- Ensuring transparency in related-party transactions
- Involving disinterested shareholders in the approval of related-party transactions
- Holding directors accountable for their actions
- Facilitating access to corporate documents
- Increasing shareholder rights and role in major corporate decisions
- Clarifying ownership and control structures
- Requiring greater corporate transparency
Economies with the strongest protections of minority investors from self-dealing require detailed disclosure, define clear duties for directors, and offer wide access to corporate information. They also have well-functioning courts and current procedural rules that give minority investors the means to prove their case and obtain a judgment within a reasonable time.
ENSURING TRANSPARENCY IN RELATED-PARTY TRANSACTIONS
In recent years several economies such as Armenia, Burundi, Greece, Honduras, Slovenia, Tajikistan, Tunisia, the United Arab Emirates and Vietnam—have introduced legal provisions regulating disclosure of related-party transactions. Why does this matter? Providing reliable information on company dealings allows investors to monitor the activities of companies and assess the performance of their management. The OECD Principles of Corporate Governance build on the premise that solid disclosure attracts capital and maintains confidence in capital markets. (1) Corporate disclosure also has important implications for the valuation of companies. Empirical research shows that companies that disclose related-party transactions have a higher stock exchange valuation than those that do not. (2) A recent study looks at how investors reacted to the announcement by the U.S. Securities and Exchange Commission in 2007 that it would allow foreign firms listed in the United States to more easily deregister their shares and thereby opt out of U.S. reporting requirements. The study finds that the stock market reaction was negative for firms from economies with weak disclosure and governance regimes—but insignificant for those located in economies with strong investor protections. (3)
In several economies increased protections are benefiting greater numbers of investors thanks to growth in the number of enforcement cases uncovering prejudicial transactions. In Thailand, since 2005 more than 85 transactions that failed to comply with the disclosure standards have been suspended while the Thai regulator requested clarification. Thirteen of these were deemed to be prejudicial and were therefore canceled, in each case preventing damage to the company and preserving its value. (4) In the same period, the Malaysian securities commission has sanctioned more than 100 companies for noncompliance with disclosure requirements. (5)
INVOLVING DISINTERESTED SHAREHOLDERS IN THE APPROVAL OF RELATED-PARTY TRANSACTIONS
Such approval mechanisms work well only if the law does not allow many exceptions and if the approval is required at the time of the transaction. Other features can also strengthen shareholder approval provisions. Certain economies require review of the terms of these transactions by an independent body (such as an independent auditor) before their approval. The independent auditor will provide an opinion on the terms of the transaction that will help shareholders make an informed decision. But 18 economies, including Ecuador and Somalia, allow the chief executive officer or whoever is specified in the company statute to approve related-party transactions. In economies such as Barbados, Croatia and the United States, these transactions are approved by the board of directors and interested parties are allowed to vote.
HOLDING DIRECTORS ACCOUNTABLE FOR THEIR ACTIONS
Economies with the strongest protections regulate not only disclosure and approval of related-party transactions but also set out clear rules of accountability for company directors when such transactions turn out to be prejudicial. Directors need clear rules to fulfill their responsibilities effectively. Economies take different approaches to spell out clear rules on the liability of company directors in case of abusive related-party transactions. Some have a comprehensive catalogue of rights and duties of directors, while others have a special regime of liability for directors in the event of an abusive related-party transaction. Those that prescribe clear rights and duties of directors include Cambodia, New Zealand and the United Arab Emirates, which have rules encouraging directors to be prudent in the company’s day-to-day management. Economies such as Bulgaria and China do not clearly stipulate the liability of directors for abusive related-party transactions. In those economies, as long as the interested parties comply with requirements for disclosure and approval of related-party transactions, they are not liable for any harm that results.
FACILITATING ACCESS TO CORPORATE DOCUMENTS
Rights of minority investors cannot be protected without easy access to corporate information. Without access to documentary evidence, minority investors may find it difficult to prove that directors have been managing the company’s affairs improperly. Economies can have good laws, but if access to corporate information and evidence is limited or courts are inefficient, investors are unlikely to resort to judicial options.
