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. We appreciate comments received on earlier versions of this paper from Ryan LaFond and Terry Warfield and workshop participants at Florida Atlantic University, the University of Kentucky, and the University of Wisconsin Madison.

* Corresponding author University of Wisconsin - Madison 975 University Avenue Madison, Wisconsin 53706 608-262-2714

bmayhew@bus.wisc.edu

Agency Costs, Contracting, and Related Party Transactions

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

Agency Costs, Contracting, and Related Party Transactions

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

Section 402 allows loans existing at the date of the act to continue and to allow loans that are essentially in the normal course of business and at normal terms to continue. This allows financial institutions to continue 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 actions from 1997 to 2002 and found that 23 of the 277 enforcement actions were related to the failure to properly disclose related party transactions (SEC 2003).

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
This concern is consistent with the concerns based on agency theory. Enrons RP transactions provide a example of how RP transaction can reflect both evidence of one party profiting at the expense of the other and the use of RP transactions to reduce the reliability of the financial statement. Andrew Fastow, former CFO of Enron, appears to have personally profited from a number of the partnerships he created to engage in RP transactions with his employer Enron. He also was able as CFO to increase the reported profitability of Enron via these transactions. As Enron began to collapse, it became 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,

The arguments presented here that are based on agency theory assume that wealth transfers are a concern consistent 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 sample provides wide distribution of firm size and industry, but it focuses on high-profile firms considered important 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.

(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

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.

Gordon, et al. (2004) investigate RP transactions in a concurrent study. Unlike Gordon, et al., we conduct a detailed analysis of the link between compensation and RP transactions. Gordon, et al. focus on executive versus non-executive board members, we do not. Instead, we look at differences between types of transactions and transactions with directors, officers and shareholders versus firm investments such as joint 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 the same firms over two years. These differences highlight the complementary nature of our two studies to developing a richer understanding of RP transactions.

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.

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. The Rigas family members have been alleged to use Adelphia as their own personal bank obtaining loans at will and have Adelphia pay personnel expenses.

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

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 nonemployee / 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.

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 on EXECUCOMP and the Investor Responsibility 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 EXCESSi,t = 0 + 2 SIMPLEi,t + 3 COMPLEXi,t + i,t EXCESSi,t = 0 + 2 SIMPLE_DOSi,t + 3 COMPLEX_DOSi,t+ 4 INVESTi,t + i,t (3) (4) (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.
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We chose this two-stage approach to isolate the RP effect. Our results are unaffected when we consider an 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 RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1) + 5 M2Bi,t-1 + 6 SIMPLEi,t + 7 COMPLEXi,t + i,t RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1) + 5 M2Bi,t-1 + 6 SIMPLE_DOSi,t + 7 COMPLEX_DOSi,t + 8 INVESTi,t + i,t 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. (8) (7) (6)

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 include determinants 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 RP transactions.

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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 and in 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 of material 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,

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

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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.

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

14

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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 versus complex grouping was suggested to us by a number of readers and is consistent with our own extensive reading of proxy statements and footnotes.

18

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 still the second most common RP transaction type.

19

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 < 0.001) and that of the compensation committee (14 = -0.006, p-value = 0.071) are inversely related to the probability of RP transactions. We then consider the classification of RP transactions as simple and complex. Of the 790 firms reporting RP transactions, 642 (465) report simple (complex) RP transactions (of these, 317 firms report both types). The correlation coefficient between the two RP groupings is 0.263 (p-

