In a recent European Corporate Governance Institute (ECGI) Working Paper I take an industrial organization perspective to explain the regulation of related party transactions in German corporate law and the hostile stance many national policy makers and commentators take towards meaningful reforms. This approach allows to look through the superficial rhetoric that identifies a neglected divergence between the internal governance structures of companies following the German-influenced civil law tradition (two-tier board structure) on the one hand, and the common law family on the other (one-tier board structure), as the substantive reason for legitimate opposition. Instead, my explanation hinges on the significant shareholdings, primarily of financial institutions, and the interlocked management functions in deeply hierarchized corporate groups typically referred to as Germany Inc. (‘Deutschland AG’).
Germany Inc., a dense network of interfirm links originating in the 1870s and characterizing the German economy until the 2000s, was an idiosyncratic form of industrial organization that put financial institutions at the center. In my paper I argue that the consumption of private benefits in related party transactions by these key agents can be understood as a compensation for their coordinating and monitoring function in Germany Inc. As a consequence, legal tools apt to curb tunneling remained weak in Germany from the perspective of outside shareholders. While banks were in a position to use their firm-level knowledge and influence to limit rent-seeking by other related parties, their own behavior had not been subject to meaningful controls.
I verify my hypothesis in a granular analysis of those parts of German corporate law commonly seen as the main antidotes against tunneling transactions. The analysis indicates that both the capital maintenance rule and the prohibition to act to the detriment of the corporation as codified in the law of corporate groups provide a powerful backdrop against which sophisticated shareholders with granular firm-specific information can constrain rent extraction by management or controlling shareholders. The analysis also shows that both legal restrictions are largely ineffective in the hands of dispersed shareholders who are remote from tainted related party transactions, not least because individual equity holders either lack the legal capacity or the incentives to act in the collective interest of minority shareholders as a class. Hence, the statutory provisions and doctrines at the center of the agency conflict between blockholders and minority shareholders enabled financial institutions at the heart of Germany Inc. to assume a powerful, value-enhancing role as inside-monitors, but also to self-compensate for their corporate governance services. The picture is rounded off with a brief look at an amendment of the German Stock Corporation Act (‘Aktiengesetz’) that removed a key determinant of a workable majority-of-the-minority rule, and thus further facilitated the unrestricted execution of related party transactions between firms and financial institutions.
With the dismantling of Germany Inc. at the turn of the 21st century, banks seized their monitoring function and left an unprecedented void with regard to related party transactions. Hence, a ‘traditionalist’ stance which opposes law reform for related party transactions in Germany negatively affects capital market development, growth opportunities, and, ultimately, social welfare.
The paper is my contribution to a joint research project of the University of Oxford Faculty of Law and the Research Center Sustainable Architecture for Finance in Europe (SAFE) at Goethe University Frankfurt with support from the European Corporate Governance Research Fund (ECGRF). It will be published as a chapter in Luca Enriques and Tobias H. Tröger (eds), The Law and Finance of Related Party Transactions (CUP 2018).
Tobias H. Tröger is SAFE Professor of Private Law, Trade and Business Law, Jurisprudence at the Faculty of Law, Goethe University Frankfurt, Germany.