What is the right governance framework for a public company? This question sits at the core of decades of empirical and theoretical research, and yet we still lack consensus on an answer. In particular, agency-cost essentialists support governance structures that maximize accountability to the company’s shareholders, while proponents of board-centered models, as well as stakeholder governance advocates, prefer arrangements that insulate management from shareholder influence. Still others contend that there is no “one-size-fits-all” governance arrangement. Despite this range of views, agency-cost essentialists have mostly won the day. In both academic and professional circles, “good governance” is generally defined as the extent to which a company aligns management interests with shareholder interests. In addition, many companies have adopted governance structures that increase management’s alignment with shareholders and enhance shareholder power.
But as professors Kastiel and Nili reveal in their recent article “The Corporate Governance Gap,” the companies that adhere to “good governance” practices are not as prevalent as one might suspect. Moreover, these companies are not evenly dispersed. The largest public companies have bowed to pressure from academics, investors, and other “agents of change” to maximize accountability to shareholders and give them greater control and intervention rights. But beyond the S&P 500, the corporate governance landscape looks different. For example, in 2020, only 10 percent of the S&P 500 had classified boards; by contrast, over 40 percent of the 200 smallest companies in the Russell 3000 did. Likewise, as of 2020, 91 percent of S&P 500 companies had majority voting for director elections, but only 29 percent of the “Bottom 200” required it. Small public companies are also less likely to remove a supermajority voting requirement for charter amendments, give shareholders the right to call a special meeting, implement proxy access, separate the position of CEO and chair of the board, and increase board independence.
Shedding light on this “corporate governance gap” is a major contribution in itself and leads to a number of possible conclusions. In particular, Kastiel and Nili’s takeaway is that the marketplace would benefit if all firms modeled their governance on that of S&P 500 firms, and they suggest policies that would facilitate this development. However, in my response, I describe two competing interpretations of their results that would caution against implementing their recommendations.
First, although the authors conclude that the corporate governance ecosystem facing small firms is flawed, the opposite interpretation is possible. In particular, market pressures that affect the largest public firms most dramatically may drive homogeneity in governance without creating value. Indeed, the aspect of the authors’ results that is most striking, in my mind, is not the gap, but the homogeneity at the top: The largest public companies have nearly identical governance structures, and the smaller the company, the more variation you find. As the classic account of private ordering emphasizes, diversity is expected when law is enabling – so it appears that private ordering is being frustrated, rather than enhanced, at the largest public companies.
Digging into the authors’ explanation for their evidence provides more support for this point. In particular, in modern public markets, a necessary precondition for any successful governance change is support from large mutual-fund shareholders and specifically the “Big Three” (Vanguard, State Street, and BlackRock), which together cast 25 percent of the votes of S&P 500 companies, on average. As the authors recognize, mutual funds have limited resources: Their business model generally limits the amount of time and money that they can spend researching any company in their large portfolios. As a result, they (like the proxy advisers that advise them) prefer blanket, one-size-fits-all governance solutions, promulgated in the form of low-cost voting guidelines. And the Big Three’s voting guidelines closely track the arrangements that the authors argue constitute “effective governance:” majority voting for director elections, greater director independence, greater shareholder power, and an absence of antitakeover protections, among others.
In light of their influence and nearly identical governance preferences, these mutual fund blockholders contribute to the homogenization in governance that has occurred at the largest companies. By contrast, the governance of smaller companies is more likely to be determined by investors, founders, and management who bargain freely with each other and customize governance arrangements based on the unique needs of the particular company. This interpretation suggests that the corporate governance ecosystem facing large firms is flawed, rather than the other way around.
The second competing interpretation of Kastiel and Nili’s results is that the entire corporate governance ecosystem is working well, and that there are good reasons for the governance gap between large and small public companies. In particular, it is likely that small public companies reap fewer benefits from pro-shareholder governance structures than large ones. As the authors observe, smaller public companies have a much higher percentage of insider ownership compared with large public companies. For this reason, the problem of separated ownership and control is reduced, which means there is less of a need to promote accountability to shareholders through the company’s governance structure.. Small public companies are also more likely to have a controlling shareholder that can determine voting outcomes, which means that these companies will not reap much benefit from a pro-shareholder governance structure. Regardless of whether boards are staggered, and whether shareholders can elect directors by a plurality or a simple majority vote or call a special meeting, the controlling shareholder will determine the outcome of the election.
Moreover, small firms are subject to many market forces that operate as substitutes for investor activism. For example, small firms are more susceptible than large firms to takeovers or hedge fund activism. In addition, small firms have lower market shares than large firms and therefore face greater product-market competition, providing another check on managerial slack or self-dealing and rendering a shareholder-friendly governance structure less important.
Because each of these competing interpretations of Kastiel and Nilli’s results is supported by ample evidence, more research is needed to rule one of them out. The only thing that can be said for certain at this early stage, however, is that the corporate governance gap will motivate theoretical and empirical research for years to come.
 See Kobi Kastiel & Yaron Nili, The Corporate Governance Gap, 131 Yale L.J. 782, 798.
 Id. at 828-29.
 Id. at 829-36.
This post comes to us from Professor Dorothy S. Lund at USC Gould School of Law. It is based on her recent article, “In Search of Good Corporate Governance,” available here.