Agency Costs, Contracting, And Related Party Transactions

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Agency Costs, Contracting, and Related Party Transactions

Mark Kohlbeck

Brian Mayhew *

University of Wisconsin Madison

December 2004

Financial support from the University of Wisconsin, School of Business is greatly appreciated. Weappreciate comments received on earlier versions of this paper from Ryan LaFond and Terry Warfield andworkshop participants at Florida Atlantic University, the University of Kentucky, and the University ofWisconsin Madison.

* Corresponding author

University of Wisconsin - Madison975 University AvenueMadison, Wisconsin 53706608-262-2714

[email protected]


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ABSTRACT

We examine related party (RP) transactions using agency and contracting theory as guides.

Agency theory suggests opportunistic behavior can generate RP transactions; however, RP

transactions can also result from or be managed via contracting. We therefore investigate

associations between RP transactions and compensation-based incentives, monitoring

mechanisms, and links to executive compensation for a sample of 1,261 firms. We find RP

transactions are associated with weaker corporate governance, CEO stock options, and inversely

associated with CEO and directors cash compensation. In a direct analysis of CEO

compensation, we find a positive association between unexpected CEO compensation and RP

transactions with companies the firm partially owns (i.e. investments) suggesting that CEOs are

compensated for running more complex organizations. Finally, we examine returns in the period

following RP disclosure. The results suggest lower future returns for simple RP transactions

involving directors, officers and major shareholders. However, future returns are marginally

higher for companies engaged in RP transaction with investments. Our compensation and returns

analyses suggest related party transactions with investments appear to be associated with efficient

contracting, while simple transactions with directors, officers and shareholders are associated

with opportunism.

Key words: Related party, agency theory, contracting theory, compensation

Data availability: The data used in this study is available from public sources


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INTRODUCTION

Recent policy decisions by Congress suggest a need for a better understanding of related

party transactions. Even though audit standards list related party transactions as one of the red

flags indicating increased fraud risk (AICPA 2001), recent high-profile frauds continue to

involve related party (RP) transactions. For example, Enron used special purpose entities

controlled by its CFO to manipulate income and transfer cash, and Adelphia guaranteed related

party debt and provided extensive loans to executives. Congress reacted to these failures by

enacting section 402 of the Sarbanes Oxley Act banning most loans to officers and directors.1

Congress did not provide any systematic evidence in its arguments for banning these RP

transactions, nor was any discussion given as to what types of transactions should be banned. 2

The lack of systematic information suggests a need for additional RP transaction research.

This paper examines related party transactions using agency and contracting theories as a

guide. We therefore investigate compensation-based incentives and monitoring of firms that

engage in RP transactions. We then conduct in-depth analysis of the association between CEO

compensation and RP transactions. Finally we examine the association between RP transactions

and future stock returns. Agency and contracting theories suggest the type of related party

transaction matters in assessing its potential to be beneficial or detrimental to a firms

stakeholders. So, we also examine the types and nature of RP transaction in each of our analyses.

This research contributes to an emerging research stream examining RP transactions that has

1 Section 402 allows loans existing at the date of the act to continue and to allow loans that are essentiallyin the normal course of business and at normal terms to continue. This allows financial institutions tocontinue to provide normal consumer related loans at market rates to their officers and directors.2 Post Sarbanes-Oxley, the Securities and Exchange Commissions (SEC) examined enforcement actionsfrom 1997 to 2002 and found that 23 of the 277 enforcement actions were related to the failure to properlydisclose related party transactions (SEC 2003).


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evolved due to their role in a number of audit and accounting failures (Erickson et al. 2000,

Swartz and Watkins, 2003, Gordon, et al. 2004, Shastri and Kahle, 2003.).

The issuance of section 402 is consistent with the background information supporting

Statement of Financial Accounting Standard No. 57, Related Party Transactions (FAS 57). FAS

57 documented policy makers concern that related parties can exercise influence such that one of

the partys interests may be subordinate to the other.3 For example, a firm can lease a plane from

a company controlled by an executive of the firm, and pay a rate greater than what would be

required by an unrelated air service. In this case, the executive extracts some of the firms wealth

and transfers the wealth to himself via the related entity. The Financial Accounting Standards

Board (FASB) also expressed concern that related party transactions could impact the reliability

of financial information both in terms of representational faithfulness and reliability of reported

amounts (FAS 57, 15).4

Although the FASB emphasizes the potential wealth transfers associated with RP

transactions, the transactions can also be in the stakeholders best interests. For instance, some

companies have strategic investments in joint ventures or other companies to obtain access to

supplies or markets (e.g. vertical integration) and to manage risk. In addition, RP transactions

can be a component of compensation arrangements.

We incorporate insight from agency and contracting theory into why companies enter

into RP transactions. Contracting theory suggests RP transactions can be part of efficient

contracting with related parties. RP transactions can be a component of the overall formal or

informal compensation package where RP transactions substitute for cash-based compensation to

officers and directors, or provide more liquid compensation to officers and directors when

3 This concern is consistent with the concerns based on agency theory.4 Enrons RP transactions provide a example of how RP transaction can reflect both evidence of one partyprofiting at the expense of the other and the use of RP transactions to reduce the reliability of the financialstatement. Andrew Fastow, former CFO of Enron, appears to have personally profited from a number ofthe partnerships he created to engage in RP transactions with his employer Enron. He also was able asCFO to increase the reported profitability of Enron via these transactions. As Enron began to collapse, itbecame apparent that the profitability reported by Enron as a result of the RP transactions was not reliable.


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executives have high stock option levels. We therefore examine the associations between firm

compensation characteristics that suggest incentives for insiders to enter into RP transactions.

RP transactions also raise concerns based on agency theory that managers will over

consume perquisites.5 This over-consumption damages the firms stakeholders (Jensen and

Meckling 1976, Holmstrom, 1979, 1982). Related party transactions that favor the related party

to the firms detriment represent examples of perquisite consumption (i.e. inappropriate wealth

transfers). RP transactions can also alter the reliability of financial statements thereby reducing

the effectiveness of contracts designed to reduce agency conflicts. The risk that RP transactions

may damage stakeholders gives rise to a demand to monitor such transactions.

We examine the association between different monitoring mechanisms and RP

transactions. Monitoring can interact with RP transactions in two different but related ways.

First, monitors can actively discourage or prevent related parties from extracting wealth from the

firm or misreporting financial statement impacts. For example, a lender may include provisions

in the loan covenants that strictly forbid RP transactions without the lenders approval. Second,

companies that engage in RP transactions can attempt to signal to investors the transactions

benefits by adopting monitoring mechanisms designed to prevent wealth extraction or financial

misreporting by the RP. For example, a firm may assign independent directors to review RP

transactions.

We review and classify footnote disclosures from fiscal 2001 Form 10-Ks (annual

reports) and definitive proxy filings of 1,261 firms included in the S&P 1500 for which the

necessary data are available.6 We classify the RP disclosures based upon (1) whether or not a

firm discloses RP transactions, and if it discloses RP transactions, (2) who the transaction is with,

5 The arguments presented here that are based on agency theory assume that wealth transfers are a concernconsistent with our reading of FAS 57.6 The S&P 1500 includes the S&P 500, the S&P Mid Cap 400 and the S&P Small Cap 600. This sampleprovides wide distribution of firm size and industry, but it focuses on high-profile firms consideredimportant enough to include in these indices. As a result, readers should be cautioned that our findings,while interesting, might not generalize to the full market.