20

value < 0.001) indicating that the two groupings represent different firms. We partition the data based on this classification and re-estimate equation 1 (table 7).18 The partitioned results are very similar to the overall estimation. We continue to find weak governance, CEO options, and CEO ownership associated with RP transactions. However, there are two notable differences. First, larger firms are more likely to report simple RP transactions. Second, the overall results with respect to director fees and CEO cash compensation differ by the transaction type. Directors fees is only significant in the simple RP regression (3 = -0.727, p-value = 0.002) and the coefficient is substantially greater in magnitude than in the complex RP regression. CEO compensation is only significant in the complex RP regression (5 = -0.451, p-value = 0.063) while the magnitude of the coefficients between the two regressions is similar. These results suggest different transaction types may be used by directors and CEOs in compensation arrangements or other efforts to supplement compensation. Specifically, the large difference in the estimated coefficient for directors fees suggests a greater probability of simple RP transactions (for example, consulting arrangements, or legal and investing services) substituting for director cash compensation. We perform a number of sensitivity tests to check our results robustness as discussed in the following paragraphs. A common theme across all of our sensitivity tests is the effect of governance. We find that RP transactions are associated with weaker corporate governance as measured by board of director independence. Firm size is also consistently an important determinant of RP transactions. We exclude loans from our analysis consistent with Section 402 of the Sarbanes Oxley Act banning most loans to officers and directors. The RP percentage is reduced to 54 percent. Our results with respect to the cash compensation are no longer significant. These results are

18

Firms are eliminated in each regression where the firm only has RP transactions of the other type to avoid classifying a firm with a RP transaction overall as a non-RP firm in the regression.

21

consistent with the loans being using to offset lower compensation. Board size becomes positively associated with RP transactions consistent with weaker corporate governance. Many RP transactions cannot be entered and exited on short notice. The existence of RP transactions in the past may therefore explain RP transactions in 2001 either as the continuation of a previously existing relationship or as an increased propensity to enter in RP transactions. We collect RP information for our sample firms in 1998 (three years prior to our sample year) finding data for 985 firms. Although only 32 percent of the firms reporting RP transactions in 2002 also reported one in 1998, the explanatory power increases to 26 percent and the percent concordant increases to 76 percent. As expected, the prior RP transaction is significantly positive. Other results are as previously reported with the exception that the compensation variables are no longer significant. This result suggests the prior RP transaction captures the longer term compensation effect. Our descriptive analysis in table 3 implies an association between industry membership and RP transactions. To explore this further, we modify equation (1) by including industry indicator variables. Although many of the industry variables are significant, our results presented in table 6 are unaffected.

ANALYSIS OF COMPENSATION EFFECTS Table 8 documents our estimation of the compensation model under the three alternative compensation definitions.19 The results are generally consistent with the models predictions and Core, et al. (1999). Specifically, we find that CEO compensation is positively associated with prior year sales and weaker corporate governance measured by board size and director ownership across all three compensation definitions. For at least one compensation definition, we find

19

Our sample for the compensation totals 1,140 firms; 121 observations were eliminated because five years of financial statement data was not available to calculate the standard deviations of returns and ROA. The intercept and industry indicator variables for the estimation of equation 2 and the return models in table 10 are not tabulated for brevity.

22

predicted associations with investment opportunities, standard deviation of returns, duality, and board independence. Core, et al. (1999) find stronger results on certain of the variables including investment opportunities, shareholder returns, and CEO ownership. We attribute these differences to sample composition as we likely introduce additional variability by focusing on more firms but only one year. The equation (2) residuals provide our estimate of excess compensation. We regress excess compensation on RP transactions variables and report our results in table 9. RP transactions in general are not associated with excess compensation suggesting there is not a broad association between CEO compensation and RP transactions (panel A). However, when we split RP transactions into simple and complex transaction in panel B, we find a positive association between complex RP transactions and CEO compensation under both compensation definitions (2 = 180.138, p-value = 0.100 for CASH_COMP and 2 = 2037.386, p-value = 0.020 for CASH_COMP_SO). We further classify the RP transactions in panel C to separate investment-related RP transactions because these transactions may better represent complexity of operations than opportunistic transactions. It appears such investment-related RP transactions are associated with higher CEO compensation for both compensation definitions. We also find greater excess compensation associated with complex RP transactions with officers, directors or major shareholders in the case of total cash compensation plus option value (2 = 1803.101, p-value = 0.046). In sum, our analysis of RP transaction and CEO compensation does not suggest RP transactions are used as part of the CEOs compensation contract, but it does appear CEOs are compensated for the risk involved with more complex RP transactions involving investments. We next examine the association of RP transactions with future returns to differentiate between opportunism and efficient contracting (table 10). As expected, we find inverse relationships for the standard deviation of returns and the natural log of market value of equity.

