New Executive Compensation Regulations--Disclosing Related Party Transactions

Michael J. Connolly, Ira H. Jolles of Thelen Reid & Priest LLP

Related Party Disclosures-Item 404(a)

For many years, issuers have been required to disclose in their proxy statements the existence of transactions between the issuer and parties related to it. The SEC has recently amended Item 404 of Regulation S-K to broaden both the class of persons and the class of transactions requiring this disclosure.1 To summarize, the amended regulation requires disclosure of transactions entered into since the beginning of the registrant's last fiscal year, or that are currently proposed in which:

  • The registrant is a Participant;2
  • The amount involved exceeds $120,000;3 and
  • A director (including a nominee for director), officer, or 5% shareholder, or a member of their immediate families, has a "direct or indirect material interest."

As amended, Item 404(a) now requires disclosure of the following information:

  • The name of the related person and the basis for that person being a related person;
  • The related person's interest in the transaction and that person's relationship to, or in, any party with an interest in the transaction;
  • The approximate dollar value of the transaction;4
  • The dollar value of the related person's interest (computed without regard to profit or loss); and
  • Any other information that is material to investors in light of the circumstances regarding the transaction or the related person in the context of the transaction.

The determination of materiality will continue to involve consideration of the significance of the information to investors in light of all the circumstances, which includes, among other things; (a) the relationship of the related persons to the transaction; (b) the relationship between the related persons; (c) the importance of the interest to the related persons; and (d) the amount involved in the transaction. In the context of these considerations, the following Item 404(a) definitions are relevant:

  • "Transaction" includes any financial transaction, arrangement, or relationship or series of transactions, arrangements or relationships, including indebtedness and any guarantee of indebtedness (except for the indebtedness or guarantee of indebtedness of a significant shareholder).
  • "Related person" is any person who was, at any time during the disclosure period, a director or executive officer, any nominee for director for whom information required by Item 404(a) is being disclosed in a proxy or information statement involving the election of that nominee as a director, any significant shareholder, and the immediate family member of such persons or shareholder. A significant shareholder is any person who is known to the registrant to be the beneficial owner of more than 5% of any class of the registrant's voting securities.
  • "Immediate family member" has been expanded beyond child, spouse, parent, sibling, father-, mother-, son-, daughter-, brother-, or sister-in-law, to include stepchildren, stepparents, and any other person (other than a tenant or employee) sharing the household of a related person.
  • "Amount involved" is the dollar value of the transaction (or series of transactions), including the aggregate amount of all periodic payments, or installments and optional and other required payments due on or after the beginning of the registrant's last fiscal year. In the case of indebtedness, the amount involved is the largest aggregate principal amount of all indebtedness outstanding at any time since the beginning of the last fiscal year and all amounts of interest payable during such year.5

The Regulation also provides some guidance about transactions or interests that need not be disclosed, including:

  • Item 404 does not require disclosure of executive and director compensation that is disclosed under Item 402 or not required to be disclosed there.
  • A person is not deemed to have a material direct or indirect interest in a transaction because of a relationship or position with a firm, corporation, or other entity that engages in a transaction with a registrant, wherein the person's interest arises only from a directorship with the other party to the transaction and/or a direct or indirect ownership interest of less than 10% (and, in the case of a partnership, where the person is a limited partner, not a general partner, and does not hold another position in the partnership).

The instructions specifically provide that registrants need not disclose:

  • Transactions involving rates or charges determined by competitive bids, or involving the services of common or contract carriers, public utilities wherein the rates or charges are fixed by law or governmental authority, or transactions involving the services of, for example, a bank depositary of funds, transfer agent, or a trustee under a trust indenture; and
  • Related person interests arising solely from ownership of the registrant's equity securities wherein all holders of the same class of securities receive the same benefits on a pro rata basis.

Registrants will need to create or update their internal policies, procedures, and systems for tracking transactions involving related persons, or in which they participate, to reflect (i) the change in the dollar threshold to $120,000; (ii) the broader scope of the definitions of transactions and related persons; and (iii) the new test of the registrant's involvement as a participant, which now encompasses transactions involving a related person that, for instance, the registrant has arranged but to which it is not a party. Registrants will need to seek relevant transaction information including with respect to significant shareholders and regarding the identification of directors' and executive officers' immediate family members (as more broadly defined) who are involved in such transactions. Because the valuation of transactions under the revised regulations involves various factors (depending on the type of transaction), and because of the intersection of these transactions with director independence issues, registrants may wish to require internal reporting of all related party transactions regardless of amount.

