ACLE Law & Finance Seminar with Alessio M. Pacces (Erasmus School Rotterdam). Amsterdam Business School, Room 3.02. Title "Procedural and Substantive Review of Related Party Transactions: The Case for NCS (Non-Controlling Shareholders)-Dependent Directors".
In publicly traded companies, related-party transactions are an obvious vehicle for shareholder expropriation. However, they may also be efficient, particularly when they are motivated by transaction cost savings. This paper aims to identify which review of related-party transactions is not only effective (i.e. stops value-decreasing transactions) but also efficient (i.e. let value-increasing transactions occur). It is argued that there is a trade-off between these two goals, and the optimal solution is company-specific.
The review of related-party transactions can be based on substantive or procedural fairness. Ex-post review of substantive fairness by sophisticated courts, or its credible threat, can be effective in policing related-party transactions, as it is in the U.S. However, such a review may over-deter efficient related-party transactions because the latter may look unfair in hindsight, when compared with arm’s length transactions. When courts review procedural fairness, the assessment is delegated to market professionals (shareholders or 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 reviewers are not well-informed or not independent. Moreover, a regime that tries to cope with this issue by empowering non-controlling shareholders in general, as in the UK, creates another problem: activist shareholders could more easily intervene with the controller’s strategy, which may be inefficient for the particular company.
This paper recommends a different procedural standard as default regime. Related-party transactions should be considered fair when they are approved by Non-Controlling Shareholder-dependent (NCS-dependent) directors. Non-controlling shareholders should have the exclusive right to nominate, appoint and remove these directors. NCS-dependent directors should account for a minority of the board and their mandate should be limited to screening related-party transactions. This regime would be as effective as the U.S. and the UK regime, but arguably more efficient. Companies that can organize themselves efficiently without related-party transactions may opt out of this regime, for instance by choosing substantive court review or a broader mandate for NCS-dependent directors to advise on strategy issues.