Related Party Transactions: Their Origins and Wealth Effects Michael Ryngaert Department of Finance, Insurance, and Real

Estate Warrington College of Business University of Florida Gainesville, FL 32611-7168 michael.ryngaert@cba.ufl.edu (352) 392-9765 Shawn Thomas* Katz Graduate School of Business University of Pittsburgh shthomas@katz.pitt.edu (412) 648-1648 This draft: September 20, 2007 Abstract: Related party transactions are potential mechanisms for insiders to expropriate outside shareholders via self-dealing; however, there are also possible benefits to these arrangements for outside shareholders. This paper investigates the frequency, nature, and valuation consequences of related party transactions for a sample of firms in four industries. The evidence suggests that, on average, related party transactions are not harmful to outside shareholders. However, the average results obscure the fact that while transactions that pre-date a counterparty becoming a related party appear to be innocuous at worst, transactions initiated after a counterparty becomes a related party are associated with reduced shareholder wealth. We also find evidence that firms in which key executive positions are handed down to family members have lower valuations. Keywords: Related Party Transaction; Ownership Structure; Tunneling; Corporate Governance JEL classification: G32 We thank Oya Altinkilic, Leonce Bargeron, Jesse Ellis, Mark Flannery, Joel Houston, Jason Karceski, and Tome Stojcevski for helpful comments and suggestions. Any errors remain our own. *Corresponding author. E-mail address: shthomas@katz.pitt.edu (S.Thomas)

Directors and officers of corporations are charged with the duty of entering into contracts that maximize shareholder wealth. 1 These contracts can cover a broad range of transactions including raising capital, acquiring production inputs, selling firm outputs, hiring employees, leasing assets, purchasing and divesting assets, signing franchising agreements, etc. On occasion, officers and directors enter into these contracts with their relatives, large shareholders, other firms that the officers and directors are affiliated with, or even with themselves. Such contracts are commonly referred to as related party transactions (RPTs). Given that related parties can use their influence to procure such contracts and influence the terms of the contracts in their favor, RPTs are often viewed as being inconsistent with shareholder wealth maximization.2 The suspicion that RPTs are harmful to outside shareholders is seemingly supported by anecdotal evidence. For instance, in the collapse of Enron, some of the losses sustained by shareholders were the direct result of related party transactions.3 It is also common for dissident shareholders to cite RPTs as a rationale for unseating managements in proxy contests by suggesting that the RPTs are unfair to outside shareholders.4 In response to recent investor concerns about RPTs, the U.S. Securities and Exchange Commission (SEC) has proposed amended disclosure rules for RPTs, and the NYSE and Nasdaq have revised listing requirements to mandate that either a firms audit committee or another independent body of directors review and approve all RPTs.5 The potential wealth effects of RPTs in foreign markets have been examined in
1

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

recent academic studies. Cheung, Rau, and Stouraitis (2006) document that firms listed in Hong Kong experience negative abnormal stock returns when they announce that they are undertaking connected transactions. Jian and Wong (2004) find that Chinese companies frequently engage in RPTs and that the volume of RPT activity is negatively related to firm value. Jiang, Lee, and Yue (2005) find that Chinese firms that grant loans to related parties have lower firm values, all else equal. Johnson, La Porta, Lopez-DeSilanes, and Shleifer (2000) argue that while expropriation via RPTs is more likely in emerging markets with poor law enforcement, so-called tunneling via RPTs also takes place in developed countries such as the United States. With respect to RPTs in the United States, research to date has primarily focused on the characteristics of firms that report RPTs. Consistent with a negative perception of RPTs, Kohlbeck and Mayhew (2004) and Gordon, Henry, and Palia (2004) conclude that U.S. firms reporting significant RPTs also tend to exhibit weaker corporate governance practices. This paper investigates the frequency, nature, and valuation consequences of related party transactions for a sample of 234 small to midsized firms from four industries. The main contribution of the paper is to document that RPTs are not all the same, with certain classes appearing harmful for outside shareholders and other classes potentially beneficial. In particular, we argue that the timing of related party transactions can lead to different shareholder wealth impacts. We classify RPTs as either being exante or ex-post transactions. Ex-ante transactions are defined as transactions in which the firm and the related party enter into a transaction either before the firm becomes a publicly traded entity or before the counterparty becomes a related party, i.e., acquires a large block of stock or becomes an executive or director. In the case of ex-ante RPTs, it

is hard to argue that insiders use their clout to enter into the transactions to the disadvantage of outside shareholders. Nevertheless, such transactions are generally labeled as RPTs in corporate disclosures, and it is possible that the continuation and renegotiation of the terms of the transactions is subject to conflict of interest. Ex-post transactions are those that occur after the firm goes public and after the counterparty to the transaction obtains related party status. Ex-post transactions, of course, are not arms length in nature and, if of sufficient magnitude, may harm outside shareholders. The evidence suggests that the average RPT is not associated with reduced shareholder wealth (as measured by Tobins Q and return on invested capital). However, the average results obscure the fact that while ex-ante RPTs appear to be innocuous at worst, ex-post RPTs are significantly negatively associated with shareholder wealth and firm performance. An additional contribution of this paper is to investigate what can be considered a special form of RPT, the passing down of top executive positions to relatives in family firms. Again, the suspicion is that the passing down of top management positions to relatives reflects a biased choice made from a restricted labor pool. Consequently, this practice may not be value maximizing for other shareholders. In prior work examining a sample of Fortune 500 firms, Villalonga and Amit (2006) find that Tobins Q is lower when a descendant of the firms founder holds the position of CEO or chairman. For a sample of S&P 500 firms, Anderson and Reeb (2003) find that the performance of family firms is superior to non-family run firms if the founder is also the CEO, but that the performance of family firms is no better than that of non-family firms when a founders descendant is the CEO. For our sample of smaller U.S. firms, we identify cases where either the chairman, CEO or one of the top two highest paid executives was hired by a

family member or inherited their position from a family member. We document that, all else equal, firms managed by hand-me-down top executives tend to have lower Tobins Qs, consistent with family hiring destroying shareholder wealth. This complements the results of Villalonga and Amit (2006) for a set of smaller market capitalization companies. Given that related party transactions and family hiring are endogenous to some degree, we document that both of these practices are more frequently observed when officers and directors have large ownership stakes. While large ownership positions insulate management from the market for corporate control, they can also align managerial incentives with those of other shareholders. To ascertain if firms RPTs and employment practices have an independent association with firm valuations and performance, we control for the ownership characteristics (and other governance attributes) of the firms in our sample and find very similar results to those summarized above. We also investigate the relation between RPTs and subsequent outcomes that are negative for shareholders. Specifically, we examine the relation between RPTs reported for 1999 and 2000 and subsequent financial distress or securities deregistration, i.e., going dark. We find that ex-post RPTs, but not ex-ante RPTs, are significantly positively related to the likelihood a firm enters financial distress or goes dark. The latter result is consistent with insiders of firms with ex-post RPTs seeking to decrease outside scrutiny by deregistering its securities. We also find that the presence of a hand-medown top executive is negatively related to the likelihood firms encounter financial distress. While this appears to be at odds with our Tobins Q findings for family hiring, it

is consistent with greater managerial risk aversion in family firms; resulting in not only fewer exceptionally good shareholder wealth outcomes, but also fewer exceptionally bad outcomes as well. The paper proceeds as follows. Section I develops hypotheses related to the frequency and impact of RPTs. Section II details the rationale for our sample formation criteria and describes the sample. Section III examines the valuation and performance impacts of related party activity. Section IV examines the role of officer and director holdings in the prevalence of RPTs and if its inclusion as an explanatory variable affects prior results. Section V examines the relation between RPTs and family hiring, and subsequent financial distress and securities deregistration. Section VI concludes.

I. Hypothesis Development A. RPTs: Shareholder Wealth Expropriation or Shareholder Wealth Maximization? RPTs are often viewed as being detrimental to outside shareholders. Officers, directors, and large shareholders are well positioned to use their influence to enter into transactions that expropriate wealth from outside shareholders. Expropriation occurs if the firm receives less net benefit from a RPT than could have been obtained from a transaction with an unrelated counterparty. This may occur as a result of a firm agreeing to pay a related party above market prices for commodity inputs. Alternatively, a firm may pay market prices commensurate with top quality inputs but purchase inputs of inferior quality from a related party. For example, a consultant related to a director may be paid a wage similar to other consultants doing similar tasks, but the related party consultant might dispense lower quality advice than an unrelated third party. Even absent

opportunistic behavior, lapses of judgment and overconfidence might be more likely with related party transactions. For instance, firm officers and directors may overestimate the abilities of relatives when entering into contractual relationships with them. Similarly, insiders may obtain non-monetary private benefits from contracting with relatives, even those that are less competent. An alternative explanation for RPTs is that they do not damage shareholders and they arise as an efficient contracting arrangement in situations involving incomplete information. Contracting with a board member, for instance, can make sense when coordination of activities and feedback between contracting parties are important. For instance, a restaurant chain that relies heavily on franchising may have franchisees on the board of directors to ensure quick feedback on how operational changes are impacting franchisees. Similarly, it may be worthwhile to have suppliers on the board of directors in order to obtain insights on the firms supply chain or to receive quick feedback on how easy it will be to implement changes affecting suppliers. Contract efficiency can also be facilitated from the parties familiarity with each other. For instance a common form of related party transaction is a lease for a commercial property that is owned by an executive of the firm. Lease payments, in part, are priced to cover the expected losses from a tenant breaking a lease agreement. Given an officers position with the firm and his firm-specific knowledge of the tenant, the lessor-manager can be assured that the firm is not likely to break the lease, and consequently, can charge a lower rate than a third party lessor. Similarly, while a financially distressed firm might have difficulty procuring a loan from a bank, a wealthy

executive or board member may extend the firm a loan on better terms given their superior knowledge of the firms financial and operating situation. Another potential benefit of RPTs is the mitigation of holdup problems in the contracting process and the facilitation of investment in firm-specific relationships. If the parties are close by family relation, holdup problems might be less likely when renegotiating a contracts terms. Furthermore, to the extent that a related party has a large investment in the firm, the party may have financial incentives to avoid a holdup lest they compromise the value of their investment in the firm, e.g., see Klein, Crawford, and Alchian (1978) and Fee, Hadlock, and Thomas (2006). One of the most commonly cited forms of RPTs, employment-related loans, merits additional consideration. Employment-related loans are of separate interest because such transactions have been proscribed by the Sarbanes-Oxley Act of 2002 and because they are arguably part of a broader employment agreement. It is difficult to see how loans might undermine performance, especially since the loans are often used to fund stock purchases that can improve executive incentives. In fact, prominent valuebased management consultants often advocate such practices, e.g., see Young and OByrne (2001). Relocation loans may also provide an incentive for an executive to move from one job to another. The general concern is that the interest rates on such loans are not fairly priced given the potential for default, e.g., see Kahle and Shastri (2004), but the previous discussion suggests that there are valid reasons for granting such loans. In our empirical work, we treat employment-related loans separately from other RPTs.

