Controlling externalities: ownership structure and cross-firm externalities

ABSTRACTThe increasingly influential ‘universal owner’ theory posits that index funds have incentives to reduce cross-firm externalities to maximise portfolio value. We develop a more general conceptual framework for understanding how firms’ ownership structures and company law affect the internalisation of cross-firm externalities. This approach takes account of the fact that across the world most firms have controlling shareholders. We introduce the concept of ‘controller wealth concentration’ as a determinant of controllers’ pecuniary incentives to internalise externalities. Our framework suggests that, in principle, dual class (and other controlling minority) structures have the hitherto ignored advantage of allowing controllers to diversify their personal wealth (thereby potentially mitigating cross-firm externalities). We provide some evidence that controllers’ personal wealth is nonetheless typically undiversified and discuss possible reasons why controllers fail to diversify. We conclude that controlling shareholders typically have weak pecuniary incentives to internalise externalities, underscoring the importance of government regulation of externalities.KEYWORDS: Controlling shareholdersexternalitiesdual class stock AcknowledgementWe thank two anonymous referees, Dhruv Aggrawal, John Armour, Madison Condon, Luca Enriques, Zohar Goshen, Alperen Gozlugol, Daniel Hemel, Kobi Kastiel, Aniel Kovvali, Joshua Mitts, Michael Ohlrogge, Mariana Pargendler, Frank Partnoy, Elizabeth Pollman, Dan Puchniak, Gabriel Rauterberg, workshop participants at the University of Chicago, Columbia University, George Mason University and the Oxford Business Law Workshop, and conference participants at the American Law and Economics Association meetings and the Global Corporate Governance Colloquium (especially our discussant Yupana Wiwattanakantang) for helpful comments. We also thank Billy Stampfl, John Friess and Shreya Ram for outstanding research assistance. Dharmapala acknowledges the financial support of the Lee and Brena Freeman Faculty Research Fund at the University of Chicago Law School. Any remaining errors or omissions are our own.Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1 As one example of a vast literature, see Colin Mayer, ‘Reinventing the Corporation’ (2016) 4 Journal of the British Academy 53–72.2 e.g. Siva Vaidhyanathan, Antisocial Media: How Facebook Disconnects us and Undermines Democracy (Oxford University Press, 2018).3 See e.g. Simon Dietz and others, ‘“Climate Value at Risk” of Global Financial Assets’ (2016) 6(7) Nature Climate Change 676–679. This study estimates that the ‘value at risk’ of global financial assets due to climate change is quite substantial. As they explain (p. 676): ‘[T]here are two principal ways in which climate change can affect the value of financial assets. First, it can directly destroy or accelerate the depreciation of capital assets, for example through its connection with extreme weather events. Second, it can change (usually reduce) the outputs achievable with given inputs, which amounts to a change in the return on capital assets, in the productivity of knowledge, and/or in labour productivity and hence wages’.4 See Robert G Hansen and John R Lott Jr., ‘Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers’ (1996) Journal of Financial and Quantitative Analysis 43–68; Iman Anabtawi, ‘Some Skepticism about Increasing Shareholder Power’ (2005) 53 UCLA L Rev 561–599; John Armour and Jeffrey N Gordon, ‘Systemic Harms and Shareholder Value’ (2014) 6(1) Journal of Legal Analysis 35–85; John C Coffee, ‘The Future of Disclosure: ESG, Common Ownership, and Systematic Risk’ (2020) European Corporate Governance Institute-Law Working Paper; Madison Condon, ‘Externalities and the Common Owner’ (2020) 95 Washington Law Review 1; Jeffrey N Gordon, ‘Systematic Stewardship’ (2021) Columbia Law and Economics Working Paper 640.5 Many scholars express scepticism that index funds have the incentives to have much impact. See e.g. John D Morley, ‘Too Big to Be Activist’ (2018) 92 Southern California Law Review 1407; Anna Christie, ‘The Agency Costs of Sustainable Capitalism’ (January 13, 2021) 55(2) UC Davis Law Review, forthcoming, University of Cambridge Faculty of Law Research Paper No. 7/2021, Available at SSRN: https://ssrn.com/abstract=3766478; Giovanni Strampelli, ‘Can BlackRock Save the Planet? The Institutional Investors’ Role in Stakeholder Capitalism’ Harvard Business Law Review, forthcoming.6 For evidence on the prevalence of controlled ownership structures, see e.g. Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, ‘Corporate Ownership Around the World’ (1999) 54(2) The Journal of Finance 471–517; Mara Faccio and Larry HP Lang, ‘The Ultimate Ownership of Western European Corporations’ (2002) 65(3) Journal of Financial Economics 365–395; Gur Aminadav and Elias Papaioannou, ‘Corporate Control around the World’ (2020) 75(3) The Journal of Finance 1191–1246; Amir Amel-Zadeh, Fiona Kasperk and Martin Schmalz, ‘Mavericks, Universal, and Common Owners-The Largest Shareholders of US Public Firms’ ECGI Finance Working Paper No. 838/2022 (2022). The last of these focuses of US firms, showing that a significant fraction have controlling blockholders.7 See discussion and evidence cited in Section III infra. The original source of the FANG acronym (now FAANG to reflect the addition of Apple) is Jim Cramer from MSNBC in 2013, see Cramer: Does Your Portfolio Have FANGs?, Mad Money, Feb, 05, 2013, available at: https://www.cnbc.com/id/100436754. If we include Microsoft and Apple in the FANG grouping then these six firms represent around 25% of the S&P 500 by market capitalisation by the middle of 2021. See Edward Yardeni and Joe Abbott Stock Market Briefing: FAANGMs, July 2, 2021, available at: https://www.yardeni.com/pub/faangms.pdf.8 See Armour, Enrique and Wetzer, July 02, 2021 blog (https://www.law.ox.ac.uk/business-law-blog/blog/2021/07/corporate-carbon-reduction-pledges-beyond-greenwashing) which cites to https://climateaccountability.org/carbonmajors.html.9 We also define a related concept – the controller's delta – that represents the change in a controller's personal wealth when the value of her controlled firm increases by a dollar (taking account of any externalities that this increase in value imposes on other firms).10 A complaint was filed in the Delaware Court of Chancery in October 2022, stating (in part): ‘This is an action to remedy breaches of fiduciary duty by Meta's [the parent company of Facebook] directors and officers. Meta is the largest social media network company in the world, with 3.5 billion users—43% of humanity. Its business decisions inevitably create financial impact well beyond its own cash flows and enterprise value and have significant impacts on the global economy. While defendants have a duty to operate the Company as a business for the financial benefit of its stockholders, those stockholders are often diversified investors with portfolio interests beyond Meta's own financial success. If the decisions that maximise the Company's long-term cash flows also imperil the rule of law or public health, the portfolios of its diversified stockholders are likely to be financially harmed by those decisions … For a corporation whose impact is so widespread, the well-established doctrine of stockholder primacy cannot be rationally applied on behalf of investors without recognizing the impact of portfolio theory, which inextricably links common stock ownership to broad portfolio diversification. The economic benefits from—indeed the viability of— a system of corporate law rooted in maximising financial value for stockholders would vanish if it forced directors to make decisions that increased corporate value but depressed portfolio values for most of its stockholders. But this is precisely how the Company has operated: Defendants have ignored the interests of all of its diversified stockholders, making decisions as if the costs that Meta imposes on such portfolios were not meaningful to stockholders. This circumstance is particularly troubling because it favors the small subset of stockholders who control the Company through the ownership of highly concentrated positions of high-voting common stock, including the Company's CEO and Chairman. For this controlling subset, maximising the value of the Company by undermining the global economy is financially beneficial’. See McRitchie v. Zuckerberg et al., available at: https://theshareholdercommons.com/wp-content/uploads/2022/10/Stamped-Complaint-FINAL-10.3.22.pdf.11 See e.g. Lucian A Bebchuk, Reinier H Kraakman and George Triantis, ‘Stock Pyramids, Cross-Ownership and Dual Class Equity: The Mechanisms and Agency Costs of Separating Control From Cash-Flow Rights’ in R Morck ed., Concentrated Corporate Ownership (2000) 445–460; Ronald W Masulis, Cong Wang and Fei Xie, ‘Agency Problems at Dual-Class Companies’ (2009) 64 Journal of Finance 1697; Renee Adams and Daniel Ferreira, ‘One Share-One Vote: The Empirical Evidence’ (2008) 12 Review of Finance 51.12 See e.g. Paul A Gompers, Joy Ishii and Andrew Metrick, ‘Extreme Governance: An Analysis of Dual-Class Firms in the United States’ (2010) 23(3) The Review of Financial Studies 1051–1088 for empirical evidence, and Lucian A Bebchuk and Kobi Kastiel, ‘The Untenable Case for Perpetual Dual-Class Stock’ (2017) 103 Va L Rev 585: for a normative discussion.13 Despite the emphasis in the discussion so far on negative externalities, such as those typically associated with climate change, the analysis above can be straightforwardly extended to the case of positive externalities. In principle, it is possible that firms may generate positive externalities for each other. Then, an undiversified controller (with high CWC) would fail to internalise these positive externalities and choose too