Incestuous share dealing: Meaning, Criticisms & Real-World Uses

What Is Incestuous Share Dealing?

Incestuous share dealing refers to transactions involving the shares of a company where the parties involved have pre-existing, close relationships that could lead to a conflict of interest. These relationships typically extend beyond ordinary arm's-length market transactions, often involving insiders, affiliated entities, or individuals with significant influence over the company. It falls under the broader umbrella of corporate governance concerns, specifically addressing how companies manage relationships and transactions that could potentially disadvantage shareholders or other stakeholders. Such dealings raise questions about fairness, transparency, and the integrity of a company's financial operations.

History and Origin

The concept of scrutinizing transactions between closely related parties, including what is termed incestuous share dealing, has evolved alongside the development of modern financial markets and corporate law. As companies grew in size and complexity, and as ownership became dispersed, the potential for those in control to exploit their positions for personal gain at the expense of other shareholders became a recognized risk. Regulatory bodies and corporate governance frameworks emerged to address these concerns.

For instance, the U.S. Securities and Exchange Commission (SEC) has long mandated disclosures of "transactions with related persons." Item 404 of Regulation S-K, for example, requires public companies to disclose any transaction exceeding a certain monetary threshold where a related person has a direct or indirect material interest.⁷ Similarly, international bodies like the Organisation for Economic Co-operation and Development (OECD) have developed comprehensive principles of corporate governance that emphasize the importance of monitoring and managing potential conflicts of interest, including those arising from related-party transactions.⁶ These principles, first published in 1999 and regularly updated, serve as an international benchmark for policymakers and market participants. The Public Company Accounting Oversight Board (PCAOB) also established Auditing Standard AS 2410, which sets requirements for auditors to evaluate a company's identification, accounting for, and disclosure of related party relationships and transactions, aiming to strengthen auditor performance in this critical area.⁵

Key Takeaways

Incestuous share dealing involves transactions where close relationships between parties may create conflicts of interest.
These dealings can undermine shareholder value and market confidence due to concerns over fairness and transparency.
Strict regulatory disclosure requirements and auditing standards exist to monitor and mitigate the risks associated with such transactions.
Robust corporate governance practices, including independent board of directors and strong audit committee oversight, are crucial in preventing abusive incestuous share dealing.

Interpreting Incestuous Share Dealing

Interpreting incestuous share dealing primarily involves assessing whether a transaction between related parties was conducted on terms equivalent to an arm's-length transaction, meaning as if the parties were unrelated and acting independently in their own self-interest. If the terms are unfavorable to the company or its general body of shareholders, the dealing is considered problematic. The evaluation often requires careful due diligence and scrutiny of pricing, conditions, and the underlying business rationale. The presence of incestuous share dealing can signal weaknesses in a company's internal controls and its commitment to upholding its fiduciary duty to all shareholders.

Hypothetical Example

Consider a hypothetical public company, "Tech Innovations Inc.," whose CEO, Mr. Smith, also holds a significant stake in a private software development firm, "CodeGen Solutions." Tech Innovations announces its intention to acquire CodeGen Solutions for a substantial sum, paid largely in Tech Innovations' shares. This scenario would immediately raise red flags for potential incestuous share dealing.

To properly evaluate this:

The board of directors of Tech Innovations, particularly its independent members, would need to scrutinize the valuation of CodeGen Solutions to ensure it is fair and not inflated due to Mr. Smith's interest.
An independent third-party valuation might be commissioned.
Mr. Smith would be expected to recuse himself from voting on the acquisition.
The transaction would be disclosed in Tech Innovations' financial reporting to alert investors to the related-party nature of the deal.
If the acquisition price were deemed excessive compared to market rates for similar companies, and if the transaction primarily benefited Mr. Smith, it could be seen as abusive incestuous share dealing, potentially leading to a decrease in Tech Innovations' shareholder value.

Practical Applications

Incestuous share dealing is a critical area of focus in several practical contexts within the financial world. It frequently surfaces in:

Regulatory compliance: Regulators worldwide, such as the SEC in the United States, impose strict disclosure requirements for related-party transactions to protect investors.⁴
Auditing and Financial Reporting: Independent auditors pay close attention to related-party transactions, following standards like PCAOB AS 2410, to ensure they are properly identified, accounted for, and disclosed in financial statements.³
Mergers and acquisitions: During M&A activities, thorough due diligence is performed to uncover any hidden related-party transactions that could affect the deal's fairness or value.
Investor Relations and Shareholder Value Protection: Institutional investors and minority shareholders are highly attuned to incestuous share dealing as it can indicate potential value extraction or preferential treatment, eroding trust and investment returns.

