Distribution, Competition, and Antitrust / IP Law

Are Mutual Index Funds Anti-Competitive?

They may be, according to a thought-provoking article by Harvard Law School Professor Einer Elhauge entitled “Horizontal Shareholding as an Antitrust Violation” (July 21, 2015), available here.

In a nutshell, Professor Elhauge’s argument is:

  • Large institutional investors (mutual funds and, presumably, ETFs) own fairly large shareholdings in horizontal competitors throughout the economy – for example, from 2013-15, seven shareholders controlled 60% of United Airlines, 27.5% of Delta airlines, 22.3% of Southwest Airlines, and 20.7% of JetBlue Airlines. The problem is particularly acute for index funds, which routinely invest in horizontal competitors in an industry;
  • Basic economic theory suggests that this sort of “horizontal shareholding” may result in diminished incentives to compete – because if firm A gains profit/market share by lowering prices, shareholders who own stock in both firm A and competitor B (or competitors B and C, or B and C and D, etc.) will see at least some loss in profitability in their other holdings;
  • Recent econometric studies suggest that in markets where shareholdings are concentrated in this manner, higher prices are not only observed, but are also attributable to the “excess” concentration;
  • These horizontal shareholdings explain some persistent economic puzzles, including (a) executive compensation being based on industry performance, rather than corporate performance, (b) the failure of high corporate profits to lead to high growth, and (c) the recent rise in economic inequality; (*)
  • Antitrust law – as it is currently formulated – can reach these horizontal shareholdings under Clayton Act Section 7, and the passive investor exception is not a bar to legal action, because (a) funds actively insert themselves into management discussions and so are not purely “passive” and (b) even if they are, the passive exception does not apply if the acquired stock is actually used (by voting or otherwise) to lessen competition substantially or to attempt to do so; and
  • Regardless of the Section 7 passive investor exception, Sherman Act Section 1 and FTC Act Section 5 apply to horizontal shareholding acquisitions.

As I said, provocative and intriguing stuff. But I have some questions.

  • Mutual fundsandETFs are owned (I assume predominantly) by individuals. Many (most?) of those individuals are also employees in the labor markets. Why would those owners want to see unduly high executive compensation, lower growth, or higher income inequality? If the answer is there is an information gap or asymmetry, why does it persist? If firms subject to fund ownership can figure out (even without communication) that they shouldn’t vigorously compete due to their common owners, why can’t mutual/ETF fund managers figure out that fund owners don’t want fund managers tocontribute to anticompetitive behavior?
    • Perhaps most stock is ultimately held by investors who benefit more in their role as investors than they do as workers.  Additionally, perhaps there is a collective action problem at the fund investor level – even though we would all be better off with a stronger economy, when choosing to invest money, we each have incentives to pick the fund with the highest rate of return.
  • All things being equal, the higher level of horizontal holdings, the moremonopoly-level profits one would expect to be extracted. Yet we apparently see horizontal shareholdings by funds in the 4-6% range (and in any event usually under 10% for any particular fund). If the horizontal ownership strategy were so successful, wouldn’t we expect to see even higher ownership levels? What does it mean that we don’t?
    • Perhaps regulatory obligations kick in at 5% and 10%, and over 15% may require a Hart-Scott-Rodino filing. If there’s no current appetite to bring enforcement actions in this space, however, I wouldn’t think these modest expansion barriers (filing requirements) would be much of an impediment to larger holdings.
    • Perhaps it would be just as profitable to have 5% stakes in four anticompetitive marketsrather than a 20% stake in one anticompetitive market. But:
      • If 4×5% is just as profitable as one 20% holding, doesn’t that suggest that 20×1% is also just as profitable? But we apparently don’t typically see 20×1%, and if we did, it’s not clear to me it would be objectionable. It seems to me that, if the horizontal shareholdings theory is generally correct, one would expect to see higher rates of return (and more anticompetitive effects) with higher levels of shareholding (though the effect may not be linear). So I still wonder about the relatively low levels here.
      • Also, it may be more difficult and expensive to amass and manage a portfolio of many small holdings as opposed to one larger one. Again, if that’s true, how do we explain the absence of larger horizontal shareholdings?
    • Is there anything in securities law and regulation that allows for horizontal ownership and/or communication with management and that would otherwise preempt the application of antitrust law?
    • Would antitrust enforcement lessen fund diversification? And if so, can the pro-competitive effects of antitrust enforcement be balanced against the reduction in diversification in a quantitative manner?
    • To the extent there is an issue, can it be solved by giving funds a choice – either limit their holdings, or agree not to become actively involved in firm management or governance? The article suggests the answer may be yes – “if index funds alone would create a problem of anticompetitive horizontal shareholding in a concentrated market, and those index funds feel the benefits of diversification across all firms in that market exceed the benefits of influencing corporate governance, they could commit not to communicate with management or vote their shares.”

In short – it’s a very interesting theory. But it’s early days, and I think we need some more consideration – and evidence – to evaluate it.

P.S. – The paper also argues that increased antitrust enforcement in the 1930s under Thurman Arnold was a substantial reason for the United States’ emergence from the Great Depression. Certainly the timing of AAG Arnold’s appointment lines up neatly with the decrease in the unemployment rate. As they say, correlation is not causation – but again it’s a very interesting point.

(*) The basic arguments are that (a) the use of industry performance measures is not a bug but a feature for institutional investors who are invested across the industry, because managers who increase individual corporate performance by competing with rivals decrease institutional investor profits across the industry by decreasing industry profits; (b) with horizontal shareholdings, firms acting in the interests of their shareholders have incentives to constrain output rather than expand; and (c) anticompetitive markets raise returns on capital (which is invested in firms whose product prices are inflated) but also lower the effective returns to labor through (i) higher product prices that lower the purchasing power of wages and (ii) the exercise of monopsony power over labor rates.

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