Self-Dealing; Approval and Disclosures Procedural Requirements

Legal systems often impose procedural requirements on self-dealing transactions to determine their structure and to encourage companies to follow a given procedure thereby making it harder for shareholder plaintiff’s to challenge procedurally fair transactions (Conac et al., 2007). Djankov et al. (2008) give examples of how the law can regulate a transaction involving self-dealing so that it replicates the terms and conditions that would exist in an arm’s-length transaction. They propose a series of regulations by which the law can regulate the approval process, including approval of any possible self-dealing transactions by disinterested shareholders, and ex ante disclosure by different parties.

Table 5: Ex approval and Disclosures procedural requirements

Approval of the transaction by disinterested shareholders
Disclosure of the transaction before it can be approved
Independent review (e.g., by a financial expert or independent auditor) before the transaction can be approved

Adopted from Djankov et al. (2008)

A manager who wishes to transact with the firm must generally receive approval from their board of directors’, or the supervisory board, for the process of entering into a self-dealing transaction.

In France, for example, all transactions concerning public companies in which a director or a shareholder with more than 10 percent of the voting rights, has a direct or indirect interest must be authorised ex-ante by the board of directors and the transaction should also be ratified by the annual shareholder meeting, following a special report by the statutory auditors. The interested party must inform the board of directors about the considered transaction and abstain from voting both within the board and at the shareholders meeting (Conac et al., 2007, pp. 10-11; French Commercial Code, Articles L. 225, pp. 38-39).

The degree of reliance of a country’s legal system on the approval of the directors of companies should be a function of the degree of independence of the outside directors sitting in the board of that country’s corporations (Lin, 1996). However, the purest case of arm’s-length endorsement of the transaction is to ask the approval by disinterested shareholders (Kraakman, 2004, p. 105). Asking approval from related parties (i.e., the controlling shareholder, CEO, and interested directors) would be non-guarantor for fair transactions practice as they may vote in favour of the transaction whenever legally possible (Djankov et al., 2008).

However, it should be noted that there are at least three factors that make asking for approval or ratification of transactions by disinterested shareholders a troublesome regulatory solution: first, the transaction costs it entails are high (Davis, 1995); second, it is difficult to find an effective way to differentiate between interested and non-interested parties (Eisenberg, 1988); third, although in theory shareholders in general are the group that is most interested in the fairness of the transaction, due to the difficulties facing collective action it is improbable that they will acquire enough information to make an informed decision (Enriques, 2000).

The second means by which the law can seek to regulate a transaction involving conflicts of interest is by mandating extensive disclosure by the company and the related party before the transaction goes through. Disclosure is widely assumed to play an important role in corporate governance (Hermalin and Weisbach, 2011), and mandatory disclosure, that alerts shareholders to related party transactions, is “among the most significant means of control in the context of public corporations” (Kraakman, 2004, p 103).

Accurate, timely, and publicly available disclosure of such transactions is essential, as it helps minority shareholders to identify potential insider abuse and take action, otherwise this minority is left in the dark. To enhance the disclosure process the law can require a review by independent third parties (e.g., independent auditor or financial experts) who make available a report on the transaction that may act as a check on the opportunism of the insiders before the transaction is approved.

Disclosure to the board is limited in its role and scope in both France and Italy, in contrast to the U.S., U.K. and Germany, where it is required from the director to disclose the nature and degree of their interest. For France and Italy, the requirement goes as far as informing the board of the existence of a suggested transaction in which they have an interest to partake (Enriques, 1998, p. 32).

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