Related Party Transactions

1
Related Party Transactions

• Professor Dr. Joseph A. McCahery
• University of Amsterdam
• 5th Annual International Accounting Conference
• Istanbul
• November 15, 2008

2
Setting the Theme

• Related Party Transactions
• Play important and legitimate role in economy
• But if left unchecked, could foster opportunism
• Points
• (1) Through related party transactions,
  controlling shareholders and managers may extract
  private benefits of control
• (2) Potential for abuse and high cost of
  regulating these transactions has led to a range
  of regulatory strategies
• (3) Strategies and techniques include mandatory
  disclosure, board approval, fiduciary duties,
  shareholder voting

3
An Aside on Me

• Research on SSRN
• http//www.ssrn.com/author208050
• Company Law Research
• Some of US and Europe
• Public and Privately listed companies
• Related Party Transactions
• OECD Improving Transparency of Related Party
  Transactions in Russia Policy Options Paper
  (April 2005)
• Corporate Governance of Non Listed Firms (Oxford
  2008)
• Asian Roundtable on Corporate Governance (Related
  Party Transactions) (May 2008)

4
Why Should One Care About Related Party
Transactions?

• Related party transactions involve transactions
  between a parent company and subsidiary
  employees an enterprise and its principal
  owners, management or members of their immediate
  families and affiliates (OECD Principles IAS 24
  (9) FASB Statement no. 57)
• Related Party Transactions can take various forms
  including
• Transfer pricing
• Asset stripping
• Inter-company loans and guarantees
• Sale of receivables to Special Purpose Vehicle
• Leasing or licensing agreement between a parent
  and subsidiary
• Illicit related party transactions limit the
  availability of external finance and leads to
  financial underdevelopment

5
Evidence on Related Party Transactions

• Djankov et al (2008) study of 72 countries which
  measures the extent to which a countrys
  regulatory environment protects minority
  shareholders from expropriation via self-dealing
  by those who control a company common law
  countries rank highest
• Henry et al (2007) empirical study of 83 SEC
  actions shows most frequent type of enforcement
  actions were loans, payments to company officers
  for services, and sales of goods or services to
  undisclosed related entities RPTs not usually
  associated mechanisms for fraud, and their
  presence need not indicate fraudulent financial
  reporting.
• Kohlbeck and Mayhew (2004) empirical study of 1,
  261 firms 10K shows inverse association between
  the probability of RP transactions and CEO and
  director cash compensation suggesting RP
  transactions may be used to supplement
  compensation

6
Typical Related Party Transaction

• Simple transaction (purchase of equipment)
  between two entities (Buyer and Seller)
  controlled by the same shareholder (Mr James),
  who is on the board of both firms.
• Key Problem
• The proposed transaction may have a business
  purpose.
• For example, purchasing the equipment may lead to
  expanded sales.
• James is on both sides of the transaction and may
  benefit if Buyer acquires overpriced equipment
  from Seller.

7
Enrons Related Party Transactions
Swaps and Sales Contracts
Managing Member- Fastow
30 million of compen-sation
ENRON
SPE
General Partner
SPE
Outside Equity
LJM1/ LJM2 LPs
SPE
SPE
350 million
SPE
3 equity participations
Enron stock exchanged For SPE notesThe Phantom
Stock
8
Problems Identifying Related Party Transactions

• Problem
• How do we distinguish between those valuable
  transactions that yield benefits for companies
  and those abusive transactions which are
  influenced by a conflict of interest and can be
  costly for investors?
• Enron and Parmalat illustrate difficulty of
  identifying these transactions
• Evidence
• Studies indicate most financial frauds
  apparently do not involve related party
  transactions (Henry et al. 2007 SEC 2003)
• But failure to identify related party
  transactions one of the top ten audit
  deficiencies (Beasley et al. 2001)

9
Strategies for Accountants and Auditors

• Wide range of available strategies for
  accountants and auditors to facilitate disclosure
• Prompt, continuous updating of information on
  related party transactions to market (listing
  rules)
• Tool kit approach to identify material
  transactions (AICPA statement of Auditing
  Standard 45, sec 334)
• Criteria identifying material transactions
• Information on management controls information
  systems
• Extended audit and
• Review procedures for company transactions.

10
What Mechanism Detect Fraud and Illicit Related
Party Transactions?

• Detection is just a matter of time
• Uncovered by
• Internal audit
• Whistle blowers
• External auditors
• Parties on other side of transaction
• Security analysts
• Plaintiffs bar press

• Seldom uncovered by regulators
• Board responsibility
• establish effective detection system

11
Role of Corporate Governance

• Detect and deter expropriation via
• Theft
• Fraud
• Related party transactions
• Transfer pricing
• Negatively Detect and deter bad decisions and
  their continuation

• Positively engender efficient contracting
  between all parties (investors, lenders,
  managers, employee)
• Obtain resources on best possible terms
• Use them in best possible fashion