B. Historical Context of RPTs

An additional factor to consider with respect to RPTs is historical context. Some RPTs originate after an arms-length relationship between the contracting parties is already in place. For instance, Starbucks Coffee had a pre-existing arrangement with Pepsi Cola Bottling to bottle and ship Starbucks products when the CEO of Pepsi Bottling joined the Starbucks board. Presumably, the invitation to join the board was extended because Pepsi Bottlings CEO had experience with the sale of packaged Starbucks products that could aid in the formation of strategies. Similarly, Abercrombie & Fitch invited the head of its advertising firm to be on its board. Advertising is a vital component of Abercrombie & Fitchs sales approach. Thus, the presence of their advertising strategist on the board makes sense from a business perspective. In both of these cases, there is no real suspicion that an incompetent party received a contract for goods and services. It is possible that the prices paid for services rendered could have escalated after board membership was obtained, but this is likely a lesser problem than having the wrong party provide the service. Another example of potentially harmless RPTs arises after a firm goes public. In this case, contracts may be in place that were negotiated absent any conflict of interest, yet these contracts are considered RPTs for disclosure purposes after an IPO. For example, when the owner of a privately held corporation decides to build a headquarters, he may fund the construction of the building by injecting his own capital (via an equity infusion) into the firm or by financing the construction directly and then leasing the building to the firm. Given limited liability laws, it may make more sense from a diversification point of view for the executive to own the property himself and lease it to the firm he manages, as the executive retains ownership of a valuable asset in the event of

a firm bankruptcy. Once the firm goes public, however, this lease is reported as a RPT. Undoing the lease to avoid the appearance of impropriety may result in a needless and costly relocation. For example, when the management of Quality Dining was criticized for leasing restaurant sites from top management, it was pointed out that the leases predated the firm going public and were at below market rates.6 Similarly, when a subsidiary of a parent firm is spun off to shareholders (such as Too Inc. being spun off by The Limited Inc.), it makes sense to have the former parent (and significant shareholder) continue to provide back-office support functions as long as the former parent is the lowest cost provider. Firms frequently have other similar related party transactions in place at the time of their IPOs. If these transactions have the potential to be viewed negatively by the market, then they must be justified at the time of the IPO or risk negatively affecting the offer price. Similarly, when one firm acquires another firm, the acquirer may inherit preexisting arrangements that are priced into the acquisition value and the acquirer may be ill advised to terminate these arrangements. The above-mentioned ex-ante transactions might be distinguished from ex-post transactions in terms of their impact on outside shareholders. Ex-post transactions occur when the transactions are entered into after the related party has obtained a board seat, executive position, or large share voting block. Hence, ex-post transactions are more likely than ex-ante transactions to suffer from a conflict of interest.

C. Family Firms and Family Employment in Top Executive Positions

6

See Battaglia (2000).

A special form of RPT, that is generally not reported as such, is employment of relatives in family firms. Family firms are often described as firms where either the founder and/or his relatives hold board or executive positions and/or large ownership stakes. In the present context, we are less interested in the precise definition of a family firm and more interested in situations where a top executive was hired or promoted by a family member or was able to become a successor to a family member due to shareholdings or influence within the firm. Note that this can occur in cases where the executive is not a member of the founding family, though in practice, this is rare. The arguments about the desirability of this practice are similar to the arguments for or against RPTs in general. The concern is that the best party to hold important executive positions is not hired in order to advance the private interests or ambitions of one group of shareholders, the family. Simply put, an executive placed in his position by other family members might not be the best qualified or might pursue goals more consistent with the objective function of the family rather than of the shareholders. On the other hand, the fact that the family member may have a longer term outlook for running the company might aid in the accumulation of reputational capital with suppliers and/or make it less likely that the manager will be myopic with respect to investment decisions, e.g., see Burkhart, Panunzi, and Shleifer, (2003).

D. Predictions Relating to Hypotheses The shareholder expropriation hypothesis predicts that the presence of RPTs will be associated with decreased shareholder wealth and firm performance while the efficient contracting hypothesis suggests no harm or possibly a benefit to shareholders from the

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existence of RPTs. To ascertain whether the average RPT harms or benefits shareholders, we examine whether higher levels of RPT activity are associated with higher or lower Tobins Q ratios and returns on invested capital (ROIC). If the transactions are harmful on net, then we would anticipate the existence of substantial RPT activity to be associated with lower Q ratios and ROIC. We also expect that any observed negative effects of RPTs will largely be driven by the subset of RPTs entered into when a conflict of interest existed. These include RPTs that were entered into after the firm went public and after the contracting party became a related party. RPTs initiated before significant conflicts of interest existed are less likely to be associated with negative effects for outside shareholders. Finally, following Villalonga and Amit (2006), it is expected that situations where executives are hired or promoted by a family member will be associated with lower firm valuations.

II. Empirical Design and Sample Construction A. Sample Construction For large corporations, some agency violations may have little observable impact on firm value. For instance, if the CEO of IBM can pressure the board of directors to overpay a family member for a service by $10 million a year, this may have an undetectable impact on IBMs share price given the firms $100 billion plus market capitalization. With smaller corporations, in contrast, relatively modest agency violations (in dollar terms) can lead to large revaluations in the firms stock prices. There might also be reasons why larger firms are less susceptible to agency costs arising from RPTs. News publications such as the Wall Street Journal delight in uncovering what appear to

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be improprieties (at the expense of shareholders) by managers of large, well known companies. Such free monitoring can lead to erosion of executive reputation and even litigation and civil penalties, causing managers of larger corporations to check their behavior. For smaller firms, these violations are less likely to be publicized, even in cases in which they are real, suspect, and observable. Further, because many smaller firms are controlled by a relatively small number of investors, easily observable agency violations may be nearly impossible to prevent in a cost effective manner, e.g., see Ang, Cole, and Lin (2000). Accordingly, we focus on small to mid-sized firms in our analysis. We also focus on a small set of industries that have a substantial number of firms in them. The rationale or opportunity for related party transactions is likely greater in particular industries. Sampling from a broad cross-section of firms might miss this important fact. Also, since we seek to study performance differences based on the presence of related party transactions, it is important to focus on industries in which being small is not an overwhelming competitive disadvantage. Finally, it is easier to accurately control for industry performance with a small set of industries. Given that we also want to examine the association between RPT activity and subsequent financial distress or securities deregistration, we select our sample period so that several years of post-sample data are available. To satisfy these sample formation goals, we use the Compustat database to obtain a list of all firms with assets between $20 million and $2 billion at the end of fiscal year 1999. From this list we purge limited partnerships, foreign incorporated firms, and ADRs. We then identify four-digit Standard Industrial Classification (SIC) code industries where at least 70% of the firms had a positive return on assets (defined as

12

operating income before depreciation divided by total assets) in 1999 and there were at least 10 firms with assets between $20 million and $2 billion in the industry. Since we want at least 40 firms in each industry, we combine four-digit SIC industries into industry groups when the fundamental business models appear to be similar. The resulting sample includes firms from the following four industry groupings: restaurants, retail apparel and accessories, apparel manufacturing, and trucking. We supplement the Compustat sample with firms that had the same SIC codes as our industry firms and that had data available from the SECs website.7 For each sample firm, we collect data on corporate governance and related party transactions from the proxy statements and/or 10-k filings containing compensation data for fiscal year 1999 and fiscal year 2000. The firms in our sample are listed in Appendix A.

B. Firm characteristics, performance, and governance Table I reports summary statistics for our sample. The mean (median) firm in our sample has accounting assets of $322.7 million ($177.2 million). Firm size is similar across industries, though the restaurant industry has the smallest average and median asset sizes. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business as a public company or as a subsidiary of a public company. For most firms, firm age is the number of years (prior to the year 2000) since the firm conducted their equity IPOs. Firm age is often difficult to define because a firm may alter its line of business and/or because a firm might stay very small before it gets access to public capital markets and grows aggressively. Our definition captures the first time that the business that represents the firms primary activity had access to public
7

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

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capital markets by either being a public firm or part of one. The average age of our sample firms is 17 years. The average market value of equity for our firms on June 30, 2000 was $374.1 million, with a median of $79.9 million.8 The smallest median market value corresponds to restaurants and the smallest average market value to trucking. Pre-tax ROIC averages 18.1%, with a median of 18.3%. This figure is measured as the sum of operating earnings (before interest, depreciation and taxes) plus lease payments divided by invested capital. Invested capital is defined as total assets plus seven times lease payments minus non-interest bearing current liabilities. Apparel retail has the highest average ROIC and apparel manufacturing the lowest. The average and median Tobins Q ratios are 1.427 and 1.017, respectively.9 Apparel retail has the highest average Q ratio and trucking the lowest. The median number of directors on the board is seven for the entire sample with relative uniformity across industry medians. Roughly half of all firms have a staggered board, which is fairly consistent across our four industries with trucking having the lowest percentage at 42.9%. We sort directors into executives and their relatives, grays (former executives and those with business dealings with the firm and interlocking directors), and independent directors, where a director is classified as an independent
Market value of equity is based on shares outstanding (Compustat item 25) at the end of the 1999 fiscal year. The shares outstanding are multiplied by the stock price from CRSP as of June 30, 2000. If no price is available on that date, we use the last quoted price on the stock after the end of the 1999 fiscal year and if there is no price quote after the end of the fiscal year we set the price equal to the Compustat share price at the end of the fiscal year (item 199). All prices are split adjusted. 9 We calculate the June, 2000 Q ratio as the market value of equity minus the book value of equity (item 60) plus total assets minus deferred taxes (item 35) all divided by total assets (item 6). In the event the book value of equity is negative (eight cases), we reset the Q ratio to one if earnings before extraordinary items (item 18) are also negative (five cases). This adjustment is necessary because, by construction, Q ratios must be greater than one for such observations. Firms with negative book equity and negative earnings are likely to have market value of debt below book value of debt. Hence, we lower their Q ratios with this adjustment. In fact, most of these firms were in financial distress. The Q ratio for June, 2001 is calculated similarly.
8

