Blinded by ‘Fairness’: Why We Need (Strong) Procedural Safeguards in Screening Self-Dealing and Obtaining a Fair Price Is Not the Answer

Abstract

Ex post court review of related party transactions (RPTs) is one of the main mechanisms to deal with the problem of value diversion in public companies via self-dealing and is extensively made use of in Delaware and until relatively recently in most continental European countries. Such court review has also become to be known as the ‘fairness test’ whose contours may change depending on the jurisdiction and contexts in which it is applied. This study takes issue with the court review of actualized transactions under certain standards from two different perspectives. Firstly, it is argued that the behavioral insights derived from studies by behavioral economists and psychologists suggest that a legal regime that solely depends on the court review of substantive merits of RPTs without any (strong) procedural safeguard may fail to create a robust regime against value diversion. Secondly, acknowledging that the court review of substantive merits of RPTs may be inevitable in some cases, the study then turns its attention to the fairness test itself that compares the terms of an RPT to an arm’s length transaction, and argues that such an objective test fails to fully prevent value diversion. Accordingly, a recalibration of the test and a new framework are proposed.

1 Introduction

Self-dealing transactions are an important issue to address in publicly traded corporations¹ in order to protect (minority) shareholders as public investors. They are a particular manifestation of the agency problem between controlling shareholders and minority shareholders in controlled companies and between directors/managers and dispersed shareholders in widely held companies. Through such transactions [also called related party transactions (RPTs)] corporate insiders (controlling shareholders and directors/managers)² may expropriate company value at the expense of (minority) shareholders. Jurisdictions resort to ex ante and ex post mechanisms to deal with the problem of value diversion in public corporations via self-dealing. Ex ante mechanisms manifest themselves in the form of procedural safeguards. By requiring prospective transactions with insiders to go through certain mechanisms, they attempt to create arm’s length conditions (with an eye to obtaining a fair transaction for the corporation). Ex post mechanisms, on the other hand, include court review of actualized transactions under certain standards to prevent value diversion. Generally, courts police whether the company in question has suffered any prejudice from the transaction, although the exact manifestation of the court review varies in different jurisdictions.³ Such court review has also become to be known as the ‘fairness test’ whose contours may change depending on the jurisdiction and contexts in which it is applied.⁴ A procedural and a substantive safeguard can also be combined.⁵ In fact, every jurisdiction uses a mix of procedural and substantive safeguards. Yet, the weight of protection provided by these mechanisms varies.⁶

Adopting ex post court review without any procedural safeguard in screening RPTs is in fact implementing a liability rule on RPTs.⁷ Any liability rule like an ex post court review under a fairness standard removes the hold-out problem and any costs associated with going through the procedural safeguard.⁸ The efficacy of such a review by a court in vetting self-dealing is well covered in the literature.⁹ This study, however, puts forward two further, unrecognized problems of the ex post court review of RPTs. The first is theoretical. Based on behavioral insights derived from social studies, I argue that a legal regime that solely depends on the court review of substantive merits of RPTs without any (strong) procedural safeguard may create unintended and unhealthy consequences with regard to deterring value diversion via self-dealing by corporate insiders.¹⁰ In the cost-benefit analysis of designing an appropriate regime against value diversion via self-dealing, lawmakers should also consider these consequences. Summarily, I submit that there are also behavioral grounds that may support implementing a type of procedural safeguard in screening RPTs alongside more traditional grounds that cast doubt on the efficiency and effectiveness of court review of RPTs.

The second problem with the ex post court review of RPTs which this study reveals is practical and relates to the current application of the fairness test in most jurisdictions. The basic test utilized by the courts when reviewing RPTs involves scrutinizing whether the terms of the RPT reflect what could have been obtained in an arm’s length bargain. However, this study argues that whether an objective market price has been obtained should not be the only inquiry as transacting at the market price does not necessarily prevent the enrichment of corporate insiders at the expense of (minority) shareholders. The risk is that the transaction may result in a complete waste or a loss of value for the company even if the transaction price is fair or at the level of the market price, and even if corporate insiders share this loss, there may be related gains for them that offset their share of loss. So, RPTs should be evaluated not only objectively but also from the position of the company. What is needed is a test that also takes into account, inter alia, the subjective value of the asset which is bought or sold by the corporation, rather than a test that only ensures that the transaction corresponds to the objective market price. Accordingly, a new framework is proposed. Moreover, I argue that the appropriate remedy to deter corporate insiders from entering into value-diverting RPTs is disgorgement of profits. If the only consequence of the court review of RPTs (either under the current test or under the proposed framework) is compensation of the harm suffered by the company, related parties may still reap substantial benefits from the conflicted transaction. In other words, in addition to loss-based remedies (ensuring a fair price), there should also be a remedy for disgorgement of profits.

Section 2 starts with an account of the ex post court review of RPTs under substantive standards in different regimes alongside an examination of the potential benefits and problems associated with such a mechanism. Subsequently, Section 3 makes a new case for the need for (strong) procedural safeguards to oversee RPTs, based on behavioral insights. Section 4, acknowledging the persisting need for a court review of merits of RPTs in some cases, makes suggestions to recalibrate the test as applied by the courts in order to fully prevent the enrichment of corporate insiders at the expense of (minority) shareholders.

2 The Court Review of Related Party Transactions

The court review of RPTs involves any ex post inspection by courts of RPTs under certain standards to ensure that they are not prejudicial to the interests of the company, including (minority) shareholders. Jurisdictions may resort to such a review without or with accompanying procedural safeguards. Below, I examine the use of the court review as a main mechanism to prevent value diversion in some jurisdictions.

