Related Party Transactions Their Origins and Wealth Effects

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Related Party Transactions: Their Origins and Wealth Effects

Michael RyngaertDepartment of Finance, Insurance, and Real Estate

Warrington College of Business

University of FloridaGainesville, FL [email protected]

(352) 392-9765

Shawn Thomas*Katz Graduate School of Business

University of [email protected]

(412) 648-1648

This draft: September 20, 2007

Abstract:

Related party transactions are potential mechanisms for insiders to expropriate outsideshareholders via self-dealing; however, there are also possible benefits to thesearrangements for outside shareholders. This paper investigates the frequency, nature, andvaluation consequences of related party transactions for a sample of firms in fourindustries. The evidence suggests that, on average, related party transactions are notharmful to outside shareholders. However, the average results obscure the fact that whiletransactions that pre-date a counterparty becoming a related party appear to be innocuousat worst, transactions initiated after a counterparty becomes a related party are associatedwith reduced shareholder wealth. We also find evidence that firms in which keyexecutive positions are handed down to family members have lower valuations.

Keywords: Related Party Transaction; Ownership Structure; Tunneling; CorporateGovernance

JEL classification: G32

We thank Oya Altinkilic, Leonce Bargeron, Jesse Ellis, Mark Flannery, Joel Houston,Jason Karceski, and Tome Stojcevski for helpful comments and suggestions. Any errorsremain our own.

*Corresponding author.E-mail address:[email protected] (S.Thomas)


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Directors and officers of corporations are charged with the duty of entering into

contracts that maximize shareholder wealth. 1 These contracts can cover a broad range of

transactions including raising capital, acquiring production inputs, selling firm outputs,

hiring employees, leasing assets, purchasing and divesting assets, signing franchising

agreements, etc. On occasion, officers and directors enter into these contracts with their

relatives, large shareholders, other firms that the officers and directors are affiliated with,

or even with themselves. Such contracts are commonly referred to as related party

transactions (RPTs). Given that related parties can use their influence to procure such

contracts and influence the terms of the contracts in their favor, RPTs are often viewed as

being inconsistent with shareholder wealth maximization.2

The suspicion that RPTs are harmful to outside shareholders is seemingly

supported by anecdotal evidence. For instance, in the collapse of Enron, some of the

losses sustained by shareholders were the direct result of related party transactions.3

It is

also common for dissident shareholders to cite RPTs as a rationale for unseating

managements in proxy contests by suggesting that the RPTs are unfair to outside

shareholders.4 In response to recent investor concerns about RPTs, the U.S. Securities

and Exchange Commission (SEC) has proposed amended disclosure rules for RPTs, and

the NYSE and Nasdaq have revised listing requirements to mandate that either a firms

audit committee or another independent body of directors review and approve all RPTs.5

The potential wealth effects of RPTs in foreign markets have been examined in

1 Jensen and Meckling (1976) assert that firms are simply legal fictions which serve as a nexus for a set ofcontracting relationships among individuals.2 See, for example, Emshwiller (2003).3 See Thomas (2002).4 See, for example, Battaglia (2000).5 SEC Release No. 33-8655 available at www.sec.gov/rules/proposed/33-8655.pdfand SEC Release No.34-48745 available at www.sec.gov/rules/sro/34-48745.htm.


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recent academic studies. Cheung, Rau, and Stouraitis (2006) document that firms listed

in Hong Kong experience negative abnormal stock returns when they announce that they

are undertaking connected transactions. Jian and Wong (2004) find that Chinese

companies frequently engage in RPTs and that the volume of RPT activity is negatively

related to firm value. Jiang, Lee, and Yue (2005) find that Chinese firms that grant loans

to related parties have lower firm values, all else equal. Johnson, La Porta, Lopez-De-

Silanes, and Shleifer (2000) argue that while expropriation via RPTs is more likely in

emerging markets with poor law enforcement, so-called tunneling via RPTs also takes

place in developed countries such as the United States. With respect to RPTs in the

United States, research to date has primarily focused on the characteristics of firms that

report RPTs. Consistent with a negative perception of RPTs, Kohlbeck and Mayhew

(2004) and Gordon, Henry, and Palia (2004) conclude that U.S. firms reporting

significant RPTs also tend to exhibit weaker corporate governance practices.

This paper investigates the frequency, nature, and valuation consequences of

related party transactions for a sample of 234 small to midsized firms from four

industries. The main contribution of the paper is to document that RPTs are not all the

same, with certain classes appearing harmful for outside shareholders and other classes

potentially beneficial. In particular, we argue that the timing of related party transactions

can lead to different shareholder wealth impacts. We classify RPTs as either being ex-

ante or ex-post transactions. Ex-ante transactions are defined as transactions in which the

firm and the related party enter into a transaction either before the firm becomes a

publicly traded entity or before the counterparty becomes a related party, i.e., acquires a

large block of stock or becomes an executive or director. In the case of ex-ante RPTs, it


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is hard to argue that insiders use their clout to enter into the transactions to the

disadvantage of outside shareholders. Nevertheless, such transactions are generally

labeled as RPTs in corporate disclosures, and it is possible that the continuation and

renegotiation of the terms of the transactions is subject to conflict of interest. Ex-post

transactions are those that occur after the firm goes public and after the counterparty to

the transaction obtains related party status. Ex-post transactions, of course, are not arms

length in nature and, if of sufficient magnitude, may harm outside shareholders. The

evidence suggests that the average RPT is not associated with reduced shareholder wealth

(as measured by Tobins Q and return on invested capital). However, the average results

obscure the fact that while ex-ante RPTs appear to be innocuous at worst, ex-post RPTs

are significantly negatively associated with shareholder wealth and firm performance.

An additional contribution of this paper is to investigate what can be considered a

special form of RPT, the passing down of top executive positions to relatives in family

firms. Again, the suspicion is that the passing down of top management positions to

relatives reflects a biased choice made from a restricted labor pool. Consequently, this

practice may not be value maximizing for other shareholders. In prior work examining a

sample of Fortune 500 firms, Villalonga and Amit (2006) find that Tobins Q is lower

when a descendant of the firms founder holds the position of CEO or chairman. For a

sample of S&P 500 firms, Anderson and Reeb (2003) find that the performance of family

firms is superior to non-family run firms if the founder is also the CEO, but that the

performance of family firms is no better than that of non-family firms when a founders

descendant is the CEO. For our sample of smaller U.S. firms, we identify cases where

either the chairman, CEO or one of the top two highest paid executives was hired by a


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family member or inherited their position from a family member. We document that, all

else equal, firms managed by hand-me-down top executives tend to have lower Tobins

Qs, consistent with family hiring destroying shareholder wealth. This complements the

results of Villalonga and Amit (2006) for a set of smaller market capitalization

companies.

Given that related party transactions and family hiring are endogenous to some

degree, we document that both of these practices are more frequently observed when

officers and directors have large ownership stakes. While large ownership positions

insulate management from the market for corporate control, they can also align

managerial incentives with those of other shareholders. To ascertain if firms RPTs and

employment practices have an independent association with firm valuations and

performance, we control for the ownership characteristics (and other governance

attributes) of the firms in our sample and find very similar results to those summarized

above.

We also investigate the relation between RPTs and subsequent outcomes that are

negative for shareholders. Specifically, we examine the relation between RPTs reported

for 1999 and 2000 and subsequent financial distress or securities deregistration, i.e.,

going dark. We find that ex-post RPTs, but not ex-ante RPTs, are significantly

positively related to the likelihood a firm enters financial distress or goes dark. The latter

result is consistent with insiders of firms with ex-post RPTs seeking to decrease outside

scrutiny by deregistering its securities. We also find that the presence of a hand-me-

down top executive is negatively related to the likelihood firms encounter financial

distress. While this appears to be at odds with our Tobins Q findings for family hiring, it


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is consistent with greater managerial risk aversion in family firms; resulting in not only

fewer exceptionally good shareholder wealth outcomes, but also fewer exceptionally bad

outcomes as well.

