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The Role of the Board in Related Party Transactions Jospeh A. McCahery University of Amsterdam 2006 OECD Policy Dialogue on Corporate Governance in India New Delhi February 16-17, 2006 Setting the Theme Related Party Transactions Play important and legitimate role in economy

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the role of the board in related party transactions

The Role of the Board in Related Party Transactions

Jospeh A. McCahery

University of Amsterdam

2006 OECD Policy Dialogue on Corporate Governance in India

New Delhi

February 16-17, 2006

setting the theme
Setting the Theme
  • Related Party Transactions
    • Play important and legitimate role in economy
    • But if left unchecked, could foster opportunism
  • Points
    • (1) Through related party transactions, controlling shareholders and managers may extract private benefits of control
    • (2) Potential for abuse and high cost of regulating these transactions has led to a range of regulatory strategies
    • (3) Strategies and techniques include: mandatory disclosure, board approval, fiduciary duties, shareholder voting
regulating related party transactions
Regulating Related Party Transactions
  • LEGAL FRAMEWORK for Related Party Transactions:
  • Mandatory Disclosure
  • Duty of Loyalty
  • Board Approval
  • Shareholder Voting

Availability of external finance increases and leads to financial development

why should one care about related party transactions
Why Should One Care About Related Party Transactions?
  • Related party transactions involve transactions between a parent company and subsidiary; employees; an enterprise and its principal owners, management or members of their immediate families; and affiliates (OECD Principles; IAS 24 (9); FASB Statement no. 57)
  • Related Party Transactions can take various forms including:
    • Transfer pricing;
    • Asset stripping;
    • Inter-company loans and guarantees;
    • Sale of receivables to Special Purpose Vehicle;
    • Leasing or licensing agreement between a parent and subsidiary
  • Illicit related party transactions limit the availability of external finance and leads to financial underdevelopment
typical related party transaction

Mr. James

Mr. James owns 90% of Seller Co. shares

Mr. James owns 60% of Buyer Co. shares

Seller Co.

Buyer Co.

Buyer Co. buys equipment from Seller Co.

Typical Related Party Transaction
  • Simple transaction (purchase of equipment) between two entities (“Buyer” and “Seller”) controlled by the same shareholder (“Mr James”), who is on the board of both firms.
  • Key Problem:
    • The proposed transaction may have a business purpose.
      • For example, purchasing the equipment may lead to expanded sales.
    • James is on both sides of the transaction and may benefit if Buyer acquires overpriced equipment from Seller.
legal regulation of related party transactions
Legal Regulation of Related Party Transactions
  • Problem:
    • How do we distinguish between those valuable transactions that yield benefits for companies and those abusive transactions which are influenced by a conflict of interest and can be costly for investors?
    • Enron and Parmalat illustrate difficulty of identifying these transactions
    • Wide range of available strategies for accountants and auditors to facilitate disclosure
      • Prompt, continuous updating of information on related party transactions to market (listing rules)
      • Tool kit approach to identify material transactions (AICPA statement of Auditing Standard 45, sec 334):
        • Criteria identifying material transactions;
        • Information on management controls; information systems;
        • Extended audit; and
        • Review procedures for company transactions.
enron s related party transactions
Enron’s Related Party Transactions

Swaps and Sales Contracts

Managing

Member-

Fastow

$30 million

of

compen-sation

ENRON

SPE

General

Partner

SPE

Outside

Equity

LJM1/

LJM2

LPs

SPE

SPE

$350 million

SPE

3% equity participations

Enron stock exchanged

For SPE notes—The Phantom Stock

what mechanism detect fraud and illicit related party transactions
Detection is just a matter of time

Uncovered by:

Internal audit

Whistle blowers

External auditors

Parties on other side of transaction

Security analysts

Plaintiffs bar press

Seldom uncovered by regulators

Board responsibility:

establish effective detection system

What Mechanism Detect Fraud and Illicit Related Party Transactions?
role of corporate governance
Detect and deter expropriation via

Theft

Fraud

Related party transactions

Transfer pricing

Negatively: Detect and deter bad decisions and their continuation

Positively: engender efficient contracting between all parties (investors, lenders, managers, employee)

Obtain resources on best possible terms

Use them in best possible fashion

Role of Corporate Governance
limits of effective board monitoring
Limits of Effective Board Monitoring?
  • Non-executive Directors can play an important role
    • (1) informed;
    • (2) incented;
    • (3) independent.
  • But, this is difficult for independent directors to achieve:
    • 1) being informed requires time and energy in getting to know the company, its managers and its strategy;
    • (2) being incented requires the monitor to have an interest in the company’s outcomes
    • (3) making it difficult to be independent
  • Effective external board members have to be part of the management process. How can a director be independent of a CEO he has helped hire or of a business strategy that he has assisted designing?
what mix of measures is required
What Mix of Measures is Required?

