Archives For mutual funds

I posted this originally on my own blog, but decided to cross-post here since Thom and I have been blogging on this topic.

“The U.S. stock market is having another solid year. You wouldn’t know it by looking at the shares of companies that manage money.”

That’s the lead from Charles Stein on Bloomberg’s Markets’ page today. Stein goes on to offer three possible explanations: 1) a weary bull market, 2) a move toward more active stock-picking by individual investors, and 3) increasing pressure on fees.

So what has any of that to do with the common ownership issue? A few things.

First, it shows that large institutional investors must not be very good at harvesting the benefits of the non-competitive behavior they encourage among the firms the invest in–if you believe they actually do that in the first place. In other words, if you believe common ownership is a problem because CEOs are enriching institutional investors by softening competition, you must admit they’re doing a pretty lousy job of capturing that value.

Second, and more importantly–as well as more relevant–the pressure on fees has led money managers to emphasis low-cost passive index funds. Indeed, among the firms doing well according to the article is BlackRock, “whose iShares exchange-traded fund business tracks indexes, won $20 billion.” In an aggressive move, Fidelity has introduced a total of four zero-fee index funds as a way to draw fee-conscious investors. These index tracking funds are exactly the type of inter-industry diversified funds that negate any incentive for competition softening in any one industry.

Finally, this also illustrates the cost to the investing public of the limits on common ownership proposed by the likes of Einer Elhague, Eric Posner, and Glen Weyl. Were these types of proposals in place, investment managers could not offer diversified index funds that include more than one firm’s stock from any industry with even a moderate level of market concentration. Given competitive forces are pushing investment companies to increase the offerings of such low-cost index funds, any regulatory proposal that precludes those possibilities is sure to harm the investing public.

Just one more piece of real evidence that common ownership is not only not a problem, but that the proposed “fixes” are.

regulation-v41n3-coverCalm Down about Common Ownership” is the title of a piece Thom Lambert and I published in the Fall 2018 issue of Regulation, which just hit online. The article is a condensed version our recent paper, “The Case for Doing Nothing About Institutional Investors’ Common Ownership of Small Stakes in Competing Firms.” In short, we argue that concern about common ownership lacks a theoretically sound foundation and is built upon faulty empirical support. We also explain why proposed “fixes” would do more harm than good.

Over the past several weeks we wrote a series of blog posts here that summarize or expand upon different parts of our argument. To pull them all into one place:

One of the hottest topics in antitrust these days is institutional investors’ common ownership of the stock of competing firms. Large investment companies like BlackRock, Vanguard, State Street, and Fidelity offer index and actively managed mutual funds that are invested in thousands of companies. In many concentrated industries, these institutional investors are “intra-industry diversified,” meaning that they hold stakes in all the significant competitors within the industry.

Recent empirical studies (e.g., here and here) purport to show that this intra-industry diversification has led to a softening of competition in concentrated markets. The theory is that firm managers seek to maximize the profits of their largest and most powerful shareholders, all of which hold stakes in all the major firms in the market and therefore prefer maximization of industry, not firm-specific, profits. (For example, an investor that owns stock in all the airlines servicing a route would not want those airlines to engage in aggressive price competition to win business from each other. Additional sales to one airline would come at the expense of another, and prices—and thus profit margins—would be lower.)

The empirical studies on common ownership, which have received a great deal of attention in the academic literature and popular press and have inspired antitrust scholars to propose a number of policy solutions, have employed a complicated measurement known as “MHHI delta” (MHHI∆). MHHI∆ is a component of the “modified Herfindahl–Hirschman Index” (MHHI), which, as the name suggests, is an adaptation of the Herfindahl–Hirschman Index (HHI).

HHI, which ranges from near zero to 10,000 and is calculated by summing the squares of the market shares of the firms competing in a market, assesses the degree to which a market is concentrated and thus susceptible to collusion or oligopolistic coordination. MHHI endeavors to account for both market concentration (HHI) and the reduced competition incentives occasioned by common ownership of the firms within a market. MHHI∆ is the part of MHHI that accounts for common ownership incentives, so MHHI = HHI + MHHI∆.  (Notably, neither MHHI nor MHHI∆ is bounded by the 10,000 upper limit applicable to HHI.  At the end of this post, I offer an example of a market in which MHHI and MHHI∆ both exceed 10,000.)

In the leading common ownership study, which looked at the airline industry, the authors first calculated the MHHI∆ on each domestic airline route from 2001 to 2014. They then examined, for each route, how changes in the MHHI∆ over time correlated with changes in airfares on that route. To control for route-specific factors that might influence both fares and the MHHI∆, the authors ran a number of regressions. They concluded that common ownership of air carriers resulted in a 3%–7% increase in fares.

As should be apparent, it is difficult to understand the common ownership issue—the extent to which there is a competitive problem and the propriety of proposed solutions—without understanding MHHI∆. Unfortunately, the formula for the metric is extraordinarily complex. Posner et al. express it as follows:


  • βij is the fraction of shares in firm j controlled by investor I,
  • the shares are both cash flow and control shares (so control rights are assumed to be proportionate to the investor’s share of firm profits), and
  • sj is the market share of firm j.

The complexity of this formula is, for less technically oriented antitrusters (like me!), a barrier to entry into the common ownership debate.  In the paragraphs that follow, I attempt to lower that entry barrier by describing the overall process for determining MHHI∆, cataloguing the specific steps required to calculate the measure, and offering a concrete example.

Overview of the Process for Calculating MHHI∆

Determining the MHHI∆ for a market involves three primary tasks. The first is to assess, for each coupling of competing firms in the market (e.g., Southwest Airlines and United Airlines), the degree to which the investors in one of the competitors would prefer that it not attempt to win business from the other by lowering prices, etc. This assessment must be completed twice for each coupling. With the Southwest and United coupling, for example, one must assess both the degree to which United’s investors would prefer that the company not win business from Southwest and the degree to which Southwest’s investors would prefer that the company not win business from United. There will be different answers to those two questions if, for example, United has a significant shareholder who owns no Southwest stock (and thus wants United to win business from Southwest), but Southwest does not have a correspondingly significant shareholder who owns no United stock (and would thus want Southwest to win business from United).

