By Tilman Kuhn, Partner, White & Case and Cristina Caroppo, Associate, White & Case
Links between competitors based on investors’ parallel ownership of stock in them have come under the spotlight of the antitrust community. In particular, institutional investors – such as BlackRock, Vanguard or State Street – who invest into thousands of companies but hold only minority stakes that do not give them control (or “competitively significant influence” under German antitrust law), have become a focus of the recent debate. Although the empirical evidence that these shareholdings may have anti-competitive effects, and the underlying “theory of harm” is far from clear and convincing, the issue has found its way into at least the European Commission’s decisions and led to OECD meetings and FTC Hearings in the US. Therefore, it is likely here to stay, and investors and their portfolio companies (i.e., typically publicly listed companies) should take it into account when considering corporate transactions in industries with substantial common ownership.
Here are five things companies need to know about the issue.
What is the theory and where is it coming from?
In a nutshell: Critics claim that common ownership structures, i.e., where investors have parallel minority ownership in competitors, reduce competition in the industry concerned, because – allegedly – the portfolio companies’ managements will act in a way that maximises their investors’ total equity portfolio profits, rather than the individual profits of the companies they are leading. In that way, they would compete less vigorously with their rivals than without common ownership. Although it is not controversial that common ownership can harm competition – after all, a complete merger is a special case of common ownership –, many claims in the literature, merger decisions, and policy discussions, are based on an inconsistent and/or unpersuasive theory, or misapplications of well-understood theories.
In principle, the theory assumes that managers care about the returns to their owners, but because the owners typically have different common ownership interests, they have different preferences over the manager’s choices. Therefore, the manager has to(i) know what the owners’ specific interests regarding specific competitive actions are, and (ii) decide how much weight to give each owner’s preferences in deciding what to do.
Who are the advocates of the theory and what do they argue?
The discussion is primarily based on three academic papers on the airline industry, the banking sector, and executive compensation. The airline paper, which is at the origin of the discussion, estimates an average ticket price increase of 3-7% based on common ownership in the industry.
Probably the most outspoken critic of common ownership has even argued that common shareholdings are unlawful under antitrust laws, calling it the “greatest anticompetitive threat of our time”.
On this basis, some authors have called for antitrust action, including (i) that acquisitions of minority shareholdings in “concentrated markets” should require merger control filings and review, (ii) regulatory approaches to limit common ownership either by limiting the size of the shareholding (e.g., to not more than 1%) or the number of companies institutional investors are allowed to acquire stock in, and (iii) tighter corporate governance rules for institutional investors.
However, the empirical work is neither comprehensive, nor convincing or mature enough to justify such drastic changes to well-established merger control concepts. In addition, the papers’ evidential value has been criticised heavily both regarding their empirical and theoretical foundations, due to inconsistencies in the data and counter-studies that failed at replicating the outcomes, as well as shortcomings in the applied methodology. One relatively obvious objection regarding the airline paper is that there were significant market changes during the period under review, such as 9/11 and airline insolvencies, which certainly had an impact on prices and were totally unrelated to any common ownership structure identified in the industry.
How does the issue come into play in antitrust practice?
The issue can be tackled from two angles from a merger control perspective or under the “cartel prohibition” (prohibition of agreements or concerted practices restricting competition, e.g., Article 101 TFEU).[i] Further, under the pertinent merger regimes, it could be dealt with when (i) investors acquire minority shareholdings or when (ii) portfolio companies merge with competitors.
As regards (i), most merger control regimes do not capture minority acquisitions below the level of control or at least substantially below 25%. Even under the German concept of “competitively significant influence”, it would seem to be a stretch to consider the investor’s acquisition of stakes of less than 10% without board representation or other forms of governance positions or rights, and without controlling a portfolio company active in the same market an upstream or a downstream market, or a market closely neighboring to the target’s market, as a notifiable concentration. The US regime is an exception but provides for an “investment only” exemption in case of passive investments.[ii]
Hence, the discussion will likely primarily focus on mergers between portfolio companies, where it has two dimensions: (i) it may well be that mergers of competing companies in industries with substantial common ownership will be blocked at lower “thresholds” based on the theory that portfolio companies’ market shares alone tend to underestimate concentration in the industry, and that the remaining competitors will abstain from vigorous competition because they have common investors; (ii) where competition authorities require divestitures for merger clearance, they need to consider whether common ownership calls into question a divestiture buyer’s independence from the merging parties.
Regarding (i), there are two established types of anti-competitive effects that could arise from mergers between competitors, namely unilateral or coordinated effects. First, unilateral effects could arise from common ownership structures if management of several portfolio companies unilaterally decided to compete less vigorously with their competitors to maximize industry profit and please their common investors. Overall, this leads to reduced competition between the companies. Second, the common ownership structure could increase the incentives for tacit parallel behaviour (i.e., coordinated effects) between the competing companies due to increased market transparency.
The above-mentioned unilateral effects concerns are based on the model of “partial” or “cross-ownership, i.e., direct ownership of stock in one competitor by another. It is established that such direct ownership between competitors can potentially harm competition, due to (i) reduced incentives of the acquirer to compete with the target, (ii) the acquirer’s potential to influence the target’s strategy/conduct, and/or (iii) access to competitively sensitive information.
However, these assumptions are not per se applicable to the model of common ownership. While one may assume that each investor has a unilateral interest to maximize not only one portfolio company’s but the investor’s entire portfolio companies’ output, the theory lacks a reasonable explanation as to why the companies’ management might also have such an interest. Notably, in many cases, managers are compensated to a significant extent in stock (options) and, hence, they have at least an incentive to maximize their own company’s profit to secure and/or increase their own compensation.
