Related Party Transactions: Policy Options and Real-world Challenges (with a Critique of the European Commission Proposal)

Luca Enriques is Allen & Overy Professor of Corporate Law at University of Oxford, Faculty of Law.

Transactions between a corporation and a “related party” (a director, the dominant shareholder, or an affiliate of theirs) are a common instrument for those in control to divert value from a corporation, especially in countries with concentrated ownership. While direct evidence of value diversion via related party transactions (RPTs) is obviously hard to obtain, widespread use of RPTs has been observed for example in China (in the form of inter-company loans) and South Korea (also as a tool to transfer wealth from one generation of controllers to the next in avoidance of inheritance taxes), has been vividly reported for post-privatization Russia and Italy (where corporate scandals, such as Parmalat and, more recently, Fondiaria-Sai, often go together with significant RPT activity). Anecdotal evidence of value extraction via RPTs also exists with regard to the US (think of the Hollinger case and those reported in Atanasov et al.’s paper on law and tunneling, available here). Their (ab)use at Russian and East-Asian companies listed in the UK has recently prompted the UK Listing Authority to stiffen its already strict provisions on RPTs (see here; for a news report on RPTs at one of these East-Asian companies—Bumi, now renamed Asia Mineral Resources—see here).

In my article Related Party Transactions: Policy Options and Real-world Challenges (with a Critique of the European Commission Proposal), published in 16 European Business Organization Law Review 1 (2015), and available here (and here as a working paper), I provide a comparative and functional overview of how laws deal with RPTs and criticize a recent European Commission proposal for a harmonized EU regime on RPTs (see Article 9c of the Proposal for a Directive of the European Parliament and of the Council amending Directives 2007/36/EC and 2013/34/EU, available here).

As a starting point, the paper highlights the reasons why related party transactions (RPTs) are so common around the world: in business-unfriendly jurisdictions (characterized by a punitive tax system, unsophisticated or corrupt tax officials, ill-defined property rights, slow and unpredictable, if not corrupt, courts, and a bad, value destroying bankruptcy system), RPTs are almost a form of self-defense for successful businesses. In countries with better institutions, they may be a legacy of a period with worse institutions and, anyhow, a clever way for those in control to extract private benefits.

Next, the article better identifies the phenomenon as a specific form of potentially abusive behaviour by dominant shareholders and managers, i.e., as an instrument for tunneling, asking why many jurisdictions provide for specific regulations on RPTs in addition to general rules or standards on tunneling. It is argued that the reasons for that are, on the one hand (and quite simply), that the international policy debate on tunneling is framed in terms of RPTs and domestic policymakers are just receptive of that language and focus. On the other, rules applying to RPTs are more easily complied with and enforced than rules relying on broader terms such as “conflicts of interest” or value extraction. Detecting a RPT is easier than deciding on a case-by-case basis whether, in a given issue, a director or a dominant shareholder may have a direct or indirect interest.

Then, the article describes the main legal tools used to prevent corporate agents from diverting value from the corporation via RPTs (prohibitions, procedural safeguards, i.e. independent director and/or majority of the minority approval, disclosure, fairness opinions, and ex post standard-based review by a court), highlighting the conditions for them to be effective in curbing tunneling behavior.

Further, the article provides a critical assessment of the measures put forth by the European Commission to harmonise rules on RPTs. The main criticism is that the proposed rules appear to be loose in some respects (due to under-inclusiveness and only seemingly strict, but in fact weak procedural safeguards and disclosure rules) and excessively strict in others (due to over-inclusiveness). Unfortunately, laxity and strictness, rather than balancing each other to produce a workable and reasonable solution, will exacerbate the negative effects of each and likely lead to overall weakened investor protection.

Finally, the article argues that no regulation of RPTs (or tunneling) can succeed in preventing minority shareholder expropriation in the absence of sophisticated enforcement actors (specialised courts and/or an active and committed securities regulator) and non-legal supporting institutions, such as an independent financial media industry and anti-tunneling social norms.

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