Assessing the incentive of one firm, Firm J (to correspond to the formula above), to pull its competitive punches against another, Firm K, requires calculating a fraction that compares the interest of the first firm’s owners in “coupling” profits (the combined profits of J and K) to their interest in “own-firm” profits (J profits only). The numerator of that fraction is based on data from the coupling—i.e., the firm whose incentive to soften competition one is assessing (J) and the firm with which it is competing (K). The fraction’s denominator is based on data for the single firm whose competition-reduction incentive one is assessing (J). Specifically:

  • The numerator assesses the degree to which the firms in the coupling are commonly owned, such that their owners would not benefit from price-reducing, head-to-head competition and would instead prefer that the firms compete less vigorously so as to maximize coupling profits. To determine the numerator, then, one must examine all the investors who are invested in both firms; for each, multiply their ownership percentages in the two firms; and then sum those products for all investors with common ownership. (If an investor were invested in only one firm in the coupling, its ownership percentage would be multiplied by zero and would thus drop out; after all, an investor in only one of the firms has no interest in maximization of coupling versus own-firm profits.)
  • The denominator assesses the degree to which the investor base (weighted by control) of the firm whose competition-reduction incentive is under consideration (J) would prefer that it maximize its own profits, not the profits of the coupling. Determining the denominator requires summing the squares of the ownership percentages of investors in that firm. Squaring means that very small investors essentially drop out and that the denominator grows substantially with large ownership percentages by particular investors. Large ownership percentages suggest the presence of shareholders that are more likely able to influence management, whether those shareholders also own shares in the second company or not.

Having assessed, for each firm in a coupling, the incentive to soften competition with the other, one must proceed to the second primary task: weighing the significance of those firms’ incentives not to compete with each other in light of the coupling’s shares of the market. (The idea here is that if two small firms reduced competition with one another, the effect on overall market competition would be less significant than if two large firms held their competitive fire.) To determine the significance to the market of the two coupling members’ incentives to reduce competition with each other, one must multiply each of the two fractions determined above (in Task 1) times the product of the market shares of the two firms in the coupling. This will generate two “cross-MHHI deltas,” one for each of the two firms in the coupling (e.g., one cross-MHHI∆ for Southwest/United and another for United/Southwest).

The third and final task is to aggregate the effect of common ownership-induced competition-softening throughout the market as a whole by summing the softened competition metrics (i.e., two cross-MHHI deltas for each coupling of competitors within the market). If decimals were used to account for the firms’ market shares (e.g., if a 25% market share was denoted 0.25), the sum should be multiplied by 10,000.

Following is a detailed list of instructions for assessing the MHHI∆ for a market (assuming proportionate control—i.e., that investors’ control rights correspond to their shares of firm profits).

A Nine-Step Guide to Calculating the MHHI∆ for a Market

  1. List the firms participating in the market and the market share of each.
  2. List each investor’s ownership percentage of each firm in the market.
  3. List the potential pairings of firms whose incentives to compete with each other must be assessed. There will be two such pairings for each coupling of competitors in the market (e.g., Southwest/United and United/Southwest) because one must assess the incentive of each firm in the coupling to compete with the other, and that incentive may differ for the two firms (e.g., United may have less incentive to compete with Southwest than Southwest with United). This implies that the number of possible pairings will always be n(n-1), where n is the number of firms in the market.
  4. For each investor, perform the following for each pairing of firms: Multiply the investor’s percentage ownership of the two firms in each pairing (e.g., Institutional Investor 1’s percentage ownership in United * Institutional Investor 1’s percentage ownership in Southwest for the United/Southwest pairing).
  5. For each pairing, sum the amounts from item four across all investors that are invested in both firms. (This will be the numerator in the fraction used in Step 7 to determine the pairing’s cross-MHHI∆.)
  6. For the first firm in each pairing (the one whose incentive to compete with the other is under consideration), sum the squares of the ownership percentages of that firm held by each investor. (This will be the denominator of the fraction used in Step 7 to determine the pairing’s cross-MHHI∆.)
  7. Figure the cross-MHHI∆ for each pairing of firms by doing the following: Multiply the market shares of the two firms, and then multiply the resulting product times a fraction consisting of the relevant numerator (from Step 5) divided by the relevant denominator (from Step 6).
  8. Add together the cross-MHHI∆s for each pairing of firms in the market.
  9. Multiply that amount times 10,000.

I will now illustrate this nine-step process by working through a concrete example.

An Example

Suppose four airlines—American, Delta, Southwest, and United—service a particular market. American and Delta each have 30% of the market; Southwest and United each have a market share of 20%.

Five funds are invested in the market, and each holds stock in all four airlines. Fund 1 owns 1% of each airline’s stock. Fund 2 owns 2% of American and 1% of each of the others. Fund 3 owns 2% of Delta and 1% of each of the others. Fund 4 owns 2% of Southwest and 1% of each of the others. And Fund 4 owns 2% of United and 1% of each of the others. None of the airlines has any other significant stockholder.

Step 1: List firms and market shares.

  1. American – 30% market share
  2. Delta – 30% market share
  3. Southwest – 20% market share
  4. United – 20% market share

Step 2: List investors’ ownership percentages.

Step 3: Catalogue potential competitive pairings.

  1. American-Delta (AD)
  2. American-Southwest (AS)
  3. American-United (AU)
  4. Delta-American (DA)
  5. Delta-Southwest (DS)
  6. Delta-United (DU)
  7. Southwest-American (SA)
  8. Southwest-Delta (SD)
  9. Southwest-United (SU)
  10. United-American (UA)
  11. United-Delta (UD)
  12. United-Southwest (US)

Steps 4 and 5: Figure numerator for determining cross-MHHI∆s.

Step 6: Figure denominator for determining cross-MHHI∆s.

Steps 7 and 8: Determine cross-MHHI∆s for each potential pairing, and then sum all.

  1. AD: .09(.0007/.0008) = .07875
  2. AS: .06(.0007/.0008) = .0525
  3. AU: .06(.0007/.0008) = .0525
  4. DA: .09(.0007/.0008) = .07875
  5. DS: .06(.0007/.0008) = .0525
  6. DU: .06(.0007/.0008) = .0525
  7. SA: .06(.0007/.0008) = .0525
  8. SD: .06(.0007/.0008) = .0525
  9. SU: .04(.0007/.0008) = .035
  10. UA: .06(.0007/.0008) = .0525
  11. UD: .06(.0007/.0008) = .0525
  12. US: .04(.0007/.0008) = .035
    SUM = .6475

Step 9: Multiply by 10,000.

MHHI∆ = 6475.

(NOTE: HHI in this market would total (30)(30) + (30)(30) + (20)(20) + (20)(20) = 2600. MHHI would total 9075.)


I mentioned earlier that neither MHHI nor MHHI∆ is subject to an upper limit of 10,000. For example, if there are four firms in a market, five institutional investors that each own 5% of the first three firms and 1% of the fourth, and no other investors holding significant stakes in any of the firms, MHHI∆ will be 15,500 and MHHI 18,000.  (Hat tip to Steve Salop, who helped create the MHHI metric, for reminding me to point out that MHHI and MHHI∆ are not limited to 10,000.)

