The Effect of Governance on the Valuation of Related Party Transactions: Evidence from East Asia

This study explores the role of governance in mitigating agency problems associated with related party transactions (RPTs). This research is designed to explore the relationship between governance and related party transactions on firm value.  While RPTs are normally executed in the ordinary course of business, conflicting views exist on their economic effects.  The efficient transaction theory views RPTs as value-enhancing activities that can reduce transactions costs, optimize internal resource allocation, and improve return on assets. In turn, the conflict of interest theory views RPTs as value-decreasing activities that can be abused to expropriate shareholders’ wealth.  From the perspective of contingency theory, different types of RPTs may have different valuation effect. This is because contingent factors concerning institutional environment and specific organizational contexts create different underlying incentives surrounding RPTs.  The conflicting views on the valuation effect of RPTs are more apparent in the institutional setting of an emerging market such as East Asia.  On one hand, RPTs are perceived as rational and beneficial in emerging market where most diversified business adds value by replicating the functions of institutions that are missing in the market.  On the other hand, abusive RPTs are facilitated in emerging market where inappropriate institutional, law and legal enforcement shields controlling shareholders from internal governance structure.  Further, while cases of abusive RPTs in East Asia are noted in several fraud incidences involving related parties, there are considerable efforts to improve the regulatory requirements surrounding RPTs including strengthening the capital market regulations and approval procedures on RPTs. 

In this study, we posit that high quality governance may be able to reduce the risk of appropriation involving RPTs.  Hence, in countries with high quality governance embedded in their institutional environment, RPTs are more likely to be engaged by managers to enhance shareholders wealth.  We test whether RPTs are associated with firm value, and if so, whether the strength of the relation depends on the quality of the country-level governance.  We employ total value of related party transactions to measure RPTs and an aggregate index of legal and political institutions to rate country-level governance.  Our sample consists of 278 publicly listed companies from East Asian countries, namely Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand.  Our findings are expected to add to the evidence on the value of RPTs from the perspective of emerging countries where severe agency conflicts and weak investor protection increase the likelihood of higher risk of managerial rent diversion as compared to the developed countries. Further, we consider the role of country-level governance in explaining the valuation effect of RPTs. This perspective is commonly neglected in prior studies that tend to focus on a single-country setting.  Our study is also significant as it sheds some light on the significance of the recent regulatory reforms, which influence both the internal and external governance mechanisms, in explaining the variations in the economic consequences of RPTs.