Certain economies including Israel and Japan, permit full access to documentary evidence both before and during the trial. Cyprus, France and the United Kingdom allow shareholders to request the appointment of a government inspector with full powers to verify and obtain copies of any corporate document. El Salvador, Singapore and South Africa require that all company documents related to the case be open for inspection during the trial. Cambodia, Libya and República Bolivariana de Venezuela permit limited or no access to evidence during the trial, making it virtually impossible for minority investors to prove their case.
Economies with the strongest protections of minority investors also grant extensive rights to shareholders and increase their role in major corporate decisions. They provide governance safeguards protecting shareholders from undue board control and entrenchment. In addition, they require corporate transparency on ownership stakes, compensation, audit and financial prospects. The following section measures if such rights in corporate governance are available in publicly listed companies and whether a subset of relevant rights and safeguards are available in limited companies.
INCREASING SHAREHOLDER RIGHTS AND ROLE IN MAJOR CORPORATE DECISIONS
Rights of shareholders are better protected in economies where the powers between shareholders and management are effectively allocated. Major corporate decisions should require shareholder’s approval to prevent dissipation and/or mismanagement of assets. Other rights, such as preemption rights, must be guaranteed for shareholders in order to foster an environment of financial reliability and ownership stability.
Economies including Indonesia and Montenegro require shareholder approval for the sale of 51% of a company’s assets, whereas Switzerland and Uruguay demand shareholder approval every time a company issues shares up to the authorized capital. Bahrain and Ireland grant shareholders automatic preemption rights every time a company issues new shares. Whenever there are changes to the voting rights of a class of shares, economies including Argentina and the 17 member states of the Organization for the Harmonization of Business Law in Africa, known by its French acronym OHADA,(6) require the approval of the holders of the affected shares.
CLARIFYING OWNERSHIP AND CONTROL STRUCTURES
A clear ownership structure and separation of functions in companies reduce the risk of agency problems. Ethiopia, Latvia and Pakistan prohibit the CEO from also being chair of the board of directors. Belarus, Dominica and Serbia require boards of directors to include independent and non-executive members. In Algeria, Guyana and Lebanon directors on the board can be removed without cause by shareholders before the end of their term. Boards of directors in listed companies in Bangladesh, Turkey and República Bolivariana de Venezuela must include separate audit committees composed solely of board members. In Kazakhstan, Mongolia and Zimbabwe a potential buyer must make a tender offer to all shareholders upon acquiring 50% of the company.
REQUIRING GREATER CORPORATE TRANSPARENCY
Studies show that minority shareholders' rights are better protected in economies promoting transparency through the disclosure of corporate information. Information asymmetry can result in fraud, financial crisis, adverse selection and moral hazard. Investors are entitled to receive accurate, effective and sufficient information which would lead to financial stability, reduction of fraud and manipulation and better company governance in general.
Australia, Belgium and Brazil require companies to disclose direct and indirect beneficial ownership stakes representing 5%. Companies in Brunei Darussalam and the Russian Federation must disclose information about board members’ other directorships as well as basic information on their primary employment. In Italy and Kuwait, companies must also disclose the compensation of individual managers. Germany, Oman and Sri Lanka require listed companies and limited liability companies to have their annual financial statements audited by an external auditor and mandate the disclosure of the audit reports in the case of listed companies.
1. OECD (Organisation for Economic Co-operation and Development). 2004. OECD Principles of Corporate Governance. Paris: OECD.
2. Kohlbeck, Mark, and Brian Mayhew. 2010. “Valuation of Firms That Disclose Related-Party Transactions.” Journal of Accounting and Public Policy 29 (2): 115–37.
3. Fernandes, Nuno, Ugur Lel and Darius P. Miller. 2010. “Escape from New York: The Market Impact of Loosening Disclosure Requirements.” Journal of Financial Economics 95 (2): 129–47.
4. Information provided by the Securities and Exchange Commission of Thailand.
5. Information provided by Securities Commission Malaysia.
6. The 17 members of OHADA are Benin, Burkina Faso, Cameroon, the Central African Republic, Chad, the Comoros, the Democratic Republic of Congo, the Republic of Congo, Côte d’Ivoire, Equatorial Guinea, Gabon, Guinea, Guinea-Bissau, Mali, Niger, Senegal and Togo.