Mike Sykuta and I have been blogging about our recent paper on so-called “common ownership” by institutional investors like Vanguard, BlackRock, Fidelity, and State Street. Following my initial post, Mike described the purported problem with institutional investors’ common ownership of small stakes in competing firms.

As Mike explained, the theory of anticompetitive harm holds that small-stakes common ownership causes firms in concentrated industries to compete less vigorously, since each firm’s top shareholders are also invested in that firm’s rivals.  Proponents of restrictions on common ownership (e.g., Einer Elhauge and Eric Posner, et al.) say that empirical studies from the airline and commercial banking industries support this theory of anticompetitive harm. The cited studies correlate price changes with changes in “MHHI∆,” a complicated index designed to measure the degree to which common ownership encourages competition-softening.

We’ll soon have more to say about MHHI∆ (admirably described by Mike!) and the shortcomings of the airline and banking studies.  (Look for a “Problems With the Evidence” post.)  First, though, a few words on why the theory of anticompetitive harm from small-stakes common ownership is implausible.

Common ownership critics’ theoretical argument proceeds as follows:

  • Premise 1:    Because institutional investors are intra-industry diversified, they benefit if their portfolio firms seek to maximize industry, rather than own-firm, profits.
  • Premise 2:    Corporate managers seek to maximize the returns of their corporations’ largest shareholders—intra-industry diversified institutional investors—and will thus pursue maximization of industry profits.
  • Premise 3:    Industry profits, unlike own-firm profits, are maximized when producers refrain from underpricing their rivals to win business.


  • Conclusion:  Intra-industry diversification by institutional investors reduces price competition and should be restricted.

The first two premises of this argument are, at best, questionable.

With respect to Premise 1, it is unlikely that intra-industry diversified institutional investors benefit from, and thus prefer, maximization of industry rather than own-firm profits. That is because intra-industry diversified mutual funds tend also to be inter-industry diversified. Maximizing one industry’s profits requires supracompetitive pricing that tends to reduce the profits of firms in complementary industries.

Vanguard’s Value Index Fund, for example, holds around 2% of each major airline (1.85% of United, 2.07% of American, 2.15% of Southwest, and 1.99% of Delta) but also holds:

  • 1.88% of Expedia Inc. (a major retailer of airline tickets),
  • 2.20% of Boeing Co. (a manufacturer of commercial jets),
  • 2.02% of United Technologies Corp. (a jet engine producer),
  • 3.14% of AAR Corp. (the largest domestic provider of commercial aircraft maintenance and repair),
  • 1.43% of Hertz Global Holdings Inc. (a major automobile rental company), and
  • 2.17% of Accenture (a consulting firm for which air travel is a significant cost component).

Each of those companies—and many others—perform worse when airlines engage in the sort of supracompetitive pricing (and corresponding reduction in output) that maximizes profits in the airline industry. The very logic suggesting that intra-industry diversification causes investors to prefer less competition necessarily suggests that inter-industry diversification would counteract that incentive.

Of course, whether any particular investment fund will experience enhanced returns from reduced price competition in the industries in which it is intra-industry diversified ultimately depends on the composition of its portfolio. For widely diversified funds, however, it is unlikely that fund returns will be maximized by rampant competition-softening. As the well-known monopoly pricing model depicts, every instance of supracompetitive pricing entails a deadweight loss—i.e., an allocative inefficiency stemming from the failure to produce units that create greater value than they cost to produce. To the extent an index fund is designed to reflect gains in the economy generally, it will perform best if such allocative inefficiencies are minimized. It seems, then, that Premise 1—the claim that intra-industry diversified institutional investors prefer competition-softening so as to maximize industry profits—is dubious.

So is Premise 2, the claim that corporate managers will pursue industry rather than own-firm profits when their largest shareholders prefer that outcome. For nearly all companies in which intra-industry diversified institutional investors collectively hold a significant proportion of outstanding shares, a majority of the stock is still held by shareholders who are not intra-industry diversified. Those shareholders would prefer that managers seek to maximize own-firm profits, an objective that would encourage the sort of aggressive competition that grows market share.

There are several reasons to doubt that corporate managers would routinely disregard the interests of shareholders owning the bulk of the company’s stock. For one thing, favoring intra-industry diversified investors holding a minority interest could subject managers to legal liability. The fiduciary duties of corporate managers require that they attempt to maximize firm profits for the benefit of shareholders as a whole; favoring even a controlling shareholder (much less a minority shareholder) at the expense of other shareholders can result in liability.

More importantly, managers’ personal interests usually align with those of the majority when it comes to the question of whether to maximize own-firm or industry profits. As sellers in the market for managerial talent, corporate managers benefit from reputations for business success, and they can best burnish such reputations by beating—i.e., winning business from—their industry rivals. In addition, most corporate managers receive some compensation in the form of company stock. They maximize the value of that stock by maximizing own-firm, not industry, profits. It thus seems unlikely that corporate managers would ignore the interests of stockholders owning a majority of shares and cause their corporations to refrain from business-usurping competition.

In the end, then, two key premises of common ownership critics’ theoretical argument are suspect.  And if either is false, the argument is unsound.

When confronted with criticisms of their theory of anticompetitive harm, proponents of common ownership restrictions generally point to the empirical evidence described above. We’ll soon have some thoughts on that.  Stay tuned!

The antitrust industry never sleeps – it is always hard at work seeking new business practices to scrutinize, eagerly latching on to any novel theory of anticompetitive harm that holds out the prospect of future investigations.  In so doing, antitrust entrepreneurs choose, of course, to ignore Nobel Laureate Ronald Coase’s warning that “[i]f an economist finds something . . . that he does not understand, he looks for a monopoly explanation.  And as in this field we are rather ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on monopoly explanations frequent.”  Ambitious antitrusters also generally appear oblivious to the fact that since antitrust is an administrative system subject to substantial error and transaction costs in application (see here), decision theory counsels that enforcers should proceed with great caution before adopting novel untested theories of competitive harm.

The latest example of this regrettable phenomenon is the popular new theory that institutional investors’ common ownership of minority shares in competing firms may pose serious threats to vigorous market competition (see here, for example).  If such investors’ shareholdings are insufficient to control or substantially influence the strategies employed by the competing firms, what is the precise mechanism by which this occurs?  At the very least, this question should give enforcers pause (and cause them to carefully examine both the theoretical and empirical underpinnings of the common ownership story) before they charge ahead as knights errant seeking to vanquish new financial foes.  Yet it appears that at least some antitrust enforcers have been wasting no time in seeking to factor common ownership concerns into their modes of analysis.  (For example, The European Commission in at least one case presented a modified Herfindahl-Hirschman Index (MHHI) analysis to account for the effects of common shareholding by institutional investors, as part of a statement of objections to a proposed merger, see here.)

