Fifteen Eighty Four

The quality of corporate governance, ie the effectiveness of institutions that contain agency costs, is a key component of asset allocation. In countries characterized by concentrated ownership, minority shareholder expropriation, also known as tunneling, is the main concern from the perspective of outside investors. Tunneling can be the outcome of a number of expropriation techniques. A common way to extract value from the controlled corporation is for the dominant shareholder to engage in transactions with it at favourable terms (so-called related party transactions or, hereafter, ‘RPTs’).

Informed investors are aware of the risk of tunneling: they will thus discount the share price at which they are willing to invest. In practice, however, the probability and scope of the looming expropriation are hard to gauge ex ante and therefore the appropriate discount is difficult to establish, leading to noisy estimates. In addition, even with perfect pricing, from the perspective of social planners in individual countries, tunneling, by raising firms’ cost of capital, makes equity markets less vibrant, reduces funding opportunities for businesses and ultimately impairs growth. That explains the focus on tunneling, and often more specifically on related party transactions, by international economic organizations (such as the World Bank and the OECD), supranational and national legislators.

Tunneling can be the outcome of a number of expropriation techniques.

However, individual RPTs can be in the best interest of the individual company involved and create value for society as a whole. While in most cases a transaction in the best interest of the company will also create value for society, and vice versa, that may not always be the case. We can call transactions that are in the best interest of the company ‘fair’ and those that enrich the relevant parties (without offsetting third-party effects) ‘value-creating’.

Corporate lawmakers around the world attempt to strike the right balance between the need to curb insiders’ tunnelling and preserving the advantages of letting a company enter into fair and value-creating RPTs. They have to do so in the knowledge that, in a world of information asymmetries and uncertainty, distinguishing between transactions that are ‘good’ and transactions that are ‘bad’ is difficult even for internal decision-makers, let alone for outsiders, including enforcement institutions, that frequently can neither observe nor verify critical facts. Here, the following fundamental questions arise: (1) who screens ‘good’ RPTs in the best interest of the company and society at large from ‘bad’ or harmful ones? (2) How does the screen work? (3) When does it operate (before or after the RPT is entered into)?

In a recently published book, ‘The Law and Finance of Related Party Transactions’ (Cambridge University Press: 2019), leading scholars in the field of law and finance from around the world provide a comprehensive analysis of the challenges legislators face in regulating related party transactions in a socially beneficial way. The volume combines contributions that examine the theoretical foundations of an efficient regulation of related party transactions with chapters that look at specific legal regimes from an empirical and/or comparative law perspective. The selection of jurisdictions surveyed grants in-depth insights on a broad variety of regulatory strategies and their interdependence with socio-economic and political conditions. The book not only provides state of the art scholarship but also allows readers to draw conclusions on which regulatory responses work under which circumstances.

The Law and Finance of Related Party Transactions by Luca Enriques and Tobias H. Troger