The Role of the Board in Related
Party Transactions
Jospeh A. McCahery
University of Amsterdam
2006 OECD Policy Dialogue on Corporate Governance in India
New Delhi
February 16-17, 2006
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
Regulating Related Party Transactions
LEGAL FRAMEWORK for Related Party Transactions:
(1) Mandatory Disclosure
(2) Duty of Loyalty
(3) Board Approval
(4) Shareholder Voting
Availability of external
finance increases and leads
to financial development
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
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.
Mr. James
Mr. James owns 60% of
Buyer Co. shares
Mr. James owns 90%
of Seller Co. shares
Seller Co.
Buyer Co.
Buyer Co. buys equipment from Seller Co.
 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.
Legal Regulation of 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
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.
Enron’s Related Party Transactions
Swaps and
Sales
Contracts
Managing
MemberFastow
SPE
ENRON
$30 million
of
compensation
General
Partner
SPE
SPE
SPE
SPE
Enron stock exchanged
For SPE notes—The Phantom Stock
Outside
Equity
LJM1/
LJM2
LPs
$350 million
3% equity participations
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
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
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
company’s outcomes
(3) making it difficult to be independent
Effective external board members have to be part of the management
process. How can a director be independent of a CEO he has helped hire
or of a business strategy that he has assisted designing?
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 needed as well.
Legal Framework:
Corporate Law
Fiduciary duties; board
approval; shareholder voting;
Prohibitions on certain
transactions
Mandatory Disclosure:
Listing Rules and Securities
Regulation
Codes of Conduct:
-Comply or explain approach
-Defines and regulates
material conflicts; disclosure
rules on holdings; rules on
shareholders’ rights;
liability rules for directors
Fiduciary Duties
Similar approaches in common law and civil law jurisdictions—less
willing to review conflicted transactions approved by board
US has more developed case law:
Duty of loyalty: proscribes mangers from entering self-dealing or unfair
transactions
(1) Courts review conflicted transactions, but less willing to review
decisions approved by disinterested director
(2) Incentives for direct and derivative shareholder suits (procedural
obstacles are high outside US)
Prohibitions on Conflicted Transactions
Company loans prohibited to buy company stock (§ 402 SOXA)
Restrictions on transactions between managers and third parties (noncompete rule for top executives, Gr)
Insider trading: restrictions on short-term sales (16(b) and SOXA
amendments; UK Listing Authority’s 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])
Board Approval
Anglo-Saxon & some Continental European jurisdictions encourage board
approval of conflicted transactions: supplies strong protection from
shareholder challenge
1) US states that follow Revised Model Business Corporation Act
(RMBCA) give business judgment rule protection to conflicted
transactions after approval
2) Non-RMBCA (Del) permit such approval to shift the burden of
proof to fairness (or unfairness) from the defending director to the
challenger
3) Board approval of conflicted transactions (NL,Fr)
4) Directors must disclose personal interests in company related
transactions (§ 317CA 1985; Comment to §5.02(a)(1) ALI
Principles on Corporate Governance 1994)
5) Minority shareholder approval of controlling shareholder
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)
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)
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 system—front end costs
Restricted impact—does not impact all firms equally
Administrative Liability for non-notification
Interested parties must disclose 20%
Administrative measures needed
Follow best practice—adopt codes, internal systems
The Role of Best Codes for Curbing Related Party
Transactions
SOFT LAW SUPPLEMENT
Shareholders
Supervisors
Directors
Information &
Incentive Problems:
Family
members
•Adverse selection
Employees
•Moral Hazard
Self-dealing
Creditors
Others
Supervisory Board
-Disclose any conflicts
to shareholders
-Termination
-Conflicted transactions
require approval
-Whistleblowers
protected from
retalitation
What is the Evidence?
 Lopez-de-Silanes et al. constructed a new index of shareholder protection for 72
countries.
 Addresses specifically the protection of minority shareholders against selfdealing 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 antidirector 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.
 Results support findings in earlier work, but also show that theoretically-grounded
measures of investor protection are closely tied to financial development.
