The Virtue of Common Ownership in an Era of Corporate Compliance

“Common ownership” describes a structure in which a small group of large institutional investors—such as BlackRock, Vanguard, State Street Advisors and Fidelity—have significant ownership in horizontal competitors. Between 1980 and 2012 common ownership rates increased dramatically. Since its rise in popularity, common ownership has become the topic of heated debate. A growing body of scholarship now criticizes the common ownership phenomenon, arguing that it causes corporations to compete less vigorously with each other, thereby harming consumers. Accordingly, many scholars now call for legal and regulatory intervention in order to limit common ownership levels. Furthermore, this criticism has spurred the Justice Department’s investigation of potential antitrust issues arising from common ownership. On the other side of the debate, many scholars argue that the dangers of common ownership on competition are overblown. These scholars conclude that there is no need for intervention.

While this common ownership-anti-trust debate shows no signs of waning, little attention, if any, has been given to the virtue of common ownership in corporate law. This Article aims to fill that void by showing how common ownership may actually contribute to robust corporate governance, a field in which institutional investors play an important role.

The field of corporate governance has undergone a dramatic change over the last decade. Modern corporate governance involves a global trend in law and regulation enforcement targeting companies with common features, i.e., companies that are doing the same type of business (frequently in the same geographical area), and operate within the same industries. These companies are exposed to similar common risks of criminal investigations and proceedings, and as a result, the potential for significant collateral harm. These companies are exposed to what I term—macro legal risks.

These risks, associated mainly with the healthcare (pharmaceuticals), finance and energy industries, require the affected companies to take precautionary steps to comply with laws and regulations. Often these precautionary steps are similar to steps taken at comparable companies operating within the same industry that have been investigated and then subsequently settled with enforcement authorities. Over the last decade, the U.S. Department of Justice (DOJ), Securities and Exchange Commission (SEC), Environmental Protection Agency (EPA), Federal Trade Commission (FTC), Internal Revenue Service (IRS) and other enforcement authorities have increasingly focused on corporate enforcement. These authorities have increased criminal enforcement actions after the quieter years of the 1980s-1990s.

The upshot here for institutional investors is that enforcement trends now focus on entire industries, rather than on companies with specific features. This means that institutional investors who invest heavily in the same industry due to common ownership will have an easier time responding to legal and regulatory challenges. For example, during the last few years, the DOJ and the SEC have used the FCPA to focus on particularly risky industries such as healthcare and energy, industries that interact with foreign officials in the sale and promotion of their products.

When dealing with macro legal risks, common ownership may allow institutional investors to govern companies in which they invest more efficiently. They may do this through voting, or through engagements with companies’ officers and directors. This will lead to minimizing corporate wrongdoing. Since macro legal risks are common to multiple companies, common ownership has the potential to provide institutions with three interrelated merits: (1) enhanced incentives for monitoring macro legal risks; (2) privileged access to rulemaking and lawmaking that allows institutional investors to recognize legal developments; and (3) experimental learning of macro legal risks.

First, macro legal risks, by their very nature, expose entire industries to similar types of risks, as well as expensive and often irreversible damages. Therefore, common ownership creates an aggregate exposure for each institutional investor. The level of exposure is directly correlated with the level of common ownership. Higher levels of common ownership create higher exposure to macro legal risk and thus are more likely to increase incentives of institutional investors to be aware of legal risks and respond to them by better monitoring the level of compliance of companies in which they invest.

Furthermore, given that macro legal risks involve features that are common to multiple companies that operate within the same industry and use similar techniques and strategies, common ownership allows institutional investors to use a one-size-fits-all approach, rather than a firm-specific approach, to corporate governance, or more specifically corporate compliance. Institutional investors do not need to have the information or resources necessary to tailor different arrangements to the particular features of individual companies. Instead, they only need to be able to identify macro trends and patterns, giving less weight to firm-specific differences. Therefore, institutional investors can enjoy the advantages associated with economies of scale and spread costs of identifying and responding to the macro legal risks over a large number of companies. Accordingly, institutional investors incur relatively low costs of identifying and responding to macro legal risks, and their incentives to monitor companies are likely to increase. Given this explanation, which I discuss further later in the Article, the familiar “passivity story,” describing institutional investors that are reluctant to engage in corporate governance issues because they do not coincide with their business models, is less valid here. In the same vein, common ownership may help reduce institutional concerns regarding the free-rider problem. The Article provides concrete examples of institutional investors’ engagement with companies regarding macro legal risks, reflecting their enhanced incentives.

The second merit of common ownership, privileged access to the process of making law and regulation, is a natural result of the dramatic growth of institutional investors’ ownership over the last three decades. Due to their growing power, institutional investors have become increasingly involved in discussions and roundtables held in Congress and the SEC, engaging in ongoing dialogue with these authorities. As such, institutional investors are able to identify upcoming trends and patterns in law and regulation, positioning them to both inform companies in which they invest about potential exposure and to require them to implement the necessary checks and controls. The Article includes examples of how institutional investors engage in dialogue with regulators in an attempt to get involved with the rulemaking process. Limiting common ownership may unintentionally limit institutions’ ability to enjoy the benefits of comfortable access to policymaking.

Regarding the third merit of common ownership, experimental learning of macro legal risks, common ownership has the potential to improve institutional investors’ understanding of market conditions, changes in interpretation of existing statutes, strategic decisions of enforcement authorities, and more. Large investors have significant stakes in many American companies operating within the same industry. Macro legal risks are not unique to a single company, but are common to many companies that operate within the same industry. Once the DOJ or the SEC commences an investigation against a certain company in which institutional investors invest (the “infected” company), the investigation becomes public through official reports, and investors with a large stake in the infected company should become aware of the investigation and the nature of the allegedly illegal corporate activity. Thus, companies that share a common institutional investor with the infected company are more likely to take appropriate steps to comply with laws and regulations and minimize macro legal risks. Here, common ownership provides institutional investors with accumulated experience that allows them to capitalize on accrued knowledge. Institutional investors can use common ownership to enhance information flow regarding lessons learned from investigations and proceedings. Common ownership creates a network of interlocking companies in which institutional investors may acquire expertise and experience, which they can then implement in other companies. Thus, common ownership has the potential to enhance efficient learning processes and information flow among companies and consequently improve corporate governance and compliance.

The complete paper is available for download here.