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director if he or she has never worked for the firm, has no relative working for the firm, and has no business transactions with the firm (besides director duties).10 These classifications are based on the proxy statement and/or 10-k filing related to the 1999 fiscal years compensation as defined by Compustat. The disclosures generally come in early 2000. Less than half (44.4%) of the boards of directors have a majority of independent directors. The highest percentage of independent majority boards is apparel manufacturing at 50.9% and the lowest to trucking with only 31.0%. In addition, we identify if the firm has multiple directors from the same family. Twenty-nine percent of all firms have multiple family members on the board of directors. This percentage ranges from 40.5% in trucking to 18.6% in restaurants. With respect to ownership, the average officer and director holdings in our sample is 32.30%, with the highest level in trucking at 38.2% and the lowest in restaurants with 29.1%.11

C. Related Party Transactions and Employment Loans Firms are required to report any transaction, or series of similar transactions, between the firm and its managers, directors, large (>5%) shareholders, or their respective families provided the amounts in the transaction(s) exceed $60,000. These disclosures appear in the firms proxy statements and/or their 10-k filings with the SEC.12 The disclosures sometimes include loans related to employment and incentive contracts

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

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of executives. We exclude employment related loans from our definition of RPTs and track them as a separate item in our empirical analysis. Among the items included in our definition of RPTs are leases, purchases and/or sale of goods and services, non-employment loans, financing arrangements, and asset sales and purchases. In Appendix B, we outline how we assign dollar values for each transaction. It should be noted that in some cases the potential for loss may be less than the dollar value of the transaction. For example, a firm could lose the entire balance of a non-employment loan if the related party defaults, but if the firm purchased $1 million of goods from a related party, then the loss (overpayment) for those goods could be well less than $1 million. Another feature of these transactions is that they are often recurring in nature. For example, leases and loans run for multiple years, hence, they show up as a RPT multiple years even though there is one transaction date. Similarly, firms often purchase or sell goods to a related party for multiple years. Table II contains descriptive statistics on RPTs and employment related loans. These statistics are for 1999, but the results are similar for 2000 (not reported). Nearly 71% of firms report at least one RPT, 62.0% report combined RPTs greater than $60,000, 55.2% report combined RPTs greater than $200,000, and 32.9% report combined RPTs greater than $1 million. Clearly, RPTs are not uncommon in our sample of firms. Apparel manufacturers consistently report the fewest RPTs for all cutoff levels of RPT activity. A chi-square classification test reveals that the differences across industries in terms of the frequency of RPTs greater than $200,000 are significant at the 5% level. Table II further reveals that the mean RPT level is 2.86% of total firm assets. The median RPT total is 0.15% of assets. Nearly 31% of firms have total RPTs that exceed

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one percent of firm assets. While the one percent threshold might not seem all that large, it is conceivable that moderately-sized RPTs may still have valuation implications. If insiders are engaging in questionable RPTs of modest, yet non-trivial, magnitudes, then the existence of the RPTs may be indicative of insiders attitudes towards shareholder wealth maximization. Questionable attitudes could raise concerns about insiders decisions in other areas of firm operations as well, e.g., disgorging profits to shareholders, project selection, etc. Concerns about the decision making of executives could depress firm valuations beyond the impact of the RPTs themselves. Table II also reports the frequencies of employment related loans for various cutoff levels. Roughly 23% of firms with employment loans exceed the $60,000 threshold, 17.0% exceed the $200,000 threshold, 5.7% exceed the $1 million threshold and only 2.6% of the employment related loans exceed 1% of total assets. Hence, in terms of their frequency and magnitude, employment related loans are relatively less common and smaller in volume than other RPTs. Table III reports the fraction of firms in the sample and industry subsamples with certain types of RPTs with sums in excess of $200,000 in 1999. Products and services is a broad category that includes advertising and marketing, management or consulting services, purchased transportation for trucking firms, licensing revenue for apparel sales, and actual purchases/sales of physical products. Given the broad classification definition, this category has the largest frequency among the various types of RPTs. The level is fairly consistent across industries ranging from 27.9% for restaurants to 35.8% for apparel retailers. Some common subcategories of products and services that often receive attention in the business press include consulting services and purchase of aircraft

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services from a related person. Both of these items are relatively rare, with less than 5% of firms reporting such transactions across the entire sample.13 Transactions in which the firm leases something (other than aircraft) from a related party are frequently observed and are most prevalent among apparel retailers, followed by restaurants. This pattern is not too surprising given these firms typically have numerous store locations. Retail properties may make good investments for related parties because they can be re-leased to other parties, whereas investments in manufacturing plant or equipment may be more firm specific. Among the industries in our sample, franchising RPTs are exclusive to the restaurant industry, with 18.6% of our sample of restaurant firms reporting an amount greater than $200,000. Restaurant chains frequently franchise store locations and franchises are often run by executives, founders, directors, and/or their family members. As discussed above, it may be desirable to have franchisees on the board to offer insights about the restaurant chains business. For instance, most of the directors of Papa Johns Inc. were franchisees of the firms pizza concept. Asset sales or purchases involving related parties in amounts greater than $200,000 are observed for 9.0% of the firms in our sample. We observe no asset sales or purchases greater than $200,000 for apparel manufacturers, while 15.1% of restaurants report such RPTs. Again, this is likely due in part to the fact that individual site locations are more likely to be viewed as investments by related parties and these sites can be easily bought or sold by restaurant chains.

13

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

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Payments in excess of $200,000 to related parties for legal services are not common. Loans to related parties greater than $200,000, independent of employment related loans, occur for 6.8% of the sample. Nearly as many firms (4.7%) report receiving loans (or loan guarantees for a fee) in excess of $200,000 from related parties. Other types of RPTs exceeding $200,000 are reported for 4.7% of our sample firms.14 As argued in Section II, the timing of RPTs is likely a determinant of the wealth consequences of RPTs for outside shareholders. Table IV details RPTs (excluding employment-related loans) by their magnitude and historical timing. The historical timing of specific RPTs is determined by examining proxy filings, prospectuses, and 10-k filings going back as far as 1978 in some cases. Ex-ante transactions are those that were entered into before there was a potential conflict of interest, i.e., transactions entered into before the time that the related party obtained an executive position, directorship, or significant shareholdings or before the firm became publicly traded.15 These ex-ante transactions are distinguished from transactions that were initiated after the counterparty became a related party, i.e., ex-post transactions. As Table IV indicates, the frequency of ex-ante transactions is similar to the frequency of ex-post transactions regardless of the magnitude of the RPTs or the year for which we observe the RPTs being reported. The main finding in Table IV is that many transactions identified as RPTs originated when there was arguably no serious potential conflict of interest between outside shareholders and the counterparties to the transactions.
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These other transactions include investments in company businesses, joint venture deals, payments to related party charities, and banking relationships. 15 If a relationship expands after a counterparty becomes a related party, e.g., the sale of goods increases by 180%, then it is still considered an ex-ante transaction. If the relationship takes on an entirely new dimension, e.g., a counterparty leases property to a firm prior to becoming an insider but subsequently sells the property to the firm after becoming an insider, then the new transaction is considered an ex-post transaction. Ex-ante includes cases where there is a simultaneous announcement of a contractual relationship and the contracting party becoming a related party.

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D. Family Employment Founders, or those who later become influential at a company, may oversee the hiring or promotion of relatives to high ranking executive positions. These personnel decisions may be based on an overestimation of a relatives skill or a desire to see a relative advance within an organization. Using various internet searches and inspections of corporate proxy statements, we identify cases where a person who is presently the board chairman, CEO, and/or one of the two highest-paid executives was hired to that position at a time when his or her relative was the top executive or board chairman of the company in question or took the position as part of an apparent succession plan.16 Table V illustrates that 20.5% of the firms in our sample have what we refer to as a hand-me-down top executive. This situation is most common in the trucking business and least common in the restaurant industry. The differences across industries are significant at the 1% level, suggesting certain industries are more amenable to this practice. We also expand the definition of family hiring and promotion to include any case where an executive meeting the criteria, was listed as a top five paid executive by the firm in question. As reported in Table V, the incidence of a family hired executive increases to 25.2% using this alternative definition.
In some cases, this variable has a value of one when the executive is not related to the founder, because the executives family became influential after the founding. In some situations, the executive may have held the position for more than 20 years, because he or she succeeded a relative, often a parent, to that position. In a small number of cases, the dummy variable has a value of one even though the founder is still active in the company. This would include cases where the founder is the Chairman, but her child was hired as the number two person in the organization. There are also some cases where the dummy variable equals zero, in spite of apparent family ties in the organization. For instance, there are two cases where the descendant of the founder is in a top position, but in both cases, the relative came back to the company after their father left the business by buying back into the business and reasserting family control. Hence, they were not hired or promoted by family ties or influence. There are also two cases, where the number one and two executives are from the same family, but in these two cases the executives had not changed roles since the founding of the company and could be viewed as co-founders.
16

20

III. RPTs, Shareholder Wealth, and Firm Performance A. RPTs and Tobins Q We investigate the association between non-trivial RPTs and various performance metrics using regression analysis. Tobins Q ratios are frequently used as performance indicators, especially in studies of the effect of firm governance on valuation, e.g., see Morck, Shleifer, and Vishny (1988). To explain cross-sectional variation in Q ratios in June, 2000, we first create a dummy variable equal to one if the sum of all nonemployment loan RPTs exceeds 1% of total end-of-period assets, and zero otherwise.17 To control for the potential impact of employment-related loans, we create a dummy variable equal to one if the sum of all employment-related loans exceeds 1% of end-ofperiod assets, and zero otherwise. We also include a dummy variable to indicate if the firm has a hand me down top executive. We control for firm size (age) by including the log of total firm assets (firm age in years) as an independent variable. For our sample, larger firms are likely to be the most successful businesses, because they were expanded as profitable firms often are. Hence, larger firms may have higher Q ratios. Firms that have been publicly traded for a shorter time are more likely to have greater growth options, hence, we expect these firms to have higher Q-ratios. We also include dummy variables to control for industry effects. We first run a regression where we do not distinguish between the timing of the RPTs, i.e., ex-ante or ex-post. The results in column 1 of Table VI ratios show no