Ex-Ante
Ex-Post
Public Enforcement
Results
Ex-Ante Control of Self-Dealing
United Kingdom
United States
Average English origin
Approval by
disinterested
shareholders
1
0
0.48
1.00
1.00
0.62
1.00
1.00
0.95
1.00
0.00
0.48
1.00
0.67
0.68
Ex-ante
private control
of self-dealing
1.00
0.33
0.58
France
Italy
Average French origin
1
0
0.25
1.00
0.00
0.35
1.00
0.50
0.64
1.00
0.00
0.25
1.00
0.17
0.41
1.00
0.08
0.33
Germany
Japan
Average German origin
0
0
0.14
0.33
0.33
0.38
0.50
1.00
0.43
0.00
0.00
0.43
0.28
0.44
0.41
0.14
0.22
0.28
Sweden
Average Scandinavian
0
0.00
1.00
0.73
0.00
0.40
0.00
0.20
0.33
0.44
0.17
0.22
Average Civil Law
World Average
0.20
0.28
0.40
0.46
0.56
0.67
0.29
0.35
0.42
0.49
0.31
0.39
2.48
1.72
0.80
1.26
T-Stat (numbers in bold are significant at 10%)
1.99
4.55
1.48
3.52
2.23
3.52
1.72
3.19
0.21
1.72
1.20
0.02
2.05
1.35
0.24
0.21
3.36
2.65
0.56
0.79
Country
Common vs. Civil
French vs Common
French vs German
French vs Scandinavian
Disclosure
by Buyer
Disclosure by Independent
James
review
Ex-ante
disclosure
Ex-Ante
Ex-Post
Public Enforcement
Results
Ex-Post Control of Self-Dealing
Disclosure
Ease of
Ease of holding
Ex-post
Standing to
Access to Ease of proving
Anti-selfCountry
Rescission holding Mr. approving body
in periodic
private control
sue
evidence wrongdoing
dealing index
filings
James liable
liable
of self-dealing
United Kingdom
1.00
1.00
0.33
0.50
0.50
1.00
0.71
0.85
0.93
United States
1.00
1.00
1.00
1.00
1.00
0.75
0.94
0.97
0.65
Average English origin
0.78
0.90
0.62
0.64
0.74
0.73
0.73
0.76
0.67
France
Italy
Average French origin
1.00
1.00
0.44
1.00
1.00
0.53
0.33
0.00
0.11
0.00
0.00
0.28
0.50
0.50
0.34
0.00
0.25
0.41
0.40
0.38
0.34
0.70
0.69
0.39
0.85
0.39
0.36
Germany
Japan
Average German origin
0.40
0.80
0.56
1.00
1.00
0.79
0.00
0.00
0.05
0.50
1.00
0.39
0.50
1.00
0.50
0.25
0.75
0.47
0.44
0.69
0.44
0.42
0.74
0.50
0.28
0.48
0.39
Sweden
Average Scandinavian
0.40
0.56
1.00
0.80
0.00
0.13
0.50
0.60
0.50
0.40
1.00
0.75
0.63
0.55
0.51
0.55
0.34
0.39
Average Civil law
World average
0.48
0.57
0.63
0.71
0.10
0.25
0.34
0.43
0.39
0.49
0.46
0.54
0.39
0.49
0.44
0.53
0.37
0.46
8.04
8.70
2.10
2.88
6.60
6.73
1.85
1.72
5.75
5.12
0.44
0.29
Common vs Civil
French vs Common
French vs German
French vs Scandinavian
3.76
3.91
1.19
0.77
2.41
3.04
1.64
1.12
9.68
7.89
1.39
0.24
T-Stat (numbers in bold are significant at 10%)
3.46
4.35
4.26
3.74
4.26
5.30
1.23
2.17
0.87
2.40
0.50
3.53
Ex-Ante
Ex-Post
Public Enforcement
Results
Public Enforcement
Approving parties
Country
Applicable fines Prison term
United Kingdom
0.00
0.00
United States
0.00
0.00
Average English origin
0.37
1.26
Mr. James
Applicable fines Prison term
0.00
0.00
0.00
0.00
0.26
1.58
Public enforcement
index
0.00
0.00
0.30
France
Italy
Average French origin
1.00
0.00
0.42
5.00
0.00
2.39
0.00
0.00
0.32
0.00
0.00
1.89
0.50
0.00
0.40
Germany
Japan
Average German origin
1.00
0.00
0.50
5.00
0.00
3.36
1.00
0.00
0.36
5.00
0.00
2.29
1.00
0.00
0.46
Sweden
Average Scandinavian
1.00
0.60
2.00
2.40
1.00
0.60
2.00
0.80
1.00
0.55
Average civil law
World average
0.46
0.43
2.66
2.28
0.36
0.33
1.89
1.81
0.43
0.39
1.70
1.35
0.90
0.01
T-Stat
0.75
0.44
0.22
1.19
0.39
0.35
0.43
0.87
1.09
0.75
0.50
0.74
Common vs Civil
French vs Common
French vs German
French vs Scandinavian
0.68
0.35
0.49
0.74
Stock Market Capitalization and
Control of Self-Dealing
Dependent Variable: Stock-market-capitalization-to-GDP ratio
[1]
Approval by disinterested shareholders
[2]
[3]
[4]
[5]
27.35c
[15.54]
43.37c
[22.45]
Ex-ante disclosure
43.64b
[21.89]
Ex-ante private control of self-dealing
42.42a
[16.15]
Disclosure in periodic filings
62.50b
[29.99]
Difficulty proving wrongdoing
Ex-post private control of self-dealing
Ln GDP/POP
Time to collect on a bounced check
Constant
Observations
R-squared
Robust standard errors in brackets
[6]
23.73a
[4.61]
-15.11c
[8.50]
-70.01
[57.90]
72
0.397
21.26a
[4.35]
-15.02c
[7.94]
-63.44
[49.14]
72
0.404
22.82a
[4.36]
-13.95c
[7.63]
-77.61
[51.07]
72
0.411
20.20a
[4.17]
-15.80c
[9.32]
-53.15
[58.34]
72
0.406
20.85a
[4.08]
-16.14c
[8.70]
-63.19
[54.85]
72
0.408
73.09a
[26.31]
19.50a
[4.09]
-14.66c
[8.45]
-67.67
[53.83]
72
0.428
300
Anti-Self-Dealing Index and
Stock Market Capitalization
200
Hong Kong
100
Switzerland
-100
0
Finland
Tunisia
-1
South Africa
Malaysia
Zimbabwe
United Kingdom
Singapore
Jordan
Luxembourg
Chile
Canada
Greece
Philippines
China
Pakistan
Kenya
Australia
Jamaica
Nigeria
India
United
StatesTaiwan
Sweden
Indonesia Thailand
Bolivia
Netherlands
Ghana
Sri Lanka Peru
Morocco
Egypt
Ukraine Uganda
France
Colombia
Russia
PolandArgentina
EcuadorSpain
Bulgaria
Italy Portugal
Brazil
Hungary
Turkey
Romania
Israel
Slovak
Rep.
