abstract. A reliable system of corporate governance is considered an important requirement for the long-term success of public companies and for the good of society at large. After decades of research and policy advocacy, there is a growing sense that corporations are finally nearing the promised land: boards of public corporations seem more diverse, large investors seem more engaged, and directors seem more accountable than ever. But is this perception accurate? While many large, high-profile companies tend to serve as role models of desirable governance practices, the picture of corporate governance—as this Article reveals—is considerably different in the far corners of corporate America, away from the limelight of the Fortune 500 and within the universe of small-cap corporations. In these smaller, less-scrutinized corporations, the adoption of governance arrangements is less systematic and often significantly departs from the norms set by larger companies. This results in what this Article calls the “Corporate Governance Gap.”

What prompts this governance gap? Corporate governance, we argue, is not self-driven. It requires engagement with agents and forces of change, which, as we detail theoretically and empirically, are less likely to be as prevalent or effective for smaller corporations. Corporate governance scholars have long debated the merits of contractual freedom in corporate law. This debate cannot be resolved without a fuller understanding of how governance terms are disseminated in the marketplace and without a recognition of the Corporate Governance Gap between large and small companies.

This Article, the first to address the sharp divide in the governance of American corporations, makes three key contributions. First, using a comprehensive, hand-collected dataset, it offers an empirical account of the differences in governance practices, shedding new light on the corporate governance of small-cap firms. Second, the Article develops a theoretical account of the forces that promote corporate governance changes, which help explain the stark governance gap. Finally, the Article proposes policy reforms aimed at overcoming the gap between large and small firms’ corporate governance norms, with the potential of prompting a new line of inquiry regarding the role of key governance agents in smaller public companies.

authors. Kobi Kastiel is Associate Professor of Law, Tel Aviv University; Senior Research Fellow and Lecturer on Law, Harvard Law School. Yaron Nili is Associate Professor of Law and Smith-Rowe Faculty Fellow in Business Law, University of Wisconsin Law School. The Authors would like to thank Michal Barzuza, Lucian Bebchuk, Alma Cohen, Ofer Eldar, Yuval Feldman, Zohar Goshen, Assaf Hamdani, Cathy Hwang, Jesse Fried, Nadelle Grossman, Adi Libson, Dorothy Lund, Elizabeth Pollman, Gideon Parchomovsky, Ed Rock, Holger Spamann, Roy Shapira, Steven Davidoff Solomon, Eric Talley, Roberto Tallarita, Andrew Tuch and the participants at the Israeli Institute for Advanced Studies Seminar, the Corporate Law Academic Webinar Series (CLAWS) Workshop, the 2021 National Business Law Scholars Conference, the Harvard Law School Workshop in Empirical Law and Economics, the Duke University School of Law Faculty Workshop, and the University of Wisconsin Faculty Workshop. Shir Avital, Jonathan Bukshpan, Megan Christopher, Katie Gresham, Gabrielle Kiefer, Marcy Shieh, Emma Shamburek, Merav Shwartz, Gretchen Winkel, and Yuval Yogev provided excellent research assistance. We are especially grateful to the editorial staff of the Yale Law Journal for their exceptional suggestions and edits.

Introduction

Corporate America is omnipresent. From their financial impact on our retirement accounts and communities, to their environmental and social policies, corporations can act as drivers of change or as bricks of resistance. But corporate America is not an abstract concept. It is the aggregate of thousands of corporations, each operating independently and guided by its own set of governance policies. From climate change to gender equality, corporations—and the corporate governance policies that drive them—wield the power to transform society.1

Corporate governance discourse has long realized the important social role of corporations and the significance of governance to fulfilling that role. Dating back to Adolf A. Berle and Gardiner C. Means’s renowned examination of the modern corporation,2 the exploration of how and why corporations operate in the ways they do has dominated academic debate3 and regulatory policy,4 ushering the field of empirical corporate governance.5

After decades of research and policy advocacy, there is a growing sense that corporations are finally nearing the promised land. Boards of public corporations seem more diverse, large investors more engaged, and directors more accountable than ever. But is this perception really true? While many large, high-profile companies tend to serve as role models of “good” governance practices, the picture, as this Article reveals, is much different in the far corners of corporate America.

Stepping away from the limelight of the Standard & Poor’s 500 (S&P 500)
corporations6 and into the universe of small-cap corporations, governance standards differ significantly. In these smaller, less scrutinized corporations, the adoption of governance arrangements is less organized and systematic, often representing a significant departure from the norms set by larger companies. We call this the “Corporate Governance Gap.” Beyond Apple, Google, and General Electric, there is a whole universe of publicly traded companies—3,530 to be exact7—many of which have corporate governance regimes that have little in common with the polished ones seen in the staple corporations of our society.

