A brief history of corporate governance over the last five hundred years can be concisely encapsulated in three key developments: independent directors as the epitome of fiduciary responsibilities, disclose or abstain principle to eradicate insider trading, and dishonesty being filtered out through stringent approval processes and disclosures of related party transactions.
In the initial days of corporate history, related party transactions were declared void-abnitio, and in one specific judicial decision in the USA, it was held void-abnitio even after obtaining shareholders’ approval. In due course, it was realised that related party transactions are per say not undesirable, though it could be a primary conduit for dishonest transactions that deprive shareholders of their rightful gains. This realisation changed the approach of regulators from banning RPTs to regulating them and requiring that these transactions be disclosed in financial statements.
This article poses five questions for determining if a RPT is desirable or harmful for the “unrelated” shareholders or stakeholders
- Is there alignment of beneficial interests between the decision makers and the shareholders?
A key concept in evaluating RPT is the alignment of beneficial interest between the decision makers and the shareholders. For instance, in a transaction with Wholly Owned Subsidiary, the beneficial interests of the shareholders of the holding company and a WOS is one and the same. Hence these transactions are not detrimental to the interest of the shareholders, despite commercial interests favouring one party at the cost of another.
- Are there benchmarks for comparing the fairness of a transaction with the Related Party?
The desirability of a RPT from good governance viewpoint is based on the fairness of transaction for both the parties. A transaction in the ordinary course of business provides the benchmark for judging the fairness of the sale transaction due to the availability of price lists and discount policies applicable for all customers which can be used to judge the fairness of a sale transaction versus the Related Party. Likewise in case of purchases of raw materials and items of regular consumption, comparable price paid to other vendors provides the benchmark, thereby enabling transactions in the ordinary course of business to be judged whether it is at arms’ length basis or not.
- Is there genuine economic benefit obtained from the transaction with the related party?
In large groups, the presence of a corporate office with many centralised corporate functions provides the benefit of specialisation and economies of scale. Given these benefits, a RPT for shared services may not be detrimental to shareholders’ interest, if the terms or the parameters determining the proportion of shared expenses remain consistent over longer periods of say 5 years or more.
- Is the transaction essential for the business?
RPTs for employment of KMPs and Directors are essential for the effective and efficient management of business. The basis for judging its fairness is the compensation paid by its peers for fulfilling similar roles and responsibilities.
- Is the transaction commercially prudent?
Inter-corporate loans and advances are a regular feature among the RPTs in large groups. Often loans and advances are a means to provide financial support to the entity that may not be readily available from third party lenders. Hence terms on which the loan is given is critical as it needs to cover the risk associated with the venture to make it commercially prudent. This will ensure that the unrelated parties are not adversely affected by this transaction.
Due to the taint associated with its origin and repeated use for dishonest transactions that costs unrelated shareholders, all RPTs are looked at with a hint of suspicion. The five questions posed above could help the prudent decision maker to separate the cheese from chalk and promote good governance in their company.