A recent draft paper by Bates White economists Daniel P. O’Brien and Keith Waehrer raises major questions about recent much heralded research (reported in three studies dealing with executive compensation, airlines, and banking) that has been cited to raise concerns about common minority shareholdings’ effects on competition.  The draft paper’s abstract argues that the theory underlying these concerns is insufficiently developed, and that there are serious statistical flaws in the empirical work that purports to show a relationship between price and common ownership:

“Recent empirical research purports to show that common ownership by institutional investors harms competition even when all financial holdings are minority interests. This research has received a great deal of attention, leading to both calls for and actual changes in antitrust policy. This paper examines the research on this subject to date and finds that its conclusions regarding the effects of minority shareholdings on competition are not well established. Without prejudging what more rigorous empirical work might show, we conclude that researchers and policy authorities are getting well ahead of themselves in drawing policy conclusions from the research to date. The theory of partial ownership does not yield a specific relationship between price and the MHHI. In addition, the key explanatory variable in the emerging research – the MHHI – is an endogenous measure of concentration that depends on both common ownership and market shares. Factors other than common ownership affect both price and the MHHI, so the relationship between price and the MHHI need not reflect the relationship between price and common ownership. Thus, regressions of price on the MHHI are likely to show a relationship even if common ownership has no actual causal effect on price. The instrumental variable approaches employed in this literature are not sufficient to remedy this issue. We explain these points with reference to the economic theory of partial ownership and suggest avenues for further research.”

In addition to pinpointing deficiencies in existing research, O’Brien and Waehrer also summarize serious negative implications for the financial sector that could stem from the aggressive antitrust pursuit of partial ownership for the financial sector – a new approach that would be at odds with longstanding antitrust practice (footnote citations deleted):

“While it is widely accepted that common ownership can have anticompetitive effects when the owners have control over at least one of the firms they own (a complete merger is a special case), antitrust authorities historically have taken limited interest in common ownership by minority shareholders whose control seems to be limited to voting rights. Thus, if the empirical findings and conclusions in the emerging research are correct and robust, they could have dramatic implications for the antitrust analysis of mergers and acquisitions. The findings could be interpreted to suggest that antitrust authorities should scrutinize not only situations in which a common owner of competing firms control at least one of the entities it owns, but also situations in which all of the common owner’s shareholdings are small minority positions. As [previously] noted, . . . such a policy shift is already occurring.

Institutional investors (e.g., mutual funds) frequently take positions in multiple firms in an industry in order to offer diversified portfolios to retail investors at low transaction costs. A change in antitrust or regulatory policy toward these investments could have significant negative implications for the types of investments currently available to retail investors. In particular, a recent proposal to step up antitrust enforcement in this area would seem to require significant changes to the size or composition of many investment funds that are currently offered.

Given the potential policy implications of this research and the less than obvious connections between small minority ownership interests and anticompetitive price effects, it is important to be particularly confident in the analysis and empirical findings before drawing strong policy conclusions. In our view, this requires a valid empirical test that permits causal inferences about the effects of common ownership on price. In addition, the empirical findings and their interpretation should be consistent with the observed behavior of firms and investors in the economic and legal environments in which they operate.

We find that the airline, banking, and compensation papers [that deal with minority shareholding] fall short of these criteria.”

In sum, at the very least, a substantial amount of further work is called for before significant enforcement resources are directed to common minority shareholder investigations, lest competitively non-problematic investment holdings be chilled.  More generally, the trendy antitrust pursuit of common minority shareholdings threatens to interfere inappropriately in investment decisions of institutional investors and thereby undermine efficiency.  Given the great significance of institutional investment for vibrant capital markets and a growing, dynamic economy, the negative economic welfare consequences of such unwarranted meddling would likely swamp any benefits that might accrue from an occasional meritorious prosecution.  One may hope that the Trump Administration will seriously weigh those potential consequences as it examines the minority shareholding issue, in deciding upon its antitrust policy priorities.

Bloggers have had much to say about the DC Circuit’s proxy access decision.  Of special note is our own Jay Verret and Steve Bainbridge, who adds a useful roundup.   I have a few additional comments.

First, I want to pick up on Jay’s comment that the decision shows the SEC “is an agency with too many lawyers and not enough economists.”  Indeed, the court emphasized that

the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters. * * *

The court condemned the SEC’s disregard of rigorous empirical evidence, noting its failure to utilize “readily available,” evidence of expenditures in proxy contests, and to appropriately weigh the Buckberg-Macey study of the negative effects of electing dissident shareholder nominees.

The court also criticized the SEC’s dismissal of the possible effect of 14a-11 in distracting management by noting that managers already need to incur such costs because of shareholders’ exercise of their state law rights.  The court said: “As we have said before, this type of reasoning, which fails to view a cost at the margin, is illogical and, in an economic analysis, unacceptable” (citation omitted).

Second, the opinion highlights the importance of comments and dissents given rising judicial distrust of the SEC (here’s more on that). This is indicated by the court’s citation of the Buckberg-Macey report noted above, and its reference to the Paredes and Casey dissents to 14a-11. Even if the Commission’s decision might seem to be a foregone conclusion, the fact that the SEC is now essentially in judicial receivership means that these expressions of views will be heard in another venue. There’s also the (possibly slim) hope that the SEC majority will get the message and start listening to such views.

Third, it is worth noting the court’s holding “that the Commission failed adequately to address whether the regulatory requirements of the ICA reduce the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance.”  I have shown why it is a mistake for federal regulators to treat investment companies like ordinary state-created business associations instead of the misshapen creatures of statute that they are.

Fourth, and perhaps most important, is the court’s concluding remark that its holding striking down the rule on other grounds left it “no occasion to address the petitioners’ First Amendment challenge to the rule.”

I have previously discussed the First Amendment argument in this case. My recently published article, The First Amendment and Corporate Governance, covers the potential implications of Citizens United for regulation of corporate governance and commercial speech generally.  Suffice it to say for present purposes that regulation of speech under rules like 14a-11 is vulnerable to a First Amendment challenge.  After CU, it is no longer possible to dismiss this speech as merely “corporate” or internal corporate governance speech.  It may be, at least in some cases, part of the political debate that must be heard regardless of the identity of the speaker and the direct audience.