Consider the case of gender diversity on corporate boards. Today’s general consensus among scholars and news outlets is that boards are steadily inching towards gender parity.8 The S&P 500 was lauded in 2019 when the last remaining all-male board finally added a woman member.9 But this narrative ignores the reality in many small-cap companies that are approximately ten years behind large-cap companies in terms of board gender diversity. As of 2021, 25% of the companies with less than $500 million in assets had no female directors on their boards.10 Additionally, when California enacted Senate Bill 826 in 2018, which required publicly traded companies’ boards to add at least one woman to their ranks,11 the preponderance of noncompliant companies were small companies.12 Despite this striking noncompliance, most of the discussion surrounding this new law focused on its success in bringing women onto the boards of the largest corporations in the state.13

Diversity on boards is just one of many examples of the sharp divide between America’s largest corporations and small-cap corporations. As this Article reveals in its novel empirical examinations, stark governance disparities between large and small corporations prevail across a myriad of governance metrics. Compiling historical data over the last twenty years, we compare governance provisions of S&P 500 companies with those of small public companies and find 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.14 We also find that investors tend to focus on large companies, with 70% of all shareholder proposals and 80% of all exempt activist campaigns targeted at the S&P 500 companies.15 Similarly, the “Big Three” indexing giants of Wall Street (BlackRock, State Street Global Advisors, and Vanguard) heavily focus their engagement efforts on large companies.16

These profound differences matter because the 3,000 companies that are not in the S&P 500 still account for about 30% of the U.S. capital markets—a collective value of $10 trillion.17 The limited attention that these firms receive from investors, as well as other important market participants, 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. A small oil-drilling company can still create massive environmental harm, and a small manufacturing company can still pollute a nearby river with carcinogens affecting nearby cities. While the harm caused by any single megafirm may be larger than one generated by a comparable mid-sized or small firm, there are significantly more small firms in the marketplace and their cumulative impact on their investors and other stakeholders is substantial.

Properly addressing the Corporate Governance Gap involves more than merely recognizing departures from investors’ desired norms set by larger companies. It also requires a careful review of the factors that create and preserve the Gap. Corporate governance, we argue, is not self-driven. It requires engagement with agents and forces of change, which, as we detail theoretically and empirically, are less likely to be as prevalent or effective within smaller corporations.

The sharp divide in governance practices cannot be explained away by hypothesizing that smaller organizations require drastically different governance arrangements—although that may be the case in some instances.18 Despite a clear consensus among investors regarding the desirability of governance structures across all firms, smaller companies do not react as uniformly or as quickly compared to large firms. This raises not only the questions of how governance policies change and what drives that change, but also how a distorted view of governance may affect public perception, investment choices, and regulatory intervention.

Indeed, despite the alternative governance universe of smaller companies, much of the current discourse in both practice19 and academia20 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. The attention frequently directed at these large corporations is often pivotal in shaping policies and perceptions of corporate governance.21 However, the human tendency to assume that trends observed in large corporations exist across the board is as problematic as estimating an iceberg’s size based on the size of its tip.

The focus on larger companies is particularly concerning considering the increasing use of trading platforms by retail investors. Over the last half century, institutional investors had overtaken retail investors22 in the U.S. securities markets.23 However, the introduction of mobile-trading apps, such as Robinhood Markets, Inc. (Robinhood), disrupted the retail-brokerage industry by offering free trading via a user-friendly mobile app.24 Robinhood attracted millions of investors, mostly millennials,25 thereby increasing retail investing.26 Robinhood’s “gamified” interface makes investing cheap and accessible, leading some in this new generation of retail investors to make risky and uninformed investments.27 Equally important, the incursion of retail investors into small-cap companies also means that these investors may be unintentionally buying into markedly different governance arrangements, to which many large institutional investors are opposed.

In recent years, scholars have debated the benefits of large investors’ push towards market-wide one-size-fits-all governance arrangements.28 Importantly, we do not take the view that there is a one-size-fits-all governance regime, nor do we discount the value of governance diversity. Instead, we show that even when governance arrangements are viewed as desirable by market participants (regardless of their merit), they are disseminated differently in small-cap companies because the channels of “governance making” in these companies are deficient.

In contrast, when these “governance making” channels operate well, they ensure active engagement and “push and pull” between managers and shareholders, so that powers are spread across constituencies and managers’ actions do not remain unchecked. Properly functioning channels do not reduce governance diversity where needed. As the data presented in Part II show, the governance terms of large and visible companies do vary, suggesting that investors in these companies do not always adopt the one-size approach even if they have more power to do so.

This Article proceeds as follows. Part I sets the stage by reviewing the metamorphosis of corporate governance in the United States, highlighting four key forces that have brought corporate governance to the forefront: regulatory intervention, the rise of institutional investing, the emergence of proxy advisors,29 and the rise of shareholder activism. But at the same time that “best practice” seems to be omnipresent among large companies, it seems to be absent from a large swath of the public markets. Part I addresses this discrepancy, emphasizing the importance of governance actors in driving governance change and explaining their relative absence and ineffectiveness in smaller companies.

Part II provides a pioneering empirical survey of the differences in governance between large- and small-cap corporations that illustrates what we term the “Corporate Governance Gap.” Drawing on a mosaic of rich and diverse data for both Standard & Poor’s 1500 (S&P 1500) and Russell 3000 companies, much of it hand-collected and coded, Part II demonstrates the stark disparity in governance terms between the two types of firms over the past twenty years. Part II also provides strong evidence of the dependence of governance making on key actors, showing that investor engagement with companies is concentrated in large-cap corporations.

Part III then moves to the key policy implications of the Corporate Governance Gap. It discusses the concrete steps that regulators, investors, and academics could take to address the disparity in governance arrangements between large and small companies. It also stresses the importance of proxy advisors as one of the few channels that contribute to governance making in smaller companies. These findings are particularly pertinent as calls to restrict proxy advisors’ operations have already resulted in regulatory action. Finally, beyond small-scale adjustments in the current corporate ecosystem, Part III recommends 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.