A notable real-world example highlighting the scrutiny of such transactions is the case of WeWork and its co-founder Adam Neumann. During WeWork's attempt to go public, revelations about significant related-party transactions, including Neumann owning stakes in buildings leased back to WeWork, raised considerable concerns among investors and analysts.² Neumann addressed these transactions, clarifying them as "related party transactions" that were approved by the board and disclosed to top investors.¹ These dealings contributed to investor apprehension regarding the company's corporate governance and ultimately impacted its valuation and initial public offering (IPO) plans.

Limitations and Criticisms

While regulatory frameworks and auditing standards aim to curb abusive incestuous share dealing, certain limitations and criticisms persist. One challenge is the inherent difficulty in precisely defining "arm's length" terms for every unique transaction, especially in complex or niche industries where comparable market data might be scarce. This can create loopholes or make it challenging for external parties to definitively prove that a transaction was not fair.

Another criticism is that while disclosure requirements enhance transparency, they do not inherently prevent all instances of self-serving transactions. They rely on the vigilance of shareholders, regulators, and the effectiveness of independent board of directors and audit committee members to scrutinize and challenge such deals. Moreover, powerful controlling shareholders or executives may still exert undue influence, potentially leading to transactions that, while technically disclosed, are still unfavorable to minority shareholders. Issues like asset stripping or preferential treatment through complex financial arrangements can sometimes emerge if oversight mechanisms are not sufficiently robust.

Incestuous Share Dealing vs. Related Party Transaction

The terms "incestuous share dealing" and "related party transaction" are closely related, but "incestuous share dealing" carries a more negative connotation and implies a potentially abusive or self-serving nature.

A related party transaction is a broad term referring to any business transaction or arrangement between a company and a "related party." Related parties, as defined by accounting standards and regulations, include a company's management, board of directors, significant shareholders, their immediate family members, and entities they control or influence. These transactions are not inherently problematic; they can be legitimate and even beneficial for a company, provided they are conducted at arm's length and fully disclosed.

Incestuous share dealing, on the other hand, specifically highlights share-related transactions where the related-party nature leads to a perceived or actual unfair advantage or detriment to the company or its broader shareholder base. It suggests that the close relationship has tainted the impartiality of the deal, raising concerns akin to insider trading or even market manipulation in terms of ethical implications, even if not strictly illegal. While all incestuous share dealings are related party transactions, not all related party transactions are considered incestuous share dealings. The distinction lies in the perceived fairness and benefit to all stakeholders.

FAQs

What constitutes a "related person" in finance?

A "related person" typically includes a company's directors, executive officers, significant shareholders (often 5% or more), and their immediate family members (spouses, parents, children, siblings, in-laws, and anyone sharing their household). Entities controlled by these individuals also fall under this definition for financial reporting purposes.

Why is incestuous share dealing a concern for investors?

Investors are concerned because incestuous share dealing suggests that company resources or assets might be diverted for the personal benefit of insiders rather than for the collective benefit of all shareholders. This can lead to a reduction in shareholder value and indicates poor corporate governance, eroding trust in management and the board.

How do regulators address incestuous share dealing?

Regulators primarily address incestuous share dealing through strict disclosure requirements. Companies are mandated to reveal details of related-party transactions in their financial statements and regulatory filings. This transparency allows investors, auditors, and other stakeholders to scrutinize the terms and assess potential conflicts of interest. Auditors also have specific standards they must follow to evaluate these transactions.

Can incestuous share dealing be legal?

Yes, technically, if an incestuous share dealing transaction is fully disclosed, approved by independent parties (like the disinterested members of the board of directors or an audit committee), and conducted on terms that are genuinely fair and comparable to arm's-length dealings, it may be legal. The "incestuous" label often implies a perceived ethical or fairness issue rather than an inherent illegality, unless it violates specific laws like those against fraud or breaches of fiduciary duty. The legality hinges on adherence to regulatory compliance and the absence of intentional deception or harm.