23

However, we find no results for the market to book ratio and inconsistent results for excess compensation. The influence of RP transactions on future shareholder returns is apparent across both compensation definitions. We find overall inverse associations that are driven by simple RP transactions with directors, officers, or major shareholders. In addition, panel C reports a positive association between future returns and investment-type RP transactions. We interpret these findings to indicate that RP transactions provide both the potential for opportunism (simple DOS results) and compensation for risk / efficient contraction (investment RP results). As a sensitivity test, we include each of the RP transactions types and parties reported in the Appendix. The association between complex RP transactions and excess compensation in panel C of table 9 are primarily a function of related business activities and stock transactions (compensation for risk). The simple transaction result in table 10 (opportunism) is a function of non-loan RP transactions. We find no systematic evidence of opportunism with respect to loans and therefore no support for the loan prohibition under the Sarbanes Oxley Act.

CONCLUSION We consider agency and contracting theory to investigate RP transactions. Agency theory suggests RP transaction can result from opportunistic behavior, however, RP transactions can also result 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 document that RP transactions are common among the S&P 1500 but vary as to transaction type. We consider compensation-based incentives affecting directors and the CEO that can influence whether the firm enters into a RP transaction. We find an inverse association between the probability of RP transactions and CEO and director cash compensation suggesting RP transactions may be used to supplement compensation. We also find a positive association between CEO options and the probability of RP transactions consistent with either RP

24

transactions providing a more liquid source of compensation, or greater ownership making it easier for the CEO and directors to engage in transactions that favor themselves individually rather than benefiting the firm. We also provide evidence that board of director independence (stronger corporate governance) is associated with a lower probability of RP transactions. These results suggest board monitoring plays a role in mitigating the occurrence of RP transactions and helps to discipline disclosure of the transactions when they do occur. The lack of results for other monitors is consistent with the reliance on the board of directors. Our investigation also suggests that depending on the type of RP transaction, RP transactions may both compensate for increased risk and result in opportunistic behavior. First, more complex RP transactions and those with investments are positively associated with excess compensation and future shareholder returns consistent with efficient contracting. However, simple RP transactions, although unrelated to excess compensation, are inversely related to future shareholder returns consistent with opportunism. Further investigation indicates that loans to officers, directors, and major shareholders are not the primary factor behind these results contradicting a motivation for the loan prohibition in the Sarbanes Oxley Act. Our sample imposes some limitations on our findings. We find mixed and weak results in our univariate analysis on institutional holdings and analyst following monitoring RP transactions. But our sample consists only of firms on major S&P indices. These index firms have high institutional holdings and analyst followings across the board, so there may not be enough variability in these measures to find an association with RP transactions. Future research should examine a broader sample to determine the extent of this limitation. We also cannot be sure that all the firms we identify as non-RP firms do not engage in RP transactions. Although we are reasonably confident we have identified the firms who disclosed RP transactions, there may be firms that enter into RP transactions and choose not to disclose the transactions.

