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The Perils of Common Ownership: Flooding Strategy

The increased concentration of shares in the hands of large institutional investors has triggered a phenomenon that I term “flooding.” The term is apt because, under this phenomenon, institutional investors push their portfolio firms towards higher levels of noncompliance. When coupled with limited enforcement capabilities, the increase in the levels of noncompliance reduces the probability that such behavior will be detected and adequately penalized. Without adequate measures in place to stem the flow, noncompliance, at first a trickle, gathers the force of a flood. The presence of large, diversified shareholders is, in fact, a disaster for the inherent trade-off between compliance and enforcement. Misconduct becomes less risky and more rewarding, changing the way in which public firms approach legal risks. 
 
Data suggests that the emerging ownership pattern in the United States increases levels of corporate tax avoidance. In this Article, I argue that this increase creates the described flooding effect, overwhelming the tax agency, which subsequently faces new enforcement challenges. I identify linkages between characteristically passive institutional ownership and tax noncompliance, while emphasizing that neither direct communication between institutional investors and managers of portfolio firms, nor coordination or collusion between corporate managers, is necessarily required for flooding to occur. Finally, I propose a double sanctions regime under which institutional investors will be penalized for the tax avoidance behavior of their firms. Such a regime will moderate the incentive for public corporations and their institutional shareholders to engage in higher levels of tax avoidance.