Related party transactions (RPTs) are a common corporate governance concern that cuts across many jurisdictions but remains hard to regulate. Allowing value-increasing RPTs while preventing the value-decreasing ones in a cost-effective way is a challenging task for regulators. Jurisdictions do it in different ways but, in general, use 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 one paper, I examine the court review of RPTs as an ex post oversight mechanism. Courts in Delaware and, until recently, Europe often use a “fairness test” to review RPTs. Ex post court review of RPTs without any procedural safeguards amounts to a liability rule on RPTs (Goshen 2003). This addresses the hold-out problem (namely, the opportunistic behavior of minority shareholders when procedural tools give them bargaining power) and any costs associated with procedural safeguards while raising thorny questions of enforcement and highlighting whether courts can understand and evaluate business transactions.
In this paper, I evaluate this regulatory design from a behavioral 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 enter into only value-increasing RPTs – is best for the group as a whole, it is in the interest of the corporate insiders to divert value from the company and, thus, other shareholders. Legal and market constraints aim to prevent corporate insiders from turning this game into a competitive one. Yet, in addition to these external constraints, what social dilemma experiments teach is that behavioral 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 exists when procedural safeguards ensure an arm’s length bargaining environment. Otherwise, corporate insiders are free to deal with the company, and vulnerable groups (such as minority shareholders) need to go after corporate insiders to make them account for their behavior. This scenario assumes and legitimates a purely self-interested approach by corporate insiders which is strengthened by another behavioral insight: the tendency to “discount hyperbolically”; in other words, the tendency of individuals to reward the imminent benefits while discounting the non-imminent punishment. Ex post control of RPTs by courts allows corporate insiders to enjoy the benefits of RPTs before having to account for the harm to the company. The insiders 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 without procedural safeguards also prompts lawsuits, which can suggest to the outside world that diverting company value is common. This discourages cooperative behavior, which, as social-dilemma games show, depends on the perceptions of others’ expectations and likely behaviors.
Another problem with court review of RPTs is the fairness test itself, whose basis is objective valuation – the price range within which third-party market participants would be willing to buy or sell. The problem is that objective valuation will often not be a good measure of the value diverted from the company. In most cases, that value will exceed the consideration the company receives, because the subjective value of the asset for the company is more than its objective value. For example, a sale of distribution facilities by a company to a controlling shareholder can affect the company’s competitiveness against a rival and thus reduce profits. In that case, the company would lose value as a result of the sale even if the sale price was within a reasonable range. Although the controlling shareholder would share this loss pro rata and not gain directly from the RPT, the transaction could still be profitable. For example, if the controlling shareholder used the distribution facility bought from the company at the market price to make her other business more profitable, then she could 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 another paper, I focus on a relatively popular procedural safeguard, (disinterested) shareholder vote on material RPTs, also known as majority of the minority (MOM) approval of RPTs. This RPT screening mechanism can differentiate between value-increasing and value-decreasing RPTs in a cost-effective way, but only if institutional shareholders are 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, disclosure requirements seem to have only a weak effect in promoting shareholder engagement, as a close look at the proxy voting guidelines of the largest asset managers shows. The analysis further indicates that proxy advisers play a limited role in helping institutional shareholders cast informed votes. What’s more, the quality and reliability of proxy advisers’ voting recommendations are questionable, given the very limited time and resources advisers devote to MOM votes, the complexity of RPTs, and the conflicts of interest from advising shareholders and consulting with companies.
Empirical evidence of shareholder voting on RPTs and related issues (such as say-on-pay or voting on mergers) is mixed on the effectiveness of the MOM approval to screen RPTs but still offers hints for a successful regulatory design. 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 important, if MOM approval is to be used, legal rules addressing voting and engagement incentives should be improved. Rules that require disclosure of voting policies and voting itself are unlikely to have a positive effect. I propose a requirement to provide justification for the votes cast in the context of MOM approval. Justification could involve explaining which aspects of the transaction were considered 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 might 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 behavior from a behavioral economics perspective; (iii) MOM approval is not a silver bullet but requires a well-designed and improved regulatory context to function effectively.
This post comes to us from Alperen Afşin Gözlügöl, an assistant professor in the Law & Finance Cluster of the Leibniz Institute for Financial Research SAFE, Frankfurt am Main. It is based on his two recent papers, ”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 and available here, and “Majority of The Minority Approval of Related Party Transactions: The Analysis of Institutional Shareholder Voting,” published in the European Company and Financial Law Review and available here. A version of this post appeared on the Oxford Business Law Blog.