Breaking the invisible shield: Judicial independence against related-party transactions

This paper examines the impact of judicial independence on risk-sensitive arrangements by exploiting China's circuit court reform as a quasi-natural experiment. Using panel data of A-share listed firms from 2009 to 2024 and a difference-in-differences design, we find that enhanced judicial independence significantly reduces related-party transactions (RPTs). Mechanism analyses suggest that an increase in litigation risk is the primary channel through which this effect operates. Consistent with this notion, we find that the establishment of circuit courts leads to a rise in corporate litigation. Moreover, the suppressing effect of judicial independence on RPTs is more pronounced among abnormal transactions that are subject to higher litigation risk. Further evidence indicates that the effect is more pronounced for state-owned enterprises, politically connected firms, and firms located in regions with stronger local protectionism, suggesting that judicial reform has stronger marginal governance effects on firms that historically benefited from weaker legal enforcement. Notably, we find that judicial independence complements external governance but substitutes for strong internal governance. Overall, this study underscores the foundational role of judicial independence in corporate governance and demonstrates its critical function in constraining opportunistic behavior and improving capital market order.