Procedural and Substantive Review of Related Party Transactions (RPTs): The Case for Non-Controlling Shareholder-Dependent (NCS-Dependent) Directors

A version of this paper will appear as a chapter in Luca Enriques and Tobias Tröger, eds., The Law and Finance of Related Party Transactions (Cambridge University Press, Forthcoming)

European Corporate Governance Institute (ECGI) - Law Working Paper No. 399/2018

35 Pages Posted: 7 May 2018 Last revised: 14 May 2018

Alessio M. Pacces

Erasmus School of Law, Erasmus University Rotterdam - Rotterdam Institute of Law and Economics; European Corporate Governance Institute

Date Written: May 8, 2018

Abstract

In publicly traded companies, related party transactions (RPTs) are an obvious vehicle for shareholder expropriation. However, they may also be efficient, particularly when they are motivated by transaction cost savings. This paper aims to identify which type of RPT review is not only effective (i.e. stops value-decreasing transactions) but also efficient (i.e. allows value-increasing transactions occur). The paper argues that there is a trade-off between these two goals (effectiveness and efficiency), and that the optimal solution is company-specific. The review of RPTs can be based on substantive or procedural fairness. Ex-post review of substantive fairness by sophisticated courts, or the credible threat thereof, can be effective in policing RPTs, as in the U.S. However, such a review may overdeter efficient RPTs because these may look unfair in hindsight, when compared with arm’s length transactions. When courts review procedural fairness, the assessment is delegated to market professionals (shareholders or directors) who review the transaction ex-ante and have, in principle, good incentives to approve it only if it is efficient. However, this screen becomes ineffective if the reviewers are not well-informed or not independent. Moreover, a regime that tries to cope with this issue by empowering non-controlling shareholders in general, as in the UK, creates another problem: activist shareholders could more easily intervene with the controller’s strategy, which may be inefficient for the particular company. This paper recommends a different procedural standard as the default regime. RPTs should be considered fair when they are approved by non-controlling shareholderdependent (NCS-dependent) directors. Non-controlling shareholders should have the exclusive right to nominate, appoint and remove these directors. NCS-dependent directors should account for a minority of the board and their mandate should be limited to screening related-party transactions. This regime would be as effective as those of the U.S. and the UK, and arguably more efficient. Companies that can organize themselves efficiently without RPTs may opt out of this regime, for instance by choosing a substantive court review or a broader mandate for NCS-dependent directors to advise on strategy issues.

Keywords: self-dealing, corporate governance, controlling shareholders, independent directors, Majority of Minority (MOM), Transaction Cost Economics, hedge fund activism, institutional investors

JEL Classification: D23, G34, K22

Suggested Citation

Pacces, Alessio M., Procedural and Substantive Review of Related Party Transactions (RPTs): The Case for Non-Controlling Shareholder-Dependent (NCS-Dependent) Directors (May 8, 2018). A version of this paper will appear as a chapter in Luca Enriques and Tobias Tröger, eds., The Law and Finance of Related Party Transactions (Cambridge University Press, Forthcoming); European Corporate Governance Institute (ECGI) - Law Working Paper No. 399/2018. Available at SSRN: https://ssrn.com/abstract=3167519 or http://dx.doi.org/10.2139/ssrn.3167519

Alessio Maria Pacces (Contact Author)

Erasmus School of Law, Erasmus University Rotterdam - Rotterdam Institute of Law and Economics ( email )

Burgemeester Oudlaan 50
P.O. Box 1738
Rotterdam, Zuid Holland 3000 DR
Netherlands
+31-(0)10-4081613 (Phone)
+31-(0)10-4089191 (Fax)

HOME PAGE: http://www.esl.eur.nl/profile_az/?tx_eurliaatmetismis_pi1%5Bmetis_id%5D=1050049

European Corporate Governance Institute ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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