Procedures for Approval of Related Person Transactions-Item 404(b)

Item 404(b) of Regulation S-K requires the disclosure of the description of the registrant's policies and procedures regarding the review, approval, or ratification of any transaction required to be reported under Item 404(a) as related person transactions. The material features of such policies and procedures will vary from company to company depending on the circumstances, but the Regulation, as amended, suggests that the material features may include:

  • The types of transactions covered;
  • The standards to be applied;
  • The persons or groups responsible for applying the policies and procedures; and
  • Whether the policies are in writing and, if not, how they are otherwise evidenced.

The Item 404(b) disclosure also requires identification of any transaction that is required to be reported under Item 404(a) but which was not required to be reviewed, approved, or ratified under the registrant's policies and procedures, or wherein such policies and procedures were not followed. This requirement would not include disclosure of transactions that occurred before a person became a related person unless the transaction continued after the person became a related person.

Registrants that do not have written policies and procedures for reviewing and approving related party transactions will want to seriously consider creating them. In developing new written policies and procedures, or when revising existing ones, registrants will need to consider, among other things, drafting such policies with a sufficient level of detail (considering the examples set forth in the amended Regulation) that will allow the registrant to adequately describe their material elements when providing the Item 404(b) disclosure. In addition, registrants who are listed companies will also need to consider, and may need to accommodate, in their policies, the requirements of the exchange or exchanges on which they are listed. For instance, since 1983, the New York Stock Exchange's Listed Company Manual, while expecting listed companies to discharge their responsibility for appropriately monitoring and reviewing related party transaction situations, leaves the review and oversight of such transactions to the discretion of the listed companies. Without requiring a particular method of resolution, however, the Manual does suggest that "the Audit Committee or a comparable body could be considered as the forum for review and oversight of potential conflict of interest situations."6

Promoters and Control Persons-Item 404(c)

The SEC's new rules also require registrants filing registration statements on Forms S-1 or SB-2 under the Securities Act, or on Forms 10 or 10-SB under the Exchange Act, to disclose the identity of, and transactions with, promoters at any time during the last five fiscal years. The required disclosure would include:

  • The nature and amount of anything of value received by the promoter from the company or any consideration received by the promoter from the company; and
  • Any additional information regarding assets acquired by the company from a promoter, including the principle followed, or to be followed, in determining the amount, the person or persons who made or will make the determination and their relationship to the registrant and the promoter, and the cost to the promoter if the assets were acquired by the promoter within two years prior to the transfer to the registrant.

The same disclosure is required by registrants with respect to any person who acquired control, or is part of a group (as defined in Rule 13d-5(b)(1) of the Exchange Act), that acquired control of a registrant that is a shell company (as defined by Rule 405 under the Securities Act and Rule 12b-2 under the Exchange Act).


The revised disclosure requirements, with respect to related persons transactions under Item 404 of Regulation S-K, require registrants to refine their transaction-tracking mechanisms. They also will have the effect of encouraging registrants to adopt new or revised policies and procedures that appropriately address the identification, review, and approval of related person transactions.

1 Release No. 33-8732; 34-54302; IC-27444; File No. S7-03-06.

2 As opposed to only where the company is a party.

3 Up from the former $60,000. Please note that transactions, relationships, or arrangements not required to be disclosed pursuant to Item 404 nevertheless have to be disclosed by specific category or type pursuant to Item 407 if such transactions were taken into account when assessing director independence.

4 If the transaction involves indebtedness of directors (including in certain circumstances nominee directors) or officers or their immediate family members, then the amount involved includes the largest aggregate amount of principal outstanding during the period for which disclosure is provided, the amount outstanding at the latest practicable date, the amount of principal and interest paid during the period, and the rate or amount of interest payable). The disclosure of indebtedness transactions of significant shareholders or their immediate family members is not required.

5 Indebtedness, however, does not include amounts due from the related person for goods and services purchased under usual terms for business travel and expense payments, and for other transactions in the ordinary course of business. Indebtedness that is not past-due, restructured, or a potential problem, where the lender is a bank, savings and loan, or broker dealer extending credit under Federal Reserve Regulation T, may be disclosed by a statement, if correct, that the loans were made in the ordinary course of business, on substantially the same terms as for comparable loans to unrelated parties and do not involve more than normal risk or other unfavorable features.

6 See, The New York Stock Exchange's Listed Company Manual at õ307.00 Related Party Transactions.

Thelen Reid & Priest attorneys can assist you in meeting the compliance and other challenges presented by the new regulations. To discuss these and related matters further, please contact the Thelen Reid attorney with whom you work or any of the following:

Thomas J. Igoe, Jr.

Ira H. Jolles

Michael J. Connolly

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¸2006 Thelen Reid & Priest LLP. This article has been published as an information service to clients and friends of Thelen Reid. Please recognize that the information is general in nature and must not be relied upon as legal advice. We would be pleased to discuss this information with you and its application to your specific situation, and welcome your comments and suggestions.