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(3) the nature of the transaction, and (4) whether the company discloses the transaction in its

footnotes or proxy statement. We find sixty-three percent of the sample firms disclose RP

transactions in their footnotes and/or annual definitive proxy statements. Surprisingly, a majority

of these companies (78 percent) disclose RP transactions in their proxy statements rather than

their footnotes.

We conduct multivariate analysis to investigate whether incentives for directors and

officers and monitoring mechanisms are associated with related party transactions. Our analysis

suggests board independence reduces the likelihood of RP transactions across all types of RP

transactions. We also find that RP transactions are less likely as the cash compensation to the

CEO and directors increases. However, RP transactions are more likely as CEO stock option

grants increase. These results suggest that RP transactions may be part of an overall

compensation package (either formally or indirectly). We further find that the compensation

association depends on the type of transaction, where the inverse relationship for directors fees

(CEO compensation) is associated with more simple (complex) RP transactions. The inverse

association between directors fees and simple RP transactions is particularly strong suggesting a

trade-off between RP transactions and directors compensation. However, we find limited

evidence that other monitors including outside block holders, institutional investors, debt, or the

number of analysts are associated with related party transactions.

We further analyze the compensation link by examining the association between

unexpected CEO compensation (Core et al. 1999) and RP transactions. Our investigation

suggests compensation for increased risk / complexity for RP transactions with investments. RP

transactions with firm investments (e.g. joint ventures) are positively associated with excess

compensation. We then examine subsequent stock returns to assess whether this is opportunistic

or efficient contracting. We find a positive association between investment RP transactions and

shareholder returns consistent with efficient contracting. Simple RP transactions with directors,

officers and shareholders appear unrelated to excess compensation. However, these RP


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transactions are inversely related to future shareholder returns consistent with opportunism.

Further investigation indicates that simple transactions other than loans such as leases, consulting

and legal services are the primary source of the lower returns.

Our paper provides a greater understanding of potential problems and benefits of RP

transactions.7 We provide evidence that the nature of the RP transaction is associated with its

role in efficient contracting or opportunism. It appears that simple RP transactions with directors,

officers, and shareholders, such as leases, consulting and legal fees, are associated with lower

returns and do not appear to be associated with CEO compensation consistent with insider

opportunism. In contrast, it appears complex RP transactions with investments, such as joint

venture, related business activities and overhead reimbursement plans, generate positive returns

in future periods and appear to help explain unexpected CEO compensation consistent with

efficient contracting. For policy makers, we find little systematic evidence to support recent

legislation prohibiting loans to executives and directors.

The paper proceeds as follows. First, we discuss agency and contracting theories and

provide a framework for our investigation of RP transactions. Our research design is presented

next. We then discuss disclosure requirements and describe our sample firms and their RP

transactions. The next section analyzes the determinants of RP transactions. We then consider

the association between RP transactions and compensation. The final section summarizes our

findings and outlines avenues for future research on RP transactions.

7 Gordon, et al. (2004) investigate RP transactions in a concurrent study. Unlike Gordon, et al., we conducta detailed analysis of the link between compensation and RP transactions. Gordon, et al. focus onexecutive versus non-executive board members, we do not. Instead, we look at differences between typesof transactions and transactions with directors, officers and shareholders versus firm investments such asjoint ventures or partnerships. Our sample is also substantially larger sample than their sample of 112 firms,and we avoid potential econometric issues by examining only a single year rather than pooling data for thesame firms over two years. These differences highlight the complementary nature of our two studies todeveloping a richer understanding of RP transactions.


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RELATED PARTY THEORY AND HYPOTHESES

This section uses agency and contracting theory to develop a basic framework to examine

related party transactions. We start by discussing contracting costs and incentives and then

describe agency costs and the role of monitoring in managing related party transactions. We

follow this with a discussion of the association of RP transactions with CEO compensation.

Contracting

The FASB expressed concerned that potential wealth transfers could occur from the firm

to the related party (FASB 1982). However, RP transactions can be part of contracting with

management, directors, shareholders and affiliated companies. We consider three characteristics

(referred to as compensation-based incentives) that can motivate management and directors to

enter into RP transactions.

First, related party transactions can be part of management or director compensation

arrangements. Firms that engage in related party transactions can provide lower cash

compensation to reflect the benefits to officers and directors of the RP transactions, or firms may

use the RP transactions to increase compensation to officers and directors to offset relatively

lower direct compensation. Alternatively, low relative cash compensation levels can motivate

managers and directors to enter into related party transactions in order to supplement their cash

compensation. For example, a director may enter into a consulting agreement with the company

to provide additional compensation. Under either scenario, an inverse association is expected

between the RP transactions and compensation (Murphy 1999).

Second, higher levels of stock option compensation create incentives for RP transactions.

Stock options are a less liquid form of compensation. Similar to cash compensation, RP

transactions can be used to supplement the illiquid cash flows associated with stock options or the

illiquid cash flows may motivate managers and directors to enter into RP transactions. We expect

positive associations between stock options and related party transactions in either case.


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Finally, firm ownership can create incentives and opportunities to enter into RP

transactions. As ownership increases, manager / director wealth is more dependent on share

appreciation, so firms might avoid potentially wealth decreasing RP transactions. However,

increased ownership increases the ability of insiders to enter into RP transactions with less

oversight.8 So while ownership can impact RP transactions, ex ante, we cant unambiguously

predict the direction of the impact.

Agency Costs and Monitoring

FASBs concern about RP transactions clearly focuses on the non-arms-length nature of

the transactions. The lack of an arms-length transaction gives rise to potential agency costs.

Related parties can profit from transactions at the firms or its other stakeholders expense. RP

transactions also can enable the firm to manipulate its financial statements. Manipulation can

interfere with accounting-based contracting.

Both potential agency costs tie into recent frauds at Enron, Healthsouth and other firms.

In many of these frauds, management allegedly used RP transactions both to enrich themselves

and to generate misleading financial statements. The RP disclosures prior to these failures were

particularly troublesome in that they did not provide sufficient insight into the role RP

transactions were playing in reported performance. For example: Enron engaged in a number of

large purchases and sales with related entities that created earnings that would otherwise not have

been recognized (Swartz and Watkins 2003). A recent article noted the role loans or related

parties played in the demise of the financial sector crisis of the late 1980s and early 1990s

(McTague 2004). Erickson et al (2000) also describe in some detail how RP transaction enabled

Lincoln Savings and Loan to meet important regulatory capital constraints.

Given the inherent agency costs associated with RP transactions, monitoring mechanisms

can play a role in disciplining RP transactions (Jensen and Meckling 1976, Holmstrom, 1979,

8 For example, members of the Rigas family were the major shareholders and executives of Adelphia. TheRigas family members have been alleged to use Adelphia as their own personal bank obtaining loans at willand have Adelphia pay personnel expenses.


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1982). Firms may anticipate the potential agency costs and implement effective monitoring

mechanisms to both reduce the risk of incurring high agency costs and to signal to stakeholders

the effective monitoring of RP transactions. Other major stakeholders may also desire to more

effectively monitor firms to limit the agency costs. Each of these stakeholders therefore has

incentives to monitor whether RP transactions occur and if so, how the transactions are

structured.

