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)
35 Pages Posted: 7 May 2018 Last revised: 14 May 2018
Date Written: May 8, 2018
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: Suggested Citation