Indeed, I suspect that the court’s strong language about the arbitrariness of 14a-11 may have had something to do with its desire to rest its holding solely on that ground.  This court got to avoid the First Amendment can of worms, with its uncertain implications for the validity of regulation of truthful speech under securities and other laws (lawyer regulation?).  But after CU courts will not be able to avoid this argument forever.

Janus Investment Fund’s (JIF) prospectus included a misstatement about market timing.  Its investment adviser and administrator is Janus Capital Management (JCM).  Plaintiff shareholders in the parent company, Janus Capital Group (JCG) argue in the Supreme Court that JCM should be liable as JIF’s manager for “mak[ing] an[] untrue statement of a material fact” in violation of Rule 10b-5 (and also that JCG should be liable as a control person).

The conservative five-member majority, in an opinion by Justice Thomas, rejected the argument that an investment advisor is the “maker” of the statement by its mutual fund, whose formal legal independence everybody including the SEC recognized.

The dissenters insist this ignores the reality of JCM’s control of JIF, and was not compelled by the word “make” in 10b-5. Moreover, they worried the majority’s approach could leave nobody responsible in some situations — not the managers who actually drafted a false statement nor the innocent board that made the statement.  Even the SEC couldn’t go after the managers for aiding and abetting without a primary violator.    

What’s really happening here is that the Court is facing the consequences of its 2008 Stoneridge aiding and abetting opinion and Central Bank which preceded it, as well as of the mess of mutual fund regulation left unresolved by last term’s Jones v. Harris.

The Court said its decision followed from Stoneridge’s holding denying liability of the defendant customers and suppliers because their acts didn’t make it “necessary and inevitable” that the transactions would be falsely accounted for.  In other words, the final decision was made by the company that actually made the decision to issue the disclosure documents.  Same in Janus.

The Court also noted its decision was made necessary by the decision Stoneridge elaborated on, the Court’s 1994 ruling in Central Bank to deny a private right of action against aiders and abetters:

A broader reading of “make,” including persons or entities without ultimate control over the content of a statement, would substantially undermine Central Bank. If persons or entities without control over the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.6

6 The dissent correctly notes that Central Bank involved secondary, not primary, liability. Post, at 4 (opinion of BREYER, J.). But for Central Bank to have any meaning, there must be some   distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).

We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not. In contrast, the dissent’s only limit on primary liability is not much of a limit at all. It would allow for primary liability whenever “[t]he specific relationships alleged . . . warrant [that] conclusion”—whatever that may mean. Post, at 11.

Indeed, as I commented at the time Stoneridge was decided (and as Justice Thomas acknowledged in n. 7 of yesterday’s opinion), that case’s unsatisfactory resolution made Janus necessary.  I noted that, instead of focusing on the reliance requirement, the Court should have considered “precisely what conduct gives rise to a 10b-5 cause of action, and how that conduct must be connected to the deception of investors. * * * It’s not clear how th[e] “necessary or inevitable” standard will be applied in subsequent cases.”

Unfortunately, even after Janus, we still don’t know.   William Birdthistle decries the victory of “nice legal formalities” and worries that this will “tend to encourage highly strategic behavior in future.”  More likely, the Court will now find it necessary where to draw the line on strategic legal separation as a device for avoiding 10b-5 liability.

Janus actually didn’t squarely present that problem, because the formal separation the Court relied on was baked into the law of mutual funds.  This law decrees that mutual funds should have a corporate-type legal structure, complete with a board that does little of importance, despite the fact that such a structure is inconsistent with the nature of an open-end mutual fund. As I have written, this problem gave rise to Jones v. Harris, and only Congress and not the Supreme Court can solve it.

Nor can the Court solve the Central Bank-Stoneridge-Janus aiding and abetting problem.  This comes from trying to trim the judicial oak that has grown out of the little acorn in Section 10(b) of the 1934 Act.  For years the Court let the tree grow, and then for years after a different Court has visited it every several years and tried to prune it.  The Court now essentially must choose between letting it grow wild, as Justice Breyer’s dissent in Janus would do, or rely on artificial over-formal distinctions like the one in Justice Thomas’s opinion. 

The only real solution is for Congress to cut the damn thing down and disimply a private remedy under 10(b).  Since that won’t happen either, I suppose we should just sit back and enjoy the spectacle.

The SEC staff,  acting under Dodd-Frank §913(g), has decided to recommend a “uniform fiduciary standard” for broker-dealers and investment advisors who provide investment advice to retail customers. The recommended rules would provide that

the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.

The staff recommendations “were guided by an effort to * * * recommend a harmonized regulatory regime for investment advisers and broker-dealers when providing the same or substantially similar services, to better protect retail investors. ”

The “uniform standard” will, among other things, “obligate both investment advisers and broker-dealers to eliminate or disclose conflicts of interest;” “consider specifying uniform standards for the duty of care owed to retail investors, through rulemaking and/or interpretive guidance;” and “engage in rulemaking and/or issue interpretive guidance to explain what it means to provide “personalized investment advice about securities.”

The staff will also consider how to harmonize regulation of investment advisers and broker-dealers regarding such issues as advertising, use of finders and solicitors, supervision, licensing and registration of firms.  

The staff study is misguided in two ways:  First, it’s not evidence-based. Second, it fundamentally misplaces the role of fiduciary duties.

Commissioners Casey and Paredes issued a statement emphasizing the first problem.  They begin by noting that “the views expressed in the Study are those of the Staff of the Commission and not necessarily those of the Commission as a whole or of individual Commissioners.” They then note that

the Study’s pervasive shortcoming is that it fails to adequately justify its recommendation that the Commission embark on fundamentally changing the regulatory regime for broker-dealers and investment advisers providing personalized investment advice to retail investors. * * * The Study also does not adequately recognize the risk that its recommendations could adversely impact investors.

This risk exists because ” the Study does not identify whether retail investors are systematically being harmed or disadvantaged under one regulatory regime as compared to the other.” Thus, the study fails to fulfill Dodd-Frank’s mandate to evaluate the “effectiveness of existing legal or regulatory standards of care” applicable to broker-dealers and investment advisers.

In particular, Commissioners Casey and Paredes say the Study “may not only fail to resolve investor confusion but ” may in fact create new sources of confusion” and

unduly discounts the risk that, as a result of the regulatory burdens imposed by the recommendations on financial professionals, investors may have fewer broker-dealers and investment advisers to choose from, may have access to fewer products and services, and may have to pay more for the services and advice they do receive. Any such results are not in the best interests of investors; nor do they serve to protect them.