17

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

21

significant association between firm value and RPT activity. The coefficient on the RPT dummy is small with a relatively large White-adjusted standard error. The coefficient on the hand-me-down top executive variable is negative and significant at the 5% level. Larger and younger firms have higher Tobins Q ratios, all else equal. In column 2 of Table VI, we replace the single dummy variable for nonemployment loan RPT activity with two dummy variables that also capture the timing of the RPTs. An ex-ante RPT dummy variable is set equal to one if the value of RPTs (exclusive of employment loans) initiated before a contracting party was conflicted is greater than 1% of total firm assets. An ex-post RPT dummy variable is set equal to one if the value of RPTs (exclusive of employment loans) initiated after the related party had influence at a firm is greater than 1% of total assets. The coefficient on the ex-ante dummy is positive, but falls just short of statistical significance at the 10% level. The coefficient on the ex-post RPT dummy is relatively large, negative, and significantly different from zero at the 1% level. Furthermore, the difference in the ex-post and exante coefficients is also significantly different from zero at the 5% level. Hence, we interpret these results as indicating that RPTs that are questionable in terms of their armslength enactment are associated with substantially lower firm valuations, especially relative to ex-ante transactions. The relatively large coefficient on the ex-post RPT dummy, -0.372, in column 2 of Table VI, indicates that seemingly modest ex-post RPT activity is associated with dramatically lower firm values. The average RPT to asset ratio equals 0.071 for firms with an ex-post RPT dummy equal to one. Our Q-ratio is also scaled by assets, so the magnitude of the wealth effect implied by the dummy coefficient is large relative to the

22

magnitude of the average RPT. We conjecture that this is consistent with the presence of ex-post RPTs proxying for pervasive concerns about insiders attitudes towards shareholder wealth maximization and alignment of interests with outside shareholders. The coefficient on the presence of employment related loans is statistically insignificant. The coefficient on the hand-me-down top executive variable is again significant at the 5% level for the specification in column (2), consistent with top executives being hired and promoted by family members having a negative association with Tobins Q. This is consistent with Villalonga and Amit (2006).18 For robustness, we repeat the analysis for Q ratios calculated for June, 2001 and RPT activity reported in 2000, as well as for the hand-me-down top executive dummy variable updated for the year 2000. These results are reported in columns 3 and 4 of Table VI. The disadvantage of these regressions is that 14 firms leave the sample between 1999 and 2000. However, the results are similar to those for 1999. The coefficient on ex-post RPTs is again large, negative, and significantly different from zero. It is also significantly different from the coefficient on ex-ante transactions, which is again positive but not significant at conventional levels. The coefficients on the handme-down top executive dummies are again negative but not significant at conventional levels.19 The coefficient on the presence of employment related loans is again statistically insignificant.

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

18

23

In sum, the results from the Tobins Q regressions suggest that the average RPT is not associated with negative valuation consequences for shareholders, but RPTs initiated after a party becomes conflicted are associated with negative valuation consequences.20

B. RPTs and firm ROIC We also examine how the level of RPT activity is associated with a firms ROIC in 1999 and 2000. The regression specifications are similar to those used in the Tobins Q regressions. The level of 1999 (2000) RPT activity is used to explain ROIC for 1999 (2000). One slight concern with these regressions is that some of the 1999 RPT activity may have actually taken place in early 2000 but was reported in firm disclosures relating to 1999 activity. This adds noise to the RPT dummy for this specification. When we include all explanatory variables, the coefficient on the ex-post RPT dummy is negative and significant at the 10% level in 1999 and at the 1% level in 2000. The employment loan and ex-ante RPT dummies are insignificantly different from zero. Thus, the ROIC results reinforce the Tobins Q results for RPTs. The same cannot be said for the handme-down top executive variable. The coefficients are generally positive though not nearly statistically significant for both 1999 and 2000. This is difficult to reconcile with the Tobins Q results. Of course, year to year results for ROIC may be more volatile than Tobins Q and, while ROIC may be satisfactory in a given year, it is possible that the Q ratios reflect fears of future mismanagement by hand-me-down top executives or future decisions that will favor family members over shareholders.
20

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

24

C. RPTs and Executive Compensation In the particular case of RPTs with top executives, RPTs may be viewed as substitutes or supplements to executive compensation reported in the compensation tables in SEC filings. For instance, a CEO may receive a lower salary in exchange for greater RPTs that are arguably less observable to outside shareholders; see, e.g., Bebchuk and Jolls (1999) and Rajan and Wulf (2006).21 To investigate the nature of the relation between excess compensation and RPTs, we regress measures of excess compensation (both total and cash compensation) calculated as in Berger, Ofek, and Yermack (1997) against ex-ante and ex-post officer and director RPT variables (results not reported to conserve space). The coefficients on the ex-ante and ex-post officer and director RPT variables enter the regressions with relatively small positive coefficients; however, the coefficients are not significant at conventional levels suggesting that RPTs are not primarily undertaken to compensate executives in ways that are less observable to outside shareholders.

IV. Corporate Governance, RPTs and Family Employment A. Officer and Director Holdings and RPTs One weakness of the prior analysis is that it does not control for broader corporate governance characteristics of sample firms. RPT activity and nepotism in hiring may be related to weaker corporate governance practices at some firms, e.g., see Kohlbeck and

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

21

25

Mayhew (2004) and Gordon, Henry, and Palia (2004). Thus, we investigate the factors associated with RPTs and family employment. To do so, we estimate logit models explaining RPT activity and the incidence of hand-me-down top executives. Since, by definition, a RPT is deemed to exist if a transaction is undertaken with an investor holding a large amount of voting stock, we only examine the RPTs of officers and directors, excluding those transactions with large shareholders that are not on the board of directors. As governance variables, we use the existence of a staggered board of directors, the existence of multiple family members on the board of directors, and the extent of voting control of officers and directors. For the voting control variable, we use the percentage of voting stock held by officers, directors and their families, but truncate the variable at 50% if voting control exceeds 50% (since holding additional votes beyond 50% confers no additional control). If members of the board control voting stock that entitles them to elect half the directors or more, we set the officer and director holdings dummy variable equal to 50% as well. The presence of a staggered board is often associated with weak governance and multiple family members on the board may encourage cronyism. We do not include measures of the shares held by independent directors or the fraction of board members that are independent directors since such variables are affected by the presence of RPTs. For example, if every director engages in RPTs, then the fraction of directors that are outsiders will be zero. To avoid circular causation, we use a dummy variable indicating multiple family members on the board rather than a variable measuring inside versus outside board members. Given that we merely wish to

26

demonstrate that governance factors may affect the incidence of family employment and RPTs, excluding an inside versus outside director variable is not problematic. Table VIII reports the results from the logit models. We find that significant control of voting shares by insiders is associated with more ex-ante and ex-post RPTs and with greater likelihood of hand-me-down top executives. We also find that the presence of multiple family members on the board of directors significantly increases odds of having a hand-me-down top executive. The presence of a staggered board has no statistically significant influence on the odds of having RPTs or a hand-me-down top executive. Industry affiliation is also important, but this appears to have less to do with governance and more to do with the relative opportunities for RPTs across industries. While some governance variables explain RPT and family employment activity, others do not. Nevertheless, this suggests that we may wish to control for governance variables in our value and performance regressions to see if governance variables, rather than the presence of conflicted transactions, drive the results from Tables VI and VII. In Table IX we present regression results controlling for the corporate governance practices of sample firms. Columns 1 and 2 (3 and 4) present models explaining June, 2000 Tobins Q ratios (fiscal year 2000 ROIC). These performance metrics correspond best with the governance variables reported (mostly) during the spring of 2000. For governance measures, we include several measures of ownership and board composition. Officer and director holdings (expressed as a percentage of total shares) are defined as shares beneficially owned by the directors and officers assuming all options listed as beneficially held are exercised. Officers and director holdings > 25% (40%) is a dummy variable that equals one if officer and director voting power exceeds 25% (40%) of

27

outstanding shares. Independent majority board equals one if more than half of the directors are independent, i.e., they do not work for the firm, have a relative working for the firm, or have business transactions with the firm. In short, the results including the governance proxies are very similar to those reported in Tables VI and VII. Ex-post RPT activity is again negatively and significantly associated with firm value and performance while the presence of hand-me-down top executives is associated with reduced firm value. Thus, it does not appear that our previous results were driven by omitted governance proxies. Interestingly, our regressions also offer mixed evidence on the associations between firm value, performance, and ownership structure for our sample of small firms. For instance, in column 1, none of the governance variables themselves enter the regression with significant coefficients consistent with ownership structure and firm performance being unrelated, e.g., see Demsetz and Lehn (1985). However, in column 2, insider ownership is positively related to firm value but, high levels of insider voting control are associated with lower firm value, e.g., see McConnell and Servaes (1990).

V. RPTs, Financial Distress, and Going Dark As an additional check on outcomes associated with RPTs, we examine whether the incidence of financial distress or going dark is higher for firms with significant levels of RPTs. Clearly, financial distress is evidence of a firm continuing to perform (exceedingly) poorly while going dark deprives shareholders of liquidity and information about the firms they own.

28

Table X presents the results of logistic regressions of subsequent financial distress and going dark on the magnitude and timing of related party transactions and the presence of hand-me-down top executives. The dependent variable in column 1 is an indicator variable that takes a value of one if a firm is in financial distress after fiscal year end 1999 but prior to December 30, 2004 and zero otherwise.22 In our sample, 15.0% of firms enter financial distress. Ex-ante and ex-post RPT dummy variables are based on RPT activity exceeding one percent of total assets in either fiscal year 1999 or 2000. As reported in column 1 of Table X, ex-ante RPTs (ex-post RPTs) are negatively (positively) associated with the likelihood of subsequent financial distress. Only the positive coefficient on ex-post RPTs is significant at the ten percent confidence level. This is consistent with the findings for Tobins Q and return on invested capital. Interestingly, the coefficient on the hand-me-down top executive dummy is negative and significant, perhaps reflecting greater managerial risk aversion in family firms. The dependent variable in column 2 is an indicator variable that takes a value of one if a firm goes dark. Going dark is defined as the firm filing for securities deregistration unrelated to a bankruptcy filing and unassociated with a merger or cash payout in a liquidation. We also include one case where a firm was delisted and stopped filing 10-K and 10-Q disclosures for multiple years.23 In our sample, only 3.85% of firms go dark. As reported in column 2 of Table X, ex-post RPTs are positive and significantly associated with the likelihood that a firm will go dark. This finding is

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

22

29

consistent with insiders of these firms seeking to protect private benefits of control and decrease outside scrutiny, e.g., see Marosi and Massoud (2004) and Leuz, Triantis, and Wang (2006). The coefficient on hand-me-down top executive and ex-ante RPTs are both positive but not significant at conventional levels.