Association with CEO Compensation

We rely further on agency and contracting theories to interpret expected associations

between RP transactions and CEO compensation. We focus on the CEOs compensation as 1) the

CEO should have involvement in most if not all RP transaction decision-making and 2) a

majority of the RP transactions are associated with the CEO and his / her family and affiliates.

If RP transactions are a part of contracting, we expect to see a complementary association

between the presence of RP transactions and compensation. That is, RP transactions are a

component of optimal compensation and we would expect an inverse association with excess

compensation. We would also expect a non-negative association with future returns.

Alternatively, RP transactions may be symptoms of insider opportunism which is more

difficult to evaluate. If RP transactions are opportunistic, we would expect a positive association

between RP transactions and excess compensation. However, a positive association between RP

transactions and excess compensation could also represent additional risk created by the RP

transactions, or more complex relationships with affiliated businesses that warrants additional

compensation. We consider the association with future returns to differentiate between

opportunistic and risk explanations.

RESEARCH DESIGN

We develop two sets of models to investigate the RP hypotheses developed in the

preceding section. First, we develop a multivariate equation to investigate factors that influence


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the firm decision to enter into a RP transaction. Second, we develop a series of equations to

examine the association with CEO compensation.

Determinant Model

The role of agency costs in engaging in RP transactions and the role of contracting allow

us to consider two sets of potential determinants. First we consider an association between RP

transactions and compensation-based incentives for evidence that RP transactions are part of a

contracting arrangement. Second, we consider the association between monitoring and RP

transactions. We also include the natural log of total assets to control for size and remove any

related biases from our estimation model.

Our compensation-based incentives focus on CEO and directors compensation and firm

ownership. Cash compensation levels are the sum of salary, bonuses, and other annual

remuneration for CEOs and the sum of the retainer and maximum meeting fees for directors. The

cash compensation levels are converted into relative rankings that are scaled to range from zero to

one.9 Non-cash compensation in the form of stock options is measured as the decile ranking of

the Black-Scholes value of options granted to the CEO during the past three years. The use of

three years corrects for the variability of options grants. The decile rankings of the number of

shares and exercisable options owned by the CEO and non-employee directors as a percentage of

total shares outstanding measure their respective firm ownership.

We include the presence of outside block holders, level of institutional ownership,

number of analyst following, long-term debt leverage ratio, and board of directors characteristics

to capture monitoring features. We use an indicator variable equal to one when at least one non-

employee / non-director owns more than 5 percent of the equity (Dlugosz, et al. 2004). The

percentage of common shares outstanding held by institutions and the number of analysts

following the company proxy for monitors on behalf of shareholders (Schleifer and Vishny,

1986). The long-term debt ratio provides a measure for the presence of creditor monitors (Watts

9 We use scaled ranking as opposed to scaled compensation to mitigate the effect of extreme outliers.


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and Zimmerman 1986). We also include four board of directors characteristics to capture

director monitoring suggested by prior research (Beasley 1996, Bhagat and Black 2002, Klein

1998, 2002a, and 2002b). Independence of the board of directors and of the compensation

committee is consistent with stronger monitoring. Greater board size and duality of the chairman

/ CEO represent weaker monitoring.

Our determination of RP transaction model is as follows:

Prob(RPi,t) = F(1 + 2 LNASSETSi,t + 3 DIR_FEESi,t + 4 DIR_OWNERSHIP,i,t +

5 CEO_CASHCOMPi,t + 6 CEO_OPTIONVALUEi,t + 7 CEO_OWNERSHIPi,t +

8 BLOCKi,t + 9 INSTi,t +10 ANALYSTSi,t + 11 LEVi,t + 12 BDSIZEi,t +

13 BD_INDi,t + 14 COMPCOMM_INDi,t + 15 DUALITYi,t + i,t) (1)

where F is the cumulative standard normal distribution function, RP is an variable equal to one if

the firm disclosed a related party transaction in either the footnotes or proxy, LNASSETS is the

natural log of the firms year-end assets, DIR_FEES is the quintile ranking of the sum of the

annual retainer and maximum meeting fees, DIR_OWNERSHIP is the decile ranking of the ratio

of the number of shares and exercisable options held by non-employee directors to total shares

outstanding, CEO_CASHCOMP is the decile ranking of the CEOs cash compensation during the

year, CEO_OPTIONVALUE is the decile ranking of Black-Scholes value of options granted to

the CEO during the past three years, CEO_OWNERSHIP is the decile ranking of the ratio of

shares owned and exercisable options held by the CEO to the total shares outstanding, BLOCK is

an indicator variable equal to one if the firm has one or more outside block holders and zero

otherwise, INST is the percentage of common shares outstanding held by institutions as of each

quarters most recently reported institutional holdings, ANALYSTS is the number of analyst

following the firm as of the earnings announcement, LEV is the ratio of year-end long-term debt

to total assets, BDSIZE is the number of directors on the board of directors, BD_IND is the

percentage of board members that are independent, COMPCOMM_IND is the percentage of


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compensation committee members that are independent, and DUALITY is an indicator variable

equal to 1 if the CEO is the Chairman of the Board.

Compensation Models

Our research design investigating the associations between RP transactions and CEO

compensation consists of two parts. First, we derive an estimate of optimal CEO compensation.

We then use the models residual as our measure of unexpected (or excess) compensation and

investigate the link with RP transactions. Second, we consider the association of RP transactions

with future returns controlling for excess compensation.

Core, et al. (1999) model optimal CEO compensation as a function of economic

determinants where compensation is expected to be increasing in size, growth, profitability, and

shareholder returns. Their investigation then considers whether compensation is affected by

corporate governance. Core et al. (1999) hypothesize and find that compensation is generally

expected to be increasing in weaker corporate governance. We adopt the Core et al. (1999)

compensation model here to obtain each firms estimate of expected CEO compensation

controlling for economic and governance determinants.10

COMPi,t = 0 + (1j INDi,t) +2 SALESi,t-1 + 3 MBi,t-1 + 4 ROA,i,t-1 + 5 RETi,t-1 +

6 SDROAi,t-1 + 7 SDRETi,t-1 + 8 DUALITYi,t + 9 BDSIZEi,t + 10 BD_INDi,t +

11 CEO_OWNERSHIPi, t + 12 DIR_OWNERSHIPi,t + 13 BLOCKi,t +

14 BLOCK_INi,t + i,t (2)

where COMP is one of the following CEO compensation measures: CASH_COMP is total CEO

cash compensation, or CASH_COMP_SO is the total CEO cash compensation plus the Black

Scholes value of stock option grants during the year, IND is a vector of indicator variables to

capture industry membership, SALES is firm sales, MB is the mean ratio of the market to book

value of equity over the previous five years, ROA is return on assets, RET is the natural log of

10 We include all the variables from Core et al. (1999) that are available onEXECUCOMP and the InvestorResponsibility Research Center report.


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one plus the annual shareholder return, SDROA is the standard deviation of ROA over the

previous five years, SDRET is the standard deviation of annual shareholders returns over the

previous five years, BLOCK_IN is an indicator variable equal to one if the firm has one or more

non-CEO inside block holders and zero otherwise, and the remaining variables are the same as

used in equation (1).