The paper proceeds as follows. Section I develops hypotheses related to the

frequency and impact of RPTs. Section II details the rationale for our sample formation

criteria and describes the sample. Section III examines the valuation and performance

impacts of related party activity. Section IV examines the role of officer and director

holdings in the prevalence of RPTs and if its inclusion as an explanatory variable affects

prior results. Section V examines the relation between RPTs and family hiring, and

subsequent financial distress and securities deregistration. Section VI concludes.

I. Hypothesis Development

A. RPTs: Shareholder Wealth Expropriation or Shareholder Wealth Maximization?

RPTs are often viewed as being detrimental to outside shareholders. Officers,

directors, and large shareholders are well positioned to use their influence to enter into

transactions that expropriate wealth from outside shareholders. Expropriation occurs if

the firm receives less net benefit from a RPT than could have been obtained from a

transaction with an unrelated counterparty. This may occur as a result of a firm agreeing

to pay a related party above market prices for commodity inputs. Alternatively, a firm

may pay market prices commensurate with top quality inputs but purchase inputs of

inferior quality from a related party. For example, a consultant related to a director may

be paid a wage similar to other consultants doing similar tasks, but the related party

consultant might dispense lower quality advice than an unrelated third party. Even absent


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opportunistic behavior, lapses of judgment and overconfidence might be more likely with

related party transactions. For instance, firm officers and directors may overestimate the

abilities of relatives when entering into contractual relationships with them. Similarly,

insiders may obtain non-monetary private benefits from contracting with relatives, even

those that are less competent.

An alternative explanation for RPTs is that they do not damage shareholders and

they arise as an efficient contracting arrangement in situations involving incomplete

information. Contracting with a board member, for instance, can make sense when

coordination of activities and feedback between contracting parties are important. For

instance, a restaurant chain that relies heavily on franchising may have franchisees on the

board of directors to ensure quick feedback on how operational changes are impacting

franchisees. Similarly, it may be worthwhile to have suppliers on the board of directors

in order to obtain insights on the firms supply chain or to receive quick feedback on how

easy it will be to implement changes affecting suppliers.

Contract efficiency can also be facilitated from the parties familiarity with each

other. For instance a common form of related party transaction is a lease for a

commercial property that is owned by an executive of the firm. Lease payments, in part,

are priced to cover the expected losses from a tenant breaking a lease agreement. Given

an officers position with the firm and his firm-specific knowledge of the tenant, the

lessor-manager can be assured that the firm is not likely to break the lease, and

consequently, can charge a lower rate than a third party lessor. Similarly, while a

financially distressed firm might have difficulty procuring a loan from a bank, a wealthy


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executive or board member may extend the firm a loan on better terms given their

superior knowledge of the firms financial and operating situation.

Another potential benefit of RPTs is the mitigation of holdup problems in the

contracting process and the facilitation of investment in firm-specific relationships. If the

parties are close by family relation, holdup problems might be less likely when

renegotiating a contracts terms. Furthermore, to the extent that a related party has a

large investment in the firm, the party may have financial incentives to avoid a holdup

lest they compromise the value of their investment in the firm, e.g., see Klein, Crawford,

and Alchian (1978) and Fee, Hadlock, and Thomas (2006).

One of the most commonly cited forms of RPTs, employment-related loans,

merits additional consideration. Employment-related loans are of separate interest

because such transactions have been proscribed by the Sarbanes-Oxley Act of 2002 and

because they are arguably part of a broader employment agreement. It is difficult to see

how loans might undermine performance, especially since the loans are often used to

fund stock purchases that can improve executive incentives. In fact, prominent value-

based management consultants often advocate such practices, e.g., see Young and

OByrne (2001). Relocation loans may also provide an incentive for an executive to

move from one job to another. The general concern is that the interest rates on such loans

are not fairly priced given the potential for default, e.g., see Kahle and Shastri (2004), but

the previous discussion suggests that there are valid reasons for granting such loans. In

our empirical work, we treat employment-related loans separately from other RPTs.

B. Historical Context of RPTs


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An additional factor to consider with respect to RPTs is historical context. Some

RPTs originate after an arms-length relationship between the contracting parties is

already in place. For instance, Starbucks Coffee had a pre-existing arrangement with

Pepsi Cola Bottling to bottle and ship Starbucks products when the CEO of Pepsi

Bottling joined the Starbucks board. Presumably, the invitation to join the board was

extended because Pepsi Bottlings CEO had experience with the sale of packaged

Starbucks products that could aid in the formation of strategies. Similarly, Abercrombie

& Fitch invited the head of its advertising firm to be on its board. Advertising is a vital

component of Abercrombie & Fitchs sales approach. Thus, the presence of their

advertising strategist on the board makes sense from a business perspective. In both of

these cases, there is no real suspicion that an incompetent party received a contract for

goods and services. It is possible that the prices paid for services rendered could have

escalated after board membership was obtained, but this is likely a lesser problem than

having the wrong party provide the service.

Another example of potentially harmless RPTs arises after a firm goes public. In

this case, contracts may be in place that were negotiated absent any conflict of interest,

yet these contracts are considered RPTs for disclosure purposes after an IPO. For

example, when the owner of a privately held corporation decides to build a headquarters,

he may fund the construction of the building by injecting his own capital (via an equity

infusion) into the firm or by financing the construction directly and then leasing the

building to the firm. Given limited liability laws, it may make more sense from a

diversification point of view for the executive to own the property himself and lease it to

the firm he manages, as the executive retains ownership of a valuable asset in the event of


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a firm bankruptcy. Once the firm goes public, however, this lease is reported as a RPT.

Undoing the lease to avoid the appearance of impropriety may result in a needless and

costly relocation. For example, when the management of Quality Dining was criticized

for leasing restaurant sites from top management, it was pointed out that the leases pre-

dated the firm going public and were at below market rates.6

Similarly, when a

subsidiary of a parent firm is spun off to shareholders (such as Too Inc. being spun off by

The Limited Inc.), it makes sense to have the former parent (and significant shareholder)

continue to provide back-office support functions as long as the former parent is the

lowest cost provider.

Firms frequently have other similar related party transactions in place at the time

of their IPOs. If these transactions have the potential to be viewed negatively by the

market, then they must be justified at the time of the IPO or risk negatively affecting the

offer price. Similarly, when one firm acquires another firm, the acquirer may inherit pre-

existing arrangements that are priced into the acquisition value and the acquirer may be

ill advised to terminate these arrangements.

The above-mentioned ex-ante transactions might be distinguished from ex-post

transactions in terms of their impact on outside shareholders. Ex-post transactions occur

when the transactions are entered into afterthe related party has obtained a board seat,

executive position, or large share voting block. Hence, ex-post transactions are more

likely than ex-ante transactions to suffer from a conflict of interest.

C. Family Firms and Family Employment in Top Executive Positions

6 See Battaglia (2000).


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A special form of RPT, that is generally not reported as such, is employment of

relatives in family firms. Family firms are often described as firms where either the

founder and/or his relatives hold board or executive positions and/or large ownership

stakes. In the present context, we are less interested in the precise definition of a family

firm and more interested in situations where a top executive was hired or promoted by a

family member or was able to become a successor to a family member due to

shareholdings or influence within the firm. Note that this can occur in cases where the

executive is not a member of the founding family, though in practice, this is rare.

The arguments about the desirability of this practice are similar to the arguments

for or against RPTs in general. The concern is that the best party to hold important

executive positions is nothired in order to advance the private interests or ambitions of

one group of shareholders, the family. Simply put, an executive placed in his position by

other family members might not be the best qualified or might pursue goals more

consistent with the objective function of the family rather than of the shareholders. On

the other hand, the fact that the family member may have a longer term outlook for

running the company might aid in the accumulation of reputational capital with suppliers

and/or make it less likely that the manager will be myopic with respect to investment

decisions, e.g., see Burkhart, Panunzi, and Shleifer, (2003).