It is fair to say that in the US, or rather in Delaware, ex post court review of RPTs constitutes a main method although, as will be seen, courts incorporate procedural aspects into their review and/or encourage companies and corporate insiders to use procedural safeguards.¹¹ In Delaware, the main standard used by the courts is called ‘the entire fairness test’. Controlling shareholders¹² and directors/managers are fiduciaries under Delaware law and their transactions with the company will be subject to such a test.¹³ The test involves two aspects: fair dealing and fair price.¹⁴ Fair dealing starts with full disclosure of the conflict and material facts surrounding the transaction, and involves considerations of how the transaction was initiated, structured, negotiated and approved. On the other side, fair price indicates the consideration of the substantive merit of the transaction. Generally, the former requirement boils down to the fact that an RPT occurs by following steps that mimic arm’s length bargaining¹⁵ while the latter involves the determination of whether the terms of the RPT (most importantly the financial terms) are comparable to those that would have been obtained in contracting with a non-related party.¹⁶

Controlling shareholders and directors/managers bear the burden of proving ‘entire fairness’.¹⁷ This is where the role of procedural safeguards (once more) comes into play.¹⁸ In the case of transactions with controlling shareholders, the burden of proof shifts to the plaintiffs if the RPT was approved by a well-functioning committee of independent directors or a well-informed majority of disinterested shareholders.¹⁹ In the case of RPTs that do not involve controlling shareholders (like RPTs with directors/managers), such approval leads to a review under the business judgement rule instead of the entire fairness standard.²⁰ A relatively recent decision with regard to mergers with controlling shareholders extended the review under the business judgement rule to such transactions on the condition of dual approval, i.e., approval by a special committee of independent directors and the majority of minority shareholders.²¹

Delaware law differs from the standards of review applied by the courts in other jurisdictions in that it merges procedural and substantive aspects into a single oversight of RPTs. In continental European countries,²² while the role of procedural safeguards has been limited, the ex post review of substantive merits of RPTs by courts appears to play a considerable role.²³

In Germany, for example, there has, until very recently, been no overall, united concept and regulation of RPTs.²⁴ Until the very recent implementation of the Shareholders’ Rights Directive II, there was a limited setting where some procedural safeguards could apply.²⁵ Courts, on the other hand, have abundant opportunity to review RPTs in cases based on the duty of loyalty of corporate insiders,²⁶ group law provisions, the prohibition of concealed distributions²⁷ and a specific criminal law provision as regards breach of trust (Untreue).^28,29

France, too, makes limited use of procedural safeguards.³⁰ Although there is a requirement of board of directors’ approval and shareholder ratification, the real protection against value diversion afforded by these steps is very weak.³¹Ex post court review of RPTs, on the other hand, remains important, and mostly takes the form of criminal liability for the abuse of corporate assets (abus de biens sociaux) and civil liability for directors authorizing harmful self-dealing practices in which case courts scrutinize whether the transactions have damaged the company.³²

Italy, however, made an important step in utilizing strong procedural safeguards in its regulation of RPTs,³³ having previously mostly relied on ex post court review of RPTs and being considered as a jurisdiction of high-volume value diversion.³⁴

In all these jurisdictions (Germany, France and Italy), courts have applied different standards for transactions between the members of a corporate group.³⁵ In the case of intra-group transactions, courts not only scrutinize a particular RPT, but also make an evaluation of the overall relationship of the company in question with the group.³⁶ However, jurisdictions follow different paths in doing so. Germany, being the strictest in this regard, requires in the case of both contractual and de facto groups³⁷ that any loss stemming from acting in the interest of the group rather than in the particular interest of the company in question be compensated.³⁸ In Italy, more flexibly, the parent will not be liable for any damage stemming from an intra-group transaction if it has been offset, taking into consideration ‘the overall results of the parent’s management and coordination activity’.³⁹ In France, the Rozenblum doctrine provides the most flexibility. As long as the structure of the group is stable, there is a coherent group policy and an overall equitable distribution of costs and revenues among group members, subsidiaries may sacrifice their own interests for the corporate group and the parent may divert value from one of its subsidiaries.⁴⁰

2.1 Benefits of the Court Review of RPTs

The merit of a tool to screen RPTs lies in whether such a tool prevents value-decreasing RPTs while allowing value-increasing ones, and this should be done preferably in a (most) cost-effective way. Ex post court review might well be an effective and efficient method of overseeing RPTs, especially if the setting allows a stringent and easy enforcement of standards to which RPTs are subject.⁴¹

The primary benefit of preferring the ex post court review of an RPT over an ex ante procedural (approval) requirement is the same as that of adopting a liability rule instead of a property rule.⁴² Based on a novel theory that classifies legal protections against value diversion via self-dealing into ‘property rules’ and ‘liability rules’, Goshen defines legal protection as a property rule if ‘any contemplated transaction tainted with self-dealing cannot proceed without the minority owners’ consent’, while ‘a liability rule allows transactions tainted with self-dealing to be imposed on an unwilling minority but ensures that the minority is adequately compensated in objective market-value terms.’⁴³ The ex post court review of RPTs qualifies as a liability rule because without any procedural safeguard, corporate insiders will not need the consent of disinterested parties to execute an RPT, but will be required to enter into ‘fair’ RPTs.⁴⁴

The benefit of such a rule is that it will prevent the hold-out problem. The procedural safeguards that empower (minority) shareholders to approve or veto the relevant RPT directly or indirectly (through the requirement of disinterested shareholder approval or the requirement of minority shareholder-dependent director approval) may lead (minority) shareholders to use this power to hold out in an attempt to extract more consideration from the related party, and may ultimately prevent beneficial and fair transactions from being carried out.⁴⁵ The prevention of the hold-out problem, however, may not be as real as readily assumed. Firstly, the value the minority attaches to the asset may be the correct value of the asset for the corporation, which indicates that the transaction was in fact unfair. Secondly, because holding out may also harm the minority (as there is a danger that beneficial and fair transactions will not be entered into as a result), the threat to hold out may not be that credible.⁴⁶

Another benefit of adopting ex post court review instead of ex ante requirements is that the costs associated with other mechanisms can be done away with. For example, requiring RPTs to be subject to the approval of the majority of disinterested shareholders brings with it various other costs for companies. Holding an extraordinary general meeting for every RPT or deferring the completion of transactions until the date of the ordinary meeting, and obtaining fairness opinions from independent financial advisors to be sent to shareholders, dealing with activist hedge funds that may misuse shareholder votes on RPTs are a few examples of such costs.