(1) Greater involvement of non-executive directors needed for those transactions that may imply a conflict of interest with management or controlling shareholder;

(2) By imposing penalties on false disclosure, a legal mandate allows honest companies to distinguish themselves;

(3) Effective private intermediaries are essential to detect and deter complex related party transactions; and

(4) Since a reputation model alone will not work, codes of conduct are needed as well.

legal framework

Corporate Law

Fiduciary duties; board

approval; shareholder voting;

Prohibitions on certain

transactions

Mandatory Disclosure:

Listing Rules and Securities

Regulation

Codes of Conduct:

-Comply or explain approach

-Defines and regulates

material conflicts; disclosure

rules on holdings; rules on

shareholders’ rights;

liability rules for directors

Legal Framework:
fiduciary duties
Fiduciary Duties
  • Similar approaches in common law and civil law jurisdictions—less willing to review conflicted transactions approved by board
  • US has more developed case law:
  • Duty of loyalty: proscribes mangers from entering self-dealing or unfair transactions

(1) Courts review conflicted transactions, but less willing to review decisions approved by disinterested director

(2) Incentives for direct and derivative shareholder suits (procedural obstacles are high outside US)

prohibitions on conflicted transactions
Prohibitions on Conflicted Transactions
  • Company loans prohibited to buy company stock (§ 402 SOXA)
  • Restrictions on transactions between managers and third parties (non-compete rule for top executives, Gr)
  • Insider trading: restrictions on short-term sales (16(b) and SOXA amendments; UK Listing Authority’s Model Code §2)
  • Ban on insider trading by officers and directors prior to disclosure of material, non-public information (Art 2, EU Market Abuse Directive [2003])
board approval
Board Approval

Anglo-Saxon & some Continental European jurisdictions encourage board approval of conflicted transactions: supplies strong protection from shareholder challenge

  • 1) US states that follow Revised Model Business Corporation Act (RMBCA) give business judgment rule protection to conflicted transactions after approval
  • 2) Non-RMBCA (Del) permit such approval to shift the burden of proof to fairness (or unfairness) from the defending director to the challenger
  • 3) Board approval of conflicted transactions (NL,Fr)
  • 4) Directors must disclose personal interests in company related transactions (§ 317CA 1985; Comment to §5.02(a)(1) ALI Principles on Corporate Governance 1994)
  • 5) Minority shareholder approval of controlling shareholder transactions (§5.10 ALI Principles of Corporate Governance)
shareholder voting
Shareholder voting
  • Shareholder voting (alternative to board approval)
    • Fr: (Art L. 225-40 Code de commerce)—requires shareholder approval of conflicted transactions
    • Other jurisdictions have less demanding rules:
    • UK (charter provisions)
    • US, Gr (self-dealing transactions not subject to shareholder approval)
mandatory disclosure us
Mandatory Disclosure: US
  • Stringent disclosure mandates (publicly listed firms)
    • US securities law (SEC S-K,(all major transactions, 5%); item 402 (executive compensation); 404 (certain relationships & related party transactions)
    • Accounting rules (GAAP: SFAS 57 (related party disclosure): all material transactions between firm & officers
    • State law: fiduciary duty law requires disclosure of conflicted transactions
    • Sarbanes-Oxley 16(a): officers must disclose trades in companies shares (w/in two days)
mandatory disclosure presupposes effective enforcement
Mandatory Disclosure Presupposes Effective Enforcement
  • EU & US Experience
      • Effective enforcement tools needed
      • Presumption: clear, open, effective disclosure
    • Trade-offs
      • Capital market implications
      • Facilitates other regulatory tools and institutions
  • But may create burdens
    • May be costly for companies
    • Centralized disclosure system—front end costs
    • Restricted impact—does not impact all firms equally
  • Administrative Liability for non-notification
    • Interested parties must disclose 20%
    • Administrative measures needed
    • Follow best practice—adopt codes, internal systems
the role of best codes for curbing related party transactions

Corporate

Governance

Guideline

The Role of Best Codes for Curbing Related Party Transactions

SOFT LAW SUPPLEMENT

Shareholders

Supervisors

  • Information & Incentive Problems:
  • Adverse selection
  • Moral Hazard
  • Self-dealing

Directors

Family members

Employees

Creditors

Supervisory Board

-Disclose any conflicts to shareholders

-Termination

-Conflicted transactions require approval

-Whistleblowers protected from retalitation

Others

what is the evidence
What is the Evidence?
  • Lopez-de-Silanes et al. constructed a new index of shareholder protection for 72 countries.
    • Addresses specifically the protection of minority shareholders against self-dealing transactions benefiting controlling shareholders.
    • Better grounded in theory than index of anti-director rights (LLSV 1997, 1998)
  • Anti-self-dealing index exhibits some of the same properties as both the anti-director rights index, and the indices of shareholder protection through securities laws (LLS 2006).
    • It is sharply higher in Common law than in French civil law countries.
    • Statistically significant and economically strong predictor of stock market development across countries.
  • Results support findings in earlier work, but also show that theoretically-grounded measures of investor protection are closely tied to financial development.
ex post control of self dealing
Ex-Post Control of Self-Dealing

Ex-AnteEx-Post Public Enforcement Results

public enforcement
Public Enforcement

Ex-AnteEx-PostPublic Enforcement Results

anti self dealing index and stock market capitalization
Anti-Self-Dealing Index and Stock Market Capitalization
  • Figure II: Partial-regression leverage plot of stock market capitalization and ex-ante control of self-dealing, controlling for Log GDPpc and efficiency of the judiciary.
anti self dealing index and ln firms pop
Anti-Self-Dealing Index and Ln Firms / Pop
  • Figure IV: Partial-regression leverage plot of Log listed firms per million people against the index of anti-self-dealing, controlling for Log GDPpc and efficiency of the judiciary..
anti self dealing index and ipos gdp
Anti-Self-Dealing Index and IPOs/GDP
  • Figure V: Partial-regression leverage plot of IPOs-to-GDP against anti-self-dealing in regressions controlling for Log GDPpc and efficiency of the judiciary..
anti self dealing index and block premium
Anti-Self-Dealing Index and Block Premium
  • Figure VI: Partial-regression leverage plot of Block Premium against the index of anti-self-dealing, controlling for Log GDPpc and efficiency of the judiciary..