VI. Conclusion For a sample of 234 firms in four industries, we document that related party transactions are fairly common. We find that roughly half of the sizable RPTs in our sample are initiated when conflicts of interest are likely minimal (before a firm goes public or before the contracting party acquires a large block of stock in or a managerial/board position with the firm). We find that the presence of large RPTs generally has an insignificant statistical relationship with Q ratios and operating performance. However, we find strong evidence that RPTs entered into after a

contracting party becomes a related party are negatively associated with firm value and performance. This association is not merely a reflection of poor overall governance structures of the firms involved as ex-post RPTs continue to be strongly associated with lower firm value and performance even in the presence of controls for governance structure. In sum, our evidence suggests that ex-post transactions (non-arms-length transactions at inception) are associated with reduced shareholder wealth whereas ex-ante transactions are not associated with reduced shareholder wealth and may well represent efficient contracting outcomes. These results are intuitive and consistent with potential benefits and costs of related party transactions for outside shareholders. These results

30

also have implications for recent proposed or adopted changes in reporting and listing requirements by the SEC and the major U.S. stock exchanges, respectively. While the focus of the changes has largely been to expand disclosure of RPT activity, our findings suggest that additional required disclosures should be particularly aimed at facilitating investors in determining whether RPTs are of the ex-ante or ex-post variety, the characteristic that our analysis suggests is most important in assessing the potential for RPTs to negatively impact outside shareholders. Additionally, we find some evidence supporting the notion that when top executives are hired by family members or inherit key executive positions, those firms tend to have lower Q ratios. This supports prior work on this topic for larger firms and is consistent with related party employment being damaging to outside shareholders. Finally, we also find that ex-post RPTs increase the likelihood that a firm will either encounter financial distress or go dark. These results are consistent with shareholders of these firms being penalized for poor performance and perhaps consistent with insiders of these firms seeking to protect private benefits of control by decreasing outside scrutiny of their financial statements.

31

References Anderson, Ronald, and David Reeb, 2003. Founding family ownership and firm performance: evidence from the S&P 500. Journal of Finance 58, 1301-1327. Ang, James, Rebel Cole, and James Wuh Lin, 2000. Agency costs and ownership structure. Journal of Finance 55, 81-106. Battaglia, Andy. Shareholders seek Quality Dining, wage proxy board battle, Nations Restaurant News, February 28, 2000. Bebchuk, Lucian, and Christine Jolls, 1999. Managerial value diversion and shareholder wealth. Journal of Law, Economics, and Organization 15, 487-502. Berger, Philip, Eli Ofek, and David Yermack, 1997. Managerial entrenchment and capital structure. Journal of Finance 52, 1411-1438. Burkhart, Mike, Fausto Panunzi, and Andre Shleifer, 2003. Family firms. Journal of Finance 58, 2167-2201. Cheung, Yan-Leung, Raghavendra Rau, and Aris Stouraitis, 2006. Tunneling, propping, and expropriation: evidence from connected party transactions in Hong Kong. Journal of Financial Economics 82, 343-386. Demsetz, Harold, and Kenneth Lehn, 1985. The structure of corporate ownership: causes and consequences. Journal of Political Economy 93, 1155-1177. Emshwiller, John R., Business Ties: Many Companies Report Transactions with Top officers, Wall Street Journal, December 29, 2003. Fee, C. Edward, Charles Hadlock, and Shawn Thomas, 2006. Corporate equity ownership and the governance of product market relationships. Journal of Finance 61, 1217-1251. Gordon, Elizabeth, Elaine Henry, and Darius Palia, 2004. Related party transactions and Corporate Governance, Advances in Financial Economics 9, 1-27. Jensen, Michael, and William Meckling, 1976. Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3, 305-360. Jian, Ming, and T.J. Wong, 2004. Earnings management and tunneling through related party transactions: evidence from Chinese corporate groups. Working paper, Chinese University of Hong Kong.

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Jiang, Guohua, Charles M.C. Lee, and Heng Yue, 2005. Tunneling in China: the surprisingly pervasive use of corporate loans to extract funds from Chinese listed companies. Working paper, Cornell University. Johnson, Simon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andre Shleifer, 2000. Tunneling. The American Economic Review 90, 22-27. Kahle, Kathleen, and Kuldeep Shastri, 2004. Executive loans. Journal of Financial and Quantitative Analysis 39, 791-811. Klein, Benjamin, Robert G. Crawford, and Armen A. Alchian, 1978. Vertical integration, appropriable rents, and the competitive contracting process. Journal of Law and Economics 21, 297-326. Kohlbeck, Mark, and Brian Mayhew, 2004. Agency costs, contracting, and related party transactions. Working paper, University of Wisconsin. Leuz, Christian, Alexander Triantis, and Tracy Wang, 2006. Why do firms go dark? causes and consequences of voluntary SEC deregistrations. Working paper, European Corporate Governance Institute. Marosi, Andras, and Nadia Massoud, 2004. Why do firms go dark? Working paper, University of Alberta. McConnell, John J., and Henri Servaes, 1990. Additional evidence on equity ownership and corporate value. Journal of Financial Economics 27, 595-612. Morck, Randall, Andrei Shleifer, and Robert W. Vishny, 1988. Management ownership and market valuation: an empirical analysis. Journal of Financial Economics 20, 293315. Rajan, Raghuram, and Julie Wulf, 2006. Are perks purely managerial excess? Journal of Financial Economics 79, 1-33. Thomas, William C., 2002. The rise and fall of Enron. Journal of Accountancy, Vol. 193, Issue 4. Yermack, David, 2006. Flights of fancy: corporate jets, CEO perquisites, and inferior shareholder returns. Journal of Financial Economics 80, 211-242. Young, S. David, and Stephen OByrne, 2001. EVA and value based management, a practical guide to implementation. McGraw Hill, New York, NY. Villalonga, Belen, and Raphael Amit, 2006. How do family ownership, control, and management affect firm value? Journal of Financial Economics 80, 385417.

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Appendix A. Sample firms and Compustat GVKEYs

ABERCROMBIE & FITCH -CL A ALLIED HOLDINGS INC AM-CH INC AMERICAN FREIGHTWAYS CORP AMERN EAGLE OUTFITTERS INC ANNTAYLOR STORES CORP APPLEBEES INTL INC ARK RESTAURANTS CORP ARKANSAS BEST CORP ARNOLD INDUSTRIES INC ASHWORTH INC AVADO BRANDS INC BARRY (R G) CORP BEBE STORES INC BENIHANA INC -CL A BIG BUCK BREWERY&STEAKHOUSE BIG DOG HOLDINGS INC BOB EVANS FARMS BOYD BROS TRANSPORTATION INC BRAZIL FAST FOOD CORP BRINKER INTL INC BROWN SHOE CO INC BUCA INC BUCKLE INC BUFFETS HOLDINGS INC CACHE INC CANNON EXPRESS INC CASUAL MALE CORP CASUAL MALE RETAIL GRP INC CATO CORP -CL A CBRL GROUP INC CD&L INC CEC ENTERTAINMENT INC CELADON GROUP INC CHAMPPS ENTMT INC CHARLOTTE RUSSE HOLDING INC CHARMING SHOPPES INC CHAUS (BERNARD) INC CHECKERS DRIVE-IN RESTAURANT CHEESECAKE FACTORY INC CHICOS FAS INC CHILDRENS PLACE RETAIL STRS CHRISTOPHER & BANKS CORP CINTAS CORP CKE RESTAURANTS INC CLAIRES STORES INC COLE KENNETH PROD INC -CL A 63643 28933 16394 15302 30059 21828 16665 11872 1743 1766 21519 24675 2061 111662 2163 63044 65484 2282 30177 62710 3007 2436 119893 25234 11815 2595 13201 13292 13381 2818 3570 61583 15092 29612 65088 125275 2938 12378 24671 25737 27981 65430 25108 3062 6346 3087 30277 COLUMBIA SPORTSWEAR CO CONSOLIDATED FREIGHTWAYS CP COOKER RESTAURANT/OH COVENANT TRANSPRT INC -CL A CUTTER & BUCK INC DARDEN RESTAURANTS INC DAVE & BUSTER'S INC DAVIDS BRIDAL INC DEB SHOPS INC DELIAS INC OLD DENNYS CORP DONNA KARAN INTL INC DONNKENNY INC DRESS BARN INC DURANGO APPAREL INC EACO CORP EATERIES INC ELLIS PERRY INTL INC ELXSI CORP ENBC CORP FACTORY 2-U STORES INC FAMOUS DAVES OF AMERICA INC FINLAY ENTERPRISES INC FLORSHEIM GROUP INC FORWARD AIR CORP FOX & HOUND RESTAURANT GROUP FRESH CHOICE INC FRIEDMANS INC -CL A FRIENDLY ICE CREAM CORP FRISCH'S RESTAURANTS INC FROZEN FOOD EXPRESS INDS FURRS RESTAURANT GRP -CL A GADZOOKS INC GARAN INC GARDEN FRESH RESTAURANT CORP GERBER CHILDRENSWEAR INC G-III APPAREL GROUP LTD GOODYS FAMILY CLOTHING INC GUESS INC GYMBOREE CORP HAGGAR CORP HAMPTON INDUSTRIES HAROLDS STORES INC HARTMARX CORP HEARTLAND EXPRESS INC HOT TOPIC INC HUNT (JB) TRANSPRT SVCS INC 105936 63975 15415 30877 61171 31846 60923 120716 3824 64184 19398 63170 28450 4072 27843 13187 12533 28303 10733 63419 13842 63930 31683 31016 29206 65128 25981 28997 66004 4911 4918 14292 61397 4993 31811 111530 19402 24621 63447 28018 25987 5456 14083 5505 12840 63621 5783

34

ICH CORP ICONIX BRAND GROUP INC IL FORNAIO AMERICA CORP INTIMATE BRANDS INC -CL A INTL FAST FOOD CORP INTRENET INC ISAACS I C & CO INC J. ALEXANDER'S CORP JACK IN THE BOX INC JERRYS FAMOUS DELI INC JOS A BANK CLOTHIERS INC KASPER A S L LTD KELLWOOD CO KENAN TRANSPORT CO KLLM TRANSPORT SERVICES INC KNIGHT TRANSPORTATION INC K-SWISS INC -CL A LANDAIR CORP LANDRYS RESTAURANTS INC LANDSTAR SYSTEM INC LESLIE FAY COMPANIES INC LITTLE SWITZERLAND INC LIZ CLAIBORNE INC LONE STAR STEAKHOUSE SALOON LUBYS INC M S CARRIERS INC MADDEN STEVEN LTD MAIN STREET RESTAURANT GROUP MARTEN TRANSPORT LTD MATLACK SYSTEMS INC MAX & ERMAS RESTAURANTS MAXWELL SHOE CO INC -CL A MAYORS JEWELERS INC/DE MCNAUGHTON APPAREL GROUP INC MENS WEARHOUSE INC MERITAGE HOSPITALITY GROUP MEXICAN RESTAURANTS INC MORGAN GROUP INC -CL A MORGANS FOODS INC MORRISON MGMT SPECIALISTS MORTONS RESTAURANT GROUP INC MOTHERS WORK INC MOTOR CARGO INDUSTRIES INC NATHAN'S FAMOUS INC NAUTICA ENTERPRISES INC NEW WORLD RESTAURANT GROUP NORTH FACE INC NPC INTERNATIONAL INC