25

References American Institute of Certified Public Accountants. 1983. Statement on Auditing Standards No. 45, Related Parties. New York, NY: AICPA. American Institute of Certified Public Accountants. 2001. Accounting and Auditing for Related Parties and Related Party Transactions. New York, NY: AICPA. Beasley, M. 1996. An empirical analysis of the relation between the board of director composition and financial statement fraud. The Accounting Review 71 (October): 443-465. Bhagat, S. and B. Black. 2002. The non-correlation between board independence and long-term firm performance. The Journal of Corporation Law (Winter): 231-272. Core, J., R. Holthausen, and D. Larker. 1999. Corporate governance, chief executive officer compensation, and firm performance. Journal of Financial Economics 51: 371-406. Dlugosz, J., R. Fahlenbrach, P. Gompers, and A. Metrick. 2004. Large bocks of stock: prevalence, size, and measurement. Working paper, Harvard University, The Ohio State University, and the University of Pennsylvania. Emshwiller, J. 2003. Many companies report transactions with top officials. The Wall Street Journal (December 29, 2003): 1. Erickson, M., B. Mayhew, and W. Felix, Jr. 2000. Why do audits fail? Evidence from Lincoln Savings and Loan. Journal of Accounting Research 38 (Spring): 165-194. Financial Accounting Standards Board. 1982. Statement of Financial Accounting Standards No. 57, Related Party Disclosures. Norwalk, CT: FASB (FAS 57) Gordon, E., E. Henry, and D. Palia. 2004. Related party transactions: associations with corporate governance and firm value. Working paper, Rutgers Business School. Holmstrom, B. 1979. Moral hazard and observability. The Bell Journal of Economics 10: 74-91. Holmstrom, B. 1992. Contracts and market for executives: comment in Contract Economics, L. Weign and H. Wijkander (editors). Blackwell Publishers. Jensen, M. and W. Meckling. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3 (October): 305-360. Klein, A. 1998. Firm performance and board committee structure. Journal of Law and Economics 41: 275-299. Klein, A. 2002a. Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics 33 (August) 375-400. Klein, A. 2002b. Economic determinants of audit committee independence. The Accounting Review 77 (April): 435-452. McTague, J. 2004. Secrets of the Vault. Barons (July 5): 13.

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Murphy, K. 1999. Executive compensation in Handbook of Labor Economics, volume 3, O. Ashenfelter and D. Card (editors), New Holland. Securities and Exchange Commission. 1999. Staff Accounting Bulletin No. 99, Materiality. Washington, D.C.: S.E.C. (SAB 99). Securities and Exchange Commission. 2003. Report Pursuant to Section 704 of the SarbanesOxley Act of 2002. Washington, D.C.: SEC. Securities and Exchange Commission. 2004a (as amended). Regulation S-X (17 CFR Section 210). Washington, D.C.: SEC. Securities and Exchange Commission. 2004b (as amended). Regulation S-K (17 CFR Section 229). Washington, D.C.: SEC. Schliefer, A. amd R. Vishny. 1986. Large shareholders and corporate control. Journal of Political Economy 94: 461-488. Shastri, K. and K. Kahle, 2003. Executive loans. Working paper, University of Pittsburgh. Swartz, M. and S. Watkins. 2003. Power failure: the insider story of the collapse of Enron. New York: Doubleday. Watts, R. and J. Zimmerman. 1986. Positive Accounting Theory. Englewood Cliffs, NJ: Prentice Hall.

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Appendix - Definitions of Related Party Variables Types of Related Parties Directors, Officers, and Shareholders Related party is a director, an officer of the company, or a major shareholder of the company (> 5 percent ownership). Related party is an affiliate of a director, officer, or major shareholder of the company. Related party is identified as a joint venture or other operation in which the company has a less than 100% investment that is not consolidated.

Affiliates Investment

Types of Related Party Transactions Loans to related party The company made loans to related parties. Employee loan programs are considered one related party transaction. A related party has either loaned amounts or guaranteed debt of the company. The company guaranteed debt of a related party. The company and the related party have entered into an agreement where the related party provides consulting services to the company. The company obtains either legal or investment services from the related party. The company has entered into an agreement with the related party to lease space or aircraft. The company and the related party are involved in business activities, including research and development activities, that are related to the companys main operations. The activities typically result in sales, cost of sales, R&D expense, receivables, and payables. The related party provides the company services that are incidental to the companys main operations. The company and the related party have entered into an agreement for one party to provide administration services to the other for a fee. The company and the related party have entered into transactions involving transfers of assets, business, and / or ownership interests.

