When are self-dealing transactions harmful?

Julius Chikomwe
LAST week, we discussed the origins of self – dealing as well as its characteristics. Our three-part discussion attempts to elucidate self-dealing in light  of the increasing incidence of this phenomenon in our financial sector and elsewhere.
Not all self-dealing is harmful, however. In theory, there are instances where self-dealing could be beneficial to a company. Nevertheless, such instances, if at all they do arise in real life, are very few and perhaps too far apart to be of any significance.
A good example of such a situation would be an insider who, after knowing that his company is looking for a residential property to purchase, is anxious to make a quick sale and offers to sell his house to the company at a discount. Before making his offer, the interested director declares his interest in the transaction. Acting on his disclosure, the disinterested directors of the company then follow all the procedural and substantive fairness safeguards against self-dealing. Eventually, a decision is reached to purchase the interested director’s house and this decision is carried out. Such self-dealing would be beneficial to the company. When, therefore, is self-dealing harmful to the company?
A self-dealing transaction is harmful to the company when it is unfair. A self-dealing transaction is defined as unfair when” its outcome is less advantageous to the company than the outcome would have been if the transaction had been agreed to on the company’s behalf by a rational, well informed decision maker who was independent and loyal, that is, not affected by conflict of interest” (Lucas Enriques, 2000).
Quantifying Damage Suffered by the Company
From the formula discussed above, the damage that is suffered by a company as a result of an unfair self-dealing transaction is equal to the difference in the outcome and the hypothetical outcome of the transaction that would have been agreed upon by an independent decision-maker.
To illustrate the formula’s application, let’s suppose that company in our earlier hypothetical example the company desires to purchase an immovable property for one of its executives.

One of the company’s directors decides to sell his house to the company at an inflated price of US$500 000 instead of the house’s true market value of US$350 000. The fact that the selling director is on both sides of the transaction is not disclosed to the company or any of the other disinterested directors. As a result, the company pays the purchase price of US$500 000 because the transaction was approved by an interested director or directors instead of the US$350 000 that the company would have paid had the transaction been approved by independent directors. The damage that is suffered by the company is US$150 000.
Clearly, this result is prejudicial to the company and its shareholders.
Regulating Self-dealing
How does corporate law attempt to prevent self-dealing in companies? Corporate law has legal tools that can be deployed by companies, their boards of directors and shareholders to regulate unfair self-dealing. As will be seen, all self-dealing regulatory tools lie within a framework that’s bound on one hand by the need to avoid under-deterrence, and the need to avoid the risk of overkill on the other.
Under-deterrence occurs when a self-dealing regulatory framework does not sufficiently counteract directors’ incentives to engage in self-dealing. To be effective and meaningful, a self-dealing regulatory framework must avoid the risk of overkill effects, that is, either imposing liability on directors for transactions that are perfectly fair or implementing rules that are over-inclusive, which would prohibit even value-increasing transactions.
An effective self-dealing regulatory framework must therefore seek to strike a balance between these two constraints. What are the legal tools that may be deployed to regulate self-dealing? These are:
Seemingly, prohibition or banning self-dealing out-rightly is the easiest way to prevent self-dealing transactions. However, due to the practical necessities of running big enterprises, such a rigid rule would not provide an optimum solution. Instead, the practice across many jurisdictions today is to apply selective prohibition by forbidding specific corporate acts, while leaving insiders with discretion on all other issues not specifically covered by the proscription. For example, under Sections 176 and 177 of the Companies Act, tax-free payments and loans to company directors are specifically prohibited.
Disclosure & Ratification
Disclosure of interests that are adverse to those of the company is perhaps the most important preventive tool there is against self-dealing transactions. The rationale behind the disclosure strategy is three fold.
First, it is believed that disclosure helps capital markets to operate more efficiently because it allows prices to reflect the perceived fairness or unfairness of self-dealing transactions. Second, disclosure provides useful information for the basis on which the market can form a judgment on the integrity of corporate insiders, their reputation and, as a consequence, demand for their services in the market of corporate insiders. Third and lastly, disclosure is a cost-effective way of providing the companies’ stakeholder community with information that it needs to challenge the unfairness of self dealing transactions. In this way, self- dealing transactions are subjected to the scrutiny of a much wider audience with disparate interests and therefore, an insider’s chances of successfully pushing through a self-dealing transaction, are less likely.
Under United States securities laws for example, securities regulations require companies to disclose in their annual accounts, indebtedness of managers or members of their immediate family to the corporation exceeding USD60 000 or transactions in which directors or their immediate families have a “direct material” interest.
Approval /Ratification by the Board
Approval or ratification by a company’s board of directors of a self-dealing transaction is based on the expectation that there are enough disinterested directors who can effectively negotiate a self-dealing transaction after the necessary disclosures have been made by the director or directors that are conflicted. It’s necessary to point out there is an important legal distinction between “approval” and “ratification” in corporate law.
“Approval” signifies authorisation of a corporate action prior to its implementation. “Ratification”, on the other hand, is the approval of a corporate action, by the appropriate corporate authority, after the corporate act has been implemented. Because of this, it can be said that “ratification” is by its nature, a corrective procedure that is carried out to cure the absence of appropriate approvals, for corporate acts that have already been implemented.
Approval/Ratification by Shareholders
A company may also secure authority to proceed with a self-dealing transaction if the transaction receives the prior approval of the company’s shareholders or if the transaction is ratified by the company’s shareholders.
However, approval or ratification by shareholders has characteristics that render it an unattractive option, and therefore, one that is to be employed where it is absolutely necessary.
First, the transaction costs of this particular option are very high. Second, both interested and disinterested parties participate in the vote. Consequently, the outcome of a voting process in which interested parties have participated can hardly be said to be pure, tainted as it is, by the vote of the interested parties.
Julius Chikomwe is a Harare Attorney. This article was written in his personal capacity. His email address is jc@wsc.co.zw N.B. This article is for informational purposes only and is not intended as basis for decisions in specific situations. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship.