Related party transactions (RPTs) are a common corporate governance issue across many jurisdictions but remain hard to regulate. Allowing value-increasing RPTs while preventing the value-decreasing ones in a cost-effective way makes regulating these transactions a challenging task. Jurisdictions have different regimes in place but, in general, make use of either procedural safeguards or substantive standards enforced by the courts (or a combination of both). In two recent papers, I pursue the question of how to design an effective and efficient RPT regulation, based on a discussion of two prevalent oversight tools.
In my paper ‘Blinded by “Fairness”: Why We Need (Strong) Procedural Safeguards in Screening Self-Dealing and Obtaining A Fair Price Is Not the Answer’, forthcoming in the European Business Organisation Law Review, I examine the court review of RPTs as an ex post oversight mechanism. Courts’ review of RPTs often takes the form of a ‘fairness test’. It has been utilised in Delaware and until relatively recently in continental Europe. Adopting ex post court review of RPTs without any procedural safeguard amounts to implementing a liability rule on RPTs (Goshen 2003). This addresses the hold-out problem and any costs associated with procedural safeguards while raising thorny questions of enforcement and bringing the ability of courts to understand and evaluate business transactions into the foreground.
In this paper, I evaluate this regulatory design from a behavioural economics perspective. Similar to social dilemmas, self-dealing can be considered either a competitive or a cooperative game between corporate insiders and (minority) shareholders. While cooperation—that is when corporate insiders only enter into value-increasing RPTs—is the best for the group as a whole, it is in the interest of the corporate insiders to divert value from the company, expropriating (other) shareholders. Legal and market constraints aim at preventing corporate insiders from turning this game into a competitive one. Yet, in addition to these external constraints, what social dilemma experiments teach is that behavioural insights matter. It is important to construct social contexts that promote cooperative behaviour and create internal constraints as well.
In the case of RPTs, such a context is created when legal regimes implement procedural safeguards that produce an arm’s length bargaining environment. Absent this, corporate insiders are at large to deal with the company, and vulnerable groups (such as minority shareholders) play tag to make corporate insiders account for their behaviour. This context both assumes and legitimates the adoption of a purely self-interested preference function by corporate insiders. This self-regarding function is strengthened by another behavioural insight: the tendency to ‘discount hyperbolically’. When there is only an ex post control of RPTs by courts, corporate insiders are to account for the harm suffered by the company after they have enjoyed benefits. In such a case, they will not be concerned (irrationally) with the consequences of their value diversion due to a hyperbolic discount while they enjoy immediate benefits. Court review of RPTs instead of procedural safeguards creates also fiduciary lawsuits which can send, when in sufficient number, the signal that diverting company value is a normal and common behaviour. This is damaging in terms of framing a social context that encourages cooperative behaviour because, as social dilemma games show, the former depends on the perceptions of others’ expectations and likely behaviours.
Another problem with the court review of RPTs is the fairness test itself. The basis of this test is objective valuation—the price range third-party market participants would be willing to buy or sell at. The problem is that objective valuation will often not be a good proxy for the value-diversion from the company. In most cases, the value lost by the company will be more than the consideration it receives because the subjective value of the asset for the company is more than its objective value. An example is when a sale of distribution facilities by the company to the controlling shareholder affects its competitiveness against a rival company in an area, and thus results in less profitability. In this case, the company will still lose value as a result of the sale even if it has occurred within a reasonable range of market prices. Although the controlling shareholder will share this loss pro rata and does not directly gain from the RPT, the transaction can still be profitable. For example, if the controlling shareholder uses the distribution facility bought from the company at the market price in order to make her other business more profitable, then she can easily offset losses resulting from the operations of the controlled company. Accordingly, I offer a new parameter for the court review of RPTs, where the value-loss for the company (or subjective valuation) will be taken into consideration even if the RPT is found to conform to arm’s length transactions.
In my paper ‘Majority of The Minority Approval of Related Party Transactions: The Analysis of Institutional Shareholder Voting’, forthcoming in the European Company and Financial Law Review, I focus on a relatively popular procedural safeguard, namely (disinterested) shareholder vote on material RPTs, also known as majority of the minority (MOM) approval of RPTs. For this RPT screening mechanism to serve the general purpose of differentiating between value-increasing and value-decreasing RPTs in a cost-effective way, first and foremost, institutional shareholders need to get informed and vote intelligently.
Despite the popularity of MOM approval among academic and policy circles (see, eg, Djankov et al. 2003; Atanasov et al. 2011, EU Commission 2014), my analysis shows that, due to agency problems, it is unlikely that institutional investors and asset managers (whether they pursue an indexing or an active management strategy) have sufficient (financial) incentives to monitor RPTs and cast informed votes on RPTs, even if the latter would harm the interests of ultimate beneficiaries. Moreover, the regulatory response to promote shareholder engagement in the form of disclosure requirements seems to have a weak effect in this regard, as a close look at the proxy voting guidelines of the largest asset managers shows. The analysis further indicates that proxy advisors have a limited role to play in helping institutional shareholders to cast informed votes. A number of factors, including very limited time and sources that are devoted to MOM votes combined with the complexity of RPTs, and conflicts of interests of proxy advisors stemming from both advising shareholders and consulting companies, make one doubt the quality and reliability of proxy advisors’ voting recommendations.
Available empirical evidence on shareholder voting on RPTs and related issues (such as say-on-pay or shareholder voting on mergers & acquisitions) delivers mixed results as to the effectiveness of the MOM approval tool to screen RPTs but still offers hints for a successful regulatory design along with the theoretical examination. Ultimately, if not well-designed, MOM approval can quickly evolve into a costly rubberstamp process rather than a screening tool.
Both theory and evidence suggest that institutional shareholders have stronger incentives to monitor RPTs when (financial) stakes are high. This means that MOM approval should be used when RPTs pass a relatively high materiality threshold and in companies where institutional shareholders would have comparatively larger ownership (such as companies listed in the premium segment). Most importantly, if MOM approval is to be used, legal rules addressing voting and engagement incentives should be improved. Rules that require, on a comply or explain basis, the disclosure of voting policies and voting itself are unlikely to have a positive effect. I propose introducing a requirement to provide justification for the votes cast in the context of MOM approval. The justification requirement may involve explaining, inter alia, which aspects of the transaction were deemed to be value-decreasing or value-increasing, and how the conclusion was reached. While this requirement would clearly increase disclosure costs, the benefits could be substantial. It may nudge institutional shareholders into voting intelligently and prevent over-reliance on other sources.
Overall, my two papers make the following arguments: (i) the fairness test applied in the court review of RPTs should be modified; (ii) effective RPT regimes should not rely only on court review without procedural safeguards to create social contexts conducive to promoting non-value-diverting behaviour from a behavioural economics perspective; (iii) MOM approval is not a silver bullet but requires a well-designed and improved regulatory context to function effectively.
Alperen Afşin Gözlügöl is Assistant Professor in the Law & Finance Cluster of the Leibniz Institute for Financial Research SAFE, Frankfurt am Main.