D. Predictions Relating to Hypotheses

The shareholder expropriation hypothesis predicts that the presence of RPTs will

be associated with decreased shareholder wealth and firm performance while the efficient

contracting hypothesis suggests no harm or possibly a benefit to shareholders from the


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existence of RPTs. To ascertain whether the average RPT harms or benefits

shareholders, we examine whether higher levels of RPT activity are associated with

higher or lower Tobins Q ratios and returns on invested capital (ROIC). If the

transactions are harmful on net, then we would anticipate the existence of substantial

RPT activity to be associated with lower Q ratios and ROIC. We also expect that any

observed negative effects of RPTs will largely be driven by the subset of RPTs entered

into when a conflict of interest existed. These include RPTs that were entered into after

the firm went public and after the contracting party became a related party. RPTs

initiated before significant conflicts of interest existed are less likely to be associated with

negative effects for outside shareholders. Finally, following Villalonga and Amit (2006),

it is expected that situations where executives are hired or promoted by a family member

will be associated with lower firm valuations.

II. Empirical Design and Sample Construction

A. Sample Construction

For large corporations, some agency violations may have little observable impact

on firm value. For instance, if the CEO of IBM can pressure the board of directors to

overpay a family member for a service by $10 million a year, this may have an

undetectable impact on IBMs share price given the firms $100 billion plus market

capitalization. With smaller corporations, in contrast, relatively modest agency violations

(in dollar terms) can lead to large revaluations in the firms stock prices. There might

also be reasons why larger firms are less susceptible to agency costs arising from RPTs.

News publications such as the Wall Street Journal delight in uncovering what appear to


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be improprieties (at the expense of shareholders) by managers of large, well known

companies. Such free monitoring can lead to erosion of executive reputation and even

litigation and civil penalties, causing managers of larger corporations to check their

behavior. For smaller firms, these violations are less likely to be publicized, even in

cases in which they are real, suspect, and observable. Further, because many smaller

firms are controlled by a relatively small number of investors, easily observable agency

violations may be nearly impossible to prevent in a cost effective manner, e.g., see Ang,

Cole, and Lin (2000). Accordingly, we focus on small to mid-sized firms in our analysis.

We also focus on a small set of industries that have a substantial number of firms

in them. The rationale or opportunity for related party transactions is likely greater in

particular industries. Sampling from a broad cross-section of firms might miss this

important fact. Also, since we seek to study performance differences based on the

presence of related party transactions, it is important to focus on industries in which

being small is not an overwhelming competitive disadvantage. Finally, it is easier to

accurately control for industry performance with a small set of industries.

Given that we also want to examine the association between RPT activity and

subsequent financial distress or securities deregistration, we select our sample period so

that several years of post-sample data are available.

To satisfy these sample formation goals, we use the Compustat database to obtain

a list of all firms with assets between $20 million and $2 billion at the end of fiscal year

1999. From this list we purge limited partnerships, foreign incorporated firms, and

ADRs. We then identify four-digit Standard Industrial Classification (SIC) code

industries where at least 70% of the firms had a positive return on assets (defined as


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operating income before depreciation divided by total assets) in 1999 and there were at

least 10 firms with assets between $20 million and $2 billion in the industry. Since we

want at least 40 firms in each industry, we combine four-digit SIC industries into industry

groups when the fundamental business models appear to be similar. The resulting sample

includes firms from the following four industry groupings: restaurants, retail apparel and

accessories, apparel manufacturing, and trucking. We supplement the Compustat sample

with firms that had the same SIC codes as our industry firms and that had data available

from the SECs website.7

For each sample firm, we collect data on corporate governance

and related party transactions from the proxy statements and/or 10-k filings containing

compensation data for fiscal year 1999 and fiscal year 2000. The firms in our sample are

listed in Appendix A.

B. Firm characteristics, performance, and governance

Table I reports summary statistics for our sample. The mean (median) firm in our

sample has accounting assets of $322.7 million ($177.2 million). Firm size is similar

across industries, though the restaurant industry has the smallest average and median

asset sizes. Firm age is the number of years, prior to the year 2000, for which the firm

operated in its current line of business as a public company or as a subsidiary of a public

company. For most firms, firm age is the number of years (prior to the year 2000) since

the firm conducted their equity IPOs. Firm age is often difficult to define because a firm

may alter its line of business and/or because a firm might stay very small before it gets

access to public capital markets and grows aggressively. Our definition captures the first

time that the business that represents the firms primary activity had access to public

7 http://www.sec.gov/edgar.html.


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capital markets by either being a public firm or part of one. The average age of our

sample firms is 17 years.

The average market value of equity for our firms on June 30, 2000 was $374.1

million, with a median of $79.9 million.8 The smallest median market value corresponds

to restaurants and the smallest average market value to trucking. Pre-tax ROIC averages

18.1%, with a median of 18.3%. This figure is measured as the sum of operating

earnings (before interest, depreciation and taxes) plus lease payments divided by invested

capital. Invested capital is defined as total assets plus seven times lease payments minus

non-interest bearing current liabilities. Apparel retail has the highest average ROIC and

apparel manufacturing the lowest. The average and median Tobins Q ratios are 1.427

and 1.017, respectively.9

Apparel retail has the highest average Q ratio and trucking the

lowest.

The median number of directors on the board is seven for the entire sample with

relative uniformity across industry medians. Roughly half of all firms have a staggered

board, which is fairly consistent across our four industries with trucking having the

lowest percentage at 42.9%. We sort directors into executives and their relatives, grays

(former executives and those with business dealings with the firm and interlocking

directors), and independent directors, where a director is classified as an independent

8 Market value of equity is based on shares outstanding (Compustat item 25) at the end of the 1999 fiscalyear. The shares outstanding are multiplied by the stock price from CRSP as of June 30, 2000. If no priceis available on that date, we use the last quoted price on the stock after the end of the 1999 fiscal year and if

there is no price quote after the end of the fiscal year we set the price equal to the Compustat share price atthe end of the fiscal year (item 199). All prices are split adjusted.9 We calculate the June, 2000 Q ratio as the market value of equity minus the book value of equity (item60) plus total assets minus deferred taxes (item 35) all divided by total assets (item 6). In the event thebook value of equity is negative (eight cases), we reset the Q ratio to one if earnings before extraordinaryitems (item 18) are also negative (five cases). This adjustment is necessary because, by construction, Qratios must be greater than one for such observations. Firms with negative book equity and negativeearnings are likely to have market value of debt below book value of debt. Hence, we lower their Q ratioswith this adjustment. In fact, most of these firms were in financial distress. The Q ratio for June, 2001 iscalculated similarly.


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director if he or she has never worked for the firm, has no relative working for the firm,

and has no business transactions with the firm (besides director duties).10 These

classifications are based on the proxy statement and/or 10-k filing related to the 1999

fiscal years compensation as defined by Compustat. The disclosures generally come in

early 2000. Less than half (44.4%) of the boards of directors have a majority of

independent directors. The highest percentage of independent majority boards is apparel

manufacturing at 50.9% and the lowest to trucking with only 31.0%.

In addition, we identify if the firm has multiple directors from the same family.

Twenty-nine percent of all firms have multiple family members on the board of directors.

This percentage ranges from 40.5% in trucking to 18.6% in restaurants. With respect to

ownership, the average officer and director holdings in our sample is 32.30%, with the

highest level in trucking at 38.2% and the lowest in restaurants with 29.1%.11

C. Related Party Transactions and Employment Loans

Firms are required to report any transaction, or series of similar transactions,

between the firm and its managers, directors, large (>5%) shareholders, or their

respective families provided the amounts in the transaction(s) exceed $60,000. These

disclosures appear in the firms proxy statements and/or their 10-k filings with the SEC.12

The disclosures sometimes include loans related to employment and incentive contracts

10 If the chairman of the board received $50,000 or more extra compensation for his or her service, then shewas deemed an insider.11 This includes shares held by family members not on the board of directors. The calculation takes allshares owned and issuable within 60 days upon the exercise of options by officers, directors, and familymembers and divides by all shares outstanding plus shares issuable within 60 days upon the exercise ofoptions by the officers and directors and their family members.12 RPTs reported in the 10-k are often reported in item 13 of the 10-k entitled Certain Relationships andRelated Transactions. This item often refers the reader to the firms proxy statement. The other locationin which RPTs are reported is in the footnotes of the firms financial statements.


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of executives. We exclude employment related loans from our definition of RPTs and

track them as a separate item in our empirical analysis.