The residual from equation (2) serves as our measure of unexpected CEO compensation

that we label EXCESS. We then estimate the following models to assess the association between

various RP transaction definitions and EXCESS.11 Equation (3) assumes all RP transactions are

similar in effect. However, this assumption is rather simplistic and inconsistent with our earlier

results. We therefore relax this assumption in equations (4) and (5) by considering our simple vs.

complex classification and the whether the related party is a DOS or an investment.

EXCESSi,t = 0 + 2 RPi,t + i,t (3)

EXCESSi,t = 0 + 2 SIMPLEi,t + 3 COMPLEXi,t + i,t (4)

EXCESSi,t = 0 + 2 SIMPLE_DOSi,t + 3 COMPLEX_DOSi,t+ 4 INVESTi,t + i,t (5)

where EXCESS is the unexpected compensation estimated as the residual from equation (2), RP

is an indicator variable equal to one if the firm disclosed a related party transaction in either the

footnotes or proxy, SIMPLE is an indicator variable equal to one if the firm disclosed a simple

RP transaction, COMPLEX is an indicator variable equal to one if the firm disclosed a complex

RP transaction, SIMPLE_DOS is an indicator variable equal to one if the firm disclosed a simple

RP transaction associated with an officer, director, major shareholder, or affiliate,

COMPLEX_DOS is an indicator variable equal to one if the firm disclosed an complex RP

transaction associated with an officer, director, major shareholder, or affiliate, and INVEST is an

indicator variable equal to one if the firm disclosed a RP transaction associated with an

investment.

11 We chose this two-stage approach to isolate the RP effect. Our results are unaffected when we consideran alternative approach where the RP variables are included in equation (2)


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Core et al. (1999) also provide evidence that positive unexpected compensation is

associated with lower stock returns and associate this result with management entrenchment. We

apply this logic by extending our analysis to consider whether RP transactions have additional

effects on future stock returns to evaluate our competing hypotheses of risk and opportunism.

Core, et al. (1999) model returns as a function of excess compensation and a series of

independent variables that control for expected returns. 12 We expand their return model by

including our RP transaction variables to investigate whether RP transactions are also associated

with future shareholder returns.

RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1)+

5 M2Bi,t-1 + 6 RPi,t + i,t (6)


5 M2Bi,t-1 + 6 SIMPLEi,t + 7 COMPLEXi,t + i,t (7)


5 M2Bi,t-1 + 6 SIMPLE_DOSi,t + 7 COMPLEX_DOSi,t + 8 INVESTi,t + i,t (8)

Where MVE is market value of common equity, M2B is the ratio of market to book value of

equity, and other variables are as previously defined.

ANALYSIS OF RELATED PARTY TRANSACTIONS

We first review the basic accounting standards and SEC rules governing related party

disclosures. Our samples firms and their RP transactions are then described.

Related Party Disclosures

The FASB describes disclosure requirements for RP transactions in FAS 57. The

required disclosure include (1) the nature of the relationship, (2) a description of the transaction,

12 Similar to Core et al (1999), we will also use a raw return metric as our dependent variable and includedeterminants of a normal return as independent variables, as opposed to using excess or abnormal returns.This approach allows us to conduct in-sample tests to explicitly control for excess compensation and RPtransactions.


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(3) the dollar amounts of the transactions for each income statement period presented, (4) and

amounts due to or from related parties at the balance sheet date (FASB 1982, 2). Related parties

are identified as management, owners (10% or more), and their immediate families and affiliates

(FASB 1982, 1). Related parties also include subsidiaries, subsidiaries of a common parent and

employee trusts such as pensions; but disclosure is not required when the transactions are

eliminated in consolidation (FASB 1982, 1).

The FASB specifically states that RP transactions cannot be presumed to be equivalent to

an arms length transaction (FASB 1982, 3). FAS 57 requires that if an entity makes disclosures

to the effect that a RP transaction is equivalent to an arms length transaction, that the

representations must be substantiated. It appears the board was very concerned about disclosures

stating that RP transactions were carried out at market rates, because in many cases such

statements cannot be verified because there are no prevailing markets in the RP goods or services

(Appendix A to FAS 57). Moreover, RP transactions are not arm length by their very nature, and

to imply they are can mislead users (FASB 1982). The FASB also appeared to be concerned

about both the potential for RP transactions to affect financial statement reliability (FASB 1982,

15), and related parties ability to engage in transactions under more favorable terms than those

available to third-parties (FASB 1982, 13 - 14). The FASB concerns echo the concerns raised by

agency theory regarding related party transactions.

Both Regulation S-X and S-K discuss RP transaction disclosures from the SECs

perspective. Regulation S-X covers financial statement reporting requirements under the

securities acts, but only briefly mentions RP transactions (SEC 2004a). The section provides very

broad RP disclosure requirements. It requires RP transaction disclosure in the footnotes and on

the face of the appropriate financial statements if material, but does not include any definition of

related parties or RP transactions. The SECs financial statement reporting requirements rely on

Generally Accepted Accounting Principles (i.e. FAS 57) for its guidance.


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Regulation S-K covers disclosure of non-financial statement information in SEC filings

including registration statements, annual reports, and proxy statements. It covers disclosures of

certain relationships and related transactions in subsection 229.404 (SEC 2004b). Subsection

229.404 provides a broad overview of RP transaction disclosure requirements including who

constitutes a RP and what kind of transactions are covered. We provide a brief outline of the main

RP disclosure requirements set forth in Regulation S-K.

Regulation S-K requires the registrant to describe briefly any RP transaction in which the

amount involved exceeds $60,000 andin which the related persons had a direct or indirect

material interest, naming such person and indicating the person's relationship to the registrant, the

nature of such person's interest in the transaction, the amount of such transaction and, where

practicable, the amount of such person's interest in the transaction (SEC 2004b, subsection

229.400a). The regulation considers related parties to include management, directors, and security

holders who hold greater than 5% of voting securities in the entity. In addition, all the immediate

family members and related business entities of the related parties are considered related parties.

The SEC rules and FAS 57 are generally consistent with each other with the following

notable exception. FAS 57 requires financial statement disclosure ofmaterial RP transactions;

however, the SEC only requires disclosure and does not specify where to disclose. As discussed

later, we find that many companies do not report RP transactions in the financial statements, but

instead choose to disclose RP transaction in their annual proxy statements. Arguably materiality

based on monetary levels can explain these differences in disclosure. FAS 57 only requires

disclosure of material items in the financial statements. Regulation S-K requires disclosure of

items over $60,000 in which the party transacting has a material interest. Conceivably a

transaction can exceed $60,000 and be material to the RP but not be material to the reporting

entity. Such transactions may not require footnote disclosure according to FAS 57, but would


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require regulatory disclosure according to Regulation S-K.13 As a result, entities appear to report

the transaction in the proxy statement rather than the footnotes.

Sample Description

We start with firms included in the S&P 1500 in 2001. We eliminate 137 firms that are

not included in the Investor Responsibility Research Center report on board practices (Investor

Responsibility Research Center 2001) our source of governance variables. We exclude 54

firms for which we could not locate financial statements or proxies to obtain the RP disclosures.

We also exclude 34 firms with missing Compustat/ CRSP data and 14 ADR firms. Our final

sample contains 1,261 firms (see table 1). We then obtain executive compensation data from

EXECUCOMP and block holder data from Dlugosz, et al. (2004).

