Related party transactions (RPTs) refer to a transfer of resources, services, or obligations between a reporting entity and a related party and usually offer insiders a way to expropriate wealth from other investors via self-dealing. Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) require detailed disclosure of material RPTs in annual reports and proxy statements. However, none of these regulators provided specific guidance on firms’ corporate governance related to ensuring that RPTs work in the best interest of the firm and its stakeholders. Investors were often kept in the dark on whether the firm had an RPT governance policy, and how RPTs were reviewed and approved in the firm.

To facilitate investors’ assessment of the potential conflict of interest arising from RPTs, in 2006 the SEC amended its regulations for RPT disclosures by issuing a document titled Executive Compensation and Related Person Disclosure. This document includes a new requirement to disclose RPT governance, including material features of RPT governance policies and procedures (hereafter, RPT governance policies). Specifically, the disclosures should include (1) a statement of whether such policies are in writing and, if not, how they are evidenced; and (2) the persons or groups of persons on the board of directors or otherwise who are responsible for administering the policies. Additionally, the new regulation requires firms to disclose the types of transactions that are covered by the RPT governance policies, the standards to be applied pursuant to such policies, and any transactions that do not follow these policies.

This 2006 SEC document includes amendments to both compensation disclosures and governance disclosures. Although some studies have examined the consequence of the changes in compensation disclosures, the consequences of the changes in RPT governance disclosures have received little attention. In a recent paper, we investigate the economic consequences of the SEC regulation from two perspectives: (1) does the mandatory disclosure of RPT governance change firms’ RPT behaviors; and (2) does the mandatory disclosure of RPT governance help reduce investors’ perceived risks on RPTs?

Before 2006, only a few firms voluntarily disclosed how they monitor their RPTs.  In contrast, the 2006 SEC regulation requires that all firms disclose their RPT governance, representing an exogenous increase in RPT governance disclosure. We define firms that voluntarily disclosed their RPT governance before the 2006 regulation as already-disclosed firms (Control Group) and firms that initiated RPT governance disclosure after the 2006 regulation as newly-disclosed firms (Treatment Group). Because the already-disclosed firms have voluntarily disclosed their RPT governance prior to 2006, we expect that the impact of the 2006 regulation on the already-disclosed firms, on average, is significantly less than that on the newly-disclosed firms.

The conflict-of-interest view considers RPTs as a potentially harmful form of expropriating wealth from shareholders. The 2006 regulation improves internal monitoring because these mandatory disclosures help enhance the implicit contracting between the board and the firm as well as the contracting between firms and investors, thereby mitigating potential opportunistic behaviors of insiders. Consequently, we predict that the mandatory disclosure of RPT governance leads to a lower level of RPTs and lower cost of capital associated with RPTs. We further hypothesize that such effects are more pronounced for firms with weaker corporate governance ex ante (hereafter “low-monitored firms”) and for RPTs that are more likely to represent opportunism.

To test these hypotheses, we hand collect information regarding RPTs and RPT governance for all S&P 1500 non-financial firms from annual proxy statements for fiscal years 2004, 2007, and 2010. We find that, after the 2006 regulation, newly-disclosed firms significantly reduce RPT activities relative to already-disclosed firms. We also find that there is a significant reduction in the implied cost of capital (ICC) for newly-disclosed firms.

Using five proxies for board independence and monitoring incentives, we find evidence that changes in RPTs and ICC are more pronounced for low-monitored firms, suggesting that the effects are associated with the strength of corporate governance. Recognizing that not all RPTs are prone to opportunistic behaviors, we group RPTs into Business RPTs and Non-Business RPTs and find that the SEC regulation leads to more reduction in Non-Business RPTs, which is consistent with the conflict of interest theory.

Firms’ RPT governance varies with respect to whether it is in written form, who is the party responsible for reviewing and approving RPTs, and the extent of (long or short) RPT governance disclosures. Such choices made by the firm could have different consequences on investors’ perception of RPT risks. Hence, in additional analyses, we examine firms’ choices of RPT governance policy in the post-regulation period and assess whether such choices are associated with investors’ adjustment in ICC. We find that investors put a significantly lower RPT risk premium on firms with a written RPT policy, with a formal committee to review RPTs, and with a more extensive RPT governance disclosure, suggesting that RPT firms benefit from creating or maintaining strong RPT governance policies.

In sum, we find that the disclosure of RPT governance policies significantly reduces the occurrence of RPTs and the implied cost of equity capital associated with RPTs. Such changes are associated with strength of board monitoring, types of RPTs, and actual RPT governance policies. All findings suggest that the initiation of RPT governance disclosure required by the regulation significantly enhances firms’ RPT governance, and the quality of firms’ RPT governance matters to investors.

This post comes to us from  Professor Ole-Kristian Hope at the University of Toronto’s Rotman School of Management and Professor Haihao Lu at the University of Waterloo. It is based on their recent paper, “Economic Consequences of Corporate Governance Disclosure: Evidence from the 2006 SEC Regulation on Related-Party Transactions,” available here.