Among the items included in our definition of RPTs are leases, purchases and/or

sale of goods and services, non-employment loans, financing arrangements, and asset

sales and purchases. In Appendix B, we outline how we assign dollar values for each

transaction. It should be noted that in some cases the potential for loss may be less than

the dollar value of the transaction. For example, a firm could lose the entire balance of a

non-employment loan if the related party defaults, but if the firm purchased $1 million of

goods from a related party, then the loss (overpayment) for those goods could be well less

than $1 million. Another feature of these transactions is that they are often recurring in

nature. For example, leases and loans run for multiple years, hence, they show up as a

RPT multiple years even though there is one transaction date. Similarly, firms often

purchase or sell goods to a related party for multiple years.

Table II contains descriptive statistics on RPTs and employment related loans.

These statistics are for 1999, but the results are similar for 2000 (not reported). Nearly

71% of firms report at least one RPT, 62.0% report combined RPTs greater than $60,000,

55.2% report combined RPTs greater than $200,000, and 32.9% report combined RPTs

greater than $1 million. Clearly, RPTs are not uncommon in our sample of firms.

Apparel manufacturers consistently report the fewest RPTs for all cutoff levels of RPT

activity. A chi-square classification test reveals that the differences across industries in

terms of the frequency of RPTs greater than $200,000 are significant at the 5% level.

Table II further reveals that the mean RPT level is 2.86% of total firm assets. The

median RPT total is 0.15% of assets. Nearly 31% of firms have total RPTs that exceed


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one percent of firm assets. While the one percent threshold might not seem all that large,

it is conceivable that moderately-sized RPTs may still have valuation implications. If

insiders are engaging in questionable RPTs of modest, yet non-trivial, magnitudes, then

the existence of the RPTs may be indicative of insiders attitudes towards shareholder

wealth maximization. Questionable attitudes could raise concerns about insiders

decisions in other areas of firm operations as well, e.g., disgorging profits to

shareholders, project selection, etc. Concerns about the decision making of executives

could depress firm valuations beyond the impact of the RPTs themselves.

Table II also reports the frequencies of employment related loans for various

cutoff levels. Roughly 23% of firms with employment loans exceed the $60,000

threshold, 17.0% exceed the $200,000 threshold, 5.7% exceed the $1 million threshold

and only 2.6% of the employment related loans exceed 1% of total assets. Hence, in

terms of their frequency and magnitude, employment related loans are relatively less

common and smaller in volume than other RPTs.

Table III reports the fraction of firms in the sample and industry subsamples with

certain types of RPTs with sums in excess of $200,000 in 1999. Products and services is

a broad category that includes advertising and marketing, management or consulting

services, purchased transportation for trucking firms, licensing revenue for apparel sales,

and actual purchases/sales of physical products. Given the broad classification definition,

this category has the largest frequency among the various types of RPTs. The level is

fairly consistent across industries ranging from 27.9% for restaurants to 35.8% for

apparel retailers. Some common subcategories of products and services that often

receive attention in the business press include consulting services and purchase of aircraft


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services from a related person. Both of these items are relatively rare, with less than 5%

of firms reporting such transactions across the entire sample.13

Transactions in which the firm leases something (other than aircraft) from a

related party are frequently observed and are most prevalent among apparel retailers,

followed by restaurants. This pattern is not too surprising given these firms typically

have numerous store locations. Retail properties may make good investments for related

parties because they can be re-leased to other parties, whereas investments in

manufacturing plant or equipment may be more firm specific.

Among the industries in our sample, franchising RPTs are exclusive to the

restaurant industry, with 18.6% of our sample of restaurant firms reporting an amount

greater than $200,000. Restaurant chains frequently franchise store locations and

franchises are often run by executives, founders, directors, and/or their family members.

As discussed above, it may be desirable to have franchisees on the board to offer insights

about the restaurant chains business. For instance, most of the directors of Papa Johns

Inc. were franchisees of the firms pizza concept.

Asset sales or purchases involving related parties in amounts greater than

$200,000 are observed for 9.0% of the firms in our sample. We observe no asset sales or

purchases greater than $200,000 for apparel manufacturers, while 15.1% of restaurants

report such RPTs. Again, this is likely due in part to the fact that individual site locations

are more likely to be viewed as investments by related parties and these sites can be

easily bought or sold by restaurant chains.

13 Yermack (2006) examines the personal use of corporate-owned aircraft by company executives. Incontrast, the transactions in our sample involve aircraft owned by related parties (often executives) wholease these aircraft to the firms for corporate use.


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Payments in excess of $200,000 to related parties for legal services are not

common. Loans to related parties greater than $200,000, independent of employment

related loans, occur for 6.8% of the sample. Nearly as many firms (4.7%) report

receiving loans (or loan guarantees for a fee) in excess of $200,000 from related parties.

Other types of RPTs exceeding $200,000 are reported for 4.7% of our sample firms.14

As argued in Section II, the timing of RPTs is likely a determinant of the wealth

consequences of RPTs for outside shareholders. Table IV details RPTs (excluding

employment-related loans) by their magnitude and historical timing. The historical

timing of specific RPTs is determined by examining proxy filings, prospectuses, and 10-k

filings going back as far as 1978 in some cases. Ex-ante transactions are those that were

entered into before there was a potential conflict of interest, i.e., transactions entered into

before the time that the related party obtained an executive position, directorship, or

significant shareholdings or before the firm became publicly traded.15

These ex-ante

transactions are distinguished from transactions that were initiated after the counterparty

became a related party, i.e., ex-post transactions. As Table IV indicates, the frequency of

ex-ante transactions is similar to the frequency of ex-post transactions regardless of the

magnitude of the RPTs or the year for which we observe the RPTs being reported. The

main finding in Table IV is that many transactions identified as RPTs originated when

there was arguably no serious potential conflict of interest between outside shareholders

and the counterparties to the transactions.

14 These other transactions include investments in company businesses, joint venture deals, payments torelated party charities, and banking relationships.15 If a relationship expands after a counterparty becomes a related party, e.g., the sale of goods increases by180%, then it is still considered an ex-ante transaction. If the relationship takes on an entirely newdimension, e.g., a counterparty leases property to a firm prior to becoming an insider but subsequently sellsthe property to the firm after becoming an insider, then the new transaction is considered an ex-posttransaction. Ex-ante includes cases where there is a simultaneous announcement of a contractualrelationship and the contracting party becoming a related party.


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D. Family Employment

Founders, or those who later become influential at a company, may oversee the

hiring or promotion of relatives to high ranking executive positions. These personnel

decisions may be based on an overestimation of a relatives skill or a desire to see a

relative advance within an organization. Using various internet searches and inspections

of corporate proxy statements, we identify cases where a person who is presently the

board chairman, CEO, and/or one of the two highest-paid executives was hired to that

position at a time when his or her relative was the top executive or board chairman of the

company in question or took the position as part of an apparent succession plan.16

Table V illustrates that 20.5% of the firms in our sample have what we refer to as

a hand-me-down top executive. This situation is most common in the trucking business

and least common in the restaurant industry. The differences across industries are

significant at the 1% level, suggesting certain industries are more amenable to this

practice. We also expand the definition of family hiring and promotion to include any

case where an executive meeting the criteria, was listed as a top five paid executive by

the firm in question. As reported in Table V, the incidence of a family hired executive

increases to 25.2% using this alternative definition.

16In some cases, this variable has a value of one when the executive is not related to the founder, becausethe executives family became influential after the founding. In some situations, the executive may have

held the position for more than 20 years, because he or she succeeded a relative, often a parent, to thatposition. In a small number of cases, the dummy variable has a value of one even though the founder isstill active in the company. This would include cases where the founder is the Chairman, but her child washired as the number two person in the organization. There are also some cases where the dummy variableequals zero, in spite of apparent family ties in the organization. For instance, there are two cases where thedescendant of the founder is in a top position, but in both cases, the relative came back to the company aftertheir father left the business by buying back into the business and reasserting family control. Hence, theywere not hired or promoted by family ties or influence. There are also two cases, where the number oneand two executives are from the same family, but in these two cases the executives had not changed rolessince the founding of the company and could be viewed as co-founders.


