The Corporate Governance Gap

A reliable system of corporate governance is an important requirement for the long-term success of public companies. After decades of research and policy advocacy, there is a growing sense that many public corporations are finally nearing the promised land: their boards seem more diverse, large investors seem more engaged, and directors seem more accountable than ever. But is this perception accurate?

In a new paper, forthcoming in the Yale Law Journal, we explore this question by providing a comprehensive empirical account of the differences in the governance arrangements and shareholder engagements between large- and small-cap corporations. We compiled a rich and detailed historical dataset from a diverse array of sources, some of it hand-collected and coded, for both S&P 1500 and the bottom 200 companies of the Russell 3000 companies, which sheds new light on the corporate governance of mid- and small-cap companies.

As the paper reveals, while many large, high-profile companies are more attentive to shareholder demands and tend to serve as models of desirable governance practices, the picture is considerably different in the far corners of corporate America, away from the limelight of the S&P 500. In these smaller, less-scrutinized corporations, the adoption of governance arrangements is less organized or systematic and often significantly departs from the norms set by larger companies. This results in what this paper calls the “Corporate Governance Gap.”

We document the stark disparity in governance arrangements and the level of shareholder engagements between the S&P 500 companies and those of smaller public companies by presenting historical data over the last twenty years across a myriad of metrics. In particular, we find around a 30% gap in the implementation of annual director elections, a 60% gap in the implementation of majority voting for director elections, a 20% gap in the elimination of a supermajority requirement for amending the company charter, and a 70% gap in the implementation of proxy access. Also, many small-cap companies are approximately ten years behind large-cap companies in terms of board-gender diversity. As of 2021, 25% of the companies with an asset value under $500 million still had no female directors on their boards.

Finally, we find that key governance actors also tend to focus on large companies, with 70% of all shareholder proposals (including social and environmental proposals) and 80% of all exempt solicitations by activist shareholders targeted at the S&P 500 companies.  Similarly, the “Big Three” indexing giants of Wall Street (BlackRock, State Street Global Advisors, and Vanguard) heavily focus their engagement efforts on large-cap companies.

These profound differences matter because the ~3,000 companies that are not in the S&P 500 still account for 30% of the U.S. capital markets—a collective value of $10 trillion.  The limited attention that these firms receive from investors, as well as other important market participants (such analysts, media, and public and private enforcers) suggests that they often operate free from any meaningful disciplinary forces. This is despite the fact that their governance practices and lack of managerial oversight could have a negative impact on their investors, stakeholders, employees, and society at large. This focus on larger companies is particularly concerning due to the increasing use of modern trading platforms (such as Robinhood) by retail investors, which has led to the incursion of these investors into small-cap companies with markedly different governance arrangements.

What prompts this stark governance gap? To answer this question, we develop a theoretical account of the forces that promote corporate governance changes. Corporate governance, we argue, is not self-driven. It requires engagements by agents and forces of change, which as we detail theoretically and empirically, are less likely to be as prevalent or effective within smaller corporations.

Our findings have several important implications. First, corporate governance scholars have long debated the merits of contractual freedom in corporate law. This debate, we argue, cannot be resolved without a fuller understanding of how governance terms are disseminated in the marketplace and without recognition of the Corporate Governance Gap between large and small companies. In particular, we show that even when certain governance arrangements are viewed as desirable by market participants, they are disseminated differently in small-cap companies because the channels of “governance making” in these companies are deficient. Private actors who usually advance governance changes or engage with management are less likely to be active in mid- or small-size companies. In contrast, the attention frequently directed at large corporations is often pivotal in shaping policies and perceptions of corporate governance. And when these “governance-making” channels operate well, they ensure active engagement and “push and pull” between managers and shareholders.

Second, despite the alternative governance universe of smaller companies, much of the current discourse in both practice and academia treats corporate governance in the aggregate, often focusing on the most observable of companies—the large Fortune 500 corporations—that sway opinions and give rise to generalizations.  We, therefore, underscore the need for increased attention to the governance in smaller public companies and offer a few concrete steps that regulators, investors, and academics could take to address the disparity in governance arrangements between large and small companies. Furthermore, beyond small-scale adjustments in the current corporate ecosystem, we recommend a broader policy reform aimed at solving the problem of governance-making in smaller companies at its root, by mandating periodic voting on key governance arrangements.

Finally, our research also stresses the importance of proxy advisors as one of the few channels that contributes to governance-making in smaller companies. This role is particularly pertinent, as calls to restrict proxy advisors’ operations have already resulted in a concrete regulatory action.

The complete paper is available for download here.