The Commissioners specifically suggest further work analyzing risk- and investor- adjusted returns under the two regulatory regimes; “differences in the quality of advice or types of product recommendations as a function of the regulatory regimes;” “investor perceptions of the cost/benefit tradeoffs of each regulatory regime;” and investors’ ability to bring claims against professionals under each regulatory regime.

The Commission should take these recommendations seriously if it wants to avoid further troubles with the DC Circuit.

My own criticism of the SEC’s recommendations focuses on the second point noted above — the confusion inherent in imposing fiduciary duties on securities professionals. In my recent paper, Fencing Fiduciary Duties, I note (footnotes omitted) that the relevant Dodd-Frank provision

does not appear to impose a fiduciary duty.  The provision refers to the “best interest” standard under Section 206 of the Investment Advisers Act of 1940, and its main function appears to be to align the duties of brokers-dealers with those of investment advisers. Although the Section 206 duty has been held to be a fiduciary duty, this characterization is questionable.  It traces back to SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). which held that an advisor’s “scalping,” or purchasing shares before recommending them and then selling on the rise in market price, “operates as a fraud or deceit upon any client.”  While the Court referred to investment advisers as fiduciaries, its holding was based on an interpretation of the common law of fraud, and amounts only to a duty to disclose the material fact of an advisor’s self-interest rather than a fiduciary duty of unselfishness.  This is consistent with this paper’s analysis of the non-fiduciary nature of the duty of professionals and advisors.

Fiduciary duties are even less appropriate for brokers and dealers than they are for professionals and advisors.  Customers generally do not delegate fiduciary-type open-ended power that would justify fiduciary-type selflessness consistent with this article’s analysis. Rather, brokers, dealers and advisors take no action regarding the customer’s property without instructions.  Nor should customers expect unselfish conduct from people who are selling securities for a commission or profit. Thus, application of fiduciary duties to brokers, dealers and advisors would not be consistent with customers’ expectations and create a potential for confusion similar to that in the mutual fund situation discussed above. As Arthur Laby has recognized,

[w]hen acting as a dealer, the firm seeks to buy low and sell high–precisely what the customer seeks. It is hard to see how any dealer can act in the “best interest” of his customer when trading with her. [citing Arthur B. Laby, Reforming The Regulation Of Broker-Dealers And Investment Advisers, 65 BUS. LAW. 395, 425 (2010)].* * *

The legislative history of the Securities Exchange Act of 1934 indicates that existing law does not impose a fiduciary duty on brokers and dealers. Laby shows that plans to prohibit a broker from acting as a dealer or underwriter ultimately were squelched in favor of recognizing the “shingle theory,” which imposes a [non-fiduciary] duty to buy and sell at reasonable prices. * * *

A broker-dealer fiduciary duty also would be inconsistent with Dodd-Frank’s legislative history.  Treasury initially recommended a broker-dealer and investment adviser duty to “act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” This is clearly a fiduciary standard of unselfishness, consistent with this article’s characterization. The change from the initial proposal to the final version represents a clear rejection of the fiduciary approach.

The SEC should go no further than spelling out the disclosure duties that are appropriate to advisors, dealers and brokers.  It should not confuse the duties of securities professionals by applying the fiduciary label to non-fiduciary relationships.  This would help investors buy only the level of service and commitment to their interest that is appropriate to the relationship they are contracting for.  Investors would not have to pay a higher price for securities professionals’ unselfishness when they are also planning to exercise their own judgment and control.  They would still get enough disclosure to prudently use the services they are buying, while having the flexibility to contract for a higher level of protection when they want it.

In other words, the SEC need not, and should not, impose “fiduciary duties” on broker-dealers, and such duties are not required by Dodd-Frank.

See also my Senate testimony on fiduciary duties of investment bankers; my article, Federal Misgovernance of Mutual Funds discussing the debacle culiminating in the Supreme Court’s Jones v. Harris when Congress tried to impose a fiduciary duty concerning compensation of mutual fund advisors, and my post from last August on brokers as fiduciaries.

Fencing Fiduciary Duties

Larry Ribstein —  12 January 2011

Several years ago I wrote up my theory of fiduciary duties in an inaptly titled paper, Are Partners Fiduciaries? My basic point was that fiduciary duties are and should be narrowly applied, as befits a strict standard that transcends general norms of commercial behavior. Since then I’ve been trying to get across the notion that, yes, fiduciary duties are what I said:  strict and narrow.

My most recent effort is now on SSRNFencing Fiduciary Duties, which I presented at a conference at Boston University in October, discussed here.  Here’s the abstract:

This comment on the work of Professor Tamar Frankel builds on her encyclopedic discussion of the various types of duties that have been classified as “fiduciary.” I argue for a more precise definition and more limited application of fiduciary duties which recognizes that their usefulness depends on their being limited and separated from other duties that apply in other settings. The fiduciary duty is appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good faith and fair dealing, and to refrain from misappropriation. The fiduciary duty of unselfishness is appropriate only for a limited class of agency relationships in which the principal delegates open-ended power to the agent, and not for those who may exercise lesser power over the property of others, including co-investors, advisors, professionals, and those in confidential relationships. More broadly applying fiduciary duties could unnecessarily constrain parties from self-protection in contractual relationships, impose excessive litigation costs, provide an unsuitable basis for contracting, and impede developing fiduciary norms of behavior. This analysis of fiduciary duties helps address current issues, including those regarding the duties of brokers, dealers, and investment and mutual fund advisors. In short, fencing fiduciary duties protects both fiduciary and non-fiduciary relationships and enables parties to contract for the precise level of protection that is appropriate to the services they are purchasing. 

This work is particularly timely as Congress, the courts and the SEC seem hell-bent on stretching the fiduciary duty out of shape as part of financial reform.  I’ve discussed these issues here several times — e.g., on Goldman.  I’ve recently posted two other papers on misshapen federal fiduciary law — Federal Misgovernance of Mutual Funds, and my Senate testimony on Goldman.

Fencing Fiduciary Duties is my most complete discussion of fiduciary duties since my initial paper and includes applications to recent financial reforms, particularly including broker-dealer fiduciary duties now being considered by the SEC (which I discussed earlier here).  So read it while it’s hot.

One problem with a group blog is that you don’t always know what your co-bloggers are writing while you’re drafting a post.  I drafted the following post without realizing that Larry (and Steve Bainbridge) had already gone to town on the matter — in more detail than I, not surprisingly.  In any event, I’m posting my draft, which may be of interest to readers who aren’t as well-versed in insider trading law.  The excellent Ribstein and Bainbridge posts are here, here, and here.