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III. RPTs, Shareholder Wealth, and Firm Performance

A. RPTs and Tobins Q

We investigate the association between non-trivial RPTs and various performance

metrics using regression analysis. Tobins Q ratios are frequently used as performance

indicators, especially in studies of the effect of firm governance on valuation, e.g., see

Morck, Shleifer, and Vishny (1988). To explain cross-sectional variation in Q ratios in

June, 2000, we first create a dummy variable equal to one if the sum of all non-

employment loan RPTs exceeds 1% of total end-of-period assets, and zero otherwise.

17

To control for the potential impact of employment-related loans, we create a dummy

variable equal to one if the sum of all employment-related loans exceeds 1% of end-of-

period assets, and zero otherwise. We also include a dummy variable to indicate if the

firm has a hand me down top executive. We control for firm size (age) by including the

log of total firm assets (firm age in years) as an independent variable. For our sample,

larger firms are likely to be the most successful businesses, because they were expanded

as profitable firms often are. Hence, larger firms may have higher Q ratios. Firms that

have been publicly traded for a shorter time are more likely to have greater growth

options, hence, we expect these firms to have higher Q-ratios. We also include dummy

variables to control for industry effects.

We first run a regression where we do not distinguish between the timing of the

RPTs, i.e., ex-ante or ex-post. The results in column 1 of Table VI ratios show no

17 This is preferable because assigning a dollar value to RPTs has some nontrivial potential error associatedwith it. For instance, while we prefer to use the value of license fees from sales of licensed products, somefirms give the value of the products sold instead. Setting a cutoff figure of 1% of total assets is one way tominimize the measurement error of this variable. Results are similar with alternative cutoffs.


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significant association between firm value and RPT activity. The coefficient on the RPT

dummy is small with a relatively large White-adjusted standard error. The coefficient on

the hand-me-down top executive variable is negative and significant at the 5% level.

Larger and younger firms have higher Tobins Q ratios, all else equal.

In column 2 of Table VI, we replace the single dummy variable for non-

employment loan RPT activity with two dummy variables that also capture the timing of

the RPTs. An ex-ante RPT dummy variable is set equal to one if the value of RPTs

(exclusive of employment loans) initiated before a contracting party was conflicted is

greater than 1% of total firm assets. An ex-post RPT dummy variable is set equal to one

if the value of RPTs (exclusive of employment loans) initiated after the related party had

influence at a firm is greater than 1% of total assets. The coefficient on the ex-ante

dummy is positive, but falls just short of statistical significance at the 10% level. The

coefficient on the ex-post RPT dummy is relatively large, negative, and significantly

different from zero at the 1% level. Furthermore, the difference in the ex-post and ex-

ante coefficients is also significantly different from zero at the 5% level. Hence, we

interpret these results as indicating that RPTs that are questionable in terms of their arms-

length enactment are associated with substantially lower firm valuations, especially

relative to ex-ante transactions.

The relatively large coefficient on the ex-post RPT dummy, -0.372, in column 2

of Table VI, indicates that seemingly modest ex-post RPT activity is associated with

dramatically lower firm values. The average RPT to asset ratio equals 0.071 for firms

with an ex-post RPT dummy equal to one. Our Q-ratio is also scaled by assets, so the

magnitude of the wealth effect implied by the dummy coefficient is large relative to the


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magnitude of the average RPT. We conjecture that this is consistent with the presence of

ex-post RPTs proxying for pervasive concerns about insiders attitudes towards

shareholder wealth maximization and alignment of interests with outside shareholders.

The coefficient on the presence of employment related loans is statistically

insignificant. The coefficient on the hand-me-down top executive variable is again

significant at the 5% level for the specification in column (2), consistent with top

executives being hired and promoted by family members having a negative association

with Tobins Q. This is consistent with Villalonga and Amit (2006).18

For robustness, we repeat the analysis for Q ratios calculated for June, 2001 and

RPT activity reported in 2000, as well as for the hand-me-down top executive dummy

variable updated for the year 2000. These results are reported in columns 3 and 4 of

Table VI. The disadvantage of these regressions is that 14 firms leave the sample

between 1999 and 2000. However, the results are similar to those for 1999. The

coefficient on ex-post RPTs is again large, negative, and significantly different from zero.

It is also significantly different from the coefficient on ex-ante transactions, which is

again positive but not significant at conventional levels. The coefficients on the hand-

me-down top executive dummies are again negative but not significant at conventional

levels.19 The coefficient on the presence of employment related loans is again

statistically insignificant.

18 It is worth noting that the hand-me-down top executive results are robust to alternative definitions, suchas having any second generation employee at the firm (even if they came to the firm after all other familymembers have left) identified as a hand-me-down executive or not labeling an executive as a hand-me-down if they were present at the founding of the firm (even if at a lower employment level).19 This is due, in part, to four firms where top executives left the firm in the spring of 2001. It could beargued that their presence in operating the firm up until the spring of 2001 could affect the valuation level(negatively) in June, 2001. In fact, if we include these observations as hand-me-down top executives, thecoefficient on the hand me down dummy is negative and again significantly different from zero (at the 10%level).


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In sum, the results from the Tobins Q regressions suggest that the average RPT is

not associated with negative valuation consequences for shareholders, but RPTs initiated

after a party becomes conflicted are associated with negative valuation consequences.20

B. RPTs and firm ROIC

We also examine how the level of RPT activity is associated with a firms ROIC

in 1999 and 2000. The regression specifications are similar to those used in the Tobins

Q regressions. The level of 1999 (2000) RPT activity is used to explain ROIC for 1999

(2000). One slight concern with these regressions is that some of the 1999 RPT activity

may have actually taken place in early 2000 but was reported in firm disclosures relating

to 1999 activity. This adds noise to the RPT dummy for this specification. When we

include all explanatory variables, the coefficient on the ex-post RPT dummy is negative

and significant at the 10% level in 1999 and at the 1% level in 2000. The employment

loan and ex-ante RPT dummies are insignificantly different from zero. Thus, the ROIC

results reinforce the Tobins Q results for RPTs. The same cannot be said for the hand-

me-down top executive variable. The coefficients are generally positive though not

nearly statistically significant for both 1999 and 2000. This is difficult to reconcile with

the Tobins Q results. Of course, year to year results for ROIC may be more volatile than

Tobins Q and, while ROIC may be satisfactory in a given year, it is possible that the Q

ratios reflect fears of future mismanagement by hand-me-down top executives or future

decisions that will favor family members over shareholders.

20 We also use a different cutoff for our RPT dummies of simply $1 million of RPTs. The coefficient signsare similar with the ex-ante RPT dummy significant at the 5% level. For both the 2000 and the 2001Tobins Q regressions, the difference between the ex-ante and ex-post dummy variables is statisticallysignificant at the 10% level. The ROIC results are similar to those reported below as well.


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C. RPTs and Executive Compensation

In the particular case of RPTs with top executives, RPTs may be viewed as

substitutes or supplements to executive compensation reported in the compensation tables

in SEC filings. For instance, a CEO may receive a lower salary in exchange for greater

RPTs that are arguably less observable to outside shareholders; see, e.g., Bebchuk and

Jolls (1999) and Rajan and Wulf (2006).21 To investigate the nature of the relation

between excess compensation and RPTs, we regress measures of excess compensation

(both total and cash compensation) calculated as in Berger, Ofek, and Yermack (1997)

against ex-ante and ex-post officer and director RPT variables (results not reported to

conserve space). The coefficients on the ex-ante and ex-post officer and director RPT

variables enter the regressions with relatively small positive coefficients; however, the

coefficients are not significant at conventional levels suggesting that RPTs are not

primarily undertaken to compensate executives in ways that are less observable to outside

shareholders.

IV. Corporate Governance, RPTs and Family Employment

A. Officer and Director Holdings and RPTs

One weakness of the prior analysis is that it does not control for broader corporate

governance characteristics of sample firms. RPT activity and nepotism in hiring may be

related to weaker corporate governance practices at some firms, e.g., see Kohlbeck and

21 Bebchuk and Jolls (1999) argue that an equal substitution of the proceeds from RPTs for directmanagerial compensation leaves shareholders worse off than without the value diversion since pay in theform of proceeds from RPTs provides no incentives to maximize shareholder wealth whereas incentive-based compensation does often provide such incentives.


