Procedural and Substantive Review of Related Party Transactions (RPTs): The Case for Non-Controlling Shareholder-Dependent (NCS-Dependent) Directors
Related Party Transactions (RPTs) are transactions between a company and the executives, directors or the controlling shareholder of that company, or their associates (e.g. a company the related party owns fully or partly). Because RPTs entail an obvious conflict of interest, they are regarded with suspicion in corporate governance and are regulated by corporate law. RPTs, however, are not generally prohibited. Moreover, several companies around the world enter into RPTs as a matter of routine. For instance, manufacturing companies sometimes purchase equipment from a related party instead of an independent supplier. This operation can be efficient when it leads to transaction cost savings. However, RPTs may also be value-decreasing, particularly when they result in investor expropriation by way of tunnelling resources out of the company. Therefore, a legal regime of RPTs must screen for efficient transactions. For this purpose, I argue in this paper that a procedural review, in which courts sanction RPTs based on due process, is preferable to a substantive review, in which courts re-assess the merits of the transaction. However, to be effective at countering expropriation of non-controlling shareholders, a procedural review should be accompanied by additional safeguards.
A substantive ex-post review, or the credible threat thereof, can be effective in policing RPTs when it is performed by sophisticated courts, as is in the U.S. and particularly in Delaware. However, such a review may over-deter efficient RPTs because these too may go sour, and then look unfair in hindsight when compared with arm’s length transactions. On the contrary, when courts only review due process, the assessment is delegated to market professionals (institutional shareholders or independent 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 assessors are not well-informed or not independent. Effective RPT regimes, such as the UK, try to cope with this issue by empowering non-controlling shareholders to fire directors at will. This approach creates another problem: activist shareholders could more easily intervene with the controller’s strategy, which may be inefficient for certain companies.
In this paper, I recommend a different approach to the procedural review of RPTs. RPTs should be considered conclusively fair when they are approved by non-controlling shareholder-dependent (NCS-dependent) directors, provided that the approval is considered informed based on the prevailing professional standards for these directors. Non-controlling shareholders should have the exclusive right to nominate, appoint and remove NCS-dependent directors. These directors should account for a minority of the board and their mandate should be limited to screening RPTs only. This regime would be as effective as those of the U.S. and the UK in countering investor expropriation, but arguably better at screening for efficient transactions. This would be a default regime. Companies for which RPT operation is not crucial may opt out of it, for instance by choosing a substantive court review or a broader mandate for NCS-dependent directors to advise on strategy issues.