The Regulation Of Related Party Transactions In Mergers & Acquisition

Merger and Acquisition (M&A), as a result of a growing market economy, has become a key strategy for business expansions and their profit maximization. Theoretically speaking, related party transactions in M&A, reasonable and inevitable to some extent, is neutral in nature: it is neither a pure market practice nor can be categorized as insider trading. The related party, resorting to M&A transactions amongst themselves, aims to cut the transaction cost, improve the transaction efficiency and carry out a range of restructuring for the listed company, thereby enhancing its competitiveness for future development; meanwhile, the related party also seeks higher investment returns as the value of the listed company rises.However, given the lack of a sufficient competition and free market choice, as well as special relationships and non-profit seeking purposes amongst the related party, there might be an overlapping or convergence in the interest of the M&A parties. Coupled with an underdevelopment of intermediate institutions in valuation and auditing, M&A is vulnerable to manipulation, therefore spawning an array of problems, not least of which is the damage on securities market integrity. Numerous researches have shown that the controlling shareholder, particularly in ownership concentrated businesses, has the motivation and capability to expropriate the interest of the listed company and concerned interest-holders. As a matter of fact, related party transactions in M&A is often an effective leverage for the controlling shareholder to impose the expropriation. More often than not, they turn their own interests into the company's and engage in tunneling the listed company as they enter into an abusive related party transactions in M&A to benefit personally at the expense of creditors, medium and small shareholders and even the state as a whole.The ownership split reform has initialized major transformations of the market in China; the gradual splitting of the equity structure of the listed company and an increasing amount of M&A calls for a well-developed market and improvement in related arrangements. This country, however, still sees an underdevelopment of regulations and enforcement measures, leading to a frequent occurrence of non-fair and unfair related transactions, which not only impedes the synergistic and scale economics effect from M&A but also jeopardizes the development of its capital market.Based on the current legislative and regulatory circumstances in China, the paper attempts to address the following three questions. First, why is there a need for regulations? This provides theoretical underpinnings for related party transactions in M&A. Secondly, what is the objective of the regulations. Thirdly, how to regulate, ie., how to put together an appropriate regulation pattern and a specific system arrangement according to the general characteristics of M&A and the ongoing situation of related party transactions in China's securities market. More specifically, with an eye on enhancing the regulation philosophy and measures for China's related party transactions, the research embarks upon a comparative study into the M&A regulation ideas as well as legislation system in different countries, then further probes into the changes in the related party transactions in M&A after China's ownership split reform. The detailed suggestions are also put forward concerning the adjustment of the regulation idea and improvement of specific regulatory arrangements.The whole paper is divided into five chapters apart from the introduction. Chapter one, subdivided into three sections, provides an overview of the relevant theories. The first section deals with the basic concept of merge and acquisition, making clear their similarities and differences; it also investigates the current situation of M&A in China, arguing that it is saddled with too much government interference, massive speculations and its legislative and regulatory framework is out of line with the current developments. The second section, apart from the reference to the basic concept of related party and related party transactions, explores the general characteristics of the related party transactions in M&A and contends that its higher proportion and greater impact than its counterpart in everyday business operation lends it to the key target of regulation; it also touches upon the positive and negative effects brought by related party transactions, with the latter lying more in the damage on securities market integrity and the expropriation of the state interest than the interest of the company, its medium and small shareholders and creditors. The third section introduces several theories regarding regulation before exploring the four component parts of related party transactions in M&A; it then proposes six targets for its regulation with regard to the negative effects mentioned above and analyzes what it entails in detail.Chapter two, subdivided into three sections, conducts a comparative study of the regulation of related party transactions in M&A from the perspectives of the legislative system, related party definition and information disclosure system. The first section, after a comprehensive review of the legislative system for related party transactions in M&A in various foreign countries, points out that, despite specific differences, there appears to be commonalties in their regulatory framework, which mainly resorts to the body of law such as company law, securities law, accounting law and tax law. In order to keep consistence with the legislation patterns and research conventions of the statutory country, the section systematically introduces China's legislative and regulatory system for related party transactions in M&A in the order of the laws'legal ranks and their force and effect --- basic laws, administrative rules, department regulations as well as rules of self-regulation of security exchanges --- while highlighting the deficiencies in the above laws and regulations. The second section, taking into account the international accounting standards and the definition of related party in US, Japan and Germany, maintains that, in China, the definition of related party is consistent with that in international regulations as well as the legislation philosophy in developed countries. The third section is mainly devoted to a comparative study of information disclosure systems. As the cornerstone of the securities market regulation, a mandatory information disclosure system has been essential in monitoring and curbing abusive related party transactions in M&A. After reviewing the information disclosure practices in International Accounting Standards Committee and in US, Britain, Canada, Hong Kong and Taiwan, the section argues that the main body, timing and approaches of information disclosure has yet to be specified even though the system itself is already in place in China.Chapter three to Chapter five is the main body of the paper. It investigates in detail how to enhance the regulation of related party transactions in M&A with regard to regulation principles, internal regulation systems and external regulation systems.Chapter three is devoted to the improvement of regulation principles for related party transactions in M&A, which is indispensable to curbing abusive transactions during M&A and streamlining the related legislative system. The first section explores the extension and nature of the"piercing the corporate veil"principle and its underlying theoretical rationale. It argues that, in China's case, even though the principle has been established in the new Company Law, there is still a lack of specification as to the range of its application and hence its practicability; therefore, judicial explanation from the Supreme People's court has to be called for. The second section introduces the deep rock doctrine. In the case of a markedly insufficient investment from the controlling shareholder, it is essential not only to pierce the corporate veil and directly subject the controlling shareholder to the inspection of the creditors, but also to consider underinvestment the credit from its abusive related party transactions, which in turn will deny its