The second theory, i.e., potential coordinated effects arising from common ownership, seems at first sight less far-fetched – management of competing companies could have an incentive to compete less vigorously if they can be sure that their rivals will act similarly. However, such tacit coordination between competitors is only realistic if certain key conditions are met.
In particular, the management of such companies would need to be able to identify the group of common investors that has common interests and how those interests translate into concrete action as well as be reasonably certain that their rivals also understand these interests and actions to be taken the same way. Moreover, the focal point for coordination of concrete competitive action is unclear. In any event, a common understanding between rivals would seem to require that the investors influence their portfolio companies’ management. And this assumption is what the authors believe weakens the theory of harm drastically. This is because there is no evidence that it is typically even possible for institutional investors to influence management’s competitive behaviour, and/or that investors have (parallel) incentives to do so.
As regards both factors, (institutional) investors and portfolio companies alike should take the chance to shape the current discussion. They should clarify whether and how investors’ contacts with portfolio companies involve competitive topics at all. Also, how the portfolio companies’ managers’ compensation schemes and other factors incentivise them to maximise only the profits of the company they are leading, not those of the entire industry. It seems highly doubtful that large institutional investors with stock in thousands of companies via different funds with different investment strategies actually have the capacity to engage with their portfolio companies’ management on specific competitive actions, and whether all institutional investors’ interests and incentives are aligned.
In the same vein, it is highly doubtful that investors with stock in upstream and downstream companies have the incentive to maximize profit at one level while simultaneously harming their investments in an upstream/downstream market. This is another key argument for investors to demonstrate how unrealistic the theory is in a real-world business scenario.[iii]
Is there already case-law?
While the debate is still at a very early stage, the discussion already found its way into US[iv]and EU merger control law. In particular, the European Commission picked up the issue in two recent agricultural merger decisions, i.e., Dow/DuPont and Bayer/Monsanto.
In Dow/DuPont (2017), the Commission assessed whether and how common ownership in the agrochemicals sector influenced the remaining competitors’ incentive to fill the (alleged) gap of industry innovation the merger was deemed to cause. Notably, the Commission did not find that shareholders had influenced the companies’ management; the only thing it found was “that large shareholders have a privileged access to the companies’ management and can, therefore, share their views and have the opportunity to shape the companies’ management’s incentives accordingly”. Based on this assumption, the Commission used common shareholding in the agrochemicals industry “as an element of context in the appreciation of any significant impediment to effective competition” and found that the remaining competitors would have less incentive to engage in vigorous innovation competition.[v]
In its Bayer/Monsanto decision (2018), the Commission went one step further and speculated – without finding any evidence – that “[i]n a hypothetical scenario, the 23 common shareholders of DowDuPont and Monsanto that have a total portfolio value in all firms of EUR 1,000 million or more could decide to vote in a coordinated manner in a view to maximizing the value of their portfolio in the seeds and traits, and crop protection industry.”
On the divestiture side, e.g., as regards BASF’s independence as a suitable remedy buyer, the Commission found “that the debate regarding common shareholdings is relatively recent and not yet entirely settled” and came to the conclusion that the remedy transaction would not increase the level of common ownership significantly. However, the Commission did not address the apparent inconsistency of finding issues with common ownership and the investors’ likely influence on the portfolio companies when assessing whether the main transaction impeded competition.
What will the near-term future bring?
The claims for action – i.e., increased merger regulation in “concentrated industries”[vi], regulatory approaches regarding limited investing opportunities, etc. – will not pass by without a trace and could in particular drastically decrease the benefits of passive index fund investments. It may also impede pro-competitive mergers between portfolio companies.
Especially in light of the far-reaching conclusions the Commission reached in its Dow/DuPontdecision, it will be difficult for companies to find arguments against the Commission’s critical attitude towards common ownership structures that fits the antitrust authorities’ currently prevailing perception that many markets are too concentrated and that income and wealth inequality is growing.
[i] The following will be limited to the merger control aspect.
[ii] As regards the US and its “solely for investment exception” under the Clayton Act, Elhauge requests US antitrust agencies could pursue future common ownership investments under a Clayton provision that prohibits “any stock acquisition that leads to anticompetitive impact”. However, the US focus seems to be and to remain on Section 1 of the Sherman Act and whether common ownership leads to agreements to improperly share competitively sensitive information, allocate markets, or fail to compete.
[iii]Besides the alleged investors’ influence described above, the scenario of coordination between competing companies only becomes realistic if all participants can determine whether there are “cheaters” and effectively sanction them, i.e., market transparency plays a decisive role in this theory of harm. However: it is unclear, how competing portfolio companies benefit from their common investors’ insight into their rival’s business activities if it wasn’t for the investors to ensure the companies coordinated their behaviour. This, however, would raise clear hub-and-spoke antitrust issues, and would require clear empirical evidence (which the theory still lacks).
[iv] In 2016, US investment company ValueAct entered into a settlement agreement with the US Department of Justice and paid USD 11 million to settle allegations that it (i) failed to submit a filing under the Hart-Scott-Rodino Act for its minority investments in Baker Hughes and Halliburton, and (ii) attempted to influence certain business decisions related to the Baker Hughes/Halliburton merger.
[v]Notably, the Commission came to a number of additional broad and far-reaching unqualified conclusions that will probably have an important impact on future merger decisions, e.g.: “[t]he economic literature provides empirical evidence showing that “passive” investors are active owners” and “[t]he economic literature show that firms’ incentives to increase prices increase with partial ownership of competitors.
[vi]Especially unspecific claims for measures in “concentrated industries” that lack a clear-cut checklist as to how to define such industries, lead to increased legal uncertainty for the companies’ self-assessment whether to notify an acquisition of shares.