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E-MailFiona Scott Morton is Theodore Nierenberg Professor of Economics at Yale School of Management; Herbert Hovenkamp is James G. Dinan University Professor at Penn Law and the Wharton School of Business. This post is based on their recent article, forthcoming in the Yale Law Journal. Related research from the Program on Corporate Governance includes The Growing Problem of Horizontal Shareholding (discussed on the Forum here), and Horizontal Shareholding (discussed on the Forum here), both by Einer Elhauge.
“Horizontal shareholding” occurs when a number of equity funds own shares of competitors operating in a concentrated product market. For example, the four largest mutual fund companies might be the four largest shareholders of all the major United States airlines. A growing body of empirical literature concludes that under these conditions market output is lower and prices higher than they would otherwise be.
Here we consider how the antitrust laws might be applied to remedy such situations, identifying the issues that the courts are likely to encounter. We assume that the firms in a concentrated product or service market are not fixing prices. Nor are the managers of the funds that acquire interests in their shares agreeing with each other about how to purchase or vote the shares or otherwise influence the behavior of these firms. If either of these two horizontal agreements exists it is independently actionable under §1 of the Sherman Act.
Competition economists initially failed to recognize the impact of institutional investors on competition, perhaps because the funds held relatively small shares in competitors. The last two decades has seen a dramatic change. For a competition problem to arise from large shareholders holding product market competitors, those owners must have the incentive and the ability to soften the intensity of competition. Large shareholders of course engage in corporate governance. Indeed, many activists have been encouraging better and increasing corporate governance over the last few decades, and we see evidence of large mutual funds engaging in oversight of their portfolio companies.
The theory literature to date does not identify what mechanism funds may use to soften competition. One model popular in the literature is to assume the management of the competing firms maximize the profits of their owners (the funds), which they can do because they know how much of their rivals each of their owners owns. Alternative, and simpler possibilities include: fund managers can encourage a common strategy among product market rivals, monitor product market rivals, raise the patience level, or value for the future, of rival management teams, or, most easily, fail to mimic the actions of an owner that holds only one firm.
Antitrust legality does not depend on exactly how ownership by these funds raise prices. For example, in merger analysis it is also the case that, although market concentration correlates both theoretically and empirically with higher prices, the precise mechanism by which competition is injured in any particular case may not be known. However, the “effects” test in §7 of the Clayton Act makes it unnecessary to determine the precise mechanism. For example, at the time a merger’s legality is assessed antitrust enforcers may not know whether the firms are likely to engage in traditional explicit collusion or some other form of cooperative or noncooperative price coordination.
Section 7 of the Clayton Act is triggered when one firm “acquires” either the stock or assets of another firm. Transactions leading to horizontal shareholding are “horizontal” mergers, even though each individual stock transaction is between noncompeting companies. For example, Vanguard’s purchase of 15% of United Airlines is not a horizontal merger because the two firms are not competitors. However, if Vanguard should then buy 15% of Delta Airlines the result would be that a single firm now holds partial ownership of two competing airlines.
Antitrust enforcement policy against horizontal shareholding by mutual funds presents some novel legal issues. First, merger analysis must always consider efficiencies, and at two different stages. First it must consider whether the acquisition itself produces efficiencies sufficient to offset any anticompetitive effects. Second it must consider the welfare effects of any proposed remedy.
While nearly all naked cartels are challenged upon discovery, only a small percentage of mergers are challenged. That is so because we do not expect efficiency gains from cartels. If their only likely effects are negative, a harsh rule against them is in order. While the form of horizontal shareholding is a merger by stock acquisition, in substance the structure that is created resembles a cartel rather than a merger. An ownership stake by a mutual fund in a particular airline does not create efficiencies in the downstream product market where the reduction in competition (e.g. air travel) is located. The usual tradeoff is absent because only the anticompetitive effect of the ownership stake is present. Thus, merger rules governing horizontal shareholding should presumptively be harsh.
The most promising remedy against a horizontal merger is divestiture, which is well established in merger law, would require funds to sell off shares sufficient to eliminate the offensive overlap. Such divestitures may harm mutual fund purchasers by reducing the collusion-like profits that result from horizontal shareholding. However, a private gain resulting from collusion is hardly a qualifying merger efficiency but only an anticompetitive wealth transfer.
A second harm antitrust enforcement might impose on purchasers of mutual funds is the lower level of diversification that might result from selective divestiture. However, diversification across industries is much more valuable to funds than diversification within an industry. Further, there is some new evidence that the extent of this efficiency loss is small compared to the variance across existing mutual funds. More importantly, however, application of the rule of reason normally requires an enforcer to compare the gains from additional diversification to the harms from higher product prices. In this setting, the gains accrue to owners of mutual funds while the higher prices are paid by consumers in the product market (e.g. airline consumers). These are completely different markets with different sets of consumers. Current antitrust law does not permit a court to offset proven consumer harm in one market with gains in a different market. In any event, the losses that would accrue from lower portfolio diversification would very likely be dwarfed by the gains from achieving competition in the product market.
Section 7 contains an exemption for acquisitions that are “solely for investment.” The provision was intended to apply to passive investors who do not “by voting or otherwise” bring about a noncompetitive result. Most courts hold that this exemption applies only where the acquisition in question did not “substantially lessen competition” at all, which means that it would be lawful whether or not it was solely for investment.
What about a partial acquisition that is either not challenged or approved initially, but that poses a threat to competition later on? Here, the merger law is clear: at least in the case of government plaintiffs, a consummated acquisition can be challenged at the time it becomes anticompetitive, even if that occurs long after the acquisition itself.
In sum, §7 of the Clayton Act is a promising vehicle for combatting the anticompetitive effects of horizontal shareholding, should they be found. As decades of merger enforcement has established, it is not necessary for a challenger to articulate exactly how harmful coordinated interaction might occur, but only to show a likelihood that it will occur. On the question of remedy, at this writing partial divestitures seem to be most promising, although care must be taken that they be properly coordinated across all segments of a market.
The complete article is available for download here.
