Dhammika Dharmapala Writes on the Effect of Ownership Structure on a Firm's Ability to Internalize Externalities

Controlling Externalities: Ownership Structure and Cross-Firm Externalities

Our new working paper on “Controlling Externalities: Ownership Structure and Cross-Firm Externalities” develops a general conceptual framework for understanding how firms’ ownership structure and corporate law affect the internalization of cross-firm externalities and proposes a new metric (called “Controller Wealth Concentration”) designed to provide a simple characterization of the incentives of controllers in this regard. We use this metric—and other sources of evidence—to argue that the prevalence of controlling shareholders around the world (including at many important US firms) poses a significant challenge to the internalization of cross-firm externalities through the influence of diversified owners such as index funds. Further, this suggests that working toward better regulation and liability regimes may be inescapable, even though these have their own challenges.

In recent years, debates over the social purpose of corporations have taken center stage in both public discourse and in corporate law scholarship. This development has been spurred by rising concern about externalities generated by the activities of corporations, such as those associated with climate change and harmful speech. A central underlying premise of these debates is 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. In contrast, most firms in the world—including many important firms in the US—have controlling shareholders. These include many of the firms that are thought to be large contributors to the aforementioned externalities. Our paper examines whether index funds can influence such firms to internalize externalities, and explores other potential mechanisms to achieve this aim.

Read more at Harvard Law School Forum on Corporate Governance