Controlling Externalities: Ownership Structure and Cross-Firm Externalities

Paper Authors: Dhammika Dharmapala, Vikramaditya Khanna

In recent years, debates over the social purpose of corporations have taken center stage amidst rising concern about externalities (such as those associated with climate change and harmful speech) generated by firms. A key motivation is the claim that government regulation and liability regimes appear not to be functioning sufficiently well to force firms to internalize these externalities. There is thus rising interest in exploring alternative mechanisms. In particular, a rapidly growing body of scholarship argues that index funds increasingly approximate diversified “universal owners” with incentives to maximize portfolio value (and thus to internalize cross-firm externalities). However, much of this analysis has focused on diffusely held US firms, while most firms in the world (including many important firms in the US), and many firms thought to be large contributors to these externalities, are controlled firms. Could index funds influence such firms to internalize externalities; if not, what other options might we consider? This paper examines these related questions within a more general conceptual framework for understanding how firms’ ownership structure and corporate law affect the internalization of cross-firm externalities. First, we provide novel empirical evidence suggesting that index funds are not well positioned to force controlled firms to internalize their cross-firm externalities (in particular, that index funds’ environmental engagements are concentrated among firms in countries with dispersed ownership structures). Second, we document that controlling shareholders are common among the largest firms in the energy, automobile, and technology sectors. Third, we explore the incentives of controllers by introducing the concept of “controller wealth concentration” (CWC): the fraction of a controller’s aggregate personal wealth that consists of stock in the firm that she controls. The lower the CWC the more scope there is for the controller to hold investments in other firms affected by the externalities created by the controlled firm. A low CWC is a necessary (though not sufficient) condition for controllers to have a pecuniary incentive to take cross-firm externalities into account (indeed, controllers with low CWC may be more effective than index funds in getting controlled firms to internalize their externalities because of their status as controllers). Fourth, we construct measures of CWC for the controlling shareholders of a global sample of large technology-focused firms. For this sample, CWC is very high relative to that of a diversified portfolio, typically varying from about 50% to close to 100%, despite the existence of controlling minority ownership structures (CMS) – such as dual class stock – that permit controlling shareholders to exert control while holding modest cash flow rights. Thus, we conclude that undiversified controlling shareholders constitute a significant obstacle to the internalization of cross-firm externalities, limiting the ability of universal owners to encourage their investee firms to internalize such externalities. Are there then steps that can be taken to encourage controllers to diversify more? Our framework suggests that, in principle, dual class structures (and other CMS) have the hitherto ignored advantage of allowing controllers to diversify their personal wealth (thereby potentially mitigating cross-firm externalities). Yet, we find that controllers do not typically diversify and lower their CWC even when they maintain control through dual class structures or other CMS. We discuss possible reasons - including founders’ over-optimism about their firms, the need to incentivize founders’ ongoing effort, and founders’ incentives to defer capital gains taxes – to explain why controllers fail to diversify. We then discuss other measures that might encourage controllers to diversify, but conclude that they are unlikely to have very large effects. Globally, a large fraction of corporations have controlled ownership structures. For these firms, the lack of controller diversification makes it difficult to identify mechanisms to internalize corporate externalities, besides increasing regulation and enhancing liability (although these solutions present their own challenges).