Agency Costs, Contracting, and Related Party Transactions

Abstract

We examine related party (RP) transactions using agency and contracting theory as guides. Agency theory suggests opportunistic behavior can generate RP transactions; however, RP transactions can also result from or be managed via contracting. We therefore investigate associations between RP transactions and compensation-based incentives, monitoring mechanisms, and links to executive compensation for a sample of 1,261 firms. We find RP transactions are associated with weaker corporate governance, CEO stock options, and inversely associated with CEO and director's cash compensation. In a direct analysis of CEO compensation, we find a positive association between unexpected CEO compensation and RP transactions with companies the firm partially owns (i.e. investments) suggesting that CEO's are compensated for running more complex organizations. Finally, we examine returns in the period following RP disclosure. The results suggest lower future returns for simple RP transactions involving directors, officers and major shareholders. However, future returns are marginally higher for companies engaged in RP transaction with investments. Our compensation and returns analyses suggest related party transactions with investments appear to be associated with efficient contracting, while simple transactions with directors, officers and shareholders are associated with opportunism.

Keywords: Related party, disclosure, governance

JEL Classification: M41, G34, J33, G38