5823 20204 65434 61445 25300 11807 66062 11538 13092 61446 30138 65126 6376 12624 12331 30861 22205 114418 28765 21440 12450 24312 6768 25025 6831 12169 29382 23113 12625 15089 7132 30193 13866 29806 25167 13759 62698 28632 7575 62351 25334 27936 65915 7696 10033 62330 63199 7761

NUTRITION MGMT SVCS -CL A O'CHARLEY'S INC OLD DOMINION FREIGHT ONE PRICE CLOTHING STORES OSHKOSH B'GOSH INC -CL A OSI RESTAURANT PARTNERS INC OTR EXPRESS INC OXFORD INDUSTRIES INC P F CHANGS CHINA BISTRO INC P.A.M. TRANSPORTATION SVCS PACIFIC SUNWEAR CALIF INC PANERA BREAD CO PAPA JOHNS INTERNATIONAL INC PATRIOT TRANSN HOLDING INC PAUL HARRIS STORES PHILLIPS-VAN HEUSEN CORP PHOENIX RESTAURANT GROUP INC PICCADILLY CAFETERIAS INC PIERCING PAGODA PJ AMERICA INC POLO RALPH LAUREN CP -CL A PRANDIUM INC PREMIUMWEAR INC QUALITY DINING INC QUIKSILVER INC RAINFOREST CAFE INC RARE HOSPITALITY INTL INC REEDS JEWELERS INC ROADHOUSE GRILL INC ROADWAY CORP ROCKY BRANDS INC ROSS STORES INC RUBIO'S RESTAURANTS INC RUBY TUESDAY INC RYAN'S RESTAURANT GROUP INC S & K FAMOUS BRANDS INC SALANT CORP SAMUELS JEWELERS INC SANTA BARBARA RESTAURANT GRP SCHLOTZSKY'S INC SHELLS SEAFOOD RESTRNTS INC SHONEY'S INC SILVER DINER INC SIMON TRNSPT SVCS INC -CL A SIMON WORLDWIDE INC SKECHERS U S A INC SMITHWAY MTR XPRESS -CL A SODEXHO MARRIOTT SVCS INC SONIC CORP SPORT-HALEY INC

24945 22829 24617 13339 8193 24186 24857 8219 116503 12598 27937 24113 28397 12926 8390 8551 30818 8571 30782 63881 64891 21796 7617 29818 12868 31700 25111 12904 64051 61795 27776 9248 120557 7566 9298 9305 9382 12173 23050 61733 62694 9673 62495 61571 28556 121142 63157 66684 23697 29997

35

STAGE STORES INC STAR BUFFET INC STARBUCKS CORP STEAK N SHAKE CO STEAKHOUSE PARTNERS INC STEIN MART INC STRIDE RITE CORP SUPERIOR UNIFORM GROUP INC SWIFT TRANSPORTATION CO INC SYMS CORP TACO CABANA -CL A TALBOTS INC TANDY BRANDS ACCESSORIES INC TARRANT APPAREL GROUP TIFFANY & CO TIMBERLAND CO -CL A TODAY'S MAN INC TOO INC TRAILER BRIDGE INC TRANSFINANCIAL HOLDINGS INC TRANSIT GROUP INC TRANSPORT CORP AMERICA INC TROPICAL SPORTSWEAR INTL CP TUMBLEWEED INC UNIFIRST CORP UNITED RETAIL GROUP INC UNO RESTAURANT CORP URBAN OUTFITTERS INC US XPRESS ENTP INC -CL A USA TRUCK INC USF CORP VICORP RESTAURANTS INC WENDY'S INTERNATIONAL INC WERNER ENTERPRISES INC WESTERN SIZZLIN CORP WET SEAL INC -CL A WHITEHALL JEWELLERS INC WILSONS LEATHER EXPERTS INC WOLVERINE WORLD WIDE WORLDWIDE RESTAURANT CONCEPT YRC WORLDWIDE INC ZALE CORP

63874 65482 25434 3424 66680 25186 10109 10198 22532 10235 25806 29264 23577 61060 13646 13554 25353 122778 65148 1418 18545 30925 65708 118797 10840 25020 13418 29150 30751 25069 24926 11162 11366 12266 31456 22612 62748 64820 11566 23769 11649 11669

36

Appendix B. Details of related party transaction sampling criteria A.1. Assigning related party transactions to a given year Related party transactions (RPTs) are included for 1999 if they are mentioned in the 10-k or proxy statement relating to 1999 results and compensation. This includes transactions that may have come shortly after the end of the fiscal year but that were completed (or pending and eventually completed) before June 30, 2000. The same criteria are used for year 2000 transactions with the deadline date being June 29, 2001. In both cases, these are also the respective dates used in the construction of Tobins Q ratios, and the resulting transactions would have been known to market participants. A number of transactions classified as RPTs in 1999 are also classified as RPTs in 2000 because they occurred in early 2000 or they spanned both years, e.g., loans with multiple years to maturity. A.2. Excluded transactions sometimes reported as related party transactions Transactions that are excluded from the sample include the firm paying taxes associated with an initial public offering, any transaction having to do with life insurance covering an executive, loans of the firm guaranteed by a related party for which the related party received no fee, and agreements to pay shareholder registration fees of insiders. Also excluded are private placements of securities that made the insider a potential related party. For example, if securities were sold to the insider and that made the insider a 5% holder (and sometimes a board member) this is not treated as a related party transaction if it was unaccompanied by any other transaction. Director fees and committee fees are also not considered RPTs, nor are private placements of securities at or above market prices (with no fees). A.3. Assigning dollar values to transactions To assign dollar values to the related party transactions, we use the following algorithm: Loans: We use the maximum amount reported outstanding on the loan to or from the firm in a given year. Amounts payable on routine product payables and leases are not included. Loan guarantees by the firm: We use the amount of the loan being guaranteed. Loan guarantees to the firm: We use only the amount paid by the firm. For instance, a guarantee without a fee is tantamount to a gift from the insider (though the insider may extend such a guarantee so as to preserve the value of his equity investment). Licensed products: We use the licensing fees earned during a year. Purchasing agent: If a fee for providing marketing or product purchases is given, we use this as the dollar value. If no fee is given, then we use the dollar value of

37

the purchases. In one case no dollar values are given; in this instance we simply use the end-of-year account payable owed. Asset sales or purchases: We use the dollar amount of the assets bought or sold. Lease transactions: We use the dollar value of rent paid during the year. Equity private placements: If sold at a discount (one case), then we use the amount of stock sold. If privately placed stock is sold at market value, then we use any underwriting fee to the party. If the security sold was preferred stock, then we use the dollar value paid for the securities since the fair value of the preferred stock is unavailable.

A.4. Defining loans to related parties as employment related or non-employment related Any loan to an executive is deemed employment related if it was made directly to the executive and it was part of an employment contract, if it was for the purchase of a home, or if it was for the purchase of company stock. Loans made to an executive for a clear business transaction such as to buy a property for leasing to the company are deemed non-employment related. If a loan had no rationale given for its existence and the loan exceeded 10 times the value of the executives base salary in the current or prior year, then the loan is deemed non-employment related.

38

Table I: Summary statistics

Sample formation starts with all firms on Compustat with assets between $20 million and $2 billion at the end of 1999. We then purge limited partnerships, foreign firms, and ADRs. We then identify four-digit Standard Industrial Classification (SIC) code industries where at least 70% of the firms had a positive return on assets, defined as operating income before depreciation (Compustat item 13) divided by total assets (item 6) in 1999 and there were at least 10 firms with assets between $20 million and $2 billion in the industry. To ensure at least 40 firms in each industry, we combine four-digit SIC industries into industry groups when the fundamental business models appear to be similar. The sample consists of 234 firms that operated in four general industries (restaurants, trucking, apparel retail, and apparel manufacturing). Sample means and medians (in parentheses) are presented for the total sample and for the four industry subsamples. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Market value of equity is based on shares outstanding (Compustat item 25) at the end of the 1999 fiscal year. The shares outstanding are multiplied by the stock price from CRSP as of June 30, 2000. If no price is available on that date, we use the last quoted price on the stock after the end of the 1999 fiscal year and if there is no price quote after the end of the fiscal year we set the price equal to the Compustat share price at the end of the fiscal year (item 199). All prices are split adjusted. Return on invested capital (ROIC) is calculated as operating income before depreciation plus the previous year's estimate of year-ahead rental commitments (item 96) divided by total assets less non-interest-bearing current liabilities (item 5) plus seven times the previous year's estimate of year-ahead rental commitments. Tobins Q is the market value of equity minus the book value of equity (item 60) plus total assets minus deferred taxes (item 35) all divided by total assets. If book value of equity was negative and earnings before extraordinary items (item 18) were negative for 1999, then we set the Q ratio equal to one. The number of directors comes from the firms proxy statements or 10-k filings. Staggered board is a dummy variable that equals one if the firm has a staggered board and zero otherwise. Independent majority board equals one if more than half of the directors are independent in the sense that they do not work for the firm, have a relative working for the firm, or have business transactions with the firm (besides director duties). Multiple family directors equals one if the firm has multiple directors from the same family and zero otherwise. Officer and director holdings (expressed as a percentage of total shares) are defined as shares beneficially owned by the directors and officers assuming all options listed as beneficially held are exercised.

All Firms Number of firms Total assets Firm age Market value of equity ROIC Tobins Q Number of directors Staggered board Independent majority board Multiple family directors Officers and director holdings 234 322.7 (177.2) 17.0 (13.0) 374.1 (79.9) 0.181 (0.183) 1.427 (1.017) 7.329 (7.0) 0.491 0.444 0.295 32.3% (27.2%)

Restaurants 86 307.7 (115.2) 15.0 (10.0) 335.6 (54.5) 0.171 (0.166) 1.365 (1.078) 7.349 (7.0) 0.511 0.477 0.186 29.1% (24.8%)

Trucking 42 359.6 (184.0) 15.7 (13.5) 188.1 (57.0) 0.194 (0.198) 1.194 (0.861) 6.929 (6.5) 0.429 0.310 0.405 38.2% (40.6%)

Apparel Retail 53 332.0 (198.5) 15.6 (13.0) 613.9 (192.3) 0.202 (0.208) 1.886 (1.384) 7.434 (7.0) 0.509 0.434 0.340 33.4% (28.2%)

Apparel Manufacturing 53 308.6 (178.4) 22.7 (14.0) 344.1 (82.1) 0.167 (0.184) 1.257 (0.942) 7.509 (7.0) 0.491 0.509 0.340 31.6% (23.3%)

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Table II: Frequency and magnitude of related party transactions and employment related loans
This table reports the fraction of firms in the sample and the industry subsamples with a sum of related party transactions (RPTs) in excess of $60,000, $200,000, and $1,000,000. Related party transactions are reported in proxy statements and the footnotes accompanying fiscal year 1999 financial statements. These transactions are defined in detail in the text but include outstanding loans, consulting payments, sales of products and services, investments, the dollar value of loan guarantees, franchising payments, legal service payments (if reported), and amounts paid in leases to or from the related party. The table also contains the mean, median, and maximum level of total RPTs scaled by 1999 total assets. RPTs/assets > 1% is a dummy variable that takes a value of one if the sum of RPTs exceeds one percent of assets and zero otherwise. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock.