Jurisdictions further make court review of RPTs available in different ways, even though they primarily adopt procedural safeguards to screen RPTs.⁴⁷ The reason is that procedural safeguards are not value-diversion-proof and resorting to a court serves as a complementary means. For example, the oversight of RPTs by an independent board or committee may not be effective because, simply put, independent directors may be biased in the case of transactions with their fellow directors,⁴⁸ may not be sufficiently informed,⁴⁹ or may be beholden to the controlling shareholder who appointed them in the first place or has the ability to remove them.⁵⁰ Moreover, in the case of a shareholder vote on RPTs, it is at least doubtful whether shareholders will be able and willing to cast an informed and genuine vote against value-diverting RPTs and for value-increasing ones.⁵¹

2.2 Problems with the Court Review of RPTs

As well as benefits, there are some problems with courts reviewing RPTs. As the efficacy of such a mechanism to screen RPTs is well covered in the literature, only a summary of such problems will be provided here.

The first and foremost concern is the ability of courts to understand and evaluate business transactions, let alone the problem of enforcement⁵² (i.e., how easily and how often the duties of shareholders and directors/managers will be enforced). RPTs are more often than not complex transactions and it is important to allow value-increasing RPTs while preventing value-decreasing ones. It is a sophisticated task which not every court will be capable of conducting.⁵³ Often, expert opinions (on the value of the subject of the transaction) will be utilized. However, their accuracy and reliability are questionable.⁵⁴

Even if courts are capable players, the frequency and stringency of enforcement will remain an important issue.⁵⁵ Simply put, while the US courts are stringent in their review of RPTs and US (procedural) laws facilitate suits against corporate insiders, other jurisdictions lag behind.⁵⁶

Along with the usual problems associated with enforcing the duties of fiduciaries before the courts and subjecting RPTs to demanding standards, there might be other important enforcement problems which are, however, also less likely to occur.⁵⁷ For example, as court review of RPTs is an ex post mechanism (or remedy), it is possible that until a lawsuit against the insider who engaged in unfair transactions emerges, the insider will hide or spend most of the gains and/or his/her wealth,⁵⁸ rendering any meaningful remedy impossible or costly to achieve. Moreover, if even disclosure of conflict is not required at the time of the transaction (but only happens later when the relevant RPT is disclosed in the annual accounts), it is likely that harm to the corporation will never be rectified.

3 A Behavioral Case for the Need for Procedural Safeguards

In Section 2, the ex post court review of RPTs as a mechanism to prevent value diversion in public companies and its potential benefits and problems have been examined. In this section, the issue of devising a proper tool to screen value diversion will be studied from a much different perspective. By doing so, another case (a behavioral one) for the need for procedural safeguards as regards the oversight of RPTs will be made.

3.1 The Behavioral Foundations of Corporate Law

Conventional analysis in the (corporate) law and economics literature in general and regarding the regulation of RPTs in particular centers on constraining opportunistic behavior through the use of legal and market incentives, namely external constraints, based on the classic assumptions about human behavior. On the other hand, behavioral insights which challenge those classic assumptions, and analyses based on those insights have considerably found their way into scholarship with regard to many different issues⁵⁹ as behavioral law and economics have gained traction as a field.⁶⁰

To start with, in their seminal article, Blair and Stout put forward the behavioral foundations of corporate law based on their analysis of social phenomena like trust.⁶¹ Indicating that in contemporary legal scholarship ‘the primary factors thought to discourage corporate participants from stealing, shirking their duties, or otherwise mistreating each other are market incentives and legal rules’, they posit that ‘corporate participants cooperate with each other not just because of external constraints, but because of internal ones.’⁶² They also find the homo economicus model ‘potentially misleading when it is applied to explain the relationship between corporate law and cooperative behaviour within firms.’⁶³ They largely draw on the experimental evidence of behavior in social dilemma games,⁶⁴ applying the insights developed in social studies to some corporate law puzzles and issues.⁶⁵

Social dilemma is a phrase used by social scientists to refer to situations resembling the prisoner’s dilemma game where cooperating is the worst strategy for the individual but the best for the group as a whole.⁶⁶ Among others, it has been observed in these experiments that people may act markedly different than expected from a homo economicus, displaying cooperative behavior and maximizing group welfare rather than maximizing their own individual welfare.⁶⁷ Social context has been shown to be a critical factor that affects whether participants in social dilemma games pursue a cooperative (maximizing group welfare) or competitive (maximizing their own welfare) strategy.⁶⁸

Along with Blair and Stout’s pioneering work, one can now find numerous applications of behavioral insights to corporations and corporate law.⁶⁹ It also appears that another promising field of application is the regulation of ‘self-dealing’. Self-dealing is problematic because the agency theory suggests that agents (directors/managers or controlling shareholders) will maximize their own welfare (to the detriment of the company and other shareholders) unless legal and market constraints are in place. However, it is now known that people are not that selfish.⁷⁰ In this regard, from the perspective of regulating RPTs, what is important is not only to put in place rules that prevent value diversion by self-regarding agents, but also to promote other-regarding behavior of these agents.⁷¹