12
Limits of Effective Board Monitoring?

• Non-executive Directors can play an important
  role
• (1) informed
• (2) incented
• (3) independent.
• But, this is difficult for independent directors
  to achieve
• 1) being informed requires time and energy in
  getting to know the company, its managers and its
  strategy
• (2) being incented requires the monitor to have
  an interest in the companys outcomes
• (3) making it difficult to be independent
• Difficult to have effective independent director
  monitoring in a blockholder systemno easy
  de-biasing mechanisms

13
What Mix of Measures is Required?

• (1) Greater involvement of non-executive
  directors needed for those transactions that may
  imply a conflict of interest with management or
  controlling shareholder
• (2) By imposing penalties on false disclosure, a
  legal mandate allows honest companies to
  distinguish themselves
• (3) Effective private intermediaries are
  essential to detect and deter complex related
  party transactions and
• (4) Since a reputation model alone will not
  work, codes of conduct are also needed (code
  controls in place that specify reporting on RPTs
  to audit committee)

14
Regulating Related Party Transactions

• Basic approach
• No per se prohibition anywhere
• Regulatory constraints everywhere for directors
  and top managers
• Four main strategies
• Specific prohibitions (e.g. insider trading)
• Disclose transaction to board or public
• Board or shareholder approval
• Making managers liable

15
Prohibitions

• Company loans prohibited to buy company stock (
  402 SOXA)
• Restrictions on transactions between managers and
  third parties (non-compete rule for top
  executives, Gr)
• Insider trading restrictions on short-term sales
  (16(b) and SOXA amendments UK Listing
  Authoritys Model Code 2)
• Ban on insider trading by officers and directors
  prior to disclosure of material, non-public
  information (Art 2, EU Market Abuse Directive
  2003)

16
Disinterested Board Approval

• Applicability/Usefulness
• Listed and non listed firms
• Self-dealing, compensation, corporate
  opportunities
• Board (Japan, Germany, US) or general meeting
  (France and compensation)
• Mandatory, default or advisable?
• Opposite poles US ? France and Japan
• Practical difference is marginal
• Disclosure to the board generally required
• Liability risk in the absence of approval

17
What types of RPTs require Board Approval?

• Question are the current list of transactions
  reported sufficient?
• What other transactions should we look at?
• Family owned businessestransfer of wealth to
  next generationwithout having to pay estate tax.
  Exampleson or daughter of Chairman establish a
  private company in IT business that services the
  entire group
• Family memberssalary, benefits and compensation.
  Potential abuse by having generous pay schemes
  and benefits that may not require disclosure,
  which is especially true for SMEs. Disclose rules
  on executive pay weak in a number of emerging
  market economies

18
Duty of Loyalty

• Plays a role everywhere and requires
• Compliance with prohibitions,
• Fairness of self-dealing
• No misappropriation of corporate opportunities
• Reinforces approval requirement
• Assessing fairness
• Litigation is more common in the U.S. (but on the
  increase elsewhere)
• Role of shareholder structure in Asia and Europe

19
Transactions Involving Controlling Shareholders

• Agency Issue Controlling shareholder Minority
  shareholder
• Difference with managers
• Influence hard to contain (they have voting
  rights) and can be hidden (if not managers)
• Importance of groups of companies
• Same basic approach as for managers
• No per se prohibition anywhere
• Regulatory constraints everywhere
• But additional (exit, indemnification) or
  amended (disinterested approval) strategies

20
Amending Disinterested Approval

• Controlling shareholder dominates board and
  general meeting Credibility issue
• Procedures for disinterested approval
• Requiring directors of subsidiaries to exercise
  independent judgment and special care
  (Konzernrecht in Germany)
• Minority shareholder approval U.S. and France,
  close corporations in Germany
• Allowing minority shareholders to ask for
  independent expert France especially

21
Exit Strategy Forcing Corporate Dissolution

• Basic conditions
• Essentially for closely-held firms
• Abusive controlling shareholders (e.g.
  significant/repeated asset diversion)
• Minority shareholders claim they are oppressed
• Available in Europe and Japan, but not in
  Delaware
• Controlling shareholder buyout of minority
  shareholders if courts establishes abuse

22
Indemnification in Corporate Groups

• Two models
• Germany, with focus on legal entity
• France, with focus on economic enterprise (model
  for EU?)
• Konzernrecht
• Parent can give instructions, but must indemnify
  subsidiary
• Minority shareholders (or creditors) can sue
  parent if no indemnity
• No case law for public firms
• Only post-insolvency cases for closely held firms
• Rozenblum case
• But there must be an equitable distribution of
  costs and revenues among group members
• Parent may legitimately divert value from
  subsidiary if coherent group strategy

23
Shareholder voting

• Shareholder voting (alternative to board
  approval)
• Fr (Art L. 225-40 Code de commerce)requires
  shareholder approval of conflicted transactions
• Other jurisdictions have less demanding rules
• UK (charter provisions)
• US, Gr (self-dealing transactions not subject to
  shareholder approval)
• Restricting shareholder voting
• Eg, In 2006, SGX determined that Richard Li (who
  owns 75 of Pacific Century) was a connected
  person and would not allow him to vote in a
  proposal to sell Pacific Century 23 in PCCW.

