RPTs in SOEs: Tunneling, Propping and Policy Channeling

One of central problems in corporate law and governance is the regulation of “related-party transactions” (RPTs) – generally, transactions between two or more corporate entities that share a common controlling shareholder. A key problem in an RPT, regardless of the identity of the controlling shareholder, is the potential that the transaction may be structured so as to extract wealth from the minority shareholders for the benefit of the controller (a problem known as “tunneling” in the corporate governance literature).  In the case of a state-owned enterprise (SOE), this problem takes on distinctive contours because the controlling shareholder is an organ of the state.  Because SOEs are prevalent in the economies of many countries – both developing and developed – the regulation of RPTs in SOEs has been the focus of attention by international organizations such as the OECD and the World Bank.

In our paper, we explore the legal and policy challenges associated with RPTs in SOEs. We show that RPTs in SOEs differ from RPTs in privately owned enterprises (POEs) in at least two ways. First, in addition to the familiar tunneling problem, RPTs in SOEs may decrease social welfare when the state provides benefits to the SOE not available to POEs (“propping”). Second and more importantly, unlike the typical case with a POE, the state as controlling shareholder does not need to cause an SOE to engage in a “transaction” for it to extract benefits from the firm to the detriment of minority investors. The state can also extract benefits by engaging in what we call “policy channeling” – the state’s use of partial ownership of an SOE to achieve social or industrial policy objectives.  In fact, SOEs with minority private investors are prevalent around the world in part because governments have found them to be a useful vehicle for carrying out policies such as maintaining employment or retaining state control of the “commanding heights” of the economy for national security or industrial policy goals. As a means of carrying out these objectives, SOEs with minority private investors may be preferred over regulation and taxation for a variety of reasons, including the fact that the minority investors bear part of the cost of the policy’s implementation, and the corporate form of the SOE helps shields the policy from public participation and accountability.

After mapping the distinctive contours of these problems in SOEs, we examine the potential of different legal strategies to address them, including those proposed by the OECD, the World Bank, and recently, through stock exchange initiatives. We suggest that adaptation of some common corporate law strategies may have the potential to address policy channeling more effectively than the current recommendations of the OECD and the World Bank.