Regulation and Self-Regulation of Related Party Transactions in Italy

The following post comes to us from Luca Enriques, Professor of Business Law at LUISS University (Rome). The post is based on a paper co-authored by Professor Enriques, and Marcello Bianchi, Angela Ciavarella, Valerio Novembre and Rossella Signoretti of CONSOB (Commissione Nazionale per le Societa e la Borsa).

Agency problems and tunneling are traditional features of corporate governance in Italy. Where ownership is concentrated, dominant shareholders have both the incentives and the means to monitor managers but they may also extract private benefits through self-dealing transactions that favor the related party at the expense of minority shareholders. Pyramids and other control enhancing mechanisms (CEMs) make minorities more vulnerable to abusive self-dealing. The regulatory environment proved to be too lax. The late 1990s reforms failed to specifically address conflicts of interests in listed companies. Further, as a result of the 2003 corporate law reform, directors are allowed to vote even if their interests conflict with those of the firm and parent companies within integrated groups may legitimately force subsidiaries into possibly harmful transactions, provided some procedural and substantial requirements are met. With the exception of corporate governance codes, no specific new rule addressed the fairness of related party transactions (RPTs).

Following the early 2000s scandals (Parmalat and Cirio), the Government introduced a new general provision on RPTs entered into by listed companies, requiring them to adopt internal codes in compliance with implementing principles to be issued by Consob, the Italian securities regulator. In 2010, Consob regulated RPTs by introducing stricter procedural and disclosure requirements. Companies had some freedom in devising their internal codes: they might in fact “opt-up” from all of the provisions set forth in the regulation and even “opt-down” from some of them.

In our paper Regulation and Self-Regulation of Related Party Transactions in Italy: An Empirical Analysis, we look into how strictly firms implemented the new regulation in their internal codes given the available options. In order to measure the internal codes’ strictness, we build an indicator focusing on five key provisions that allow for opt-ups and opt-downs from the default requirements. We assign a firm-specific score for each of them, depending on their strictness. We then compute our overall indicator of RPTs codes’ strictness as a simple sum of the scores assigned to the five items. We argue that our RPT Indicator can be interpreted as a proxy for the quality of governance mechanisms in any individual company. The strictness of RPTs procedures can indeed be considered as a signal of a company’s commitment not to engage in abusive self-dealing: on the one hand, firms most inclined to engage in abusive self-dealing had an incentive to set up procedures leaving sufficient degrees of freedom; on the other, companies with no intention to extract value from minorities had little reason to adopt weak procedures as long as the reputational benefits arising from stricter internal codes outweighed higher compliance costs.

In order to test the hypothesis that the strictness of internal procedures is a proxy of the quality of corporate governance we assess whether individual companies’ choices in the use of the opt-in and opt-out clauses are affected by shareholders’ incentives to extract private benefits of control through RPTs and/or by the presence of potential dissenting voices in the board. We argue that the stronger the incentives to extract private benefits the more inclined a company should be to adopt laxer RPT internal procedures, while the presence of dissenting voices within the board should have the opposite effect.

Our analysis covers the 125 companies listed on the Italian market at the end of 2010 which were subject to the full set of regulatory provisions, representing 88% of the overall stock exchange capitalization. Preliminarily we find that blue chips and financial firms have better procedures in place: the former are probably more exposed to market scrutiny; the latter, being subject to specific industry regulation and oversight, might be under pressure to set up sound governance mechanisms.

We also find that firms’ corporate governance characteristics play a role in determining the strictness of procedures. With regard to ownership and control, widely held firms perform better than those controlled by a single shareholder or by a coalition, in line with the expectation that in controlled companies dominant shareholders typically extract value in the form of RPTs, which are on the opposite less likely in manager-controlled companies. Moreover, among controlled companies, we find laxer procedures in firms where the position of the majority shareholder is weaker in terms of cash flow rights and therefore her incentives for a positive monitoring role are lower. This is, however, not the case in companies adopting CEMs, where the need to counterbalance reputational costs normally associated with these instruments appears to lead companies into adopting stricter procedures. Further, companies controlled by a coalition of shareholders have stricter procedures than those controlled by a single shareholder, in line with the idea that mutual monitoring by coalesced block-holders hampers the extraction of private benefits of control by any of them.

Finally, we look at the role of independent directors and of directors nominated by minority shareholders following a 2005 law enabling minority shareholders to appoint at least one director from a slate of candidates of their own choice. We only look at directors appointed by institutional investors on the assumption that these directors are expressed by actual minority shareholders whose only goal is to maximize shareholder value. We find that the presence of directors nominated by institutional investors makes a difference in the implementation of RPTs rules: firms where at least one minority director sits on the board have adopted stricter procedures, no matter whether the director also sat on the special committee in charge of vetting the RPTs internal code. On the contrary, no significant effect derives from the presence and weight of independent directors.

The full paper is available for download here.

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