Title: Institutional Ownership in the Twenty-First Century
Description: The recent massive shift by Americans into investment funds and the attendant rise of a core group of institutional shareholders has transformed the financial market landscape. This dissertation explores the economic and policy implications associated with this shift to intermediated capital markets. The underlying assumption has always been that the growing presence of institutional investors in capital markets would improve the corporate governance of their portfolio companies, thereby reducing managerial agency costs and increasing firm value. My research explains why the reality deviates from that ideal. Using two novel perspectives—tax and antitrust—this dissertation reveals the disruptive effects and market distortions associated with the rise of institutional ownership. Chapter 1 of this dissertation, Common Ownership: A Game Changer in Corporate Compliance, explores the effect of overlapping institutional ownership of public companies by institutional investors on corporate tax avoidance.

Leading scholars now recognize that this type of “common ownership” can change company objectives and behavior in a way that may lead to economic distortions. This chapter explores one unexamined peril associated with such common ownership: the effect of this core group of institutional investors on the tax avoidance behavior of their portfolio companies. I show how common ownership can lead to a reduction in those companies’ tax liability by means of a newly recognized phenomenon I call “flooding.” This term describes a practice by which different companies that are owned by the same institutional shareholders simultaneously take aggressive tax positions to reduce their tax obligations. Due to the IRS’s limited audit capacity, this synchronized behavior is likely to overwhelm the agency and substantially reduce the probability that tax noncompliance will be detected and penalized. This outcome runs counter to the classic deterrence theory model (which assumes that the threat of enforcement deters noncompliance) and demonstrates how common ownership changes the way public firms approach legal risks.

By revealing the systematic compliance distortion and attendant enforcement challenges that ensue when the same investors “own it all,” this chapter also highlights a hidden social cost of common ownership. Under the domination of common institutional investors, companies can more easily shirk their taxes, reducing U.S. tax revenues by billions. Ironically, many of these same investors proclaim themselves as socially responsible stewards of the companies they own, attracting millions of individual investors who factor Environmental, Social, and Governance (ESG) issues into their investment decisions. Corporate “flooding” affords an instructive example of the weakness of so-called ESG investment model. To mitigate the detrimental effect of common ownership on corporate tax compliance, this chapter proposes a double sanctions regime, whereby institutional investors would be penalized along with their portfolio companies for improper tax avoidance. Such a regime may help restore deterrence and may incentivize institutional investors to keep their social promises.

Chapter 2 of this dissertation, The Agency Tax Costs of Mutual Funds, unveils another tax-related pitfall associated with what some scholars term the “separation of ownership from ownership” problem in intermediated markets. In such markets, retail mutual fund investors cede investment and voting decisions to institutional investors who manage the funds. As a result, actions undertaken unilaterally by financial intermediaries dictate the tax liability of passive individual investors. This chapter argues that the tax decisions of institutional investors are often guided by their own tax considerations rather than by the tax considerations of the beneficiaries who own mutual funds through conventional taxable accounts. Due to the pass-through tax rules that govern investment funds, these beneficiaries, unlike the institutional investors (who are compensated based on pre-tax performance), are tax-sensitive. These diverging incentives give rise to a new type of an agency costs problem. These agency tax costs arise from the institutional investors’ trading decisions, corporate stewardship activities, and their preferences in the mergers and acquisitions (M&A) context.

I argue that the structure of M&A deals, the method of payment used in such deals, and even the premiums paid to sellers in such deals are distorted because the votes of passive tax-sensitive retail investors are cast by tax-insensitive institutional investors. As a result, institutional investors not only fail to replicate the tax outcomes that tax-sensitive investors could have achieved had they owned stock directly, but they also distort corporate voting outcomes for all stakeholders—even those with unmediated investments. This chapter proposes several options for mitigating agency tax costs, including mandatory separation of funds based on the tax profile of the beneficiaries, heightened tax disclosure by mutual funds, decentralization of votes in mutual fund sponsors, and pass-through voting systems. These alternatives would reduce the agency tax costs of mutual funds without imposing new agency costs on tax-insensitive shareholders who also rely on institutional investors for portfolio management.

The agency tax costs problem undermines the traditional assumption that mutual funds and their individual investors have the common goal of maximizing returns. My research reveals that this underlying assumption is flawed, as it overlooks the tax rules that govern investment funds and the way these rules shape the economic incentives of mutual funds managers and advisors. These incentives create a conflict of interest between institutional investors and their tax-sensitive investors, which has been largely overlooked. The analysis of the agency tax costs problem also illuminates the ways in which the rise of financial intermediaries has impacted the tax behavior of public corporations, which in turn, has affected the tax liability of investors in capital markets. While this result has significant implications for market participants and society at large, the paths through which these effects occur and their underlying economic rationales have received little attention. This chapter addresses this scholarly gap by examining the role of corporate governance structures as well as the role of tax law and policy in shaping the tax incentives of the most powerful market actors in the U.S. economy.

Chapter 3 of this dissertation, The Corporate Governance Cartel, offers a novel antitrust perspective on a growing phenomenon in capital markets that has accompanied the rise of institutional ownership: institutional investor coalitions. Traditionally, corporate law has regarded such coalitions as desirable, a solution to the well-known collective action problem facing public shareholders. In this chapter, I challenge that view by revealing the anticompetitive risks that investor coalitions pose. This chapter shows how investor coalitions can emerge at the border between firms and markets, affecting not only the intra-firm governance arrangements of the companies held by the coalition members—but capital markets as well. At the firm/market border, cooperation among institutional investors, even around seemingly benign corporate governance issues, provides an opportunity for tacit collusion among these investors in the markets in which they compete. To illustrate this problem, I use an antitrust lens to analyze the collective efforts of institutional investors to restrict the use of dual-class stock in initial public offerings (IPOs).

This original account of the coalition against dual-class structures exposes the significant anticompetitive effects that may arise at the IPO juncture when competing buyers of shares in the primary market coordinate their response to a governance term. Since the members of the coalition collectively possess most of the expected market demand for public offerings, their joint efforts can be seen as an exercise of buyer-side power. The exploitation of such power effectively creates a cartel of buyers in the primary market, resulting in two potential economic distortions: (1) abnormal underpricing of dual-class offerings, and (2) suboptimal governance arrangements. Both distortions reveal overlooked perils associated with the massive aggregation of power by institutional investors. In my antitrust analysis of investor coalitions, I also focus on institutional investor consortiums, trade associations that promote governance principles on behalf of their institutional members, which notably are on the rise.

In analyzing these consortiums, this chapter draws upon antitrust rules relative to standard-setting organizations and explores how these anticompetitive risks are exacerbated by these investor consortiums. Finally, this chapter proposes immediate regulatory responses aimed at preventing institutional investors from engaging in collective actions that limit competition. The suggested policies represent a means to resolve the delicate tension between the goal of corporate law to encourage collaboration among shareholders and the goal of antitrust law to restrict cooperation among competitors.