The Corporate Governance Cartel

In recent years, major institutional investors in the U.S. have combined their efforts on environmental, social, and governance ('ESG') matters. Large institutional investors now vote in lockstep on a variety of corporate issues, jointly lead governance initiatives, and often adopt mutually supportive stances on social and environmental campaigns. This unprecedented cooperation has been boosted by the emergence of institutional investor consortia – advocacy groups and trade associations that represent their members’ collective interests. Chief among these organizations are the Council of Institutional Investors (CII), a trade association that represents asset managers, pension funds, and union funds with combined assets of over $40 trillion, and the Investor Stewardship Group (ISG), a coalition of more than 70 institutional investors with combined assets of over $32 trillion. These influential groups, which largely focus on promoting governance principles on behalf of their institutional members, amplify the collective power of institutional investors over corporate America.

From a corporate law perspective, this recent development is seen as a relatively positive force. Investor coalitions are often viewed as the solution to the well-known collective-action problem facing public shareholders. The underlying premise is that, by acting in concert, institutional shareholders can compel corporations to align their practices with the investors’ governance preferences. And, because institutional investors are viewed as sophisticated market players, their joint efforts should supposedly control managerial agency costs and improve firm value.

In a new article, I provide a novel, antitrust analysis that complicates this idealized picture. I explain that the corporate law analysis of investor coalitions overlooks the fact that members of such coalitions are not only co-investors in public companies but are also competitors in capital markets. In the primary market, institutional investors are the potential buyers of shares and compete on share allocation. In fact, in this market, institutional investors are not even co-investors but, rather, mere competitors. In the secondary market, they compete as asset managers, using their relative portfolio performances to attract retail investors and large sponsors. Thus, an orchestrated coalition that affects not only the intra-firm governance arrangements of the companies whose stock is held by its members but also the capital markets themselves may provide an opportunity for tacit collusion that grants members an unfair advantage in the markets in which they compete.

To develop the antitrust analysis of investor coalitions with a clear example, my article focuses on the coalition against dual-class structures – share structures that have two (or more) classes of stock with unequal voting rights. In recent years, a large group of institutional investors – including prominent asset management institutions, pension funds, and union-related funds – have joined forces against issuers of dual-class stock. With the help of their consortia, they called upon the Securities and Exchange Commission and the stock exchanges to ban the listing of dual-class stock and successfully persuaded index providers to exclude such stock from leading market indices. Moreover, they sent open letters of condemnation to companies contemplating going public with a dual-class structure and recently published a blacklist of 'Dual-class Enablers,' which includes the names of all board members who have been involved in IPOs of companies that went public with an open-ended dual-class structure (that is, a dual-class structure that does not sunset after a fixed period).

These coordinated responses to a governance term at the IPO stage create a de facto cartel of buyers in the primary market. As I show, those buyers – institutional investors – can leverage their negotiating power over issuers to secure better price- and non-price terms when dealing with share issuers. Specifically, this 'cartelesque' collective action can lead to two main market effects: the price effect and the governance-terms effect. The price effect refers to the artificial inflation of the penalty paid by issuers of dual-class stock, which depresses the prices of securities sold in capital markets and ultimately results in significant underpricing of such stock in IPOs. Such deep underpricing of dual-class stock can be inferred from a recent empirical study, which shows that the average first-day 'price bump' – the difference between the offer price and the closing price of stock on the first day of trading – is almost twice as large as for that of single-class companies’ stock. More strikingly, a listing published by Jay Ritter, which shows the most amount of money having been 'left on the table' in IPOs since 1985, reveals that the 10 most-underpriced IPOs are all of dual-class stock. In aggregate, issuers in these IPOs, which include companies such as Visa, Airbnb, and Snap, left over $26 billion on the table when going public.

The governance-terms effect refers to the capacity of the coalition to push issuers into adopting governance terms that are in line with the institutional investors’ preferences, such as a sunset provision. Indeed, since the coalition started to mobilize its efforts in earnest (approximately five years ago, in 2017), the adoption rate of time-limited sunsets among dual-class companies has doubled. As I explain in the article, both the price and the governance-terms effects entail allocational inefficiencies and adverse distributional consequences.

The capacity of the coalition to achieve these market effects is attributed to several factors. First, institutional investors account for most of the expected market demand for shares in public offerings. On average, they receive approximately 90 percent of stock sold in IPOs. Because the coalition aggregates the opinions of many institutional investors, the collective power of such members over issuers is profound. Second, these powerful market players are also providers of valuable pricing feedback during marketing activities and the book-building process. Thus, any negative view of the dual-class structure shared by institutional investors sends a strong message to the markets that such shares should be priced lower than single-class shares (some of them, such as BlackRock, even stated so publicly and explicitly), making it almost inevitable that these investors’ preference for a single-class structure will detrimentally affect the price and terms of dual-class stock.

My analysis demonstrates how investor coalitions – even around seemingly benign corporate governance issues – may be harmful to markets, causing the sort of economic harm that antitrust laws are designed to prevent. The pattern of potential anticompetitive effects that I identify suggests that policymakers must apply antitrust principles in evaluating the collective actions of institutional investors, particularly those that come to the fore in IPOs. Special antitrust attention should be given to investor consortia in particular, given their role as facilitators of joint governance initiatives that undermine competition in markets in which their members compete.

Danielle Chaim in Assistant Professor at the Faculty of Law at Bar-Ilan University.

This post appeared first on Columbia Law School's Blue Sky Blog (here).