3.2 Self-Dealing: A Cooperative or Competitive Game?

Self-dealing also roughly resembles social dilemmas in social scientists’ parlance or the prisoner’s dilemma in game theorists’ jargon. It is a game played between corporate insiders on the one side and (minority) shareholders⁷² on the other side. While cooperation between these groups, that is corporate insiders enter into only value-increasing RPTs or otherwise do no divert value, is the best for this group as a whole, it is in the interest of corporate insiders to divert value from the company, expropriating other shareholders. Legal and market incentives work towards preventing corporate insiders from diverting corporate wealth through external constraints, thus making them cooperate rather than act in their sole interest.⁷³ While legal safeguards punish or at least undo value diversion, market mechanisms incentivize good corporate governance by punishing undesirable behavior in public companies.⁷⁴ In such games, however, it is also now known that behavioral insights matter. It is important to construct social contexts that create internal constraints as well.⁷⁵

While scholars endlessly debate the shortcomings and merits of various legal safeguards to prevent value diversion in public companies through self-dealing, one of the aims of this study is to highlight one unaddressed advantage of relying on ex ante procedural safeguards rather than on direct ex post court review of RPTs based on the behavioral insights offered to us by social scientists and incorporated by some scholars into their analysis of corporate law, first and foremost by Blair and Stout. The end goal is to make the ‘self-dealing game’ cooperative (i.e., to make it work in the best interest of the company and thus all the shareholders) rather than competitive. As stated above, legal and market mechanisms serve towards this goal. However, I argue that utilizing procedural safeguards comes with the added advantage of framing a setting for cooperative behavior while sole ex post court review of the merits of RPTs would damage such a setting. In other words, procedural safeguards have the potential to promote cooperative behavior internally (as well as externally).

3.3 How Procedural Safeguards May Promote Cooperative Behavior in the Self-Dealing Game

Jurisdictions employ procedural safeguards to constrain the welfare-reducing, opportunistic behavior of corporate insiders when they attempt to turn the ‘self-dealing game’ into a competitive one (namely, when they attempt to divert value). Procedural safeguards may also directly impact the incentives of corporate insiders to divert value in the first place. For example, if a committee of independent directors were successful in vetoing value-diverting transactions, in the equilibrium, it would be expected that corporate insiders would not enter into such transactions in the first place. Instead of (or along with) procedural safeguards, jurisdictions also make use of substantive court review of RPTs, which again serves towards the attainment of the abovementioned goals.⁷⁶ As dramatic a departure as it may seem from the standard economic analysis, changing the internal preferences of corporate insiders and encouraging the emergence of a cooperative stance by manipulating the social context may also be possible.⁷⁷ If one acknowledges this,⁷⁸ another advantage of employing a procedural safeguard and not resorting to court review as the only (or main) option for the oversight of RPTs emerges.

It has been stated above that social context plays an important role in framing a game as a cooperative one even though the rational strategy is to maximize one’s own welfare (in other words, economic payoffs dictate not cooperating). For example, in social dilemma experiments, it has been identified that participants cooperate more instead of defecting when they were told to cooperate by an authority.⁷⁹ Normally, such a factor should not have a bearing on the rational decision to cooperate or not, which should only depend on a calculation of economic payoffs. In our context, too, self-dealing law utilizes this insight in a number of ways. Of course, law encourages cooperation primarily by affecting economic payoffs in undoing or preventing any value diversion. However, corporate insiders are also told that they are fiduciaries and need to act in the best interest of company; in other words, to cooperate.⁸⁰

Blair and Stout state that ‘the key to a successful fiduciary relationship lies in framing both economic and social conditions so as to encourage the fiduciary to make a psychological commitment to further her beneficiary’s welfare rather than her own.’⁸¹ In this vein, law encourages cooperative behavior by removing the expected gains from behaving to the detriment of the company (and its shareholders), but also ‘by socially framing fiduciary relationships as relationships in which the law expects the fiduciary to internalize a commitment to pursue her beneficiary’s interests rather than her own.’⁸² So, legal rules of fiduciary law must promote cooperative behavior both by threatening to sanction fiduciaries and by framing a setting in which they are prodded to cooperate. As regards self-dealing law, which can be deemed as an important part of fiduciary law, both ex ante procedural safeguards and ex post court oversight perform the first function (eliminating economic payoffs of not cooperating) although their effectiveness in this regard is greatly debated. I argue, however, that they differ in the second function, that is, framing a better social context where corporate insiders may make a better commitment to the well-being of the company.

By requiring corporate insiders to go through a tedious process that involves disinterested or independent players before concluding a transaction with the corporation, the law encourages corporate insiders to be cooperative not only by giving the disinterested or independent players veto power over the transactions they deem value-diverting, but also by framing the ‘self-dealing game’ as a process where other parties are involved and discuss the merits of the transaction. The context signals a call for cooperation to corporate insiders, which may indeed trigger this. By articulating such a process, law may influence the behavior of corporate insiders by changing their internal preferences (as well as their external incentives).⁸³

A contrast may illuminate the idea better. Consider the situation that arises when RPTs are only subject to an ex post court review whereby it is determined whether the RPT in question is prejudicial to the company or not. First of all, corporate insiders have the ability to impose an involuntary transaction upon the corporation.⁸⁴ In other words, corporate insiders are at large to deal with the corporation without any input from the independent/disinterested bodies or from shareholders vulnerable to value diversion. To be sure, any business decision, such as entering into a transaction, needs to go through the relevant applicable procedure; however, as this procedure will be dominated by the insiders (without any procedural safeguard), whether the transaction happens or not is totally controlled by the insiders. Courts, in return, scrutinize the transaction under certain substantive standards, demanding mostly fair terms or value. In such a setting, corporate insiders freely enter into RPTs which may or may not be brought before the courts and which may or may not be found to be value diverting. This means that in some cases corporate insiders have the possibility to get away with value diversion (depending on the enforcement of the fiduciary duties and how capable the courts are of catching value diversion), and in other cases they will mostly be required to either compensate the company for any harm or the transaction will be nullified. No matter how good the courts are at detecting value diversion and sanctioning it, which determines the payoff of the self-dealing game and thus external incentives,⁸⁵ such a setting does not stimulate an internal behavioral preference for corporate insiders to act in the best interest of the corporation. Rather, by leaving corporate insiders at large to deal with the company and other vulnerable shareholders playing tag to make corporate insiders account for their behavior, such a context both assumes and legitimates the adoption of a purely self-interested preference function by corporate insiders.⁸⁶ ‘[A] sphere in which the fiduciary can derive benefits from her office and redeem them – post hoc, if and when the company brings suit – at a decent price’⁸⁷ is clearly not conducive to promoting other-regarding/cooperative behavior by corporate insiders.⁸⁸