low a level of activity for her firm. Inducing the controller to diversify would lead her to internalise these externalities and therefore to increase her firm's activity level.14 A recent working paper (V Battocletti, L Enriques and A Romano, ‘Dual Class Shares in the Age of Common Ownership’ [2022] European Corporate Governance Institute-Law Working Paper 628) addresses a similar set of issues. However, their central point is that dual class structures should be restricted so that undiversified controllers become less influential and diversified index funds can exert greater influence on firms’ policies. This is quite different from the argument we develop about dual class stock potentially facilitating controller diversification. Another recent working paper (AM Pacces, ‘Controlling Shareholders and Sustainable Corporate Governance: The Role of Dual-Class Shares’ [2023] European Corporate Governance Institute-Law Working Paper [700]) also discusses the links between dual class stock and externalities. However, its central claim is that index funds – while able to internalise externalities among their portfolio firms – are unable to incentivize innovation (for instance, to reduce carbon emissions). The paper suggests that providing founder/controllers with dual class stock can incentivize the latter to innovate. Our emphasis is instead on the incentives that dual class stock creates for controller diversification.15 Four fairly significant issues are bracketed in our analysis. One concerns the rather special (albeit widely-discussed) class of externalities involving product market competition. Here, the internalisation of cross-firm externalities involves reductions in product market competition and reduces social welfare through the impact on other parties (such as consumers) whose welfare is impacted in the opposite direction to the relevant publicly-traded entities. In contrast, we focus on the case where – even though much of the externality may not be reflected in stock market values because some of the impact is on parties that are not listed firms – the stock market effects of the external harm are in the same direction as for entities outside the market. Because of this difference, our analysis would apply in reverse in the product market context. That is, ownership and control by undiversified controlling shareholders would be beneficial, as it impedes the internalisation of product market externalities. Policy would aim to prevent these controllers from diversifying their portfolios. Our framework can thus shed some light on the product market context, even though it is not our primary focus.Second, we do not directly address the case of state-owned enterprises (SOEs), where governmental entities are the controlling shareholders of publicly-traded corporations. It might be thought that political mechanisms, rather than pecuniary incentives, would be most determinative of whether SOEs take account of external harms. On the other hand, the basic premise of the literature on cross-firm externalities is that governments have failed to choose socially optimal public policies to control corporate externalities. Thus, one might not have much faith that political mechanisms would lead to the internalisation of externalities. In any event, we do not focus on the SOE setting in our discussion.Third, we do not discuss situations in which index funds might influence controlled firms in ways besides visible voting contests or engagements. There is mounting evidence in the context of diffusely held firms that index funds may often achieve certain goals without needing to proceed through (or complete or even win) a salient voting contest or engagement. See William T Allen, Reinier H Kraakman and Vikramaditya S Khanna, Commentaries and Cases on the Law of Business Organization at 6.9.3.2 (6th edn, Wolters Kluwer, 2021); Michael Garland, Jennifer Conovitz and Yumi Narita, ‘NYC's Comptroller Boardroom Accountability 3.0 Results’ (June 24, 2020) Harv L School Forum on Corp Gov. Available at: https://corpgov.law.harvard.edu/2020/06/24/nyc-comptrollers-boardroom-accountability-3-0-results/. These sorts of ‘behind-the-scenes’ deals or successes may be likely with controlled firms as well for a number of reasons. For instance, the controller might be interested in the views of index funds (outside of voting outcomes) because such funds may be important in raising capital at some other point in time, the funds may have stakes (or be able to influence those with stakes) in the controller's other firms or investments, the funds may have expertise on the topic being considered, or the funds may be socially or politically salient enough that they can influence the reputation of the firm and the controller in important ways or even influence regulation. In our analysis, we do not address these alternative ways in which index funds might be important because these deals are difficult to observe and they seem sufficiently