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Mayhew (2004) and Gordon, Henry, and Palia (2004). Thus, we investigate the factors

associated with RPTs and family employment. To do so, we estimate logit models

explaining RPT activity and the incidence of hand-me-down top executives. Since, by

definition, a RPT is deemed to exist if a transaction is undertaken with an investor

holding a large amount of voting stock, we only examine the RPTs of officers and

directors, excluding those transactions with large shareholders that are not on the board of

directors. As governance variables, we use the existence of a staggered board of

directors, the existence of multiple family members on the board of directors, and the

extent of voting control of officers and directors. For the voting control variable, we use

the percentage of voting stock held by officers, directors and their families, but truncate

the variable at 50% if voting control exceeds 50% (since holding additional votes beyond

50% confers no additional control). If members of the board control voting stock that

entitles them to elect half the directors or more, we set the officer and director holdings

dummy variable equal to 50% as well. The presence of a staggered board is often

associated with weak governance and multiple family members on the board may

encourage cronyism.

We do not include measures of the shares held by independent directors or the

fraction of board members that are independent directors since such variables are affected

by the presence of RPTs. For example, if every director engages in RPTs, then the

fraction of directors that are outsiders will be zero. To avoid circular causation, we use

a dummy variable indicating multiple family members on the board rather than a variable

measuring inside versus outside board members. Given that we merely wish to


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demonstrate that governance factors may affect the incidence of family employment and

RPTs, excluding an inside versus outside director variable is not problematic.

Table VIII reports the results from the logit models. We find that significant

control of voting shares by insiders is associated with more ex-ante and ex-post RPTs and

with greater likelihood of hand-me-down top executives. We also find that the presence

of multiple family members on the board of directors significantly increases odds of

having a hand-me-down top executive. The presence of a staggered board has no

statistically significant influence on the odds of having RPTs or a hand-me-down top

executive. Industry affiliation is also important, but this appears to have less to do with

governance and more to do with the relative opportunities for RPTs across industries.

While some governance variables explain RPT and family employment activity, others

do not. Nevertheless, this suggests that we may wish to control for governance variables

in our value and performance regressions to see if governance variables, rather than the

presence of conflicted transactions, drive the results from Tables VI and VII.

In Table IX we present regression results controlling for the corporate governance

practices of sample firms. Columns 1 and 2 (3 and 4) present models explaining June,

2000 Tobins Q ratios (fiscal year 2000 ROIC). These performance metrics correspond

best with the governance variables reported (mostly) during the spring of 2000. For

governance measures, we include several measures of ownership and board composition.

Officer and director holdings (expressed as a percentage of total shares) are defined as

shares beneficially owned by the directors and officers assuming all options listed as

beneficially held are exercised. Officers and director holdings > 25% (40%) is a dummy

variable that equals one if officer and director voting power exceeds 25% (40%) of


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outstanding shares. Independent majority board equals one if more than half of the

directors are independent, i.e., they do not work for the firm, have a relative working for

the firm, or have business transactions with the firm.

In short, the results including the governance proxies are very similar to those

reported in Tables VI and VII. Ex-post RPT activity is again negatively and significantly

associated with firm value and performance while the presence of hand-me-down top

executives is associated with reduced firm value. Thus, it does not appear that our

previous results were driven by omitted governance proxies. Interestingly, our

regressions also offer mixed evidence on the associations between firm value,

performance, and ownership structure for our sample of small firms. For instance, in

column 1, none of the governance variables themselves enter the regression with

significant coefficients consistent with ownership structure and firm performance being

unrelated, e.g., see Demsetz and Lehn (1985). However, in column 2, insider ownership

is positively related to firm value but, high levels of insider voting control are associated

with lower firm value, e.g., see McConnell and Servaes (1990).

V. RPTs, Financial Distress, and Going Dark

As an additional check on outcomes associated with RPTs, we examine whether

the incidence of financial distress or going dark is higher for firms with significant levels

of RPTs. Clearly, financial distress is evidence of a firm continuing to perform

(exceedingly) poorly while going dark deprives shareholders of liquidity and information

about the firms they own.


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Table X presents the results of logistic regressions of subsequent financial distress

and going dark on the magnitude and timing of related party transactions and the

presence of hand-me-down top executives. The dependent variable in column 1 is an

indicator variable that takes a value of one if a firm is in financial distress after fiscal year

end 1999 but prior to December 30, 2004 and zero otherwise.22

In our sample, 15.0% of

firms enter financial distress. Ex-ante and ex-post RPT dummy variables are based on

RPT activity exceeding one percent of total assets in either fiscal year 1999 or 2000. As

reported in column 1 of Table X, ex-ante RPTs (ex-post RPTs) are negatively (positively)

associated with the likelihood of subsequent financial distress. Only the positive

coefficient on ex-post RPTs is significant at the ten percent confidence level. This is

consistent with the findings for Tobins Q and return on invested capital. Interestingly,

the coefficient on the hand-me-down top executive dummy is negative and significant,

perhaps reflecting greater managerial risk aversion in family firms.

The dependent variable in column 2 is an indicator variable that takes a value of

one if a firm goes dark. Going dark is defined as the firm filing for securities

deregistration unrelated to a bankruptcy filing and unassociated with a merger or cash

payout in a liquidation. We also include one case where a firm was delisted and stopped

filing 10-K and 10-Q disclosures for multiple years.23 In our sample, only 3.85% of firms

go dark. As reported in column 2 of Table X, ex-post RPTs are positive and

significantly associated with the likelihood that a firm will go dark. This finding is

22 A firm is deemed to experience financial distress if, between its 1999 fiscal year end and December 30,2004, the firm is in bankruptcy proceedings, or has liquidated all operating assets and commonshareholders will receive no cash distributions if remaining assets and liabilities are liquidated at bookvalue.23 In this case, the firm was threatened by the SEC with deregistration proceedings. The lack of filingsrelated to possible fraud at the firm.


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consistent with insiders of these firms seeking to protect private benefits of control and

decrease outside scrutiny, e.g., see Marosi and Massoud (2004) and Leuz, Triantis, and

Wang (2006). The coefficient on hand-me-down top executive and ex-ante RPTs are

both positive but not significant at conventional levels.

VI. Conclusion

For a sample of 234 firms in four industries, we document that related party

transactions are fairly common. We find that roughly half of the sizable RPTs in our

sample are initiated when conflicts of interest are likely minimal (before a firm goes

public or before the contracting party acquires a large block of stock in or a

managerial/board position with the firm). We find that the presence of large RPTs

generally has an insignificant statistical relationship with Q ratios and operating

performance. However, we find strong evidence that RPTs entered into after a

contracting party becomes a related party are negatively associated with firm value and

performance. This association is not merely a reflection of poor overall governance

structures of the firms involved as ex-post RPTs continue to be strongly associated with

lower firm value and performance even in the presence of controls for governance

structure.

In sum, our evidence suggests that ex-post transactions (non-arms-length

transactions at inception) are associated with reduced shareholder wealth whereas ex-ante

transactions are not associated with reduced shareholder wealth and may well represent

efficient contracting outcomes. These results are intuitive and consistent with potential

benefits and costs of related party transactions for outside shareholders. These results


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also have implications for recent proposed or adopted changes in reporting and listing

requirements by the SEC and the major U.S. stock exchanges, respectively. While the

focus of the changes has largely been to expand disclosure of RPT activity, our findings

suggest that additional required disclosures should be particularly aimed at facilitating

investors in determining whether RPTs are of the ex-ante or ex-post variety, the

characteristic that our analysis suggests is most important in assessing the potential for

RPTs to negatively impact outside shareholders.

Additionally, we find some evidence supporting the notion that when top

executives are hired by family members or inherit key executive positions, those firms

tend to have lower Q ratios. This supports prior work on this topic for larger firms and is

consistent with related party employment being damaging to outside shareholders.

Finally, we also find that ex-post RPTs increase the likelihood that a firm will

either encounter financial distress or go dark. These results are consistent with

shareholders of these firms being penalized for poor performance and perhaps consistent

with insiders of these firms seeking to protect private benefits of control by decreasing

outside scrutiny of their financial statements.