The self-regarding function which the ex post court review of RPTs spurs corporate insiders to adopt becomes stronger if one considers another behavioral insight: the tendency to discount hyperbolically.⁸⁹ In other words, basically, people tend to reward the imminent benefits while discounting the non-imminent punishment.⁹⁰ In the ex post court review of RPTs, corporate insiders are to account for the harm suffered by the company after they have enjoyed the benefits for a while. In such a case, it is reasonable to believe that they will not be much concerned (irrationally) with the consequences of their breach due to a hyperbolic discount while they enjoy immediate private benefits. In that case, it is hard to promote cooperative behavior.

Attempting to resolve the difficult issue of screening RPTs through sole ex post court review instead of adopting strong procedural safeguards may also have another negative effect with regard to changing corporate insiders’ internalized preferences and framing a social context where corporate insiders are encouraged to conceive their relationships with the company and other shareholders as cooperative ones. An important finding of the experiments of behavior in social dilemma games is that the decision to cooperate or not also depends on the participants’ perceptions of others’ expectations and likely behaviors.⁹¹ Translating this finding into the corporate law context, Blair and Stout argue that while fiduciary lawsuits may deter opportunism by creating a threat that such behavior will be punished, at the same time, they ‘unavoidably send the signal that others in the business world are choosing to violate their fiduciary duties. The more suits brought, the stronger the signal.’⁹² A similar effect can be observed as regards self-dealing. The higher the number of cases that concern value diversion from the company by corporate insiders and thus breach of fiduciary duty, the more likely that such behavior will be signaled as normal and common to corporate insiders. The advantage of employing a strong procedural safeguard instead of or along with an ex post court review is that some value diversion may be prevented within the company. Fewer cases before the courts may positively shape expectations about what other players are likely to do (players not in the sense of counterparties playing the same game but all the participants playing the same self-dealing game), which in turn may affect the decision to cooperate or not (in other words, to divert value or not).⁹³

Therefore, the existence of procedural safeguards, rather than adopting mere ex post court review of RPTs (i.e., a liability rule regime), may harness the social context necessary to impede the self-regarding function of corporate insiders. Admittedly, not every procedural safeguard will function to the same extent in this regard. The potential effect of the procedural safeguard in this context will be a function of its ability to create a real arm’s length bargaining environment.⁹⁴

Furthermore, some authors emphasize the role of law in expressing and reinforcing social norms, which may in turn affect the behavior of subjects of social norms.⁹⁵ Eisenberg and Rock argue in different articles that corporate fiduciary law drives the behavior of corporate agents (care and loyalty) not through the threat of liability but by influencing the development of social norms.⁹⁶ They further contend that people might obey social norms because they may internalize these norms⁹⁷ or because of the consequences attached to a failure to obey.⁹⁸ In this sense, self-dealing law may also express and reinforce the already existing social norm of not stealing. Corporate insiders may be driven by the fear of (social) sanctions they foresee if they are caught diverting value from the company. However, this relates more or less to external constraints on the behavior of corporate insiders that determine the incentives to engage in a certain behavior (i.e., a reflection of homo economicus). More importantly and in line with the theme of this study, corporate insiders may rather internalize the norm of non-value diversion.⁹⁹ Relatedly, creating a setting by law that facilitates the preference of cooperative behavior internally may also reinforce social norms in this regard and lead corporate insiders to internalize them.¹⁰⁰

In brief, the self-dealing game is in essence a competitive one. That is, rationally, corporate insiders would endeavor to maximize their own welfare through value diversion to the detriment of the company itself and its shareholders.¹⁰¹ Legal and market mechanisms are in place to avert this. Yet, it is unreasonable and unfair to perceive all corporate insiders as ‘thieves’.¹⁰² Some are trustworthy without any legal or market sanction for any contrary behavior.¹⁰³ Social studies also reveal that such cooperative behavior can be cultivated internally and the law does this in a number of ways. In this regard, I submit that implementing a (strong) procedural safeguard in the oversight of RPTs would be a right step in this direction. One may doubt the value of constructing a setting which promotes cooperative behavior internally in the face of extensive legal and market mechanisms in today’s capital markets. Yet, each mechanism has its own limitations and costs, which makes it important that corporate insiders are nudged into changing their preferences.¹⁰⁴ Granted, economic stakes in non-cooperation may be great, which would lead corporate insiders not to cooperate (that is, to divert value).¹⁰⁵ This is the reason why virtually all legal regimes and markets implement measures against value diversion via self-dealing.¹⁰⁶ However, one should also consider in the cost-benefit analysis of such measures how they affect the internal preferences of corporate insiders based on behavioral insights alongside external incentives.¹⁰⁷

3.4 Evaluation of the Current Legal Regimes

At this point, an evaluation of the current legal regimes based on the previous parts should be made. In light of these explanations, the ‘fair dealing’ prong of the Delaware courts’ entire fairness test becomes sounder. Delaware courts not only scrutinize the substantive merits of a transaction but also pose a series of other requirements that create an arm’s length dealing environment.¹⁰⁸ Scholars have questioned this approach, asking ‘[t]o what else are shareholders entitled beyond a fair price?’¹⁰⁹ In addition, one might think that in terms of external incentives for corporate insiders to divert value, the fair terms component is sufficient because it removes any payoff from self-dealing, deterring insiders from diverting value via self-dealing in the first place.¹¹⁰ Yet, there also exists the requirement of fair dealing which corroborates the idea that self-dealing law is also concerned with the behavioral message it conveys. This approach is consistent with the setting corporate law should create as regards the oversight of self-dealing, as argued above. Furthermore, conventionally, the ‘fair dealing’ aspect of the entire fairness test has been understood as creating arm’s length bargaining with the ultimate aim of obtaining fair terms. In other words, the fair dealing aspect has been subordinated to the fair terms aspect. However, ‘fair dealing’ is important on its own as far as behavioral stimulus is concerned, whether it leads to a fair price for the company or not.