All Firms Number of firms Any transaction Total RPTs >$60k Total RPTs > $200k Total RPTs > $1,000k Mean RPTs/assets Median RPTs/assets Max. RPTs/assets RPTs/assets > 1% Employment Related Loans > $60k Employment Related Loans > $200k Employment Related Loans > $1,000k Employment Related Loans/assets > 1% 234 0.718 0.620 0.552 0.329 2.86% 0.015% 88.83% 0.308

Restaurants 86 0.756 0.674 0.640 0.384 3.02% 0.491% 46.13% 0.407

Trucking 42 0.738 0.667 0.548 0.381 1.33% 0.185% 8.52% 0.310

Apparel Retail 53 0.792 0.679 0.623 0.321 3.71% 0.170% 88.83% 0.264

Apparel Manufacturing 53 0.604 0.472 0.377 0.226 2.97% 0.000% 59.32% 0.189

0.226 0.170 0.057 0.026

0.256 0.151 0.023 0.023

0.071 0.071 0.024 0.000

0.321 0.283 0.113 0.057

0.208 0.170 0.057 0.019

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Table III: Frequency of related party transactions by type of transaction

This table reports the fraction of firms in the sample and the industry subsamples with certain types of related party transactions (RPTs) with sums in excess of $200,000 in 1999. Products and services are cases in which the firm purchases from or sells to a related party. Consulting denotes the existence of payments for consulting services. Aircraft purchase or lease pertains to payments to or from the related party for air transportation services. Lease transactions are cases in which the firm leases to or from a related party (excludes aircraft leases). Franchise payments are cases in which a related party makes cash payments to the firm pursuant to a franchising agreement. Asset sales and purchases relate to sales or purchases of businesses or individual assets. Legal fees denote the existence of payments to the related party for legal services. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock. Loans made to an executive for a clear business transaction such as to buy a property for leasing to the company are deemed non-employment related. If a loan had no rationale given for its existence and the loan exceeded 10 times the value of the executives base salary in the current or prior year, then the loan is deemed non-employment related. Loans from a related party to a company are cases in which the related party has lent money to the firm. Note these exclude cases in which the related party is a bank employee and the bank has extended a loan to the firm. Other are all related party transactions not classified as above, including payments to charities of related parties, loans from banks with bank members on the board of directors, and venture capital partnerships with related parties.

Number of firms Products and services RPTs > $200k Consulting RPTs > $200k Aircraft RPTs > $200k Lease RPTs (excluding aircraft leases) > $200k Franchise RPTs > $200k Asset sales or purchases RPTs > $200k Legal fees > $200k Non-employment related loans > $200k Loans from related party to company > $200k Other > $200k

All Firms 234 0.316 0.047 0.038 0.209 0.068 0.090

Restaurants 86 0.279 0.023 0.047 0.233 0.186 0.151

Trucking 42 0.333 0.000 0.048 0.190 0.000 0.071

Apparel Retail 53 0.358 0.113 0.019 0.302 0.000 0.094

Apparel Manufacturing 53 0.321 0.057 0.038 0.094 0.000 0.000

0.034 0.068 0.047

0.037 0.116 0.058

0.048 0.071 0.000

0.038 0.038 0.075

0.019 0.019 0.038

0.047

0.047

0.071

0.019

0.056

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Table IV: Timing and magnitude of related party transactions

This table reports the fraction of firms in the sample with related party transactions (RPTs) that are classified as ex-ante and/or ex-post in nature. The table reports these fractions for both 1999 and 2000. For the purposes of this table, RPTs do not include employment-related loans. Related party transactions (RPTs) that had their origins before the company went public or before the related party had a board seat or significant reported ownership stake are deemed to be exante in nature. A transaction is classified as ex-post if the RPT was initiated after the related party was publicly traded and had an ownership stake, executive position, or board seat. RPTs/assets > 1% is a dummy variable that takes a value of one if the sum of RPTs exceeds one percent of total assets and zero otherwise.

Timing of RPTs Year Number of firms Total RPTs > $200k Total RPTs > $1,000k RPTs/assets > 1%

Ex-ante and/or ex-post 1999 234 0.552 0.329 0.308

Ex-ante 1999 234 0.368 0.205 0.175

Ex-post 1999 234 0.321 0.154 0.132

Ex-ante and/or ex-post 2000 220 0.601 0.359 0.336

Ex-ante 2000 220 0.405 0.205 0.177

Ex-post 2000 220 0.382 0.214 0.195

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Table V: Hiring of relatives to executive positions

Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees (total compensation) was hired to their position by a family member or inherited their position from a family member. Hand-me-down top five executive is a dummy variable that takes a value of one if a family member was hired to their position among the top five highest paid employees by a family member or inherited their position from a family member. In both cases, these variables are zero if multiple family members co-found a firm and members of the same generation change positions. The variables also equal zero if there are two family executives at the top of the company who founded the firm together.

All Firms Number of firms Hand-me-down top executive Hand-me-down top five executive 234 0.205 0.252

Restaurants 86 0.047 0.093

Trucking 42 0.405 0.405

Apparel Retail 53 0.245 0.302

Apparel Manufacturing 53 0.264 0.340

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Table VI: Ordinary least squares regressions of Tobins Q ratios on the magnitude and timing of related party transactions
The dependent variable in columns 1 and 2 (3 and 4) is the Tobins Q ratio calculated as of June 30, 2000 (June 29, 2001). Tobins Q is the market value of equity minus the book value of equity plus total assets minus deferred taxes all divided by total assets. If book value of equity was negative and earnings before extraordinary items were negative, then we set the Q ratio equal to one. Related party transactions (RPTs) variables in columns 1 and 2 (3 and 4) are for transactions reported in proxy statements and the footnotes accompanying fiscal year 1999 (2000) financial statements. For the purposes of this table, RPTs do not include employment-related loans unless specified. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock. RPTs (excluding employment related loans)/assets > 1% is a dummy variable that takes a value of one if RPTs exceed 1% of total assets and zero otherwise. RPTs that had their origins before the company went public or before the related party had a board seat or significant reported ownership stake are deemed to be ex-ante in nature. A transaction is classified as ex-post if the RPT was initiated after the firm went public and after the related party had an ownership stake, executive position, or board seat. Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees was hired to their position by a family member or inherited their position from a family member. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Apparel retail, trucking, and apparel manufacturing are each dummy variables that take a value of one when the firm operates in the respective industry and zero otherwise. White-adjusted standard errors are in parentheses. ***, **, and * denote significance at the 0.01, 0.05, and 0.10 level, respectively.

Tobins Q as of: RPTs (excluding employment related loans)/assets > 1% Ex-ante RPTs (excluding employment related loans)/assets > 1% Ex-post RPTs (excluding employment related loans)/assets > 1% Employment related loans/assets > 1% Hand-me-down top executive Ln(total assets) Ln(firm age) Apparel retail Trucking Apparel manufacturing Constant Number of firms R-squared

(1) June 30, 2000 0.120 (0.212)

(2) June 30, 2000

(3) June 29, 2001 -0.048 (0.182)

(4) June 29, 2001

0.496 (0.309) -0.372*** (0.128) 0.061 (0.561) -0.450** (0.177) 0.212** (0.088) -0.195*** (0.075) 0.548** (0.243) -0.068 (0.330) 0.002 (0.172) 0.740* (0.441) 234 0.108 0.148 (0.550) -0.398** (0.164) 0.210** (0.084) -0.196*** (0.075) 0.473** (0.224) -0.141 (0.305) -0.010 (0.169) 0.794* (0.416) 234 0.142 -0.250 (0.210) -0.240 (0.200) 0.355*** (0.084) -0.375*** (0.102) 0.628** (0.287) -0.282 (0.228) 0.082 (0.185) 0.609 (0.434) 220 0.192

0.284 (0.248) -0.401*** (0.155) -0.158 (0.223) -0.230 (0.198) 0.344*** (0.082) -0.374*** (0.103) 0.541* (0.287) -0.296 (0.221) -0.010 (0.198) 0.715* (0.427) 220 0.209

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Table VII: Ordinary least squares regressions of the return on invested capital on the magnitude and timing of related party transactions
The dependent variable in columns 1 and 2 (3 and 4) is the return on invested capital (ROIC) calculated as of the end of fiscal year 1999 (2000). ROIC is calculated as operating income before depreciation plus the previous year's estimate of year-ahead rental commitments divided by total assets less non-interest-bearing current liabilities plus seven times the previous year's estimate of year-ahead rental commitments. Related party transactions (RPTs) variables in columns 1 and 2 (3 and 4) are for transactions reported in proxy statements and the footnotes accompanying fiscal year 1999 (2000) financial statements. For the purposes of this table, RPTs do not include employment-related loans unless specified. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock. RPTs (excluding employment related loans)/assets > 1% is a dummy variable that takes a value of one if RPTs exceed 1% of total assets and zero otherwise. RPTs that had their origins before the company went public or before the related party had a board seat or significant reported ownership stake are deemed to be ex-ante in nature. A transaction is classified as ex-post if the RPT was initiated after the firm went public and after the related party had an ownership stake, executive position, or board seat. Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees was hired to their position by a family member or inherited their position from a family member. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Apparel retail, trucking, and apparel manufacturing are each dummy variables that take a value of one when the firm operates in the respective industry and zero otherwise. White-adjusted standard errors are in parentheses. ***, **, and * denote significance at the 0.01, 0.05, and 0.10 level, respectively.

