolios, the mere fact that such “gains from trade” arise from common ownership does not necessarily mean that common owners want to internalize all of them. Indeed, a dominant theme in organizational economics is that individuals within a firm may rationally bear all sorts of transaction costs (e.g., agency costs) so long as the countervailing benefits exceed the costs of pursuing alternatives. For instance, while allocating more decision-making power to firm managers might give rise to large managerial agency-costs, shareholders may be willing to bear these costs if the benefits of delegating decision-making to managers (e.g., managerial firm-specific investments that improve the firm’s value) outweigh the costs of doing so.

The introduction of transaction costs to the analysis of common ownership exposes a fundamental distinction between “vanilla” instances of common ownership often depicted in the earlier literature and a contemporary setting, where large institutional investors are viewed as common owners in financial markets. These institutional investors face large information costs in effecting anti-competitive outcomes. BlackRock, for instance, must consider the potential for conflicts of interest among its clients, given how each client is a separate locus of fiduciary duties. It manages thousands of distinct clients, with thousands of unique portfolio firms. With its diversified portfolio, many of these portfolio firms are likely to have large transactions with each other, creating vertical spillovers that ought to be accounted for. Within each portfolio firm, ultimate control over pricing decisions may span across multiple hierarchies, with multiple employees (not just top management) having significant input regarding the firm’s competitive conduct. Furthermore, BlackRock is an artificial legal entity that must act through its human agents, the incentives of whom may not be completely aligned with BlackRock. Due to these information costs, BlackRock is unlikely to target particular areas of conduct in specific firms. Rather, institutional investors are more likely to advance their anticompetitive interests as common owners through subtler means. I argue that low-cost mechanisms like informal engagements that ameliorate collusion are particularly attractive for these investors.

My analysis eschews the “one-size-fits-all” policies in addressing the anti-competitive effects associated with common ownership. As the law plays a significant role in determining the magnitude of transaction costs that common owners face, the optimal policy response is likely to differ across different types of common owners. For instance, structural remedies in antitrust are likely to work well where common owners are willing and able to exercise strong control over their portfolio firms. However, as institutional managers are likely to have weak incentives to engage in direct control of their portfolio firms, structural remedies are unlikely to be effective. Instead, optimal policies should focus on the understated roles that institutional investors may play in softening competition among their portfolio firms. I propose “mechanism-specific” remedies that would change the incentives of common owners by increasing the transaction costs they face in implementing specific mechanisms of anti-competitive harm. For instance, to attenuate the potential harms to product competition through mechanisms like “voice,” I contend that antitrust policy should demand greater scrutiny of information exchanges among institutional investors and their portfolio firms. These remedies provide significant advantages over competing policy proposals.

This post comes to us from Kenneth Khoo, a lecturer at the National University of Singapore’s Faculty of Law. It is based on his recent paper, “Transaction Costs in Common Ownership,” available here.