From this standpoint, it is also regrettable that in some cases before Delaware courts, one can observe a de-emphasizing of fair dealing and rather a focus on fair price aspect.¹¹¹ On the other hand, Delaware courts also encourage the use of ex ante procedural safeguards by making it harder for the plaintiffs to challenge a self-dealing transaction approved by independent directors or disinterested shareholders.¹¹²

Procedural safeguards, however, may not be adequate on their own. For example, the requirement of disinterested board approval in the case of a transaction with the controlling shareholder may not be really meaningful for minority shareholders as the entire board, which is dependent on the controlling shareholder, will vote on the transaction.¹¹³ Nevertheless, even this requirement conveys the message that the controlling shareholder cannot freely and easily enter into transactions with the controlled company without the approval of the board of directors who are supposed to represent the company and owe fiduciary duties to (minority) shareholders. However, this does not mean that all procedural safeguards would be the same in terms of the setting in which they put corporate insiders when dealing with the company. For instance, a special committee of independent directors which has the power to negotiate, to obtain information (as well as obtain advice from a financial expert of its own choice at the company’s expense) and to veto the transaction strongly implies that corporate insiders do not have a free hand and will not be left to be chased to account for the transaction (in the sense of playing tag); rather, they need to follow a cooperative procedure. The US (Delaware), Italy and Belgium implement such a setting in different degrees.¹¹⁴ There are also proposals to give ‘minority shareholders-dependent directors’ screening power over RPTs.¹¹⁵ If adopted, not only may they strengthen the effectiveness of board approval as a procedural safeguard in preventing value diversion via RPTs,¹¹⁶ but they will also contribute towards developing a social context where corporate insiders may internalize a preference for cooperative behavior.

In this regard, the Shareholders’ Rights Directive II is a welcome development in the EU.¹¹⁷ Although the procedural safeguards have been greatly watered down in the legislative process,¹¹⁸ the end product requires Member States to adopt at least a procedural safeguard,¹¹⁹ the strength of which depends on the Member States’ implementation of the Directive.¹²⁰

Finally, US (Delaware) law may, at first glance, appear a bit different because procedural requirements/safeguards are incorporated into ex post court review. However, the ultimate outcome is the same. If corporate insiders fail to follow procedural requirements/safeguards, they will fail the entire fairness test or be subject to a more challenging inquiry. In other jurisdictions, if they ignore procedural requirements, they will face whatever consequences are attached to such conduct (nullification, compensation, fines, punishment, etc.). Delaware law may even be deemed a step ahead because, thanks to its comparatively strict and easy enforcement, corporate insiders may be less willing to disregard procedural requirements.

3.5 Conclusion

Although corporate law and governance have been a bastion of the traditional law and economics approach (based on the rational actor model), behavioral considerations regarding the corporate actors have become ubiquitous in studies. While the law might not yet have found the sweet spot with regard to the regulation of RPTs,¹²¹ it may be beneficial to also utilize the behavioral insights offered to us by social sciences in preventing value diversion through self-dealing.¹²² In this vein, this study indicates the benefits of ex ante strong procedural safeguards in contrast to mere ex post review of substantive merits of RPTs by courts in consideration of creating a social context that promotes cooperative behavior by corporate insiders.

In addition to informing sound RPT regulation, behavioral insights may also demonstrate in what (type of) companies cooperative behavior is most or least likely to emerge, allowing shareholders themselves to focus on problematic companies and to intervene if necessary.¹²³

Generally, corporations and business settings have been thought to be immune from deviations from the rational actor model because ‘irrational’ actors would be eliminated from the market.¹²⁴ Although research also abundantly shows that ‘irrationality’ may survive in such contexts,¹²⁵ the above contention is true to a certain extent. However, in our setting of self-dealing, the supposedly irrational behavior (not diverting value from the company) is highly beneficial, and would promote the individual corporate insiders who do not divert value and the corporations which do not harbor self-dealing, rather than eliminating them from the market.¹²⁶ The existence of such ‘irrational’ behavior becomes more obvious when one thinks of a question asked by a group of scholars: ‘If there are gaps in … laws, and some tunnelers do indeed take advantage of them, then why aren’t tunneling opportunities more widely exploited?’¹²⁷

Nevertheless, there is another important factor to consider: how likely it is for the behavioral insights observed in the social experiments to be duplicated in the self-dealing context.¹²⁸ Admittedly, there should be further empirical observation in this regard before more concrete steps can be taken.¹²⁹ There is great potential for research here with regard to the bounded self-interest of corporate agents and devising legal rules in channeling this towards well-known goals such as preventing value diversion.

4 Recalibrating the Fairness Test

The need for procedural safeguards, based either on the behavioral case made above or on other grounds, generally does not remove the need for court review of RPTs and thus for the fairness test. This may be so because, as mentioned above, procedural safeguards are not entirely able to prevent value diversion from the company.¹³⁰ Moreover, it should be acknowledged that an ex post court review of an RPT’s merits is inevitable in some cases even though there exists a proper procedural safeguard to prevent value diversion. Such cases include the following. Firstly, when the relevant procedural safeguards are not followed and the transaction cannot be unwound due to complexity, the court needs to award rescissory damages, which will necessarily include an evaluation of the terms of the RPT.¹³¹ For example, after a parent-subsidiary merger that did not follow the relevant procedural requirements, it may be impossible to break up the merged company (i.e., to unscramble the eggs). Secondly, even if the transaction can be rescinded, the asset sold by the company might have been acquired by a bona fide third party.¹³² This means that the transaction not duly approved, though void inter se, is not void toward a third party who did not know or should not have known about the lack of approval. Thirdly, in the case of approval by (a committee of) independent directors, the courts might need to review the terms of the RPT when ruling on the duty of care and the good faith of the approving directors.¹³³ Lastly, procedural safeguards may not apply to all RPTs. For example, the requirement of disinterested shareholder approval may only apply to material transactions defined quantitatively or qualitatively. In this case, for other transactions, a claim can still be made before the courts under a fiduciary duty standard.