Table 2 compares descriptive statistics for firms with and without RP transactions. Table

2 shows that while firms without RP transactions appear to have fewer assets than those with RP

transactions, there is not a general difference due to size. Both market value of equity and sales

do not differ, and the median assets do not differ between RP and non-RP firms.

RP firms have slightly lower directors fees, but substantially the same levels of CEO

cash compensation. CEO and director ownership are higher for RP firms. This finding is

difficult to interpret. The greater director and officer holdings should align their incentives with

shareholders better than the lower holdings of non-RP firms. However, the greater ownership of

insiders may make it easier for them to engage in transactions that favor themselves individually

rather than to benefit the firm.

The data also suggest mixed evidence of monitoring differences between RP and non-RP

firms. Non-RP firms have more independent board of directors, more independent compensations

committees, and smaller board sizes, and slightly more institutional holdings than RP firms,

13 The transactions may not be material given traditional net income and asset measures, but thetransactions may still be considered material to potential users as it may alter their decision-making. StaffAccounting Bulletin No. 99,Materiality, would therefore require disclosure (SEC 1999).


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17

consistent with greater monitoring resulting in fewer RP transactions. 14 However, it appears that

analyst following is higher for RP firms and dual CEO / Chairman roles are less common for RP

firms. The analyst following and duality metrics are both consistent with more monitoring of RP

firms. Leverage however does not differ between RP and non-RP firms. The conflicting

institutional and analyst following results may reflect the membership of our sample firms in

important S&P indices.15

Table 3 looks at the distribution of RP transactions by industry. Manufacturing

(including equipment) and utilities have lower levels of RP transactions than the average industry

by 10-12% and financial and service firms have higher rates of RP transactions than the average

industry by 9-18%. Loans to employees drive this higher rate for the regulated financial firms.

Regulators have strict guidelines for RP loans by financial institutions. Nonetheless, recent press

articles describe high levels of RP loans at certain financial institutions and raised questions

whether these high RP transaction levels bode well for the industry (McTague 2004). In contrast,

utilities, another regulated industry, have the lowest level of RP transactions.

The majority of firms disclose RP transactions only in the proxy statement (65.9%) while

22.5% disclose all RP transaction information in the footnotes. The remaining 11.6% of firms

disclose RP transactions in both the proxy and footnotes (dual disclosers), but report distinct

transactions in each location. In general, the dual disclosers are very similar in nature to the

footnote firms. Larger firms disclose RP transactions in proxy statements more often than small

firms. This difference is consistent with large firms applying a monetary materiality assessment

such that the transactions do not require disclosure under FAS 57 in footnotes, but the $60,000

monetary cut-off under Regulation S-K requires disclosure in the proxy statement. Our

multivariate results are not sensitive to the disclosure location.

14 The Big 4 public accounting firms audit over 98% of our sample, so there is no variation in auditor basedmonitoring.15 Firms in the S&P 1500 have higher institutional holdings partially because firms included in the threeS&P indexes that make up our sample are held by index funds.


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Related Parties and Type of Related Party Transactions

Table 4 provides a cross tabulation of RP (i.e. officer, affiliate or investment) and RP

transaction type (i.e. loans, leases, etc.). We provide a description of each RP transaction type in

the Appendix. In our review of footnote and proxy disclosure, it became clear that these 10

categories can be subdivided into two broad classifications: simple and complex transactions. 16

Simple transactions are straight forward transactions that involve relatively few financial

statement accounts and related parties and the disclosures are typically very clear. Simple

transactions include loans, guarantees, borrowings, consulting, legal services and leases.

Approximately 81 percent of the RP firms disclose simple transactions. In contrast, complex

transactions typically involve a number of financial statement accounts and related parties, often

include a number of conditions, and impact the financial statements in less obvious ways.

Complex transactions include related business, unrelated business, overhead, and stock

transactions. Approximately 59 percent of the RP firms report complex transactions.

RP transactions are most common with directors, officers, major shareholders (hereafter

DOSs) and their affiliates in comparison with the much lower rate among firm investments such

as joint ventures. We initially attempted to distinguish transactions between directors, officers,

and major shareholders, but the distinction between the three groups was very difficult to

maintain. In many instances an RP officer is also a director and major shareholder so drawing

distinctions seems meaningless. We attempt to distinguish between transactions between the firm

and affiliates of the DOSs such as partnerships and corporations. In cases where the DOS is the

sole partner or controlling partner, we classify it as a DOS transaction rather than an affiliate

transaction.

In general, the type of related party transactions and the related parties who engage in the

transactions differ significantly. Related business activities and loans generated the highest

16 We realize that any attempt to group transactions into categories is somewhat ad hoc. The simple versuscomplex grouping was suggested to us by a number of readers and is consistent with our own extensivereading of proxy statements and footnotes.


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19

percentage of RP transactions.17 We observed many employment related loans to officers ranging

from housing loans to stock purchase loans. But, we also observed loans to directors, and major

shareholders for a variety of other purposes. The cross tabulation shows that loans to DOSs and

their affiliates are much higher than to investments. In contrast, borrowings from RPs,

guarantees and overhead reimbursement transactions are the least common types of transactions.

These less frequent transaction are relatively more common with investments than DOSs, as are

related business activities, overhead reimbursement, and stock transactions. In addition,

transaction complexity increases as the related party moves from DOS to affiliate to investment.

We also analyze transaction type in the context of disclosure location (not tabled). Three

of the top five transaction types (loans, consulting arrangements, and legal and investment

services) are equally or more likely to be disclosed in the proxy statements than the footnotes.

This frequency suggests the more common the transaction the more likely it is to be disclosed in

the proxy statement relative to the footnote. In contrast, the other transaction types are all

relatively more likely to have footnote rather than proxy disclosure. We note that in general these

transactions are more complex than the simple loans and services that are not disclosed as

frequently in the footnotes. This suggests that firms base their materiality assessments partially

on transaction complexity. Proxy disclosure is also more common on a relative basis for

transactions with DOSs than investments, and footnote disclosure is more common for affiliates

and investment RP transactions. Common transactions with DOSs appear to be considered

immaterial.

DETERMINANTS OF RELATED PARTY TRANSACTIONS

In this section we investigate factors that influence the firm decision to enter into a RP

transaction. Table 5 provides a Pearson correlation matrix for the key variables of interest

17 Financial institutions accounted for 44 of the loans. When we exclude these transactions, loans are stillthe second most common RP transaction type.


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included in our RP determinant model. RP firms are associated with less independent boards and

the absence of outside block holders. In contrast, RP firms are more likely to have higher CEO

ownership holdings, value of options awarded to the CEO, director ownership and number of

analysts following the firm. Table 5 suggests that we do not have any unreasonably high

correlations among the independent variables that might impact our subsequent analysis.

Table 6 reports a Probit estimation of the multivariate model examining potential

determinants of RP transactions (equation 1). The model correctly classifies approximately 70

percent of firms and has a pseudo R2 of 14 percent. The estimated coefficient for firm size (2 =

0.135, p-value = 0.037) suggests larger firms are more likely to report RP transactions.

The probability of a RP transaction is influenced by both compensation-based incentives

and monitoring mechanisms. First, both directors fees (3 = -0.4847, p-value = 0.032) and CEO

cash compensation (5 = -0.446, p-value = 0.091) are inversely associated with the probability of

reporting RP transactions (i.e. as cash compensation increases, the probability of RP transactions

decreases). Second, we find a significant, positive associations with options granted to the CEO

(6 = 0.872, p-value < 0.001) and CEO ownership (7 = 0.518, p-value = 0.015). The director

ownership variable is not associated with RP transactions. These results confirm a link between

RP transactions and executive compensation that we investigate in the next section.