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Appendix A. Sample firms and Compustat GVKEYs

ABERCROMBIE & FITCH -CL A 63643

ALLIED HOLDINGS INC 28933

AM-CH INC 16394

AMERICAN FREIGHTWAYS CORP 15302

AMERN EAGLE OUTFITTERS INC 30059

ANNTAYLOR STORES CORP 21828

APPLEBEES INTL INC 16665

ARK RESTAURANTS CORP 11872

ARKANSAS BEST CORP 1743

ARNOLD INDUSTRIES INC 1766

ASHWORTH INC 21519

AVADO BRANDS INC 24675

BARRY (R G) CORP 2061

BEBE STORES INC 111662

BENIHANA INC -CL A 2163BIG BUCK

BREWERY&STEAKHOUSE 63044BIG DOG HOLDINGS INC 65484

BOB EVANS FARMS 2282

BOYD BROS TRANSPORTATION INC 30177

BRAZIL FAST FOOD CORP 62710

BRINKER INTL INC 3007

BROWN SHOE CO INC 2436

BUCA INC 119893

BUCKLE INC 25234

BUFFETS HOLDINGS INC 11815

CACHE INC 2595

CANNON EXPRESS INC 13201

CASUAL MALE CORP 13292CASUAL MALE RETAIL GRP INC 13381

CATO CORP -CL A 2818

CBRL GROUP INC 3570

CD&L INC 61583

CEC ENTERTAINMENT INC 15092

CELADON GROUP INC 29612

CHAMPPS ENTMT INC 65088

CHARLOTTE RUSSE HOLDING INC 125275

CHARMING SHOPPES INC 2938

CHAUS (BERNARD) INC 12378

CHECKERS DRIVE-IN RESTAURANT 24671

CHEESECAKE FACTORY INC 25737

CHICOS FAS INC 27981

CHILDRENS PLACE RETAIL STRS 65430

CHRISTOPHER & BANKS CORP 25108

CINTAS CORP 3062

CKE RESTAURANTS INC 6346

CLAIRES STORES INC 3087

COLE KENNETH PROD INC -CL A 30277

COLUMBIA SPORTSWEAR CO 105936

CONSOLIDATED FREIGHTWAYS CP 63975

COOKER RESTAURANT/OH 15415

COVENANT TRANSPRT INC -CL A 30877

CUTTER & BUCK INC 61171

DARDEN RESTAURANTS INC 31846

DAVE & BUSTER'S INC 60923

DAVIDS BRIDAL INC 120716

DEB SHOPS INC 3824

DELIAS INC OLD 64184

DENNYS CORP 19398

DONNA KARAN INTL INC 63170

DONNKENNY INC 28450

DRESS BARN INC 4072

DURANGO APPAREL INC 27843

EACO CORP 13187

EATERIES INC 12533

ELLIS PERRY INTL INC 28303

ELXSI CORP 10733

ENBC CORP 63419

FACTORY 2-U STORES INC 13842

FAMOUS DAVES OF AMERICA INC 63930

FINLAY ENTERPRISES INC 31683

FLORSHEIM GROUP INC 31016

FORWARD AIR CORP 29206FOX & HOUND RESTAURANTGROUP 65128

FRESH CHOICE INC 25981

FRIEDMANS INC -CL A 28997FRIENDLY ICE CREAM CORP 66004

FRISCH'S RESTAURANTS INC 4911

FROZEN FOOD EXPRESS INDS 4918

FURRS RESTAURANT GRP -CL A 14292

GADZOOKS INC 61397

GARAN INC 4993GARDEN FRESH RESTAURANTCORP 31811

GERBER CHILDRENSWEAR INC 111530

G-III APPAREL GROUP LTD 19402

GOODYS FAMILY CLOTHING INC 24621

GUESS INC 63447GYMBOREE CORP 28018

HAGGAR CORP 25987

HAMPTON INDUSTRIES 5456

HAROLDS STORES INC 14083

HARTMARX CORP 5505

HEARTLAND EXPRESS INC 12840

HOT TOPIC INC 63621

HUNT (JB) TRANSPRT SVCS INC 5783


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ICH CORP 5823

ICONIX BRAND GROUP INC 20204

IL FORNAIO AMERICA CORP 65434

INTIMATE BRANDS INC -CL A 61445

INTL FAST FOOD CORP 25300

INTRENET INC 11807

ISAACS I C & CO INC 66062J. ALEXANDER'S CORP 11538

JACK IN THE BOX INC 13092

JERRYS FAMOUS DELI INC 61446

JOS A BANK CLOTHIERS INC 30138

KASPER A S L LTD 65126

KELLWOOD CO 6376

KENAN TRANSPORT CO 12624

KLLM TRANSPORT SERVICES INC 12331

KNIGHT TRANSPORTATION INC 30861

K-SWISS INC -CL A 22205

LANDAIR CORP 114418

LANDRYS RESTAURANTS INC 28765

LANDSTAR SYSTEM INC 21440

LESLIE FAY COMPANIES INC 12450

LITTLE SWITZERLAND INC 24312

LIZ CLAIBORNE INC 6768

LONE STAR STEAKHOUSE SALOON 25025

LUBYS INC 6831

M S CARRIERS INC 12169

MADDEN STEVEN LTD 29382MAIN STREET RESTAURANTGROUP 23113

MARTEN TRANSPORT LTD 12625

MATLACK SYSTEMS INC 15089MAX & ERMAS RESTAURANTS 7132

MAXWELL SHOE CO INC -CL A 30193

MAYORS JEWELERS INC/DE 13866MCNAUGHTON APPAREL GROUPINC 29806

MENS WEARHOUSE INC 25167

MERITAGE HOSPITALITY GROUP 13759

MEXICAN RESTAURANTS INC 62698

MORGAN GROUP INC -CL A 28632

MORGANS FOODS INC 7575

MORRISON MGMT SPECIALISTS 62351

MORTONS RESTAURANT GROUPINC 25334

MOTHERS WORK INC 27936

MOTOR CARGO INDUSTRIES INC 65915

NATHAN'S FAMOUS INC 7696

NAUTICA ENTERPRISES INC 10033

NEW WORLD RESTAURANT GROUP 62330

NORTH FACE INC 63199

NPC INTERNATIONAL INC 7761

NUTRITION MGMT SVCS -CL A 24945

O'CHARLEY'S INC 22829

OLD DOMINION FREIGHT 24617

ONE PRICE CLOTHING STORES 13339

OSHKOSH B'GOSH INC -CL A 8193

OSI RESTAURANT PARTNERS INC 24186

OTR EXPRESS INC 24857OXFORD INDUSTRIES INC 8219

P F CHANGS CHINA BISTRO INC 116503

P.A.M. TRANSPORTATION SVCS 12598

PACIFIC SUNWEAR CALIF INC 27937

PANERA BREAD CO 24113

PAPA JOHNS INTERNATIONAL INC 28397

PATRIOT TRANSN HOLDING INC 12926

PAUL HARRIS STORES 8390

PHILLIPS-VAN HEUSEN CORP 8551

PHOENIX RESTAURANT GROUP INC 30818

PICCADILLY CAFETERIAS INC 8571

PIERCING PAGODA 30782

PJ AMERICA INC 63881

POLO RALPH LAUREN CP -CL A 64891

PRANDIUM INC 21796

PREMIUMWEAR INC 7617

QUALITY DINING INC 29818

QUIKSILVER INC 12868

RAINFOREST CAFE INC 31700

RARE HOSPITALITY INTL INC 25111

REEDS JEWELERS INC 12904

ROADHOUSE GRILL INC 64051

ROADWAY CORP 61795

ROCKY BRANDS INC 27776

ROSS STORES INC 9248

RUBIO'S RESTAURANTS INC 120557

RUBY TUESDAY INC 7566

RYAN'S RESTAURANT GROUP INC 9298

S & K FAMOUS BRANDS INC 9305

SALANT CORP 9382

SAMUELS JEWELERS INC 12173SANTA BARBARA RESTAURANTGRP 23050

SCHLOTZSKY'S INC 61733

SHELLS SEAFOOD RESTRNTS INC 62694

SHONEY'S INC 9673SILVER DINER INC 62495

SIMON TRNSPT SVCS INC -CL A 61571

SIMON WORLDWIDE INC 28556

SKECHERS U S A INC 121142

SMITHWAY MTR XPRESS -CL A 63157

SODEXHO MARRIOTT SVCS INC 66684

SONIC CORP 23697

SPORT-HALEY INC 29997


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STAGE STORES INC 63874

STAR BUFFET INC 65482

STARBUCKS CORP 25434

STEAK N SHAKE CO 3424

STEAKHOUSE PARTNERS INC 66680

STEIN MART INC 25186

STRIDE RITE CORP 10109SUPERIOR UNIFORM GROUP INC 10198

SWIFT TRANSPORTATION CO INC 22532

SYMS CORP 10235

TACO CABANA -CL A 25806

TALBOTS INC 29264

TANDY BRANDS ACCESSORIES INC 23577

TARRANT APPAREL GROUP 61060

TIFFANY & CO 13646

TIMBERLAND CO -CL A 13554

TODAY'S MAN INC 25353

TOO INC 122778

TRAILER BRIDGE INC 65148

TRANSFINANCIAL HOLDINGS INC 1418

TRANSIT GROUP INC 18545

TRANSPORT CORP AMERICA INC 30925

TROPICAL SPORTSWEAR INTL CP 65708

TUMBLEWEED INC 118797

UNIFIRST CORP 10840

UNITED RETAIL GROUP INC 25020

UNO RESTAURANT CORP 13418

URBAN OUTFITTERS INC 29150

US XPRESS ENTP INC -CL A 30751

USA TRUCK INC 25069

USF CORP 24926

VICORP RESTAURANTS INC 11162

WENDY'S INTERNATIONAL INC 11366

WERNER ENTERPRISES INC 12266

WESTERN SIZZLIN CORP 31456

WET SEAL INC -CL A 22612

WHITEHALL JEWELLERS INC 62748

WILSONS LEATHER EXPERTS INC 64820

WOLVERINE WORLD WIDE 11566WORLDWIDE RESTAURANTCONCEPT 23769

YRC WORLDWIDE INC 11649

ZALE CORP 11669


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Appendix B. Details of related party transaction sampling criteria

A.1. Assigning related party transactions to a given year

Related party transactions (RPTs) are included for 1999 if they are mentioned inthe 10-k or proxy statement relating to 1999 results and compensation. This includestransactions that may have come shortly after the end of the fiscal year but that werecompleted (or pending and eventually completed) before June 30, 2000. The samecriteria are used for year 2000 transactions with the deadline date being June 29, 2001. Inboth cases, these are also the respective dates used in the construction of Tobins Qratios, and the resulting transactions would have been known to market participants. Anumber of transactions classified as RPTs in 1999 are also classified as RPTs in 2000because they occurred in early 2000 or they spanned both years, e.g., loans with multipleyears to maturity.