As much as we may need to rely on ex post court review of RPTs in the context of RPT oversight, I argue that there is a need to recalibrate the test applied by the courts when reviewing transactions in order to ensure that value diversion from the company does not occur. The proposal is, in the most simple terms, that there should be a shift from primarily considering the objective value of the asset to considering its subjective value in some cases.

4.1 The Current Test

In the most basic understanding, the court, in its ex post review of an RPT, applies the arm’s length criterion, namely comparing the transaction in question with a market transaction concluded at arm’s length.¹³⁴

In reality, however, the task is more complicated. When the object of an RPT is a homogenous asset/service, there will be a market price and then necessarily the relevant benchmark will be this market price because the company could easily perform an alternative transaction in the market at the market price.¹³⁵ If there is no market price, however, or the object of an RPT is a differentiated asset/service, the court has to consider the range of prices at which a reasonable buyer or seller would be willing to buy or sell the asset/service, mostly depending on the objective valuations of experts.¹³⁶

In each case, however, the basis of the evaluation of the deal is objective valuation, whether from a market price perspective or a reasonable buyer/seller perspective.¹³⁷ Nevertheless, I submit that objective valuation will not necessarily prevent value diversion and ensure that corporate insiders do not extract private benefits from the transaction to the detriment of (minority) shareholders, as explained in detail in the next part.¹³⁸

4.2 A Proposal

The risk with the current test lies in the fact that objective valuation will not always be a good proxy for the value of the asset for the company¹³⁹ and for the value diverted from the company. One should rather consider the counterfactual, comparing the situation after the transaction with the situation of the company if the transaction had not happened.

Sometimes, the absurdity of comparing the terms of an RPT to a market transaction will be obvious. For example, ‘if a manufacturing company that lacks sufficient working capital allocates some of its scarce funds to purchase at a market price a sailing yacht’¹⁴⁰ from a controlling shareholder, the fact that the price paid for the yacht was a market price will apparently make the transaction pass the relevant test. Obviously, the company can undo the transaction in the market (i.e., sell the yacht) and recover the working capital. However, it will incur transaction costs and be deprived of the working capital for a period of time. One can reasonably assume that the balance sheet of the company will seem different after and before the transaction.

In other cases, value diversion will be subtler. In such cases, despite the fact that the transaction will happen within the reasonable range of market prices, the value lost by the company will be higher than the consideration it obtains. This may be because the specific asset will generate more value for the company than its objective valuation. In other words, the subjective value of the asset is more than its objective value. For example, if a sale of distribution facilities by the company to a corporate insider will affect its competitiveness with a rival company in an area and thus result in less profitability, the company will still lose value as a result of the sale, even if the latter has occurred within a reasonable range of market prices. There might also be positive/negative synergies between the assets, and transferring some assets from or to the company might reduce the value of remaining assets for the company and thus its profitability.¹⁴¹ In such cases, even the best price obtainable in the market may not reflect the true (subjective) value of the asset for the company.

In all these cases, although it seems that value is lost as a result of the RPT, at first glance, it is not in the interest of the controlling shareholders to make the company lose value because they will share the loss pro rata depending on the size of their shareholding and will not gain from the transaction as the latter happens within the reasonable range of market prices. So, one can reasonably assume that if the transaction appears to conform to market realities, then the RPT will not be against the interest of the company, nor of its shareholders.¹⁴² Yet, this will not always be the case. Controlling shareholders may compensate their loss resulting from the company’s suffering through profits generated via assets bought from the company or via utilizing the consideration from the sale of an asset to the company.¹⁴³ Back to the above example, if the controlling shareholder uses the distribution facility he/she bought from the company at a market price in order to make his/her other business more profitable, then he/she can easily offset losses resulting from the operations of the controlled company. A further example (but where the controlling shareholder is on the seller side of the transaction) may be a transaction whereby the controlling shareholder sells an asset to the company at the market price to meet his/her liquidity needs. Such a transaction means diversion of company funds from the company operations to fulfill the controlling shareholder’s needs, which may translate into a value loss (in the sense of opportunity cost) for the company. Even if the company will lose value as a result and the controlling shareholder will share this loss pro rata, it can be in his/her interest to enter into this transaction if his/her loss would be bigger should he/she not sell the asset to the company to meet his/her liquidity needs. Such cases are summarized in the Table 1 below.

Table 1 Stylized summary of the abovementioned cases

Moreover, such transactions may be entered into with directors/managers who do not have a (substantial) economic stake in the company nor need to worry about their positions even if the company loses some value as a result of the RPT.

Therefore, even if an RPT conforms to arm’s length transactions, there still might be a value loss for the company.¹⁴⁴ If such a suspicious fact pattern is identified, an assumption should arise that controlling shareholders (who would normally lose from such transactions on a pro rata basis) derive private benefits from entering into these transactions, enough to offset their losses. In any event, if there had been no surplus for the controlling shareholder from entering into such an RPT, the transaction would not have happened in the first place.