The Wall Street Journal is reporting that the Feds (the SEC, the FBI, and federal prosecutors in New York) are about to bring a host of insider trading charges “that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation.”  The authorities, which have been investigating the situation for three years, are boasting that their criminal and civil probes “could eclipse the impact on the financial industry of any previous such investigation.”   

The charges haven’t been filed, so we don’t know exactly who’s being accused of what, but the Journal suggests that the probe has focused on at least three matters.  First, the Feds have examined whether traders received material, non-public information about pending merger deals.  Second, authorities have focused on the activities of independent analysts and research boutiques.  In addition, they have investigated firms that provide “expert network” services to hedge funds and mutual funds.  Such firms “set up meetings and calls with current and former managers from hundreds of companies for traders seeking an investing edge.”     

The first focus — insiders’ sharing of information about pending merger deals and tippees’ trading on the basis of such information — seems pretty uncontroversial.  As a legal matter, the insiders owe a fiduciary duty to the shareholders whose stock is being traded, and in trading that stock (or effectively enlisting an accomplice tippee to do so) without first disclosing the information at issue, the insiders are failing to speak in the presence of a duty to do so.  That’s fraud, and the tippee-traders are liable as accomplices.  While I would generally prefer an approach that permits companies to establish their own insider trading policies and leaves it to capital markets to punish the value-destructive ones and reward those that enhance value, the ban on this type of insider trading is easiest to defend as a matter of policy:  An insider or tippee who trades in advance of a merger may cause a price effect that thwarts or impairs the merger deal, thereby harming the corporation and its shareholders.  Even if we left insider trading to contract, as I would prefer, I imagine that most firms and shareholders would bargain for a policy that bans trading on the basis of non-public information about a forthcoming merger.

The second and third focuses (foci?) of the Feds’ current probe, though, are more troubling.  Again, we don’t know why the feds are currently going after independent analysts, research boutiques, and firms providing “expert network” services, but we do know that they have a long history of opposing legitimate stock analysis that gives certain traders an informational advantage over others.  In the 1968 Texas Gulf Sulphur case, for example, the SEC maintained (and convinced the Second Circuit to hold) that the mere possession of material, non-public information saddles an investor with a duty to disclose that information before trading or to refrain from trading altogether.  The Supreme Court ultimately rejected such a broad imposition of the so-called “disclose or abstain” duty, recognizing that the Texas Gulf Sulphur approach would ultimately hurt investors by disabling the securities analysis business.  Analysts, after all, make money by ferreting out material, non-public information and conferring informational advantages on their clients.  Their efforts, coupled with the trading of their informed clients, make stock markets more efficient, meaning that stock prices more accurately reflect the true value of the underlying companies.  By making stock prices more accurate, analysts help prevent uninformed investors from losing their shirts when undisclosed information shocks the market.  While I wouldn’t exactly call it the Lord’s work (not after the Lloyd Blankfein blunder, at least), securities analysis is awfully good for society and shouldn’t be discouraged.

The SEC, though, didn’t give up after its first Supreme Court smackdown.  Just three years later, the Commission went after a “tippee” (Dirks) who had shared inside information with others who traded.  The inside information concerned the fact that the corporation at issue had engaged in serious accounting fraud and was consequently overvalued.  The tippee had learned about the fraud from an insider who sought the tippee’s assistance in exposing the fraud (which, incidentally, the SEC had failed to discover on its own).  The SEC took the position that the tippee “inherited” the insider’s fiduciary duty not to trade (or tip to others who might trade) because he had received information from an insider — in other words, merely receiving non-public information from an insider essentially transforms one into an insider himself.  Again, the Supreme Court rejected the SEC’s broad liability net.  Noting again that the SEC’s rule would impair the securities analysis industry, the Court held that a tippee inherits an insider’s duty to disclose or abstain only if (1) the insider breaches his duty of loyalty in sharing the information (i.e., the insider shares the information to get a personal benefit) and (2) the tippee knows or should know of the breach.

The Supreme Court’s Dirks decision threw yet another wrench into the SEC’s campaign to put all investors on a level playing field when it comes to information (market efficiency be damned!) because it seemed to allow corporate insiders to share material, non-public information with stock analysts.  In sharing non-public information with the analysts following their firm, insiders aren’t generally seeking a personal benefit, so the test for tipping isn’t satisfied and the analysts and their clients wouldn’t inherit the insiders’ duties.  The SEC therefore responsed by promulgating Regulation FD, which requires corporate insiders who share data that could consitute material, non-public information to also share that information with the general public.  If the information-sharing is intentional, the public must be informed contemporaneously with analysts; if information is unintentionally given (i.e., a “slip-up”), the general public must be promptly informed.

That sounds fair enough, right?  Well, sure.  But that fairness comes at a cost.  Since Regulation FD was adopted, corporations have become more leery of sharing information with analysts — those folks whose efforts best protect investors by ensuring that stock prices accurately reflect underlying values.  Spontaneous analyst conversations are impossible because corporations now have to publicize calls, provide call-in information to the public, etc.   When analysts need help interpreting data, or if they have follow-up questions after an analyst conference, insiders generally won’t answer their questions.  And, of course, analysts are now less interested in participating in analyst conferences, since the information being shared (with the general public) is less valuable.  As Anup Agrawal, Sahiba Chadha, and Mark Chen have shown, the result has been a reduction in the accuracy of individual and consensus analyst forecasts on corporate performance and an increase in the dispersion among forecasts.  Again, the SEC’s attempt to put investors on a level playing field seems to have impaired one of the most effective form of investor protection out there — the sell-side analyst industry.  (NOTE:  Larry has written lots of good stuff on Reg FD.  Here‘s a link to a list of posts from Ideoblog.) 

So what to make of this latest SEC/FBI/DOJ investigation?  We won’t really know until we see the allegations.  But in light of the SEC’s relentless pursuit of the securities analysis business over the years, I’m a bit worried that the current probe is focusing largely on analysts, research boutiques, and firms providing expert network services.  We shall see….

Tomorrow at Boston University I’ll be joining a distinguished group to discuss the Role of Fiduciary Law and Trust in the 21st Century, inspired by the work of Professor Tamar Frankel. 

Those who have followed my work will not be surprised that I’m going to focus on the limits of fiduciary duties, and their inappropriate application in such settings as broker-dealer conduct.   For some hints, see my previous articles, Are Partners Fiduciaries, Law v. Trust, Federal Misgovernance of Mutual Funds, and Senate testimony on the Goldman case.   