Borrowings Guarantees Consulting arrangements

Legal or investment services Leases Related business activities

Unrelated business activities Overhead reimbursement

Stock transactions

28

Table 1 Sample Determination

Firms included in the S&P 1500 Eliminations: Firms not included in IRRC database 2001 financial statements could not be located Firms with ADR shares Missing financial information on Compustat Missing return or share price data on CRSP Final sample 137 54 14 23 11

1,500

239 1,261

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Table 2 Descriptive Statistics Partitioned by Existence of Related Party Transaction

Means Variables N Assets (millions) Market value of equity (millions) Market to book value of equity Sales (millions) Annual director fees (millions) Directors ownership CEO cash compensation (millions) CEO option grants (Black-Scholes value for 1999-2001, millions) CEO ownership Outside block holders (% of firms) Institutional holdings Analyst following Leverage Board size Board of directors independence Compensation committee independence Duality
1

Medians

RP 790 12,762 7,189 2.69 5,056 0.026 5.6% 1.366 22.552 5.2% 40.3% 60.5% 9.7 0.19 9.5 61.4% 87.9% 71.6%

No RP
471 6,846 7,438 3.08 4,962 0.028 4.0% 1.227 18.115 4.2% 46.9% 62.4% 8.9 0.20 9.2 70.7% 93.6% 76.8% * *** *** * ** ** * ** * ** ***

RP 790 1,750 1,533 2.23 1,233 0.026 0.1% 0.871 4.550 2.9% 63.2% 8.0 0.17 9.0 62.5% 100%

No RP 471 1,519 1,463 2.15 1,462 0.027 0.0% 0.937 2.875 2.3% 64.8% 7.0 0.20 9.0 73.3% 100% *** *** ** *** *** **

* / ** / *** The mean (median) is significantly different at the 0.10 / 0.05 / 0.01 level using a t test of means (Wilcoxon rank sums test).
1

Sixty-three percent of the firms disclose RP transactions with an average of 2.3 RP transitions (ranging from 1 to 23) distributed as follows: 1 transaction 339 43% 2 5 transactions 108 52% > 5 transactions 43 5% Total 790 100%

30

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 Transactions Percentage of Firms with Complex Related Party Transactions

Natural Resources Manufacturing Equipment Manufacturers Technology Transportation Utilities Wholesale Retail Financial Business Services Other Services Total

3,468 4,711 10,263 5,072 5,412 16,093 2,162 4,403 42,355 2,986 3,723 10,552

2,051 4,526 6,329 4,179 3,770 8,002 5,403 8,368 5,375 2,052 3,095 5,021

1.77 2.75 3.03 3.93 2.31 1.76 2.25 3.81 2.76 2.51 2.65 2.84

40 304 163 135 35 91 53 102 155 117 66 1,261

65.0% 52.0% 51.5% 63.7% 68.6% 50.5% 66.0% 68.6% 80.6% 71.8% 78.8% 62.6%

*** ***

47.5% 38.5% 39.9% 53.3% 62.9% 38.5% 50.9% 57.8% 74.8% 59.8% 60.6% 50.9%

*** ***

47.5% 33.2% 27.0% 35.6% 51.4% 28.3% 33.0% 43.1% 41.3% 38.5% 56.1% 36.9%

***

**

***

*** ** ***

*** *

***

* / ** / *** Difference in the proportion of firms disclosing related party transactions between the industry classification and the overall proportion is significant at the 0.10 / 0.05 / 0.01 level.
1

Industry classifications are based on firm SIC codes as follows: Natural resources 0000 - 1499 Manufacturing 1500 3399, 3800 - 3999 except for those classified as technology Equipment 3400 3799 except for those classified as technology Technology 2830 2839, 3570 - 3579, 3670 03679 Transportation 4000 - 4799 Utilities 4800 - 4999 Wholesale 5000 - 5199 Retail 5200 - 5999 Financial 6000 - 6999 Business Services 7300 7399, 8100 - 8199 Other 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 314 55.7% 33 5.9% 25 4.4% 129 22.9% 169 30.0% 136 24.1% 512 90.8% *** ** *** Affiliate of Director, Officer, or Major Shareholder 143 35.6% 34 8.5% 25 6.2% 80 19.9% 134 33.3% 139 34.6% 325 80.8% *** *** *** ** *** Investment Total Transaction Type

Loans Borrowings Guarantees Consulting arrangements Legal and investment services Leases Simple RP transactions

52 46.4% 13 11.6% 14 12.5% 17 15.2% 16 14.3% 31 27.7% 81 72.3% *** ** ***

337 42.7% 50 6.3% 34 4.3% 143 18.1% 221 28.0% 189 23.9% 642 81.2%

Related business activities Unrelated business activities Overhead reimbursement Stock transactions Complex RP transactions