idiosyncratic that they do not appear to provide a reliable basis for expecting index funds to facilitate the internalisation of cross-firm externalities.Finally, we do not directly discuss in any depth conglomerate firms or diversified business groups, which are ubiquitous in many parts of the world. Conglomerate enterprises operate in various different industries, thereby partially replicating a controller with a more diversified portfolio (even when the controller's wealth is concentrated in the business group). Our framework suggests that these structures may have some under-appreciated advantages, but it should be noted that these structures often exist in legal and economic environments quite different from those in the United States.16 Anabtawi (n 4) 585.17 Condon (n 4).18 Coffee (n 4) at p. ii.19 See e.g. Lucian A Bebchuk, Alma Cohen and Scott Hirst, ‘The Agency Problems of Institutional Investors’ (2017) 31(3) Journal of Economic Perspectives 89–102. Note that index funds per se do not make decisions – their investment advisors do, and their incentives are not the same as those of a person who owns the index fund. For example, a $1 billion rise in the fund's value does not usually translate into a $1 billion rise in the advisor's fees. Fees for most index funds are very small – indeed, that is one of the key features on which they compete – so that changes in the value of the fund (e.g. holdings in one industry) may not have as significant an impact on the size of the advisor's fees and may not be worth the costs of these actions. On the other hand, there is an emerging body of empirical evidence that is broadly consistent with the claims of the universal owner theory. Professors Dyck et al. find a positive relationship between institutional ownership and firms’ environmental and social performance across 41 countries; they argue for a causal interpretation of this relationship (Alexander Dyck and others, ‘Do Institutional Investors Drive Corporate Social Responsibility? International Evidence’ [2019] 131(3) Journal of Financial Economics 693–714). Professors Chen, Dong and Lin (Tao Chen, Hui Dong and Chen Lin, ‘Institutional Shareholders and Corporate Social Responsibility’ [2020] 135(2) Journal of Financial Economics 483–504) analyse the impact on measures of firms’ corporate social responsibility (CSR) of exogenous increases in institutional ownership associated with reconstitutions of the Russell index. They find that increases in institutional ownership lead to improved CSR performance, consistent with a view that index funds encourage firms to take account of externalities. Perhaps the most direct evidence for the theory is that provided by Professors Azar et al. (J Azar and others, ‘The Big Three and Corporate Carbon Emissions Around the World’ [2021] 142(2) Journal of Financial Economics 674–696). They collect data on engagements by the ‘Big Three’ index funds (BlackRock, Vanguard, and State Street Global Advisors) on climate-related environmental issues in 2018 and 2019, using the fund sponsors’ public disclosures, across a global sample of firms. They also construct a dataset of firm-level carbon dioxide (CO2) emissions over 2005–2018. Using this data, they find that Big Three environmental engagements are targeted at large firms with high CO2 emissions. They also find that increases in Big Three index fund ownership of firms are associated with lower CO2 emissions (including when the focus is on exogenous increases in Big Three ownership generated by reconstitutions of the Russell index). This evidence does not, however, take account of the role of firms’ ownership structure in mediating the frequency of environmental engagements by the index funds or the efficacy of these interventions. Moreover, the strongest causal evidence (based on Russell index reconstitutions) is restricted to US firms, and thus only applies to a market in which controlled firms are substantially less common than in most other countries.20 See e.g. Roberto Tallarita, ‘The Limits of Portfolio Primacy’ Working paper, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3912977. In addition, Michal Barzuza, Quinn Curtis and David H Webber, ‘Shareholder Value (s): Index Fund ESG Activism and the New Millennial Corporate Governance’ (2019) argue that index funds’ increasing focus on climate change and on corporate social responsibility more generally is driven by the demands for socially responsible investing among the younger generation of investors (accountholders), rather than by considerations of internalisation of externalities.21 A recent study argues that Stewardship Codes are likely to be ineffective in countries with primarily controlled firms. See Ernest Lim and Dan W Puchniak, 'Can a Global Legal Misfit be Fixed? Shareholder Stewardship in a Controlling Shareholder and ESG World' in Dionysia Katelouzou and Dan W Puchniak (eds), Global Shareholder Stewardship (Cambridge University Press 2022). See also