Do firms benefit from related party transactions with foreign affiliates? Evidence from Korea

• Published date: 01 September 2021
• Author: Sung C. Bae,Taek Ho Kwon
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/irfi.12308

ORIGINAL ARTICLE

Do firms benefit from related party transactions

with foreign affiliates? Evidence from Korea

Sung C. Bae

1

| Taek Ho Kwon

2

1

Department of Finance, College of Business,

Bowling Green State University, Bowling

Green, Ohio

2

School of Business, Chungnam National

University, Daejon, South Korea

Correspondence

Sung C. Bae, Department of Finance, College

of Business, Bowling Green State University,

Bowling Green, OH 43403.

Email: bae@bgsu.edu

Funding information

Research Fund of Chungnam National

University, Daejon, South Korea

Abstract

We extend the existing literature on related party transac-

tions (RPTs) from a domestic to an international dimension

and uncover new evidence of resource transfer by foreign

direct investment (FDI) firms to their foreign affiliates

through overseas RPTs. Employing uniquely-constructed

RPT data of Korean firms during 2005–2010, we find signif-

icantly negative effects of such transactions on the values

of parent firms, which are further confirmed from two-stage

least square regressions after correcting for the endo-

geneity issue. Further analyses reveal that negative valua-

tion effects are most pronounced for overseas RPTs of FDI

firms which are in the high-tech industry and whose foreign

affiliates are in emerging countries. These results indicate

that high-tech FDI firms use RPTs as a means of transferring

resources to support their poorly-performing foreign affili-

ates in emerging countries, especially surrounding the global

financial crisis. We find little evidence that FDI firms use

RPTs to withdraw or tunnel investment returns of foreign

affiliates back to the home country for the benefits of

investing firms during our sample period.

KEYWORDS

firm value, foreign affiliates, global financial crisis, Korean firms,

related party transactions

JEL CLASSIFICATION

G34; G31

Received: 10 October 2018 Revised: 27 February 2020 Accepted: 3 April 2020

DOI: 10.1111/irfi.12308

© 2020 International Review of Finance Ltd. 2020

International Review of Finance. 2021;21:945–965. wileyonlinelibrary.com/journal/irfi 945

1|INTRODUCTION

Firms often engage in transactions with their related parties such as executives, board members, principal owners,

immediate families of any of these groups, and their affiliates. While the great majority of related party transactions

(RPTs, hereafter) are normal and legal, the special relationship between the involved parties creates potential con-

flicts of interest that can result in benefitting the parties involved as opposed to the shareholders.

1

In essence, RPTs

may have different purposes than common market transactions, bringing in distorted effects on firm performance

and causing social costs.

2

Because of these reasons, researchers have focused on the motives and valuation effects

of RPTs. Existing literature has advanced two theoretical hypotheses—tunneling and propping hypotheses—to

explain the potential wealth transfer of related firms and shareholders through RPTs and provided empirical evidence

generally consistent with the two hypotheses (Bae, Kang, & Kim, 2002; Buysschaert, Deloof, & Jegers, 2002; Baek,

Kang, & Lee, 2006; Cheung, Rau, & Stouraitis, 2006). Several other studies also document direct evidence on nega-

tive effects of RPTs on firm values (Cheung, Jing, Lu, Rau, & Stouraitis, 2009; Gordon, Henry, & Palia, 2004;

Kohlbeck & Mayhew, 2010).

While the current literature offers evidence on the wealth transfer among shareholders and a negative valuation

effect of RPTs, the work has dealt exclusively with domestic RPTs with limited evidence on firms in the United States

and China. In this paper, we extend the scope of the research from domestic to overseas RPTs between parent firms

and their foreign affiliates. In particular, we investigate a key research issue of how overseas RPTs affect parent

firms' values. In doing so, we develop testable hypotheses drawing from the existing literature and test them using

uniquely-constructed firm-level data.

A firm's overseas RPTs may have different motivations and purposes and thus affect firm value differently than

its domestic RPTs do. Relative to domestic transactions, a firm's overseas transactions with foreign affiliates that are

set up through foreign direct investments (FDIs, hereafter) are often vague in nature and difficult to detect and mon-

itor. Furthermore, unlike domestic transactions, overseas RPTs must be understood in the context of firms' FDIs

because RPTs play as an important mechanism to generate and transfer investment outcomes of foreign affiliates

from FDIs. A firm's FDI may allow the investing firm to internalize its resources overseas and reduce its transaction

costs when the transactions are performed inefficiently due to the imperfect domestic market (Buckley, 1989; Buck-

ley & Casson, 1976; Dunning, 1988).

3

A firm's FDI can also be understood as a decision to diversify the firm's busi-

ness operations globally (Denis, Denis, & Yost, 2002).

4

Regardless of whether the outcome of a firm's FDIs comes from reduced transaction costs or from diversifica-

tion benefits, the investment outcome of foreign affiliates is either kept as retained earnings for reinvestment in the

local country or transferred back to the parent firm. One way for the latter strategy is to distribute the investment

outcome in the form of dividends. Dividend payments to the parent firm are, however, often subject to hefty taxa-

tion by the local country and may also have a negative effect on the localization strategy of FDIs. Hence, an alterna-

tive mechanism to dividend payments is RPT, or intrafirm transaction, with the foreign affiliate through pricing

adjustments for sales and purchases of goods and services transferred. Furthermore, an FDI firm can also use RPTs

to support poorly-performing foreign affiliates without an infusion of additional capital when the parent firm values

good business prospects and/or reputation of the foreign affiliate in the local market. In this paper, we argue that

overseas RPTs must be understood from the perspective of transferring resources and investment outcomes of FDIs

between parent firms and foreign affiliates, rather than from the perspective of transferring shareholders' wealth

between majority and minority shareholders through tunneling or propping activities as advanced in the existing lit-

erature on domestic RPTs.

Our paper focuses on Korean firms, known to have engaged in significant outward FDIs and overseas RPTs in

recent years. Since Korean firms made their first outward FDIs in 1968, their FDIs have grown substantially over the

years, directed toward to both developed and emerging countries and largely propelled by the firms' desire to reduce

production costs.

5

Furthermore, according to Korea Fair Trade Commission, 35.9% of total sales and 58.7% of total

purchases by foreign affiliates of Korean FDI firms in 2012 were to and from their related firms in Korea and other

946 BAE AND KWON