199 35.3% 74 13.1% 45 8.0% 98 17.4% 304 53.9%

***

215 53.5% 79 19.7% 47 11.7%

*** *** *** ***

90 80.4% 14 12.5% 24 21.4% 27 24.1% 105 93.7%

***

327 41.4% 104 13.2%

*** **

67 8.5% 125 15.8% 465 58.8%

82 20.4% 299 74.3%

Total Related Party Type

564 100.0%

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 assuming independence 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, or and a non-wholly owned investment. Sum of the firms with the indicated related party and transaction type exceeds the total number of firms with related party transactions as some firms have multiple related party and transaction types. The percentage indicates the percentage of firms that reported the indicated combination of party and transaction type as a percentage of the total number of firms reporting related party transactions for the indicated related party type.

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Table 5 Pearson Correlation Matrix

N=1,261 1 Duality COMPCOMM_ IND RP LNASSETS DIR_FEES DIR_OWNERSHIP CEO_CASHCOMP CEO_OPTIONVALUE CEO_OWNERSHIP BLOCK INST ANALYSTS LEV BDSIZE BD_IND COMPCOMM_IND DUALITY -0.047 0.099 * 0.077 * -0.126 * 0.119 * 0.056 * 0.148 * -0.065 * -0.001 0.038 0.032 0.027 0.141 * 0.057 * 1.0 -0.165 * 0.107 * 0.122 * -0.198 * 0.114 * 0.104 * -0.110 * 0.069 * 0.083 * 0.092 * 0.054 0.058 * 0.508 * 1.0 BD_ IND -0.257 * 0.178 * 0.152 * -0.360 * 0.167 * 0.128 * -0.169 * 0.131 * 0.074 * 0.060 * 0.109 * 0.122 * 1.0 0.051 0.600 * 0245 * -0.082 * 0.369 * 0.195 * -0.191 * -0.118 * -0.128 * 0.290 * 0.095 * 1.0 -0.013 0.137 * 0.103 * -0.008 0.044 -0.031 -0.070 * 0.115 * 0.030 -0.052 1.0 0.056 * 0.589 * 0.265 * -0.226 * 0.409 * 0.451 * -0.177 * -0.136 * 0.184 * 1.0 -0.047 -0.034 0.142 * -0.141 * 0.126 * 0.229 * 0.058 * 0.235 * 1.0 -0.065 * -0.152 * 0.036 -0.106 * -0.015 0.036 -0.027 1.0 BDSIZE LEV ANALYSTS INST BLOCK CEO_ OWNERSHIP 0.083 * -0.263 * -0.041 0.001 -0.048 0.044 1.0 CEO_ OPTIONVALUE 0.085 * 0.395 * 0.307 * -0.325 * 0.448 * 1.0 CEO_ CASHCOMP -0.013 0.571 * 0.446 * -0.249 * 1.0 DIR_ OWNERSHIP 0.070 * -0.250 * -0.240 * 1.0 -0.052 0.405 * 1.0 0.051 1.0 1.0 DIR_FEES LNASSETS RP

* Significant at the 0.05 level.

1 Variables are defined as follows: RP is an indicator variable equal to one if the firm disclosed a related party transaction in either the footnotes or proxy, LNASSETS is the natural 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 the Black-Scholes value of the 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 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 compensation committee members that are independent, and DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of the Board.

34

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 + 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) Variable1 (N = 1,261) Intercept LNASSETS DIR_FEES DIR_OWNERSHIP CEO_CASHCOMP CEO_OPTIONVALUE CEO_OWNERSHIP BLOCK INST ANALYSTS LEV BDSIZE BD_IND COMPCOMM_IND DUALITY Percent Concordant Pseudo R2
+/? + ? + + Prediction Estimated Coefficient 1.882 *** 0.135 *** -0.481 ** 0.076 -0.446 * 0.872 *** 0.518 ** -0.005 -0.003 0.005 0.331 0.034 -0.031 *** -0.006 * -0.140 69.4% 14.1% p-value

0.002 0.037 0.032 0.749 0.091 < 0.001 0.015 0.969 0.273 0.640 0.396 0.218 < 0.001 0.071 0.337

* / ** / *** 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 indicator 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 the Black-Scholes value of the 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 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 compensation committee members that are independent, and DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of the Board.