This is not only an interesting topic but a hot one.  Lawmakers seem to find fiduciary duties an attractive regulatory tool: find something you don’t like, label it “fiduciary,” and throw it over to the courts and litigators.  Pursuant to Dodd-Frank, the SEC is currently studying these issues in connection with brokers and dealers.  As we saw in the litigation leading up to Jones v. Harris, discussed in my mutual funds article above, the result is often costly chaos.  I have some thoughts on dealing with the chaos by focusing on the rationale for and functions of fiduciary duties.

Last January in Citizens United the Supreme Court delivered a blow to the opponents of corporate speech by enabling corporations to spend directly on political campaigns rather than relying on PACs and lobbying. A majority of the Court concluded that public debate could be best promoted by protecting all speech, regardless of speaker. 

A sizable chunk of America thinks the Supreme Court has unleashed a corporate monster that will drown out the rest of the populace.  For example, a hysterical MarketWatch column (HT Bainbridge) asserted that “[u]nder this system, the game is over. Our democracy is dead.”  This pundit figured that corporations could use their spare cash to buy any number of elections, apparently not understanding that firms need this cash for other things.  He notes that money is flooding into “right-wing groups” but neglects to count up the union cash flowing in the opposite direction.

In any event, what can CU’s opponents do about that pesky Supreme Court opinion?  Maybe try an end-run:  limit corporate speech in the name of “shareholder protection.” And so we have the Shareholder Protection Act (SPA) currently pending in Congress.  But what I’ll call the “shareholder protection gambit” (hereafter, SPG) is unlikely to work. 

To begin with, let’s be clear that it’s not really about shareholder protection.  The “purpose and summary” supporting the SPA makes this transparent in its opening sentences: 

The [Citizens United] ruling invalidated longstanding provisions in U.S. election laws and raised fresh concerns about corporate influence in our political process. To address those concerns, the Shareholder Protection Act gives shareholders of public companies the right to vote on the company’s annual budget for political expenditures.

In other words, the bill is concerned about “corporate influence.”  Shareholders’ rights are intended “to address those concerns.”  But Citizens United explicitly rejected this “corporate influence,” or anti-distortion, rationale for corporate speech limitations.  

The shareholder protection rationale not only differs from, but is directly contrary to, the concern that activates the opposition to Citizens UnitedCU opponents worry that corporate political activity will empower corporations by flooding the political marketplace with pro-corporate money.  Yet the SPA is supposedly intended to ensure that lobbying serves corporate interests.

Whether or not shareholders’ protectors are seeking to restrict corporate speech, that’s what they’re likely to accomplish.  The shareholder rights the SPA would create cut at the core of corporate efficiency.  The main point of the corporate form is to “lock in” corporate resources under strong managerial control.  Enabling shareholders to second-guess specific managerial decisions, and introducing political debate into shareholder and director meetings, is an effective way to hobble corporations. 

Whatever its intent, the SPG, including its manifestation in the Shareholder Protection Act, is dubious policy. Here it’s useful to examine recent work by prominent and bona fide defenders of the shareholder protection gambit, John Coates and Lucian Bebchuk and Robert Jackson.  Neither has a coherent agency cost theory of corporate managers’ investments in corporate political activity — that is, why they would choose to abuse their power in this particular way.  Perhaps they can’t take it all out in pay, but surely there are more satisfying perks.  Nor do these writers show how managers’ use of corporate money for political expenditures presents a more serious agency cost problem than many other exercises of management power.  The most that Bebchuk-Jackson can come up with is that corporate political speech has “expressive significance.” But the idea that shareholders generally, many of whom now invest through pension and mutual funds, care deeply about the political expenditures of individual firms in their portfolios needs far more support than B-J’s brief hypothesizing.

Coates at least has some data.  He lists a number of hypotheses regarding corporate political activity, including that it helps the corporation and constitutes efficient compensation.  However, his his tests are not strong enough to reject non-agency-cost explanations.Coates shows that the existence and amount of firms’ corporate political activity negatively correlates with (1) shareholder democracy variables and (2) corporate value as measured by Tobin’s Q.  But (1) could equally support proponents of strong management control who assert that too much shareholder democracy is inefficient.  The correlation with corporate value could mean, among other things, that firms that are hurt most by regulation need to spend more to get the government off their backs.    

There are several other problems with the shareholder protection gambit.  Its advocates can’t explain why it is so important to protect shareholders from managers running amuck with campaign expenses but not to be concerned about corporate payments to lobbyists or managers funding PACs, both of which are exempted from the Act. Perhaps Congress does not want to completely turn off the corporate spigot.  Maybe politicians would prefer to insulate themselves from corporate-funded opposition when they reneg on their promises.  But it is not clear what these distinctions have to do with shareholder protection.

And it’s odd that after all of the literature and commentary on the problems of shareholder voting, including the fundamental free-rider problem, the distinct interests of institutional investors and activist hedge funds and concerns with “empty” voting, as well as skepticism about the value of ever-increasing disclosure to already-inundated shareholders, that informed shareholder voting should be seen as the means of liberating shareholders to express themselves.

Finally, the SPG faces serious constitutional problems following CU. The Court in Citizens United rejected the “shareholder protection” argument for banning corporate speech, noting among other things that “the procedures of corporate democracy” can protect against any abuse and that “the remedy is not to restrict speech but to consider and explore other regulatory mechanisms. The regulatory mechanism here, based on speech, contravenes the First Amendment.” This language suggests any shareholder protection defense of corporate speech regulation faces a steep uphill climb. 

The SPA is unlikely to survive this climb.  Consider the restrictions on speech it seeks to impose:

  • Majority shareholder authorization of “specific” expenditures a year in advance, thereby shackling effective corporate responses to constantly shifting legislative activity.
  • Unprecedented (for the securities laws) treble damage “fiduciary duty” liability for unauthorized expenditures.  This is likely to have a significant deterrent effect on pro-shareholder political activity, since risks to managers would dwarf any potential gains from speech that serves corporate interests.
  • Extensive quarterly and annual disclosures.
  • Significant federal regulation of formerly state-controlled corporate governance issues.
  • The SPA would apply only to corporations, with no equivalent constraints on unions.

Although the Supreme Court might tolerate some shareholder-protection regulation of speech, its reasoning in CU suggests it will not be receptive to provisions like this.  CU stressed the social value of speech.  This doesn’t mean the shareholders have to subsidize anything corporate managers want to say, but it does mean that the Court will want more than just a shareholder-protection fig leaf to justify a massive increase in the burdens of corporate speech.

The SPA will not strengthen corporate governance, but rather cut corporate political activities back to the lobbying and PACs permitted under pre-Citizens United law.  In other words, it’s designed to reverse CU.  The Court is not likely to miss this fact.