Our monitoring results provide evidence that director independence reduces the

likelihood of RP transactions. Both the overall board independence (13 = -0.031, p-value 5 percent

ownership).

Affiliates Related party is an affiliate of a director, officer, ormajor shareholder of the company.

Investment Related party is identified as a joint venture or otheroperation in which the company has a less than 100%investment that is not consolidated.

Types of Related Party Transactions

Loans to related party The company made loans to related parties. Employeeloan programs are considered one related partytransaction.

Borrowings A related party has either loaned amounts or guaranteeddebt of the company.

Guarantees The company guaranteed debt of a related party.

Consulting arrangements The company and the related party have entered into anagreement where the related party provides consultingservices to the company.

Legal or investment services The company obtains either legal or investment servicesfrom the related party.

Leases The company has entered into an agreement with therelated party to lease space or aircraft.

Related business activities The company and the related party are involved inbusiness activities, including research and developmentactivities, that are related to the companys mainoperations. The activities typically result in sales, costof sales, R&D expense, receivables, and payables.

Unrelated business activities The related party provides the company services that areincidental to the companys main operations.

Overhead reimbursement The company and the related party have entered into anagreement for one party to provide administration

services to the other for a fee.

Stock transactions The company and the related party have entered intotransactions involving transfers of assets, business, and /or ownership interests.


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Table 1 Sample Determination

Firms included in the S&P 1500 1,500

Eliminations:

Firms not included in IRRC database 137

2001 financial statements could not belocated

54

Firms with ADR shares 14

Missing financial information onCompustat

23

Missing return or share price data on

CRSP11 239

Final sample 1,261


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Table 2 Descriptive Statistics Partitioned by Existence of Related Party Transaction

Means Medians

* / ** / *** The mean (median) is significantly different at the 0.10 / 0.05 / 0.01 level using a t test ofmeans (Wilcoxon rank sums test).

1 Sixty-three percent of the firms disclose RP transactions with an average of 2.3 RP transitions (rangingfrom 1 to 23) distributed as follows:

1 transaction 339 43%2 5 transactions 108 52%> 5 transactions 43 5%

Total 790 100%

Variables 1 RP No RP RP No RP

N 790 471 790 471

Assets (millions) 12,762 6,846 *** 1,750 1,519

Market value of equity (millions) 7,189 7,438 1,533 1,463

Market to book value of equity 2.69 3.08 2.23 2.15

Sales (millions) 5,056 4,962 1,233 1,462

Annual director fees (millions) 0.026 0.028 * 0.026 0.027

Directors ownership 5.6% 4.0% ** 0.1% 0.0% **

CEO cash compensation (millions) 1.366 1.227 0.871 0.937

CEO option grants (Black-Scholesvalue for 1999-2001, millions)

22.552 18.115 4.550 2.875 ***

CEO ownership 5.2% 4.2% ** 2.9% 2.3% ***

Outside block holders (% of firms) 40.3% 46.9% **

Institutional holdings 60.5% 62.4% * 63.2% 64.8%

Analyst following 9.7 8.9 ** 8.0 7.0 **

Leverage 0.19 0.20 0.17 0.20

Board size 9.5 9.2 * 9.0 9.0

Board of directors independence 61.4% 70.7% *** 62.5% 73.3% ***

Compensation committeeindependence

87.9% 93.6% *** 100% 100% ***

Duality 71.6% 76.8% *


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Table 3 Frequency of Related Party Disclosures by Industry

Industry1

Mean

Assets

(millions)

Mean Sales

(millions)

Mean

Market to

Book

Value of

Equity

Number

of Firms

Percentage of

Firms with

Related Party

Transactions

Percentage of

Firms with

Simple Related

Party

TransactionsNatural Resources 3,468 2,051 1.77 40 65.0% 47.5% Manufacturing 4,711 4,526 2.75 304 52.0% *** 38.5%Equipment

Manufacturers10,263 6,329 3.03 163 51.5% *** 39.9%

Technology 5,072 4,179 3.93 135 63.7% 53.3% Transportation 5,412 3,770 2.31 35 68.6% 62.9% Utilities 16,093 8,002 1.76 91 50.5% ** 38.5%Wholesale 2,162 5,403 2.25 53 66.0% 50.9% Retail 4,403 8,368 3.81 102 68.6% 57.8% Financial 42,355 5,375 2.76 155 80.6% *** 74.8%Business Services 2,986 2,052 2.51 117 71.8% ** 59.8%

Other Services 3,723 3,095 2.65 66 78.8% *** 60.6% Total 10,552 5,021 2.84 1,261 62.6% 50.9%

* / ** / *** Difference in the proportion of firms disclosing related party transactions between the industry classification and at the 0.10 / 0.05 / 0.01 level.

1 Industry classifications are based on firm SIC codes as follows:Natural resources 0000 - 1499Manufacturing 1500 3399, 3800 - 3999 except for those classified as technologyEquipment 3400 3799 except for those classified as technologyTechnology 2830 2839, 3570 - 3579, 3670 03679Transportation 4000 - 4799

Utilities 4800 - 4999Wholesale 5000 - 5199Retail 5200 - 5999Financial 6000 - 6999Business Services 7300 7399, 8100 - 8199Other Services 7000 9999 except for those classified as business services


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Table 4 Related Party and Related Party Transaction Type

Related Party Type1, 2

Transaction type2 Director,Officer, or

Major

Shareholder

Affiliate of

Director,

Officer, or

MajorShareholder

Investment Total

Transaction Type

Loans 314

55.7%

*** 143

35.6%

*** 52

46.4%

337

42.7%

Borrowings 33

5.9%

34

8.5%

** 13

11.6%

** 50

6.3%

Guarantees 25

4.4%

25

6.2%

*** 14

12.5%

*** 34

4.3%

Consulting arrangements 129

22.9%

*** 80

19.9%

17

15.2%

143

18.1%

Legal and investment services 169

30.0%

** 134

33.3%

*** 16

14.3%

*** 221

28.0%

Leases 136

24.1%

139

34.6%

*** 31

27.7%

189

23.9%

Simple RP transactions 512

90.8%

325

80.8%

81

72.3%

642

81.2%

Related business activities 199

35.3%

*** 215

53.5%

*** 90

80.4%

*** 327

41.4%

Unrelated business activities 7413.1%

7919.7%

*** 1412.5%

10413.2%

Overhead reimbursement 45

8.0%

47

11.7%

*** 24

21.4%

*** 67

8.5%

Stock transactions 98

17.4%

* 82

20.4%

*** 27

24.1%

** 125

15.8%

Complex RP transactions 304

53.9%

299

74.3%

105

93.7%

465

58.8%

Total Related Party Type564

100.0%

402

100.0%

112

100.0%

790

100.0%


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Table 4 Related Party and Related Party Transaction Type (continued)

* / ** / *** Frequency of disclosure of indicated transaction and related party type is significantly different(0.10 / 0.05 / 0.01) from the expected level based on the overall occurrence rate and assumingindependence using a Chi-Square test of independence.