35

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 + 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) Simple RP (N=1,113) Variable Intercept LNASSETS DIR_FEES DIR_OWNERSHIP CEO_CASHCOMP CEO_OPTIONVALUE CEO_OWNERSHIP BLOCK INST ANALYSTS LEV BDSIZE BD_IND COMPCOMM_IND DUALITY Percent Concordant Pseudo R2
1

Complex RP (N=936)
Estimated Coefficient 2.103 *** 0.086 -0.145 -0.011 -0.451 * 0.672 *** 0.396 * -0.032 -0.004 0.012 0.323 0.020 -0.038 *** -0.005 -0.061 70.4% 16.2% p-value 0.002 0.231 0.567 0.966 0.063 0.013 0.100 0.829 0.298 0.334 0.483 0.530 < 0.001 0.146 0.711

Estimated Coefficient 1.234 * 0.181 *** -0.727 *** 0.117 -0.424 0.987 *** 0.661 *** 0.032 -0.003 0.004 0.331 0.046 -0.033 *** -0.005 -0.142 71.2% 17.2%

p-value 0.054 0.008 0.002 0.643 0.127 < 0.001 0.003 0.818 0.324 0.729 0.421 0.114 < 0.001 0.122 0.356

* / ** / *** p-value indicates significance at the 0.10 / 0.05 / 0.01 level using two-tailed significance tests.
Variables are defined as follows: F is the cumulative standard normal distribution function, RP is an indicator 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 the Black-Scholes value of the 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 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 compensation committee members that are independent, and DUALITY is an indicator variable equal to 1 if the CEO is the Chairman of the Board.
1

36

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 Variable (N = 1,140) SALES MB ROA RET SDROA SDRET DUALITY BDSIZE BD_IND CEO_OWNERSHIP DIR_OWNERSHIP BLOCK BLOCK_IN Adjusted R2
1

CASH_COMP_SO
Estimated Coefficient 0.192 *** 333.603 *** 5292.726 -203.273 1784.179 7424.160 *** 1236.683 499.644 *** -28.609 800.536 -4166.623 *** -366.051 71.0538 p-value

Prediction

Estimated Coefficient 0.043 *** -4.367 562.442 64.169 1683.469 -293.140 363.260 *** 79.718 *** -6.041 * 151.227 -416.319 ** -63.780 -62.318

p-value

+ + + + ? ? + + ? -

< 0.001 0.567 0.286 0.516 0.125 0.231 0.003 < 0.001 0.077 0.427 0.037 0.569 0.624

< 0.001 < 0.001 0.209 0.797 0.838 < 0.001 0.204 0.004 0.295 0.599 0.009 0.683 0.943

13.6%

8.3%

* / ** / *** p-value indicates significance at the 0.10 / 0.05 / 0.01 level using two-tailed significance tests.
Variables are defined as follows: 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 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, 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 the decile ranking of the ratio of the number of shares and exercisable options held by non-employee directors to total shares 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 the
1

firm has one or more outside block holders and zero otherwise, and BLOCK_IN is an indicator variable equal to one if the firm has one or more non-CEO inside block holders and zero otherwise.

37

Table 9 Regression of Discretionary Compensation on Related Party Transactions Panel A: Related Party Equation 3: EXCESSi,t = 0 + 1 RPi,t + i,t CASH_COMP Variable (N = 1,140) Intercept RP Adjusted R2
?
1

CASH_COMP_SO
Estimated Coefficient -712.909 1141.456 p-value

Prediction

Estimated Coefficient -54.665 87.525

p-value

0.513 0.407

0.285 0.176

0.0%

0.1%

Panel B: Controlling for Disclosure Complexity Equation 4: EXCESSi,t = 0 + 1 SIMPLEi,t + 2 COMPLEXi,t + i,t CASH_COMP Variable (N = 1,140) Intercept SIMPLE COMPLEX Adjusted R2
? ?
1

