1. ETH Zurich, Spring 2015 Law & Business Transactions Related Party Transactions Gérard Hertig

2. I. Dealing with Value Diversion Risk Value diversion – Previously discussed how to protect creditors against managers and shareholders – Here how to protect shareholders against managers and controlling shareholders Types of related party – Self-dealing (avoidable) Transactions with the company Influence: Terms less favorable as if at arm's length – Compensation agreements (unavoidable) – Taking corporate opportunities that belong to the firm – Appropriating the value of yet undisclosed information 25.03.2015G. Hertig2 Allowing RPT / Disclosure / Transaction Approval / Ownership

3. Examples 1 – 5 : Related-Party Transactions 1.Shareholder A would like to buy the company’s car. Is this a related-party transaction? 2.Shareholder B is the wife of the firm’s CEO and would like to rent the chalet the company owns in the Alps. Is this s related party transaction? 3.Shareholder C owns 30% of the firm’s shares and suggests to the head of personnel to hire his son as a trainee. If the son gets hired, is this s related party transaction? And what if the son had asked directly, without talking to his father? 4.D works at firm X and is asking for a pay raise. Is this a related party transaction? 5.Union E is negotiating a new model contract for the workers of firm Y. Is this s related party transaction? 25.03.2015G. Hertig3 Allowing RPT / Disclosure / Transaction Approval / Ownership

4. Examples 6 – 10 : Related-Party Transactions 6.F is the firm’s CFO and learns about a new patent that may be of interest to his firm. He acquires exclusive licensing rights from the patent’s owner. Is this a related party transaction? 7.G is a shareholder in firm Z and hears that Z wants to acquire competitor W. G quickly arranges for his bank to provide him with a significant credit line and purchases W. Is this s related party transaction? 8.H believes that firm V will buy land next to its newest factory so as to be able to expand should the products manufactured at the plant be a market hit. H buys the land adjacent to the factory. Is this a related party transaction? 9.I hears rumors that firm U will have records profits in the next quarters. He buys shares of firm U. Is this a related party transaction? 10.J, firm U’s accountant, hears the same rumors and also buys shares of firm U. Is this a related party transaction? 25.03.2015G. Hertig4 Allowing RPT / Disclosure / Transaction Approval / Ownership

5. Why Permit Related Party Transactions? Self-dealing / Taking of business opportunities – Smaller firms: Outsiders may not be able to evaluate transaction / Insiders know trade secrets and competitors’ position – Larger firms: Insiders likely to offer better terms due to lower information asymmetries Compensation and insider trading – No one agrees to work for free or to keep shares for ever – Per se prohibition would not accomplish much Ineffective when there is much at stake or recklessness Inefficient when termination and liability are a sufficient deterrent But RPT are subject to various constraints → 25.03.2015G. Hertig5 Allowing RPT / Disclosure / Transaction Approval / Ownership

6. II. Disclosing RPT Impact – Enlists capital markets to deter value diversion (lower share price) – Additional deterrence by ˃ risk of legal action by other owners – But: May deter legitimate RPT if over-enforcement Regulatory intensity – Disclosure requirement used to be more stringent in US – Convergence trend, especially for listed firms 25.03.2015G. Hertig6 Allowing RPT / Disclosure / Transaction Approval / Ownership

7. Disclosing ‘Material’ Transactions Material transactions – Transactions above a given amount or otherwise ‘significant’ – Not concluded under ‘normal’ market conditions – Counterparty has a ‘material’ interest in the firm More standards than rules but: – US: requires disclosure of any transaction ˃ US$120’000 – France: Auditors must provide special report on any material RPT – Germany: Shareholders have broad-sweeping rights to ask questions 25.03.2015G. Hertig7 Allowing RPT / Disclosure / Transaction Approval / Ownership

8. Enforcing Disclosure Requirements More verification regarding disclosure of: – Insider trades – Profit manipulation Rather standards than rules but: – US: Requires disclosure of any transaction ˃ US$120’000 – France: Auditors must provide special report on any material RPT – Germany: Shareholders have broad-sweeping rights to ask questions Strengthening gatekeeping and enforcement – Fostering monitoring by auditors – Encouraging criminal enforcement in the US – Better private enforcement outside the US (e.g. asking for special audit in F and D) 25.03.2015G. Hertig8 Allowing RPT / Disclosure / Transaction Approval / Ownership

9. III. Transaction Approval Enlisting the board as a trustee – Compliance is relatively cheap – Unlikely to object to fair transactions, likely to raise questions about suspicious ones – Board members may not be independent or able to object Providing for shareholder voting – Shareholders are the ones having to loose from RPT – Better placed than board to deal with controlling owner – Voting costs and collective action problems 25.03.2015G. Hertig9 Allowing RPT / Disclosure / Transaction Approval / Ownership

10. Board Approval Board information as a prerequisite Increasingly required for in listed companies – Managerial self-dealing – Compensation of top executive officers – Exploitation of corporate opportunities Law on the books ≠ case law – Europe and Japan: Statutes more stringent – US: Case law is much richer 25.03.2015G. Hertig10 Allowing RPT / Disclosure / Transaction Approval / Ownership

11. Examples 11 - 14 : Self-Dealing Board Approval Requirements 11.Italy: RPT with executive directors having the authority to decide on RPT 12.Germany: Lending to/significant services provided by supervisory board members 13.UK: De facto all non-routine transactions with directors of listed companies 14.France and Japan: All non-routine transactions with directors or general managers 25.03.2015G. Hertig11 Allowing RPT / Disclosure / Transaction Approval / Ownership

12. Shareholder Voting No jurisdiction requires approval of all RPT Reluctance to impose majority of minority approval for RPT with CS Increasingly required for compensation of directors and top executives in listed firms France and UK target all non-routine RPT – Discretion in defining non-routine RPT – Ex post ‘cover-up’ ratification possible 25.03.2015G. Hertig12 Allowing RPT / Disclosure / Transaction Approval / Ownership

13. RPT with controlling shareholders – Generally dealt with more leniently than RPT with managers – The U.S. as an exception Pro and contra – Large share of their wealth at stake – Contra: Dominant influence on company affairs – Political influence may explain leniency Group of companies as a special case IV. Role of Ownership Regimes 25.03.2015G. Hertig13 Allowing RPT / Disclosure / Transaction Approval / Ownership

14. Examples 15 - 19 : RPT with Controlling Shareholders 15.A owes 40% of company U shares. He would like to be driven to the airport in the company car. Is that possible? What is the proper procedure? 16.B owes 90% of company V shares. He wants to rent the villa the firm owns in Monaco over the summer. Is that possible? What is the proper procedure? 17.Family C is a major shareholder of company W. It would like to get its two children work at the firm during the summer. Is that possible? What is the proper procedure? 18.D is a major shareholder of company X. The CEO tells him that a nice vineyard is for sale in the vicinity of the firm’s headquarters. D is interested in buying the vineyard. Is that possible? What is the proper procedure? 19.E. owes 10% of Bank Y shares. He needs an additional loan to be able to renovate the apartment he owns and would like Bank Y to be the lender. Is that possible? What is the proper procedure? 25.03.2015G. Hertig14 Allowing RPT / Disclosure / Transaction Approval / Ownership