1 Related parties disclosed are classified in one of three categories the related party is an officer, director,or major shareholder (> 5 percent ownership), an affiliate of an officer, director, or major shareholder, orand a non-wholly owned investment.

2 Sum of the firms with the indicated related party and transaction type exceeds the total number of firmswith related party transactions as some firms have multiple related party and transaction types. Thepercentage indicates the percentage of firms that reported the indicated combination of party andtransaction type as a percentage of the total number of firms reporting related party transactions for theindicated related party type.


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Table 6 Determinants of Related Party Transactions

Equation 1: Prob(RPi,t) = F(1 + 2 LNASSETSi,t + 3 DIR_FEESi,t + 4 DIR_SHARES,i,t +


8 BLOCKi,t + 9 INSTi,t + 10 ANALYSTSi,t + 11 LEVi,t + 12 BDSIZEi,t + 13 BD_INDi,t +

14 COMPCOMM_INDi,t + 15 DUALITYi,t + i,t)

Variable1

(N = 1,261)

Prediction Estimated

Coefficient

p-value

Intercept 1.882 *** 0.002

LNASSETS + / - 0.135 *** 0.037

DIR_FEES - -0.481 ** 0.032

DIR_OWNERSHIP ? 0.076 0.749

CEO_CASHCOMP - -0.446 * 0.091

CEO_OPTIONVALUE + 0.872 *** < 0.001CEO_OWNERSHIP ? 0.518 ** 0.015

BLOCK - -0.005 0.969

INST - -0.003 0.273

ANALYSTS - 0.005 0.640

LEV - 0.331 0.396

BDSIZE + 0.034 0.218

BD_IND - -0.031 *** < 0.001

COMPCOMM_IND - -0.006 * 0.071

DUALITY + -0.140 0.337

Percent Concordant 69.4%

Pseudo R2 14.1%

* / ** / *** p-value indicates significance at the 0.10 / 0.05 / 0.01 level using two-tailed significance tests.

1 Variables are defined as follows: F is the cumulative standard normal distribution function, RP is an indicatorvariable equal to one if the firm disclosed a related party transaction in either the footnotes or proxy, LNASSETS is thenatural log of the firms year-end assets, DIR_FEES is the quintile ranking of the sum of the annual retainer andmaximum meeting fees, DIR_OWNERSHIP is the decile ranking of the ratio of the number of shares and exercisableoptions held by non-employee directors to total shares outstanding, CEO_CASHCOMP is the decile ranking of the

CEOs cash compensation during the year, CEO_OPTIONVALUE is the decile ranking of the Black-Scholes value ofthe option granted to the CEO over the past 3 years, CEO_OWNERSHIP is the decile ranking of the ratio of the

number of shares and exercisable options owned by the CEO to the total shares outstanding, BLOCK is an indicatorvariable equal to one if the firm has one or more outside block holders and zero otherwise, INST is the

percentage of common shares outstanding held by institutions as of each quarters most recently reported institutionalholdings, ANALYSTS is the number of analyst following the firm as of the earnings announcement, LEV is the ratio ofyear-end long-term debt to total assets, BDSIZE is the number of directors on the board of directors, BD_IND is the

percentage of board members that are independent, COMPCOMM_IND is the percentage of compensation committeemembers that are independent, and DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of theBoard.


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Table 7 Determinants of Related Party Transactions Partitioned on Complexity

Equation 1: Prob(RPi,t) = F(1 + 2 LNASSETSi,t + 3 DIR_FEESi,t + 4 DIR_SHARES,i,t +


8 BLOCKi,t + 9 INSTi,t + 10 ANALYSTSi,t + 11 LEVi,t + 12 BDSIZEi,t + 13 BD_INDi,t +

14 COMPCOMM_INDi,t + 15 DUALITYi,t + i,t)

Simple RP (N=1,113) Complex RP (N=936)

Variable1 EstimatedCoefficient

p-value Estimated

Coefficient

p-value

Intercept 1.234 * 0.054 2.103 *** 0.002

LNASSETS 0.181 *** 0.008 0.086 0.231

DIR_FEES -0.727 *** 0.002 -0.145 0.567

DIR_OWNERSHIP 0.117 0.643 -0.011 0.966

CEO_CASHCOMP -0.424 0.127 -0.451 * 0.063

CEO_OPTIONVALUE 0.987 *** < 0.001 0.672 *** 0.013

CEO_OWNERSHIP 0.661 *** 0.003 0.396 * 0.100

BLOCK 0.032 0.818 -0.032 0.829

INST -0.003 0.324 -0.004 0.298

ANALYSTS 0.004 0.729 0.012 0.334

LEV 0.331 0.421 0.323 0.483

BDSIZE 0.046 0.114 0.020 0.530

BD_IND -0.033 *** < 0.001 -0.038 *** < 0.001

COMPCOMM_IND -0.005 0.122 -0.005 0.146

DUALITY -0.142 0.356 -0.061 0.711

Percent Concordant 71.2% 70.4%

Pseudo R2 17.2% 16.2%


1 Variables are defined as follows: F is the cumulative standard normal distribution function, RP is an indicatorvariable equal to one if the firm disclosed a related party transaction in either the footnotes or proxy, LNASSETS is thenatural log of the firms year-end assets, DIR_FEES is the quintile ranking of the sum of the annual retainer andmaximum meeting fees, DIR_OWNERSHIP is the decile ranking of the ratio of the number of shares and exercisableoptions held by non-employee directors to total shares outstanding, CEO_CASHCOMP is the decile ranking of theCEOs cash compensation during the year, CEO_OPTIONVALUE is the decile ranking of the Black-Scholes value ofthe option granted to the CEO over the past 3 years, CEO_OWNERSHIP is the decile ranking of the ratio of thenumber of shares and exercisable options owned by the CEO to the total shares outstanding, BLOCK is an indicatorvariable equal to one if the firm has one or more outside block holders and zero otherwise, INST is the percentage ofcommon shares outstanding held by institutions as of each quarters most recently reported institutional holdings,ANALYSTS is the number of analyst following the firm as of the earnings announcement, LEV is the ratio of year-endlong-term debt to total assets, BDSIZE is the number of directors on the board of directors, BD_IND is the percentageof board members that are independent, COMPCOMM_IND is the percentage of compensation committee membersthat are independent, and DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of the Board.


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Table 8 Compensation Model

Equation 2: COMPi,t = 0 + (1j INDi,t) +2 SALESi,t-1 + 3 MBi,t-1 + 4 ROA,i,t-1 + 5 RETi,t-1 +

