Controlled companies – public firms where an individual, group, or another company holds majority voting power – make up a significant and growing share of the U.S. public market, accounting for over $2.2 trillion in 2019 alone. Despite their scale, these firms operate under a unique regulatory regime: The NYSE and NASDAQ adopted rules – approved by the SEC – that allow the firms to exempt themselves from key board-independence requirements established to restore investor confidence after the early 2000s corporate scandals. These firms are not required to maintain a majority-independent board or to establish fully independent nominating, governance, or compensation committees.

This optional governance exemption has broad implications. Controlled companies’ ownership structure already raises agency concerns, and their ability to bypass standard governance protections may further reduce safeguards for minority shareholders. Yet surprisingly little is known about how these companies use their regulatory leeway – or the consequences for board composition and firm value.

In a recent study, we analyze detailed governance data from proxy statements of controlled companies between 2004 and 2017. Our findings offer new insight into how these firms structure their boards, who serves on them, and what that means for investors and policy makers.

Board Composition and Director Quality

We begin by examining independent directors – those in the strongest position to monitor management – in controlled firms that elect the exemption. Compared with similar firms that do not make that election, these companies have fewer independent directors with financial or industry expertise, and their directors have smaller professional networks. In short, the independent directors are less qualified and have lower status.

Compensation data support this finding. Independent directors in controlled companies that choose the exemption receive significantly lower total, equity, and cash compensation than their peers at comparable firms – even though they face higher legal risks. These results suggest that controlled companies are less attractive to top independent-director candidates and may face challenges in recruiting and retaining high-quality board monitors.

A Tradeoff Between Inside and Independent Directors

One possible justification for weak independent directors is that inside directors – typically executives – might be more qualified. Indeed, we find directors at controlled companies that claim the governance exemption are more likely to have financial expertise and larger professional networks than their counterparts at non-exempt controlled firms.

We further test and corroborate this tradeoff with four additional qualification metrics drawn from prior research: elite education, advanced business degrees (including MBAs), legal or accounting credentials, and graduate education. These results support our core findings: Exempt firms have less qualified independent directors but more qualified inside directors across virtually all measures.

Firm-Level Consequences

If board composition reflects a substitution of expert, inside directors for independent directors, how does this tradeoff affect firm outcomes?

We examine firm outcomes that are plausibly influenced by board composition. We find that controlled companies using the exemption have lower market values (as measured by Tobin’s Q), greater information asymmetry between the firms and their investors, and signs of underinvestment – all of which could stem from weaker governance and monitoring.

Legal and Policy Implications

Our study has important implications for academics, policymakers, managers, and firm stakeholders. Critics contend that allowing certain shareholders to maintain control long after a firm goes public harms minority shareholders. Our findings validate these concerns and suggest that the ability to opt out of board reforms at controlled firms harms investors. Our findings are particularly significant in light of recent legal and policy developments.

In In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation, the Delaware Chancery Court acknowledged the governance risks in controlled firms and imposed enhanced fiduciary duties on directors. Given the lower compensation and heightened liability exposure, prospective directors may reassess whether the benefits of serving on these boards outweigh the costs – potentially exacerbating the quality issues we identify.

Additionally, our research informs the debate surrounding Delaware Senate Bill 21, which grants legal protections to insiders engaging in related-party transactions – a common feature of controlled firms. Our evidence suggests that such transactions, in an environment of weak independent oversight, may further harm the interests of minority shareholders.

Conclusion

As controlled companies continue to grow in economic significance, understanding how their governance structures affect director quality and firm outcomes becomes increasingly important. Our research shows that the ability to opt out of board independence requirements leads to a degradation in overall board quality – driven by independent directors – with measurable adverse costs for investors. These findings have clear implications for courts, policymakers, and shareholders navigating the complex tradeoffs of corporate control.

This post comes to us from professors Dain C. Donelson at the University of Wisconsin-Madison, Jennifer Glenn at The Ohio State University, and Christopher G. Yust at Texas A&M University. It is based on their recent article, “The Cost of Control: Board Structure and Firm Value in Controlled Companies,” available here.