ROIC as of fiscal year end: RPTs (excluding employment related loans)/assets > 1% Ex-ante RPTs (excluding employment related loans)/assets > 1% Ex-post RPTs (excluding employment related loans)/assets > 1% Employment related loans/assets > 1% Hand-me-down top executive Ln(total assets) Ln(firm age) Apparel retail Trucking Apparel manufacturing Constant Number of firms R-squared

(1) 1999 -0.020 (0.014)

(2) 1999

(3) 2000 -0.025* (0.015)

(4) 2000

0.001 (0.019) -0.032* (0.017) 0.017 (0.023) 0.002 (0.017) 0.032*** (0.006) -0.007 (0.007) 0.015 (0.017) 0.007 (0.016) -0.016 (0.020) 0.036 (0.031) 234 0.137 0.022 (0.023) 0.004 (0.017) 0.032*** (0.006) -0.007 (0.007) 0.013 (0.017) 0.005 (0.016) -0.018 (0.019) 0.033 (0.031) 234 0.140 -0.008 (0.025) -0.001 (0.019) 0.042*** (0.006) -0.016** (0.007) 0.003 (0.016) -0.013 (0.018) -0.028 (0.020) 0.010 (0.031) 220 0.232

0.004 (0.019) -0.074*** (0.016) 0.001 (0.025) 0.000 (0.018) 0.039*** (0.006) -0.016** (0.007) -0.009 (0.015) -0.013 (0.016) -0.041** (0.020) 0.038 (0.028) 220 0.289

45

Table VIII: Logistic regressions of officer and director related party transactions on officer and director ownership
The dependent variable in column 1 (2) is a dummy variable that takes a value of one if the ex-ante (expost) RPTs with officers and directors reported for 1999 exceed 1% of total assets and zero otherwise. Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees (total compensation) was hired to their position by a family member or inherited their position from a family member. For the purposes of this table, RPTs do not include employment-related loans. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock. RPTs that had their origins before the company went public or before the related party had a board seat are deemed to be ex-ante in nature. A transaction is classified as ex-post if the RPT was initiated after the firm went public and after the related party had an executive position or board seat. Officer and director holdings (truncated) is the percentage of votes controlled by officers and directors (assuming all options listed as beneficially held are exercised). The maximum value of the variable is 50% if the officers and directors control more than 50% of the votes or control a class of stock that elects the majority of the board of directors. Staggered board is a dummy variable that equals one if the firm has a staggered board and zero otherwise. Multiple family directors equals one if the firm has multiple directors from the same family and zero otherwise. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Apparel retail, trucking, and apparel manufacturing are each dummy variables that take a value of one when the firm operates in the respective industry and zero otherwise. Standard errors are in parentheses. ***, **, and * denote significance at the 0.01, 0.05, and 0.10 level, respectively.

Dependent Variable

(1) Officer and Director exante RPTs (excluding employment related loans)/ assets > 1% 0.034** (0.014) 0.341 (0.400) 0.436 (0.415) -0.180 (0.227) 0.128 (0.209) -0.431 (0.543) -0.097 (0.548) -0.518 (0.568) -3.259*** (1.249) 234 0.069

(2) Officer and Director expost RPTs (excluding employment related loans)/assets > 1% 0.038** (0.016) -0.245 (0.430) 0.417 (0.461) -0.303 (0.255) 0.261 (0.227) -1.406** (0.592) -1.566** (0.654) -2.398*** (0.829) -2.988** (1.405) 234 0.132

(3) Hand-me-down top executive

Officers and director holdings (truncated) Staggered board Multiple family directors Ln(firm age) Ln(total assets) Apparel retail Trucking Apparel manufacturing Constant Number of firms Pseudo R-squared

0.035** (0.014) 0.405 (0.401) 1.564*** (0.400) 0.454** (0.226) -0.088 (0.213) 1.719** (0.657) 2.384*** (0.662) 1.861*** (0.645) -5.570*** (1.412) 234 0.267

46

Table IX: Regressions of Tobins Q and return on invested capital on the magnitude and timing of related party transactions and corporate governance characteristics Dependent variable (1) (2) June 30, 2000 June 30, 2000 Tobins Q Tobins Q 0.505 (0.306) -0.406*** (0.144) 0.225 (0.548) -0.421** (0.183) 0.219** (0.099) -0.187** (0.079) 0.007 (0.008) -0.274 (0.265) 0.496 (0.310) -0.431*** (0.158) 0.198 (0.501) -0.404** (0.173) 0.233** (0.098) -0.180** (0.080) 0.014* (0.008) (3) Fiscal year 2000 ROIC 0.000 (0.019) -0.078*** (0.017) 0.001 (0.027) -0.009 (0.019) 0.042*** (0.006) -0.013* (0.007) 0.001* (0.000) -0.011 (0.021) (4) Fiscal year 2000 ROIC -0.001 (0.018) -0.077*** (0.017) -0.002 (0.026) -0.010 (0.018) 0.042*** (0.006) -0.013* (0.007) 0.001 (0.000)

Ex-ante RPTs (excluding employment related loans)/assets > 1% Ex-post RPTs (excluding employment related loans)/assets > 1% Employment related loans/assets > 1% Hand-me-down top executive Ln(total assets) Ln(firm age) Officers and director holdings Officers and director voting holdings > 25% Officers and director voting holdings > 40% Independent majority board Staggered board Apparel retail Trucking Apparel manufacturing Constant Number of firms R-squared

-0.010 (0.151) 0.053 (0.160) 0.451** (0.221) -0.159 (0.314) -0.116 (0.170) 0.640 (0.684) 234 0.149

-0.643* (0.365) 0.013 (0.153) 0.044 (0.164) 0.486** (0.224) -0.167 (0.302) -0.145 (0.172) 0.419 (0.687) 234 0.164

-0.003 (0.013) 0.006 (0.012) -0.012 (0.016) -0.017 (0.018) -0.044** (0.020) -0.005 (0.039) 220 0.308

0.006 (0.021) -0.002 (0.013) 0.007 (0.012) -0.012 (0.016) -0.018 (0.018) -0.043** (0.020) -0.006 (0.041) 220 0.308

47

Table IX: Regressions of Tobins Q and return on invested capital on the magnitude and timing of related party transactions and corporate governance characteristics (continued)
The dependent variable in columns 1 and 2 (3 and 4) is the Q ratio (return on invested capital) calculated as of June 30, 2000 (as of the end of fiscal year 1999). Tobins Q is the market value of equity minus the book value of equity (item 60) plus total assets minus deferred taxes (item 35) all divided by total assets. If book value of equity was negative and earnings before extraordinary items (item 18) were negative, then we set the Q ratio equal to one. ROIC is calculated as operating income before depreciation (item 13) plus the previous year's estimate of year-ahead rental commitments (item 96) divided by total assets less noninterest-bearing current liabilities (item 5) plus seven times the previous year's estimate of year-ahead rental commitments. Related party transactions (RPTs) variables are for transactions reported in proxy statements and the footnotes accompanying fiscal year 1999 financial statements. For the purposes of this table, RPTs do not include employment-related loans unless specified. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock. RPTs (excluding employment related loans)/assets > 1% is a dummy variable that takes a value of one if RPTs exceed 1% of total assets and zero otherwise. RPTs that had their origins before the company went public or before the related party had a board seat or significant reported ownership stake are deemed to be ex-ante in nature. A transaction is classified as ex-post if the RPT was initiated after the firm went public and after the related party had an ownership stake, executive position, or board seat. Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees (total compensation) was hired to their position by a family member or inherited their position from a family member. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Officer and director holdings (expressed as a percentage of total shares) are defined as shares beneficially owned by the directors and officers assuming all options listed as beneficially held are exercised. Officers and director holdings > 25% (40%) is a dummy variable that equals one if officer and director voting holdings exceed 25% (40%) of outstanding shares. Independent majority board equals one if more than half of the directors are independent in the sense that they do not work for the firm, have a relative working for the firm, or have business transactions with the firm (besides director duties). Staggered board is a dummy variable that equals one if the firm has a staggered board and zero otherwise. Apparel retail, trucking, and apparel manufacturing are each dummy variables that take a value of one when the firm operates in the respective industry and zero otherwise. White-adjusted standard errors are in parentheses. ***, **, and * denote significance at the 0.01, 0.05, and 0.10 level, respectively.

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Table X: Logistic regressions of subsequent financial distress or going dark on the magnitude and timing of related party transactions
The dependent variable in column 1 is an indicator variable that takes a value of one if a firm enters financial distress prior to December 30, 2004 and zero otherwise. Financial distress is defined as being in bankruptcy anytime during the beginning of 2000 to the end of 2004 or liquidating all operating assets by the end of 2004, with common equity having no value after liabilities are paid and preferred shareholders are paid (assuming all assets and liabilities are worth face value). The dependent variable in column 2 is an indicator variable that takes a value of one if a firm goes dark and zero otherwise during the same time period. Going dark is defined as deregistering the firms securities prior to entering into financial distress (as defined above) or ceasing to file 10-Ks and 10-Qs for a year concurrent with delisting and receiving a notice from the SEC indicating that it may seek deregistration of the firms securities. Deregistrations prior to a merger or liquidation payout are not included. Related party transactions (RPTs) variables in columns 1 and 2 are dummy variables for transactions in excess of one percent of firm assets as reported in proxy statements and 10-Ks for either 1999 or 2000. For the purposes of this table, RPTs do not include employment-related loans. Employment-related loans are loans made to executives for relocation or to fund the purchase of company stock in either 1999 or 2000. RPTs that had their origins before the company went public or before the related party had a board seat or significant reported ownership stake are deemed to be ex-ante in nature. A transaction is classified as ex-post if the RPT was initiated after the firm went public and after the related party had an ownership stake, executive position, or board seat. Hand-me-down top executive is a dummy variable that takes a value of one if the chairman of the board, CEO or one of the top two highest paid employees was hired to their position by a family member or inherited their position from a family member. Firm age is the number of years, prior to the year 2000, for which the firm operated in its current line of business and first was a separate public firm or a subsidiary of a public firm. Apparel retail, trucking, and apparel manufacturing are dummy variables that take a value of one when the firm operates in the respective industry and zero otherwise. Standard errors are in parentheses. ***, **, and * denote significance at the 0.01, 0.05, and 0.10 level, respectively. Dependent Variable (1) Financial Distress -0.274 (0.447) 0.830* (0.521) 1.030 (0.639) -1.432** (0.669) -0.385* (0.206) 0.336 (0.249) 0.337 (0.525) 0.751 (0.544) -0.491 (0.632) -0.797 (1.071) 234 0.108 (2) Going Dark

1999 or 2000 ex-ante RPTs (excluding employment related loans)/assets > 1% 1999 or 2000 ex-post RPTs (excluding employment related loans)/assets > 1% Employment related loans/assets > 1% Hand-me-down top executive Ln(total assets) Ln(firm age) Apparel retail Trucking Apparel manufacturing Constant Number of firms Pseudo R-squared

0.853 (0.824) 1.581** (0.803)

0.552 (0.958) -1.222** (0.528) 0.164 (0.488) -0.502 (1.223) -0.641 (1.277) -0.371 (1.247) 1.216 (2.330) 234 0.277

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