claim of the company credit. This section, digging into the nature and legal foundation of the doctrine, embraces an immediate introduction into China of the doctrine and the establishment of the priority of non-related credit to related credit, thus protecting the interest of the creditors and other shareholders in its subsidiaries. The third section is about establishing fiduciary duty of the controlling shareholder, which includes loyalty duty and care duty, with the former being the core of the issue in question. Establishing fiduciary duty of the controlling shareholder is a prerequisite to prevent abusive practices as well as a complement for shareholder equality. Therefore, this principle, together with specific regulatory arrangements and the corresponding indemnification approaches should be established and formulated immediately in Company Law in China. Chapter Four is devoted to the enhancement of internal regulation systems for the related party transactions in M&A. The internal regulations here refers to the ones imposed upon the related party transactions in M&A by medium and small shareholders and other beneficiaries by means of the power balance scheme within a listed company, ie., board of shareholders, board of directors, board of supervisors, among others. The purpose of internal regulations lies in streamlining the internal structure and operation of a listed company, improving its information disclosure system, reducing the information asymmetry, moral hazard, adverse selection as well as abusive practices during related party transactions to protect the interest of the investors as a whole. Divided into the four sections, the chapter addresses the issue with regard to the improvement of equity structure, board of shareholders, board of directors and independent directors, and board of supervision. Having reviewed the current equity structure in China, the first section presents that the controlling equities and a lack of balance scheme is the ultimate cause for abusive related party transactions; therefore, the circulation of the state-owned shares and the optimization of the equity structure, through a more intensive ownership split reform and introduction of structural investors, is called for in a bid to better internal regulations. In the second section, the author believes that the review of related party transactions and the avoiding of related shareholders are the main manifestations of the regulations of the board of shareholders in this regard; however, owing to a highly concentrated as well as dispensed equity structure in China's listed companies, the corporate governance is weak in term of the equity basis of power balance and hence the board of shareholders often fails to fulfill its due obligations. The author then argues that this can be addressed through a clearer spell-out of the duties of the board of shareholders, mandating its minimum attendees, a better cumulative voting system and proxy system. The third section deals with the optimization of board of directors system and, notably, issues concerning independent directors in view of its significance. The author contends in this section that as a result of a poor director election scheme, the board of directors is subject to manipulations from the controlling shareholder, which is worsened by the presence of insider control; therefore, it is necessary to upgrading the voting system, and responsibility system as well as the audit committee under the board of directors. As to the independent directors system, the section, backed up by way of empirical study, starts with positive comments on the ongoing practice in that it enhances transparency and democracy of decision making processes, reducing the information asymmetry and the presence of inside control and controlling shareholder's dominance; however, the author goes on to argue, the function of independent directors has still been greatly restricted as a result of the erosion of their independence and insufficient incentives; therefore, this can be addressed through an improved independent director recruitment process as well as remuneration and incentive scheme. In the fourth section, the author maintains that as a majority of the member of board of supervision themselves are employees of the company, its supervisory function is yet to be fully realized; consequently an enhanced supervisor selection system and the corresponding incentive scheme has to be established as well in addition to legally specifying of the duties and rights of supervisors so that the function of the board will be maximized.Chapter Five is devoted to the improvement of external regulations for related party transactions in M&A. The external regulations here refer to the ones imposed upon the related party transactions by, among others, executive departments, judicial departments, self-regulation organizations and intermediate institutions. Due to the complexity, invisibility and the possibility that the controlling shareholder might use its clout to avoid the review, internal regulations alone are not enough to curb abusive related party transactions during M&A; accordingly, external regulations is deemed highly necessary. This chapter, subdivided into four sections, explores the improvement of information disclosure system, company value appraisal system, intermediate institutions regulation system and judicial remedy system. The first section mainly touches upon the improvement of China's information disclosure system as its deficiencies have been thoroughly dealt with in Chapter Two. The suggestions put forward here include the specification of the disclosure principle, disclosure time and method, increase in the disclosure range and expansion in the contents of disclosure. In the second section, the author believes that the target company's value is the foundation of the finalized M&A price and has a direct bearing on its success; therefore a scientific value appraisal system is essential for the quantification and standardization of M&A and, hence, minimizing the benefit loss for the interest holders and the state as a whole during M&A. The major problems with value appraisal in China, as the author insists, consists of an unscientific appraisal approach and an underdeveloped disclosure system; therefore, efforts must be made to establish proper value appraisal idea, improve appraisal theories and approaches as well as its social environment. In the third section, the author points out that M&A is a complex social economic activity, which calls for a jointed effort from CPA firms, law firms, assets appraisal office as well as securities companies, especially when the related party transactions is involved; however, given a lack of risk sensitivity, quality service awareness and professional codes of ethics amongst intermediate institutions in China, an competitive market makes possible the fact that some would risk plotting with listed company to produce falsified audit results. As far as this situation is concerned, the author advocates the measures ranging from toughening legal penalties to the law-breaking institutions, reforming the charging system, changing the selection approach to forbidding the provision of non-audit services to a listed company and mandatory alteration of the intermediate institution. The last section is about judicial remedy system. The judicial authority's intervention with the corporate governance through litigation procedure provides external guarantee for an effective business operation and it is an inevitable choice to seek mandatory judicial interventions against the background of a lenient government control. The author argues that even though the direct action and derivative action have been legally established in China, the subject and the extent of the litigation, hence its practicability is yet to be improved. The direct action, in the author's point of view, can be enhanced through increasing the extent of litigation and preventing the abuse litigation of shareholders whereas a better derivative action can be achieved through improving the shareholding distribution arrangement, specification of the constituents of the litigation, the rights and obligation of the plaintiffs as well as increasing the range of the defendants.