The quality of corporate governance, ie the effectiveness of institutions that contain agency costs, is a key component of asset allocation. In countries characterized by concentrated ownership, minority shareholder expropriation, also known as tunneling, is the main concern from the perspective of outside investors. Tunneling can be the outcome of a number of expropriation techniques. A common way to extract value from the controlled corporation is for the dominant shareholder to engage in transactions with it at favourable terms (so-called related party transactions or, hereafter, ‘RPTs’).
Informed investors are aware of the risk of tunneling: they will thus discount the share price at which they are willing to invest. In practice, however, the probability and scope of the looming expropriation are hard to gauge ex ante and therefore the appropriate discount is difficult to establish, leading to noisy estimates. In addition, even with perfect pricing, from the perspective of social planners in individual countries, tunneling, by raising firms’ cost of capital, makes equity markets less vibrant, reduces funding opportunities for businesses and ultimately impairs growth. That explains the focus on tunneling, and often more specifically on related party transactions, by international economic organizations (such as the World Bank and the OECD), supranational and national legislators.
However, individual RPTs can be in the best interest of the individual company involved and create value for society as a whole. While in most cases a transaction in the best interest of the company will also create value for society, and vice versa, that may not always be the case. We can call transactions that are in the best interest of the company ‘fair’ and those that enrich the relevant parties (without offsetting third-party effects) ‘value-creating’.
Corporate lawmakers around the world attempt to strike the right balance between the need to curb insiders’ tunnelling and preserving the advantages of letting a company enter into fair and value-creating RPTs. They have to do so in the knowledge that, in a world of information asymmetries and uncertainty, distinguishing between transactions that are ‘good’ and transactions that are ‘bad’ is difficult even for internal decision-makers, let alone for outsiders, including enforcement institutions, that frequently can neither observe nor verify critical facts. Here, the following fundamental questions arise: (1) who screens ‘good’ RPTs in the best interest of the company and society at large from ‘bad’ or harmful ones? (2) How does the screen work? (3) When does it operate (before or after the RPT is entered into)?
In a recently published book, ‘The Law and Finance of Related Party Transactions’ (Cambridge University Press: 2019), leading scholars in the field of law and finance from around the world provide a comprehensive analysis of the challenges legislators face in regulating related party transactions in a socially beneficial way. The volume combines contributions that examine the theoretical foundations of an efficient regulation of related party transactions with chapters that look at specific legal regimes from an empirical and/or comparative law perspective. The selection of jurisdictions surveyed grants in-depth insights on a broad variety of regulatory strategies and their interdependence with socio-economic and political conditions. The book not only provides state of the art scholarship but also allows readers to draw conclusions on which regulatory responses work under which circumstances.
In the introductory chapter we not only seek to outline recurring themes and hint at original insights in the chapters but also attempt to relate the contributions to the specific policy choices European legislators have to make in their effort of implementing the rules on related party transactions in Art. 9c of the revised Shareholder Rights Directive. In particular, we ask the following questions:
- How pervasive should RPTs’ ad hoc disclosure be?
- How should independent directors be involved in the RPT approval process?
- To what extent should shareholders be given a say on RPTs?
- Which RPTs should be exempt?
- What should the role of courts and securities regulators be in the enforcement of RPT rules?
The following previous OBLB posts have summarised the contents of some of the book’s chapters:
- San Yop Kang, Optimally Restrained Tunneling: The Puzzle of Controlling Shareholders’ ‘Generous’ Exploitation in Bad-Law Jurisdictions.
- Jesse M. Fried, Powering Preemptive Rights with Presubscription Disclosure.
- Alessio Pacces, Optimal Review of Related Party Transactions: The Case for NCS-dependent Directors.
- Curtis Milhaupt and Mariana Pargendler, Related-Party Transactions in State-Owned Enterprises: Tunneling, Propping and Policy Channeling.
- Kristin Van Zwieten, The Avoidance of Related Party Transactions in Insolvency.
- Kon Sik Kim, Related Party Transaction in East Asia.
- Dan Puchniak and Umakanth Varottil, Related Party Transactions in Commonwealth Asia.
- Tobias Tröger, Germany’s Reluctance to Regulate Related Party Transactions.
- Paul Davies, Related Party Transactions: UK Model.
- Amir Licht, Be Careful What You Wish For: How Progress Engendered Regression in Related Party Transaction Regulation in Israel.
- Marcello Bianchi, Luca Enriques and Mateja Milic, Enforcing Rules on Related Party Transactions in Italy: One Securities Regulator’s Challenge.
The following chapters are available as working papers on SSRN:
- Edward B. Rock, Majority of the Minority Approval in a World of Active Shareholders.
- Assaf Hamdani and Yishay Yafeh, Institutional Investors as Minority Shareholders.
- Geneviève Helleringer, Related Party Transactions in France: A Critical Assessment.
The remaining chapters are:
- Zohar Goshen and Assaf Hamdani, Corporate Control and the Regulation of Controlling Shareholders.
- Jens Dammann, Related Party Transactions and Intragroup Transactions.
Luca Enriques is the Allen & Overy Professor of Corporate Law at the University of Oxford Faculty of Law.
Tobias H. Tröger is SAFE Professor of Private Law, Trade and Business Law, Jurisprudence at the Faculty of Law, Goethe University Frankfurt, Germany.