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Related Party Transactions (RPTs) is a phenomenon that has raised a huge debate over the last thirty years among researchers, practitioners, and regulators. While RPTs could be conducted solely for business purposes as they give rise to efficient contracting and economic efficiency, they could also be a facet of opportunism and shareholder wealth expropriation. This article explains what RPTs are, how they are conducted, and the landscape of RPTs in different parts of the world.
Related Party Transactions (RPTs)
According to the US GAAP Statement of Financial Accounting Standards, RPTs are transactions between a company and its subsidiaries, affiliates, principal owners, officers or their families, directors or their families, or entities owned or controlled by the company’s officers or their families.
From a research perspective, there are two views explaining the motivations beyond engaging in RPTs. One view posits that RPTs are mainly opportunistic transactions that are intended to “tunnel” or transfer wealth from the company to a controlling shareholder or another related party. Hence, this view assumes that RPTs represent a conflict of interest between controlling shareholders and minority shareholders.
The other view considers RPTs as a tool to enhance efficient contracting and economies of scale as the transaction costs are reduced when a transaction occurs between two related parties compared to non-related parties. Although, the debate about the nature of RPTs is still ongoing, and research findings still find evidence that could in one way or another support the two theoretical motivations of RPTs, the anecdotal evidence and the real-life incidents about RPTs are relatively alarming.
RPTs have been linked to high-profile accounting scandals such as Enron, Tyco and Adelphia in the USA, Rundenweke and Parmalat in the EU, Guangdong Kelon Electrical Holdings Company in China and many others around the world. However, it is well established that RPTs are more common in Asian economies due to two main reasons.
Main reasons that RPTs are more common in Asian economies
First, in Asian economies ownership structures are concentrated which implies that the ownership of Asian Business groups or conglomerates is more likely to be concentrated in a certain group like a family or the state. This gives rise to hiring family members or politically connected individuals in senior management or board positions which gives them sufficient power to conduct transactions to extract wealth from minority shareholders.
Second, the lack of investor protection and legal enforcement in Asian economies allows controlling shareholders to extract private control benefits through related party transactions.
The corporate governance reforms following the Asian financial crisis in 1997 designed several regulations that are designed to curb the negative effects of RPTs and to protect minority shareholders from the potential adverse effects of such transactions. Such regulations appear to be successful to a large extent in reducing the incidence of using RPTs for shareholder expropriation purposes.
Research on the effects of RPTs in other countries is relatively lacking. The main assumption is that RPTs problems are more prevalent in concentrated ownership contexts than dispersed ownership contexts. However, the extant literature also shows that RPTs could be problematic and opportunistic in any context.
The problems arising from RPTs are a function of weak corporate governance and internal control mechanisms. Thus, even if there are economic justifications for conducting transactions with related parties rather than on the open market, internal and external control mechanisms should be in place. This gave rise to several regulations for RPTs in several countries.
To mention a few, in the US the SEC issued a new regulation in 2006 that mandates RPTs disclosure by US firms and specifies how such transactions are required to be disclosed. Further, it requires firms to disclose their governance policies for the approval and ratification of RPTs.
Later, a new auditing standard was introduced by the PCAOB that increases the scope of the auditor in scrutinizing RPTs and actively increases the involvement of the audit committee of the auditee in supporting the work of the auditor on that front.
In 2013, a set of RPT-related laws were added to the Indian Company Law. One clause mentioned that RPTs conducted by Indian firms must be approved by minority shareholders after being approved by the board of directors.
In 2002, legislation was introduced in Bulgaria which was effective in reducing equity tunneling and increasing the participation of minority investors in equity offerings.
The takeaway is that the evidence on whether RPTs are normal transactions or opportunistic transactions in inconclusive. However, there are a few important precautions that should be exercised towards RPTs.
First, enhancing internal control and monitoring mechanisms through empowering the internal auditor and the audit committee to report unusual, material, or recurring transactions to the external auditor.
Second, carefully documenting and disclosing the details of RPTs in terms of the amount, the time and the transacting parties.
Third, carefully investigating the domestic laws related to conducting, accounting for, and disclosing RPTs to avoid significant litigation issues.