Based on these considerations, a new scheme for court review of RPTs is proposed. In the case of transactions with controlling shareholders, a court may still first look at whether the transaction conforms to the terms of an arm’s length transaction, the controlling shareholder carrying the burden of proof . If the transaction seems to have been carried out on market terms, the court may reasonably assume that there is no value diversion from the company because it is not normally in the interest of controlling shareholders to enter into RPTs that harm the company but do not offer them gains over market prices. However, if the plaintiffs could demonstrate the loss in the value of the company as a result of the relevant transaction, the court, as a principle, should rule for damages as such a suspicious situation indicates that there might be other gains for the controlling shareholder. Then, the controlling shareholder should be allowed to prove that he/she entered into the transaction in good faith, meaning that he/she rationally believed that it was in the best interest of the company.¹⁴⁵

A simpler framework should apply to directors/managers. Similarly, the first step will be to analyze the terms of the RPT in order to determine whether it conforms to market realities. The plaintiffs should be allowed to establish that even if the transaction conforms to market conditions, the company has lost value as a (direct) result of the transaction. The court, then, should rule for damages unless the directors/managers are able to show that they entered into the transaction in good faith.¹⁴⁶

Obviously, such a framework would be more difficult to implement.¹⁴⁷ Yet, at the same time, it would provide more protection against value diversion. Like the current court review of RPTs, it would work best in a regime with courts involving sophisticated judges adept at understanding and solving financial matters, and with procedural rules that allow the parties to acquire as much information as possible from the counter- and third parties. This is simply because such a framework would involve more complex financial valuations and projections,¹⁴⁸ and the plaintiffs would need more information (which may be in the possession of other parties) to back their claims. On the other hand, such a framework would provide a more efficient allocation of resources as it may prevent transfer of resources from the party that most values it (the company) to another party (corporate insiders).¹⁴⁹

In addition, one may argue that such a framework may lead to undue involvement of the courts ex post in business decisions that are made ex ante, which is generally undesirable because of the difficulties/perils associated with such review.¹⁵⁰ Yet, this framework would only slightly (if at all) expand the courts’ review of the business decision that led to the relevant RPT. In this framework, as a rule, the courts will still conduct their traditional analysis (i.e., comparing the terms of RPTs to their arm’s length counterparts). However, they will not stop when they establish that the RPT in question was carried out on market terms. In case there is sufficient proof that the RPT was still harmful for the company even though it was on market terms, the court will directly rule for damages (without any inquiry into the merits of the business decision to enter into the RPT) because, as explained above, especially in the case of transactions with controlling shareholders, such a situation suspiciously indicates that there might still be value diversion from the company (i.e., private benefit extraction by the insider). When the related party uses the opportunity to establish that the transaction was entered into in good faith (to avoid a damages ruling), the court’s review of the business decision to enter into the RPT is still minimal and limited to establishing whether the related party could sufficiently argue that he/she rationally believed that the transaction was in the company’s best interest.¹⁵¹

One further point is that the remedy for an unfair transaction (as understood currently or in the new framework) should be disgorgement of profits.¹⁵² Damages (either rescissory or other) or a remedy based on the appraisal standard will not be sufficient to deter corporate controllers from entering into value-decreasing transactions.¹⁵³ The reason is that even if they are held accountable to pay damages for unfair transactions, they will still be able to reap substantial benefits from the transaction, which may exceed the amount they need to pay to the company.¹⁵⁴

In brief, the fact that the RPT in question conforms to market conditions that would have been obtained in an arm’s length relationship does not mean that (i) the company does not lose value as a (direct) result of the transaction, and (ii) the controlling shareholder/directors do not gain any private benefit from the transaction. There might still be cases where there is value diversion in the broadest sense. A better framework is needed to take account of these situations as well as to provide proper remedies.

5 Conclusion

Almost all regimes implement measures against RPTs through which corporate insiders may enrich themselves at the expense of (minority) shareholders. In particular, two mechanisms come to the forefront: (i) ex ante procedural safeguards which leave the task of policing RPTs in the hands of disinterested parties before the transaction in question is completed, and (ii) ex post court review of the merits of completed RPTs. Obviously, each mechanism has its own merits and shortcomings, and certainly, the particularities of each jurisdiction may dictate how to devise proper RPT regulation.¹⁵⁵

This study approaches ex post court review of RPTs from a theoretical and practical perspective. First, it endeavors to demonstrate how sole reliance on ex post court review of RPTs without utilizing (strong) procedural safeguards may impair the robustness of a legal regime against value-diverting self-dealing. Departing from a traditional law and economics analysis that operates on the classical assumptions of human behavior, this study draws on behavioral insights distilled from social studies and indicates that the context created by a liability-rule RPT regime (i.e., a regime that relies only on ex post court review of RPTs) may not be conducive to harnessing non-opportunistic behavior of corporate controllers. Admittedly, this analysis remains tentative without relevant empirical observations in the field. Yet, scholars and regulators have long recognized the limits of conventional tools,¹⁵⁶ and new ways of making agents/fiduciaries respect the interests of principals/beneficiaries may prove valuable. It is also highlighted that self-dealing is a fertile ground for behavioral research, which so far has remained within the confines of conventional analyses.

Secondly, I argue that there is a need for a better test to be used by the courts when reviewing RPTs in order to fully prevent value diversion from companies. Although this study advocates making use of (strong) procedural safeguards based on the behavioral insights explained above, ex post court review of RPTs remains both necessary and inevitable. Nevertheless, the arm’s length criterion constitutes the main test for the courts and lacks the sophistication needed to avert the less direct attempts of corporate insiders to divert value from the company. In this regard, this study proposes a new framework for the courts to adopt. Although it is more difficult to implement, it is necessary to prevent transactions that cause loss for the company but may benefit corporate insiders. Likewise, I submit that following a breach of the fiduciary duty, the proper remedy is disgorgement of benefits, not damages. Otherwise, the latter would allow corporate insiders to reap substantial benefits from entering into value-decreasing RPTs while only compensating the harm suffered by the company. This is important as far as the incentives to deter corporate insiders from entering into value-diverting RPTs are concerned.