Saturday, 14 May 2016

Related Party Transactions, "a national sport in Asia"

I have often warned about Related Party Transactions (and its closely related cousin "Conflict of Interest"). Basically, these should be avoided by companies, and if they are unavoidable due to the nature of the business, they should be done in a very transparent and upfront manner.

In Malaysia, RPTs (and Conflict of Interest situations) are of course almost a way of life, many of the Corporate Governance abuse cases described in this blog handled about them.

GMT did recently some research regarding Hong Kong and Singapore companies.

Over 90% of all companies were engaged in some form of related party transactions in 2014. It makes us wonder if the remaining 7-8% simply forgot to declare them! These transactions averaged 7% of combined sales and expenses which is highly material to profit. A whopping 13% (46 companies) had related party transactions in excess of 20% of combined sales and expenses. However, of these, 31 were state owned enterprises (SOE) which clearly do a lot of business with other SOEs. Who knows whether they conduct business at market prices or in line with government policy? What we’re really interested in are those private companies with a large amount of related party transactions because that’s where minority shareholders are at greatest risk. That leaves us with just 15 companies which we list in alphabetic order below:

Some of GMTs findings (unfortunately the names of the companies are left out, I guess one has to subscribe to their services for that):

  • Company 1: The largest related party balances of any company GLOBALLY, at US$6.2bn. It is paid interest income on amounts owed to it but doesn’t pay interest on amounts it owes. This boosted 2014 pre-tax profit by 20%.
  • Company 2: Two CEOs have been sent to jail in the last decade.
  • Company 3: Around 45% of expenses routed through two companies owned by the founder. One of these paid the founder an estimated US$22m in dividends over the past two financial years.
  • Company 4: Building the world’s 5th tallest building in China, financed with a US dollar loan from a related party.
  • Company 5: Over 35 pages of connected party transactions.

As a safeguard, RPTs have to be evaluated by the independent directors (INEDs), if the deals are properly done at arms length.

However, as David Webb put it

Once appointed by the board, the INEDs are re-elected by shareholders at the next annual general meeting, and thereafter by rotation (typically standing every three years, if they survive that long). Unfortunately, the controlling shareholders are allowed to vote in these elections, so they nearly always determine the outcome. Yes, the sheepdog is appointed by the flock, not by the shepherd. It is a clear absurdity that the controlling shareholders effectively appoint the people who are supposed to prevent them from abusing the company. This is shareholder democracy Hong Kong-style.

In fact, INEDs are often so closely allied to the executive directors that, if the company is taken over, the INEDs resign at the same time as the executive directors, and the new controlling shareholders will appoint new "independent" directors of their choice.

GMT concludes with "Now we’re working on the rest of Asia". I certainly hope they don't skip Malaysia, there will be lots of juicy material to be found.

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