1. 1 IDENTIFYING RELATED PARTY TRANSACTIONS: POLICY TRADEOFFS JOSEPH A. McCAHERY Professor of Law Tilburg University & ECGI OECD CORPORATE GOVERNANCE ROUNDTABLE MOSCOW November 12, 2004

2. 2 Two Views and Four Points Related Party Transactions –Play important and legitimate role in economy –But if left unchecked, could foster opportunism Points –(1) Through related party transactions, controlling shareholders and managers may extract private benefits of control –(2) Potential for abuse and high cost of regulating these transactions has led to a range of regulatory strategies –(3) Strategies and techniques include: mandatory disclosure, board approval, fiduciary duties, shareholder voting –(4) Russian law definition of related party usefully supplemented by IAS 24

3. 3 Identifying related parties Broader definition recommended –Purpose: tighter definition of what constitutes affiliated party required Various legislative strategies available, but no simple formula –Establish main classes of persons that constitute affiliated or related party –Examples include FASB 57 –Avoid transplants approach, tailor to local circumstances

4. 4 Mandatory Disclosure Main pillar of regulation of conflicted transactions in most jurisdictions –US securities law (SEC S-K,(all major transactions, 5%); item 402 (executive compensation); 404 (certain relationships & related party transactions) –Accounting rules (GAAP: SFAS 57 (related party disclosure): all material transactions between firm & officers –State law: fiduciary duty law requires disclosure of conflicted transactions –Sarbanes-Oxley 16(a): officers must disclose trades in companies shares (w/in two days)

5. 5 Mandatory Disclosure (2) Prompt, continuous updating of information on related party transactions to market –Procedures to facilitate accuracy and speed Wide range of available strategies for accountants and auditors to facilitate disclosure –Tool kit approach to identify conflicted transactions: asset sales that diverge from market value, etc. –Company directors: extended audit

6. 6 (1) Effective Enforcement EU & US Experience Effective enforcement tools needed Presumption: clear, open, effective disclosure –Trade-offs Capital market implications Facilitates other regulatory tools and institutions But may create burdens –May be costly for companies –Centralized disclosure system—front end costs –Restricted impact—does not impact all firms equally Administrative Liability for non-notification –Interested parties must disclose 20% –Administrative measures needed –Follow best practice—adopt codes, internal systems

7. 7 (2) Board approval Anglo-Saxon & some Continental European jurisdictions encourage board approval of conflicted transactions 1) supplies strong protection from shareholder challenge –JSC Law—affiliated parties identified in transaction, Board votes (1000+ only independent directors) Remedies for transactions w/o approval--void or damages Tradeoffs—ex ante v. ex post Lower transaction costs for parties to bring claim Improve quality of directors

8. 8 (3) Fiduciary Duties Similar approaches in common law and civil law jurisdictions—less willing to review conflicted transactions approved by board But, US has more developed case law: Duty of loyalty: proscribes mangers from entering self- dealing or unfair transactions 1) Courts review conflicted transactions—but less willing to review decisions approved by disinterested director 2) Incentives for direct and derivative shareholder suits (procedural obstacles are high outside US)

9. 9 (4) Fiduciary Duties in Russia Provide basis for shareholders to obtain remedies –Legal requirements to act reasonably and in good faith, Corporate Governance code –Incentives to bring actions weak –Lower cost of capital if good enforcement culture develops

10. 10 Shareholder Voting Shareholder voting (alternative to board approval) –Fr: (Art L. 225-40 Code de commerce)—requires shareholder approval of conflicted transactions –Other jurisdictions have less demanding rules: US, UK –Voting: Neither costless nor perfect, but may work well in some circumstances –OECD: calls for more shareholder input into extraordinary transactions