Kazahkstan
Croatia
Panama
Iceland
Czech
Rep.
Mexico
Belgium
Ireland
Latvia
Korea
(Rep.)
Lithuania
Venezuela
Germany
El Salvador
Uruguay
Denmark
Japan
Austria
New Zealand
Norway
-.5
0
Residual ex-ante private control of self-dealing Index
.5
coef = 43.641173, (robust) se = 21.891642, t = 1.99
 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.
4
Anti-Self-Dealing Index and
Ln Firms / Pop
Romania
Bulgaria
2
Slovak Rep.
JordanIceland
HongMalaysia
Kong
Israel
Sri
Lanka
Singapore
Egypt
India
Australia
Luxembourg
Pakistan
Canada
Zimbabwe
Jamaica
Spain
New Zealand
Lithuania
Greece
Korea (Rep.)
South Africa
Chile
Croatia
PeruTaiwan
Ukraine
Denmark
Thailand
United
Kingdom
PanamaSwitzerland
Norway
Kenya
El Salvador
Sweden
Czech Rep.
Finland
NigeriaGhana
BoliviaPhilippines
United States
Turkey
Ireland
Poland
Ecuador HungaryJapan
Belgium
Kazahkstan
Indonesia
Portugal
Colombia
France
Morocco
Netherlands
Austria
Germany
Uruguay
Brazil
Russia
China
Venezuela
Argentina
Italy
Mexico
0
Latvia
-2
Tunisia
-4
Uganda
-.6
-.4
-.2
0
Residual index of anti-self-dealing
.2
.4
coef = .92828318, (robust) se = .48995258, t = 1.89
 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..
Anti-Self-Dealing Index and
IPOs/GDP
United Kingdom
6
Taiwan
Greece
4
Hong
Kong
Australia
Canada
Malaysia
0
2
Switzerland
Italy
Sweden
Korea (Rep.)
Philippines
Kenya
Zimbabwe
Egypt
India Nigeria
United Pakistan
States
Ireland Singapore
Indonesia
Sri Lanka
-2
Turkey
-4
Netherlands
-.6
-.4
Ecuador
Jordan
Spain
Germany
Venezuela
Brazil
MexicoJapan
Uruguay
Norway
Austria
Denmark
Finland
Thailand
Portugal
Peru
Belgium
Chile
Argentina
-.2
0
Residual index of anti-self-dealing
South
Africa
Colombia
France
Israel
New Zealand
.2
.4
coef = 3.7124945, (robust) se = 1.7414808, t = 2.13
 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..
.4
Anti-Self-Dealing Index and
Block Premium
Brazil
Mexico
.2
Austria
Czech Rep.
Venezuela
Korea (Rep.)
Israel
0
Netherlands
Germany
Turkey
Denmark
Japan
Switzerland
Norway
Philippines
Portugal
Chile
United States
Italy
Peru
Argentina
Sweden
Spain
-.2
FinlandTaiwan
Poland
Egypt
Singapore
New
Zealand
Hong
Kong
Malaysia
Colombia
United Kingdom
South Africa Thailand
France
Indonesia
Australia
Canada
-.6
-.4
-.2
0
Residual index of anti-self-dealing
.2
.4
coef = -.21647624, (robust) se = .07665182, t = -2.82
 Figure VI: Partial-regression leverage plot of Block Premium against the index of antiself-dealing, controlling for Log GDPpc and efficiency of the judiciary..