6 SDROAi,t-1 + 7 SDRETi,t-1 + 8 DUALITYi,t + 9 BDSIZEi,t + 10 BD_INDi,t +

11CEO_OWNERSHIPi,t + 12DIR_OWNERSHIPi,t + 13 BLOCKi,t + 14 BLOCK_INi,t +i,t

CASH_COMP CASH_COMP_SO

Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

SALES + 0.043 *** < 0.001 0.192 *** < 0.001

MB + -4.367 0.567 333.603 *** < 0.001

ROA + 562.442 0.286 5292.726 0.209

RET + 64.169 0.516 -203.273 0.797

SDROA ? 1683.469 0.125 1784.179 0.838

SDRET ? -293.140 0.231 7424.160 *** < 0.001DUALITY + 363.260 *** 0.003 1236.683 0.204

BDSIZE + 79.718 *** < 0.001 499.644 *** 0.004

BD_IND ? -6.041 * 0.077 -28.609 0.295

CEO_OWNERSHIP - 151.227 0.427 800.536 0.599

DIR_OWNERSHIP - -416.319 ** 0.037 -4166.623 *** 0.009

BLOCK - -63.780 0.569 -366.051 0.683

BLOCK_IN - -62.318 0.624 71.0538 0.943

Adjusted R2 13.6% 8.3%


1 Variables are defined as follows: COMP is one of the following CEO compensation measures: CASH_COMP is totalCEO cash compensation, or CASH_COMP_SO is the total CEO cash compensation plus the Black Scholes value ofstock option grants during the year, IND is a vector of indicator variables to capture industry membership, SALES isfirm sales, MB is the mean ratio of the market to book value of equity over the previous five years, ROA is return onassets, RET is the natural log of one plus the annual shareholder return, SDROA is the standard deviation of ROA overthe previous five years, SDRET is the standard deviation of annual shareholders returns over the previous five years,BDSIZE is the number of directors on the board of directors, BD_IND is the percentage of board members that are

independent, COMPCOMM_IND is the percentage of compensation committee members that are independent,DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of the Board, DIR_OWNERSHIP is thedecile ranking of the ratio of the number of shares and exercisable options held by non-employee directors to totalshares outstanding, CEO_OWNERSHIP is the decile ranking of the ratio of the number of shares and exercisable

options owned by the CEO to the total shares outstanding, BLOCK is an indicator variable equal to one if thefirm has one or more outside block holders and zero otherwise, and BLOCK_IN is an indicator variableequal to one if the firm has one or more non-CEO inside block holders and zero otherwise.


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Table 9 Regression of Discretionary Compensation on Related Party Transactions

Panel A: Related Party

Equation 3: EXCESSi,t = 0 + 1 RPi,t + i,t


Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

Intercept -54.665 0.513 -712.909 0.285

RP ? 87.525 0.407 1141.456 0.176


Panel B: Controlling for Disclosure Complexity

Equation 4: EXCESSi,t = 0 + 1 SIMPLEi,t + 2 COMPLEXi,t + i,t


Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

Intercept -110.208 0.154 -871.296 0.158

SIMPLE ? 88.020 0.405 252.994 0.764

COMPLEX ? 180.138 * 0.100 2037.386 ** 0.020


Panel C: Controlling for Related Party and Disclosure Complexity

Equation 5: EXCESSi,t = 0 + 1 SIMPLE_DOSi,t + 2 COMPLEX_DOSi,t+ 3 INVESTi,t + i,t


Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

Intercept -114.750 0.132 -968.548 0.111

SIMPLE_DOS ? 62.979 0.551 8.608 0.991

COMPLEX_DOS ? 168.358 0.137 1803.101 ** 0.046

INVEST ? 334.020 * 0.065 4357.574 *** 0.002



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Table 9 Regression of Discretionary Compensation on Related Party Transactions

(Continued)


1 Variables are defined as follows: EXCESS is discretionary compensation calculated as the residual from theestimation of equation 2 and the indicated compensation variable (CASH_COMP is total CEO cash compensation, orCASH_COMP_SO is the total CEO cash compensation plus the Black Scholes value of stock option grants during theyear), RP is an indicator variable equal to one if the firm disclosed a related party transaction in either the footnotes or

proxy, SIMPLE is an indicator variable equal to one if the firm disclosed a simple RP transaction, COMPLEX is anindicator variable equal to one if the firm disclosed an complex RP transaction, SIMPLE_DOS is an indicator variableequal to one if the firm disclosed a simple RP transaction associated with an officer, director, major shareholder, oraffiliate, COMPLEX_DOS is an indicator variable equal to one if the firm disclosed an complex RP transactionassociated with an officer, director, major shareholder, or affiliate, and INVEST is an indicator variable equal to one ifthe firm disclosed a RP transaction associated with an investment.


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Table 10 Regression of Returns on Discretionary Compensation and Related Party

Transactions

Panel A: Related Party

Equation 6: RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1)+

5 M2Bi,t-1 + 6 RPi,t + i,t


Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

EXCESS - 0.001 ** 0.020 0.000 0.374

SDRET - -0.277 *** < 0.001 -0.270 *** < 0.001

Log(MVE) - -0.024 ** 0.010 -0.018 * 0.055

M2B - -0.001 0.922 -0.001 0.843

RP ? -0.058 ** 0.038 -0.056 ** 0.046

Adjusted R2 8.5 8.1%

Panel B: Controlling for Disclosure Complexity


5 M2Bi,t-1 + 65 SIMPLEi,t + 7 COMPLEXi,t + i,t


Variable1

(N = 1,140)

Prediction EstimatedCoefficient

p-value EstimatedCoefficient

p-value

EXCESS - 0.001 ** 0.020 0.000 0.345

SDRET - -0.282 *** < 0.001 -0.275 *** < 0.001

Log(MVE) - -0.023 ** 0.011 -0.018 * 0.059

M2B - -0.001 0.927 -0.001 0.843

SIMPLE ? -0.061 ** 0.029 -0.060 ** 0.033

COMPLEX ? 0.006 0.817 0.011 0.691



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Table 10 Regression of Returns on Discretionary Compensation and Related Party

Transactions (Continued)

Panel C: Controlling for Related Party and Disclosure Complexity


5 M2Bi,t-1 + 6 SIMPLE_DOSi,t + 7 COMPLEX_DOSi,t + 8 INVESTi,t + i,t


Variable1

(N = 1,140)


Coefficient

p-value Estimated

Coefficient

p-value

EXCESS - 0.001 ** 0.023 -0.001 0.286

SDRET - -0.288 *** < 0.001 -0.282 *** < 0.001

Log(MVE) - -0.024 *** 0.009 -0.018 * 0.053

M2B - -0.001 0.966 -0.001 0.881

SIMPLE_DOS ? -0.061 ** 0.029 -0.060 ** 0.032

COMPLEX_DOS ? -0.011 0.687 -0.007 0.806

INVEST ? 0.073 0.122 0.083 * 0.080



1 Variables are defined as follows: RET is the natural log of one plus the annual shareholder return, IND is a vector ofindicator variables to capture industry membership, EXCESS is discretionary compensation calculated as the residualfrom the estimation of equation 2 and the indicated compensation variable (CASH_COMP is total CEO cashcompensation, or CASH_COMP_SO is the total CEO cash compensation plus the Black Scholes value of stock optiongrants during the year), SDRET is the standard deviation of annual shareholders returns over the previous five years,MVE is market value of common equity, M2B is the ratio of market to book value of equity, RP is an indicator variableequal to one if the firm disclosed a related party transaction in either the footnotes or proxy, SIMPLE is an indicatorvariable equal to one if the firm disclosed a simple RP transaction, COMPLEX is an indicator variable equal to one ifthe firm disclosed an complex RP transaction, SIMPLE_DOS is an indicator variable equal to one if the firm discloseda simple RP transaction associated with an officer, director, major shareholder, or affiliate, COMPLEX_DOS is anindicator variable equal to one if the firm disclosed an complex RP transaction associated with an officer, director,major shareholder, or affiliate, and INVEST is an indicator variable equal to one if the firm disclosed a RP transactionassociated with an investment.

Date post:	08-Aug-2018
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Agency Costs, Contracting, And Related Party Transactions

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