Though no longer surprising, corporate scandals can still involve the unexpected. Take the recent Carlos Ghosn and Nissan saga, for example. Aside from its sensational aspects, what is striking about the scandal was Ghosn’s alleged value-diverting related party transactions (“RPTs”) (see here and here). Though not unusual on their own, RPTs can be noteworthy when they occur between a director or manager (who is not a significant or controlling shareholder) and a company with a controlling shareholder. Ghosn was the chairperson of the board of directors of Nissan, which was controlled by another automobile company, Renault SA, (see here and here). This situation is contrary to the expectation of corporate law theory that, in controlled companies, controlling shareholders have sufficient (financial) incentives and skills to monitor directors or managers and prevent their value-diverting activities (see, eg, Shleifer & Vishny 1997; Gilson 2006; Conac, Enriques & Gelter 2007).

In a recent article, I use hand-collected data to analyze the phenomenon of RPTs by directors or managers in companies with concentrated or diffuse ownership. I present four possible scenarios in controlled companies: (i) the conventional wisdom, with its ”strong-monitoring hypothesis,” (ii) a “weak-monitoring hypothesis,” according to which controlling shareholders can be weak monitors because, for example, they are captured by directors or managers or have weak monitoring incentives and skills, (iii) a ”quid pro quo hypothesis,” which deems  RPTs with managers or directors as a reward (or quid pro quo) by the controlling shareholder to offset the risks or losses directors or managers incur by turning a blind eye to or allowing the controlling shareholder’s own value-diverting activities, and (iv) an “evasion hypothesis,”’ according to which controlling shareholders use directors or managers as a conduit by first allowing them to transact with the company and then transacting directly with them to acquire the relevant (company) asset in order to evade more stringent rules for controllers’ self-dealing or potential intensive media/regulatory/investor attention.

In companies with diffuse ownership, RPTs with managers or directors are generally downplayed. The conventional wisdom deems executive remuneration a more significant way to divert company value for directors or managers than other types of RPTs because, for example, directors or managers are considerably less likely to own significant business enterprises to which they can divert value from the public company they manage (see, eg, Bebchuk & Hamdani 2009; Gutiérrez & Sáez 2017). However, given the stricter regulatory regime executive remuneration may face and its eye-catching and controversial nature, directors or managers may prefer RPTs as a tunneling technique.

In order to understand which of these hypotheses can be supported by empirical evidence, I formed a dataset on RPTs entered into by directors or managers in companies listed on the prime standard of the German stock exchange for two consecutive years (2018 and 2019). These transactions include every type of transaction that was concluded with directors or managers who were not a significant or controlling shareholder, or with their related entities or persons, except for remuneration contracts and those whose value were under €10.000 (henceforth, ”relevant RPTs”). The dataset includes 301 companies in total along with descriptive statistics about their shareholding structure.

Overall, for controlled companies, the data provide support for the above hypotheses to different degrees. On the one hand, there is strong support for the conventional wisdom’s strong-monitoring hypothesis. Most of the companies did not report any relevant RPTs in two consecutive years. The types and values of RPTs also suggest, on their own, that they were not expropriating any substantial company value (especially when compared with materiality thresholds generally used in RPT regulations across different jurisdictions).

On the other hand, one can also find at least some support for two other hypotheses: the quid pro quo hypothesis, which expects collusion between managers or directors and controlling shareholders in terms of self-dealing, and the weak-monitoring hypothesis, which holds certain controllers as weak monitors. Generally, a significant number of companies with large blockholders report RPTs with directors or managers in both years (between 30-40 percent, depending on how one defines large blockholder), which may have been employed to divert company value due to weak monitoring by the controller, or as a quid pro quo. Furthermore, the quid pro quo hypothesis would predict that RPT values need not be conspicuously large; they should be just big enough to cover any risks or losses that directors or managers may face in acquiescing to abuse of control by the controlling shareholder. It would further predict that relevant RPTs should concentrate among directors tasked with the oversight of the company. Both predictions seem to be confirmed.

Out of companies with concentrated ownership that reported relevant RPTs, for a significant number (around 61 percent), these RPTs involved supervisory board members directly or indirectly – the primary oversight body for most of the companies on the German stock exchange (see, eg, Hopt 2016). Moreover, the data show that, for supervisory board members, the value of an overwhelming number of RPTs is greater than their remuneration. Thus, even RPTs of low value may be more valuable than compensation packages. In terms of the weak monitoring hypothesis, some relevant RPTs were reported by companies where controllers can be deemed as weak monitors because of their identity, such as heirs (see, eg, Villalonga & Amit 2006) and companies with diffuse ownership, or because of their relatively low shareholding (between 10 percent and 25 percent) or pyramidal share-ownership structure, which would dilute incentives to monitor due to reducing the economic stake. For the evasion hypothesis, which predicts a two-step scheme of tunneling first to the manager or director and from there to the controller, the data do not provide any supporting evidence. In contrast to what would be predicted by this hypothesis, the data show that, in most companies that reported relevant RPTs with directors or managers, controllers also directly entered into RPTs with the company, which refutes any need or preference for an evasive scheme involving company directors or managers.

Finally, in terms of companies with diffuse ownership, where executive remuneration is expected to dominate RPTs as a tunneling method, a non-negligible part of these companies (33 percent) reported RPTs with directors or managers. Also notable is that the value of most of these RPTs was higher than the relevant remuneration for the director or manager, which shows that RPTs can provide larger benefits than remuneration packages. These transactions also confirm that venues exist for directors or managers to divert company value (such as transactions concerning sales of goods or the provision of services under, among others, consulting and financial agreements).

Overall, it is likely that the extent to which the above hypotheses reflect the actual situation varies in time and from one company to another. For jurisdictions that are concerned with the problem of managerial or directorial RPTs in controlled companies, there are a few regulatory tweaks to make the RPT regime more robust. These would include (i) strengthening independent directors’ monitoring role and ensuring their independence from the controlling shareholder and (ii) excluding the controlling shareholder from the shareholder vote on RPTs with directors or managers even if he or she is not the (direct) conflicted party. In any event, there is substantial room for improvement regarding the RPT disclosure of listed companies, which occasionally suffer from the lack of clarity in the information provided regarding the identities of related parties, transaction types, and values.

This post comes to us from Alperen Afşin Gözlügöl, a junior fellow at the Center for Advanced Studies on the Foundations of Law & Finance and a prospective postdoctoral researcher at the Leibniz Institute for Financial Research SAFE, Frankfurt am Main. It is based on his recent article, “Related party transactions by directors/managers in public companies: a data-supported analysis,” available here. A version of this post appeared on the Oxford Business Law Blog.