CASH_COMP_SO
Estimated Coefficient -871.296 252.994 2037.386 ** p-value

Prediction

Estimated Coefficient -110.208 88.020 180.138 *

p-value

0.154 0.405 0.100

0.158 0.764 0.020

0.2%

0.4%

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 CASH_COMP Variable (N = 1,140) Intercept SIMPLE_DOS COMPLEX_DOS INVEST Adjusted R2
? ? ?
1

CASH_COMP_SO
Estimated Coefficient -968.548 8.608 1803.101 ** 4357.574 *** p-value

Prediction

Estimated Coefficient -114.750 62.979 168.358 334.020 *

p-value

0.132 0.551 0.137 0.065

0.111 0.991 0.046 0.002

0.4%

1.0%

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Table 9 Regression of Discretionary Compensation on Related Party Transactions (Continued)

* / ** / *** p-value indicates significance at the 0.10 / 0.05 / 0.01 level using two-tailed significance tests.
1

Variables are defined as follows: EXCESS is discretionary compensation calculated as the residual from the estimation of equation 2 and the indicated compensation variable (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), 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 an 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.

39

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 CASH_COMP Variable (N = 1,140) EXCESS SDRET Log(MVE) M2B RP Adjusted R2
1

CASH_COMP_SO
Estimated Coefficient 0.000 -0.270 *** -0.018 * -0.001 -0.056 ** p-value

Prediction

Estimated Coefficient 0.001 ** -0.277 *** -0.024 ** -0.001 -0.058 **

p-value

0.020 < 0.001 0.010 0.922 0.038

0.374 < 0.001 0.055 0.843 0.046

8.5

8.1%

Panel B: Controlling for Disclosure Complexity Equation 7: RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1) + 5 M2Bi,t-1 + 65 SIMPLEi,t + 7 COMPLEXi,t + i,t CASH_COMP Variable (N = 1,140) EXCESS SDRET Log(MVE) M2B SIMPLE COMPLEX Adjusted R2
1

CASH_COMP_SO
Estimated Coefficient 0.000 -0.275 *** -0.018 * -0.001 -0.060 ** 0.011 p-value

Prediction

Estimated Coefficient 0.001 ** -0.282 *** -0.023 ** -0.001 -0.061 ** 0.006

p-value

? ?

0.020 < 0.001 0.011 0.927 0.029 0.817

0.345 < 0.001 0.059 0.843 0.033 0.691

8.4%

8.1%

40

Table 10 Regression of Returns on Discretionary Compensation and Related Party Transactions (Continued) Panel C: Controlling for Related Party and Disclosure Complexity Equation 8: RETi,t+1 = 0 + (1j INDi,t) + 2 EXCESSi,t + 3 SDRETi,t-1 + 4 Log(MVEi,t-1) + 5 M2Bi,t-1 + 6 SIMPLE_DOSi,t + 7 COMPLEX_DOSi,t + 8 INVESTi,t + i,t CASH_COMP Variable (N = 1,140) EXCESS SDRET Log(MVE) M2B SIMPLE_DOS COMPLEX_DOS INVEST Adjusted R2
1

CASH_COMP_SO
Estimated Coefficient -0.001 -0.282 *** -0.018 * -0.001 -0.060 ** -0.007 0.083 * p-value

Prediction

Estimated Coefficient 0.001 ** -0.288 *** -0.024 *** -0.001 -0.061 ** -0.011 0.073

p-value

? ? ?

0.023 < 0.001 0.009 0.966 0.029 0.687 0.122

0.286 < 0.001 0.053 0.881 0.032 0.806 0.080

8.6%

8.3%

* / ** / *** p-value indicates significance at the 0.10 / 0.05 / 0.01 level using two-tailed significance tests.
1

Variables are defined as follows: RET is the natural log of one plus the annual shareholder return, IND is a vector of indicator variables to capture industry membership, EXCESS is discretionary compensation calculated as the residual from the estimation of equation 2 and the indicated compensation variable (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), 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 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 an 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.

41