A.2. Excluded transactions sometimes reported as related party transactions

Transactions that are excluded from the sample include the firm paying taxesassociated with an initial public offering, any transaction having to do with life insurancecovering an executive, loans of the firm guaranteed by a related party for which therelated party received no fee, and agreements to pay shareholder registration fees ofinsiders. Also excluded are private placements of securities that made the insider apotential related party. For example, if securities were sold to the insider and that madethe insider a 5% holder (and sometimes a board member) this is not treated as a relatedparty transaction if it was unaccompanied by any other transaction. Director fees andcommittee fees are also not considered RPTs, nor are private placements of securities ator above market prices (with no fees).

A.3. Assigning dollar values to transactions

To assign dollar values to the related party transactions, we use the followingalgorithm:

Loans: We use the maximum amount reported outstanding on the loan to or fromthe firm in a given year. Amounts payable on routine product payables and leasesare not included.

Loan guarantees by the firm: We use the amount of the loan being guaranteed.

Loan guarantees to the firm: We use only the amount paid by the firm. Forinstance, a guarantee without a fee is tantamount to a gift from the insider (thoughthe insider may extend such a guarantee so as to preserve the value of his equityinvestment).

Licensed products: We use the licensing fees earned during a year. Purchasing agent: If a fee for providing marketing or product purchases is given,

we use this as the dollar value. If no fee is given, then we use the dollar value of


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the purchases. In one case no dollar values are given; in this instance we simplyuse the end-of-year account payable owed.

Asset sales or purchases: We use the dollar amount of the assets bought or sold. Lease transactions: We use the dollar value of rent paid during the year. Equity private placements: If sold at a discount (one case), then we use the

amount of stock sold. If privately placed stock is sold at market value, then weuse any underwriting fee to the party. If the security sold was preferred stock,then we use the dollar value paid for the securities since the fair value of thepreferred stock is unavailable.

A.4. Defining loans to related parties as employment related or non-employment related

Any loan to an executive is deemed employment related if it was made directly tothe executive and it was part of an employment contract, if it was for the purchase of ahome, or if it was for the purchase of company stock. Loans made to an executive for aclear business transaction such as to buy a property for leasing to the company are

deemed non-employment related. If a loan had no rationale given for its existence andthe loan exceeded 10 times the value of the executives base salary in the current or prioryear, then the loan is deemed non-employment related.


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Table I: Summary statistics

Sample formation starts with all firms on Compustat with assets between $20 million and $2 billion at the end of1999. We then purge limited partnerships, foreign firms, and ADRs. We then identify four-digit Standard IndustrialClassification (SIC) code industries where at least 70% of the firms had a positive return on assets, defined asoperating income before depreciation (Compustat item 13) divided by total assets (item 6) in 1999 and there were at

least 10 firms with assets between $20 million and $2 billion in the industry. To ensure at least 40 firms in eachindustry, we combine four-digit SIC industries into industry groups when the fundamental business models appearto be similar. The sample consists of 234 firms that operated in four general industries (restaurants, trucking,apparel retail, and apparel manufacturing). Sample means and medians (in parentheses) are presented for the totalsample and for the four industry subsamples. Firm age is the number of years, prior to the year 2000, for which thefirm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm.Market value of equity is based on shares outstanding (Compustat item 25) at the end of the 1999 fiscal year. Theshares outstanding are multiplied by the stock price from CRSP as of June 30, 2000. If no price is available on thatdate, we use the last quoted price on the stock after the end of the 1999 fiscal year and if there is no price quote afterthe end of the fiscal year we set the price equal to the Compustat share price at the end of the fiscal year (item 199).All prices are split adjusted. Return on invested capital (ROIC) is calculated as operating income beforedepreciation plus the previous year's estimate of year-ahead rental commitments (item 96) divided by total assetsless non-interest-bearing current liabilities (item 5) plus seven times the previous year's estimate of year-ahead rental

commitments. Tobins Q is the market value of equity minus the book value of equity (item 60) plus total assetsminus deferred taxes (item 35) all divided by total assets. If book value of equity was negative and earnings beforeextraordinary items (item 18) were negative for 1999, then we set the Q ratio equal to one. The number of directorscomes from the firms proxy statements or 10-k filings. Staggered board is a dummy variable that equals one if thefirm has a staggered board and zero otherwise. Independent majority board equals one if more than half of thedirectors are independent in the sense that they do not work for the firm, have a relative working for the firm, orhave business transactions with the firm (besides director duties). Multiple family directors equals one if the firmhas multiple directors from the same family and zero otherwise. Officer and director holdings (expressed as apercentage of total shares) are defined as shares beneficially owned by the directors and officers assuming alloptions listed as beneficially held are exercised.

All Firms Restaurants Trucking ApparelRetail

ApparelManufacturing

Number of firms 234 86 42 53 53Total assets 322.7

(177.2)307.7

(115.2)359.6

(184.0)332.0

(198.5)308.6

(178.4)

Firm age 17.0(13.0)

15.0(10.0)

15.7(13.5)

15.6(13.0)

22.7(14.0)

Market value ofequity

374.1(79.9)

335.6(54.5)

188.1(57.0)

613.9(192.3)

344.1(82.1)

ROIC 0.181(0.183)

0.171(0.166)

0.194(0.198)

0.202(0.208)

0.167(0.184)

Tobins Q 1.427(1.017)

1.365(1.078)

1.194(0.861)

1.886(1

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Related Party Transactions Their Origins and Wealth Effects

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