24
General Disclosure Requirements

• Generally for listed firms only
• Deterrence value is highest
• Costs are excessive for non-listed firms?
• All material transactions with the firm
• Converging accounting standards
• U.S. Transactions above 60,000
• Compensation of top managers
• Individually Mandatory in US, recommended in EU
• Aggregate In Japan and various EU Member states
• Reporting of transactions in the firms shares
• Differences in compliance

25
Mandatory Disclosure US

• Stringent disclosure mandates (publicly listed
  firms)
• US securities law (SEC S-K,(all major
  transactions, 5) item 402 (executive
  compensation) 404 (certain relationships
  related party transactions)
• Accounting rules (GAAP SFAS 57 (related party
  disclosure) all material transactions between
  firm officers
• State law fiduciary duty law requires disclosure
  of conflicted transactions
• Sarbanes-Oxley 16(a) officers must disclose
  trades in companies shares (w/in two days)

26
Mandatory Disclosure Presupposes Effective
Enforcement

• EU US Experience
• Effective enforcement tools needed
• Presumption clear, open, effective disclosure
• Trade-offs
• Capital market implications
• Facilitates other regulatory tools and
  institutions
• But may create burdens
• May be costly for companies
• Centralized disclosure systemfront end costs
• Restricted impactdoes not impact all firms
  equally
• Administrative Liability for non-notification
• Interested parties must disclose 20
• Administrative measures needed
• Follow best practiceadopt codes, internal
  systems

27
The Role of Best Codes for Curbing Related Party
Transactions
SOFT LAW SUPPLEMENT
Shareholders
Supervisors

• Information Incentive Problems
• Adverse selection
• Moral Hazard
• Self-dealing

Directors
Family members
Employees
Creditors
Supervisory Board -Disclose any conflicts to
shareholders -Termination
-Conflicted transactions require
approval -Whistleblowers protected from
retalitation
Others
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Ex ante versus Ex post What is the evidence?

• Djankov, La Porta, Lopez-de-Silanes and Shleifer
  (2008) constructed a new index of shareholder
  protection for 72 countries.
• Addresses specifically the protection of minority
  shareholders against self-dealing transactions
  benefiting controlling shareholders.
• Better grounded in theory than index of
  anti-director rights (LLSV 1997, 1998)
• Anti-self-dealing index exhibits some of the same
  properties as both the anti-director rights
  index, and the indices of shareholder protection
  through securities laws (LLS 2006).
• It is sharply higher in Common law than in French
  civil law countries.
• Statistically significant and economically strong
  predictor of stock market development across
  countries.
• Djankov et als results support findings in
  earlier work, but also show that
  theoretically-grounded measures of investor
  protection are closely tied to financial
  development.

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Ex-Ante Control of Self-Dealing
Ex-Ante Ex-Post Public Enforcement Results
30
Ex-Post Control of Self-Dealing
Ex-Ante Ex-Post Public Enforcement
Results
31
Public Enforcement
Ex-Ante Ex-Post Public Enforcement Results
32
Stock Market Capitalization and Control of
Self-Dealing
33
Anti-Self-Dealing Index and Stock Market
Capitalization

• Figure II Partial-regression leverage plot of
  stock market capitalization and ex-ante control
  of self-dealing, controlling for Log GDPpc and
  efficiency of the judiciary.

34
Anti-Self-Dealing Index and Ln Firms / Pop

• Figure IV Partial-regression leverage plot of
  Log listed firms per million people against the
  index of anti-self-dealing, controlling for Log
  GDPpc and efficiency of the judiciary..

35
Anti-Self-Dealing Index and IPOs/GDP

• Figure V Partial-regression leverage plot of
  IPOs-to-GDP against anti-self-dealing in
  regressions controlling for Log GDPpc and
  efficiency of the judiciary..

36
Anti-Self-Dealing Index and Block Premium

• Figure VI Partial-regression leverage plot of
  Block Premium against the index of
  anti-self-dealing, controlling for Log GDPpc and
  efficiency of the judiciary..

37
Conclusion What is needed?

• Improved educationinvestors need to be educated
  about their rights, fiduciary duties and how to
  bring an action
• A. directors need to be trained about the
  function of fiduciary duties, RPTs, COIs, related
  disclosure rules and how to act properly in the
  case of a RPT (disclosure, recusal, and made
  aware of penalties and other sanctions)
• B. Courts also need expert training on the legal
  effects of RPTs, the relevant remedies and burden
  of proof requirements
• C. Training needed for regulators in terms of
  developing more effective investigation
  mechanisms to detect illicit RPTs

38
Some policy suggestions

• .Lower barriers for shareholders to bring
  lawsuits. Evidence suggests that lowering the
  costs and barriers to suit in Korea and Japan had
  a positive effect on the behavior of BODs vis a
  vis fiduciary duties
• ADRmay be useful to consider having special ADR
  mechanisms at exchanges or with regulators that
  would be comprised of trained arbitrators to hear
  shareholders complaints

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• Thank you.
• J.A. McCahery_at_uva.nl