Christie (n 5).22 A further conceptual point that we raise briefly here is that the growth of index fund activism may itself make controlled structures more common. For instance, consider an externality-generating firm that has value of $110 if it pollutes, but imposes a $12 aggregate cost on other publicly-traded firms. If it scales down its activity to the socially efficient level, its value falls to $100 (but it imposes no costs on other firms). Under dispersed ownership, index funds will be among the largest shareholders and can potentially influence its managers to behave in a socially efficient manner (so that the firm is worth $100). A concentrated blockholder who owns no other assets and bears no liability risk, however, would value the firm at $110 (operating at the larger scale that imposes costs on other firms). An equilibrium analysis would have to explain why such a blockholder would prefer a concentrated position in this firm rather than a diversified market portfolio (perhaps due to some idiosyncratic value of control), but it is possible that in some circumstances ownership of the firm would tend to pass to blockholders.Perhaps most pertinently, index fund activism to restrain externality-generation may give rise to an arbitrage strategy for private equity (PE) funds. In particular, a PE fund could take a concentrated position in the firm in the example above, take it private, increase its activity level, and earn returns for several years that exceed the returns under dispersed ownership (and index fund influence). The price at which the PE fund would eventually sell the firm on the public market would likely reflect reversion to a dispersed ownership structure (and renewed index fund influence). Nonetheless, the firm would generate higher returns in the interim period for the PE fund than it would have under dispersed ownership. Such an arbitrage strategy would of course generate social costs. Whether it would be privately optimal for the PE fund would depend on a variety of factors (such as the length of the interim period), and would have to be analysed more fully in an equilibrium framework. However, the possibility of such a strategy suggests that endogenous responses of ownership structure to index fund activism should be the subject of further research. It also underlines that the market for corporate control easily cannot solve – and indeed may exacerbate – problems related to externalities.23 Michael C Jensen and Kevin J Murphy, ‘Performance Pay and Top-Management Incentives’ (1990) 98(2) Journal of Political Economy 225–264. There is an extensive literature on stock-based compensation for managers – e.g. Brian J Hall and Kevin J Murphy, ‘Stock Options for Undiversified Executives’ (2002) 33(1) Journal of Accounting and Economics 3–42 – but discussion of controller incentives has been more limited. Controller's delta is defined mathematically in the Appendix, but for present purposes a simple example suffices to elaborate on the concept and why we focus more on CWC. For example, if Z owns 60% of the stock of firm F and changes in the value of firm F do not have any spillover effects on other firms, then controller's delta = 0.6 (a $1 change in firm F's value increases Z's wealth by 60 cents). On the other hand, if a $1 increase in firm F's value reduces the value of other firms by 40 cents, then Z's ownership of these other firms will affect controller's delta and hence Z's marginal incentives to raise the value of firm F. When cross-firm spillovers exist, it is not possible to compute the controller's delta without knowing the magnitude of these external effects. Thus, we focus below on computing estimates of CWC.24 See the notes to Table 1 for the sources.25 A simple example might prove illustrative. Let us assume Z controls firm F with a 60% stake, and also owns shares in each of 10 other firms. An externality produced by F generates costs of $100 to each of the 10 other firms (i.e. a total of $1000) and that externality can be prevented if F spends $110 on precautions. If Z's stake in each of the 10 other firms is 7%, then she bears $70 in losses from the externality which can be avoided at a cost of $66 to her (60% of the $110 in precautions). One would expect her to push F to take the precautions to avoid the externality, assuming that undertaking the precautions does not violate any corporate law duties that the controller may have to the minority shareholders of firm F. Moreover, because she is F's controller (and does not need to coordinate with others) she is likely to be quite successful in ensuring this happens. Simply put, a diversified controlling shareholder will likely internalise some of the costs of externalities generated by the controlled firm and is better placed than other diversified investors to make the controlled firm change its behaviour. We hasten to add that one can think of counter-examples where a diversified controller will still decide to favour