Externalities and the Common Owner

Abstract

Due to the embrace of modern portfolio theory, most of the stock market is controlled by institutional investors holding broadly diversified economy-mirroring portfolios. Recent scholarship has revealed the anti-competitive incentives that arise when a firm’s largest shareholders own similarly sized stakes in the firm’s industry competitors. This Article expands the consideration of the effects of common ownership from the industry level to the market-portfolio level, and argues that diversified investors should rationally be motivated to internalize intra-portfolio negative externalities. This portfolio perspective can explain the increasing climate change related activism of institutional investors, who have applied coordinated shareholder power to pressure fossil fuel producers into substantially reducing greenhouse gas emissions.

While institutional investors have protested their ability to influence firm-level supply and pricing decisions in the service of muting competition, they are more willing to advertise their role in seeking emissions reduction commitments, even admitting they are for the benefit of portfolio returns. These commitments, however, affect product supply and imply market power in much the same way, and provide further evidence that institutional investors are able to influence managerial decisions at the firm level for the benefit of their broader portfolio. This insight requires the amendment of the traditional view that diversified investors are “rationally reticent” and lack the incentive to engage in monitoring of firm behavior. It additionally challenges a fundamental norm of corporate governance law: the theory of shareholder primacy rests on the premise that shareholders homogeneously seek to maximize corporate profits and share value. This Article shows that in certain circumstances a majority of minority shareholders may direct the firm away from a profit-maximizing objective.