the controlled firm. Our point, however, is not that diversified controllers will always internalise enough of the costs to act in the social welfare maximising manner, but rather that they may often have incentives to do so and that compared to other diversified shareholders they may be more effective in changing the firm's behaviour. Their effectiveness in changing the controlled firm's behaviour is undoubtedly one of the reasons why controllers sometimes bear liability for their subsidiaries via statute – see Allen, Kraakman and Khanna (n 15) at Ch. 8.26 There is a vast literature on private benefits of control – see e.g. Luigi Zingales, ‘The Value of the Voting Right: A Study of the Milan Stock Exchange Experience’ (1994) 7(1) The Review of Financial Studies 125–148; Alexander Dyck and Luigi Zingales, ‘Private Benefits of Control: An International Comparison’ (2004) 59(2) The Journal of Finance 537–600.27 e.g. Lucian A Bebchuk, Reinier Kraakman and George Triantis, ‘Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Mechanisms and Agency Costs of Separating Control from Cash-Flow Rights’ in Concentrated Corporate Ownership, 295–318 (University of Chicago Press, 2000).28 An earlier version of this paper reported (using publicly-available data sources) that the majority of the largest twenty-five firms in the energy and automobile sectors had controlling shareholders. However, due to a number of factors (including the prominent role of governments as controlling shareholders, especially in the energy sector) calculations of CWC for these sectors is challenging.29 Gur Aminadav and Elias Papaioannou, ‘Corporate Control Around the World’ (2020) 75(3) The Journal of Finance 1191–1246.30 Note that any intermediate strategy on the part of Z – selling part of her stock and ending up somewhat diversified but over-weighted in F relative to F's share of the market – is clearly dominated by one or other of the choices sketched above. An intermediate strategy will result in a loss of control (and hence the loss of IVC), while leaving Z less than optimally diversified. Thus, we can focus only on the choice between the two options described above.31 By assumption, those investors who buy Z's stock at time 1 are fully diversified. Thus, they care only about the expected value when deciding how much to pay for F's stock and do not care about F's idiosyncratic risk (more generally, they would care only about the relationship between F's idiosyncratic risk and the systematic risk of the market portfolio, but the latter is assumed away here for simplicity).32 SW Bauguess, MB Slovin and ME Sushka, ‘Large Shareholder Diversification, Corporate Risk Taking, and the Benefits of Changing to Differential Voting Rights’ (2012) 36(4) Journal of Banking & Finance 1244–1253.33 As founder/controllers are typically quite wealthy, it may not be realistic to imagine that – in the counterfactual scenario in which they divest – they would invest in, for instance, an index fund. The most natural investment vehicles for wealthy individuals may involve a search for ‘alpha’ (i.e. returns in excess of those on a diversified market portfolio), and thus may not be diversified. The practical difficulties associated with controller diversification tend to reinforce the general point we make that controllers are typically undiversified.34 Obviously, this is not the only way to formulate optimism bias: Z could instead (or also) overestimate the probability of contingency 1, or believe that the downside in contingency 2 is not as bad as it really is. These alternative formulations also lead to similar conclusions, however. Another possible distinction is between optimism bias about firm F's prospects (regardless of who manages it) and optimism bias about firm F's prospects when it is managed by Z. The former would lead Z to demand high cash flow rights in F but not necessarily to maintain control (indeed, Z may be willing to sell her voting stock in a dual class setting while retaining her common stock). The latter would entail maintaining control (via the voting stock) while also holding a large amount of common stock to benefit from the perceived high returns that F is thought to generate. While these possibilities have somewhat different implications, they would both lead Z to be an undiversified holder of F stock.35 In principle, a related but distinct possibility is that Z is not over-optimistic, but rather that outside investors are irrationally pessimistic about F's value. That scenario would also induce Z to hold on to her common stock, as potential buyers would not be willing to pay its true value. This, however, requires a significant degree of market inefficiency, as underpricing due to the excessive pessimism of outside (retail) investors is readily subject to arbitrage. In contrast, it may be difficult for arbitrage to correct Z's optimism bias.36 See Lucas Ayres Barreira de Campos Barros and Alexandre Di Miceli da Silveira, ‘Over