Disclosure Reform, the SEC, and Related Party Transactions: The Case of Wal-Mart (Part 2)

Yesterday, we discussed the related party disclosure requirements imposed by the SEC.  Specifically, Item 404 of Regulation S-K requires the disclosure of any transaction with the issuer that exceeds $120,000 and that provides a director, executive officer or immediate family member with a direct or indirect material benefit.  We discussed the fact that this is a difficult test to apply, particularly in connection with indirect benefits arising out of contracts with entities doing business with the issuer. 

Some of this can be seen in connection with the relationship between Wal-Mart and Eric Scott, the son of Lee Scott, the President and CEO of Wal-Mart.  Last week, the Treasurer of Rhode Island, Frank Caprio, sent to the SEC a letter requesting an investigation into whether Wal-Mart had failed to disclose that Eric Scott worked for Jacobs Trading, a company that did business with Wal-Mart.  Specifically, the letter stated: 

• "I have been informed that Wal-Mart has conducted a substantial amount of business with Jacobs Trading Company (“Jacobs Trading”)."   
• "I have been informed that Wal-Mart has engaged Jacobs Trading to resell a substantial amount of its unsold goods, including during the most recent fiscal year ended January 31, 2007. Thus, the amount involved in these transactions may easily exceed $120,000."
• "Jacobs Trading maintains a Bentonville, Arkansas office that is staffed by Eric Scott, the son of Wal-Mart President and Chief Executive Officer Lee Scott."  

A copy of the letter is on the DU Corporate Governance web site (or will be later today).  A few days later, Julie Roehm, the former Senior Vice President for Marketing Communications at Wal-Mart, filed answers to counterclaims in a suit against the retail giant.  She included additional allegations about the relationship between Jacobs Trading, Eric Scott and Wal-Mart.  Specifically, the answer stated:   

• "H. Lee Scott, the current President and Chief Executive Officer of Wal-Mart, initiated (at a time when Mr. Scott was the Vice-President of Merchandising) an association with entrepreneur Irwin Jacobs, allowing Mr. Jacobs’ business, Jacobs Trading Company (JTC), the exclusive right to purchase unsold Wal-Mart merchandise. Jacobs Trading Company is one of several privately-held companies owned by Mr. Jacobs."
• "Mr. Scott’s son, Eric S. Scott, who initially was employed by Wal-Mart as a buyer, ultimately left Wal-Mart for employment with Jacobs Trading Company, a company which purchases unsold Wal-Mart merchandise from Wal-Mart and which is owned by Mr. Jacobs, whose relationship with Mr. Scott is described above."  

The answer is on the DU Corporate Governance web site (or will be later today). 

There are few observations that can be made about these circumstances.  First, they are only allegations.  Second, even if true, they do not necessarily establish that Wal-Mart had an obligation to disclose the relationship between Jacobs Trading and Eric Scott (there is no disclosure of this relationship in the most recent proxy statement filed by the company).   Assuming that Jacobs Trading engages in transactions with Wal-Mart that exceed $120,000, disclosure must only occur if Eric Scott has a direct or indirect material interest in them.  According to the Wall Street Journal, a Wal-Mart official indicated that this was a "non-issue" since Eric Scott was not "an executive or officer of Jacobs Trading."  

The information suggests limits on the usefulness of Item 404.  Assuming that Eric Scott does not have a material interest (direct or indirect) in the business between Wal-Mart and Jacobs Trading, it is nonetheless the case that a family member of the CEO may be receiving some type of consideration from a vendor that does business with the company the CEO is managing.  However harmless the relationship, investors presumably would want to know about it, including the amount and nature of the consideration involved and the specific position held, in order to judge for themselves its significance.  See In re Disney, Exchange Act Release No. 50882 (admin proc Dec. 20, 2004)("Item 404 disclosure sheds light on relationships that may present actual or potential conflicts of interest that may affect officers', directors' and director nominees' execution of their duties.").

Item 404, therefore, needs to be changed.  It could require the disclosure of any material payment made to a director, officer, or immediate family member by any entity involved in a transaction with the company, irrespective of whether the payment does or does not arise out of the transaction. 

Alternatively, Item 404 could require disclosure of relationships considered by the board but deemed not to result in a disclosable related party transaction.  This would resemble the requirement imposed under Item 407 of Regulation S-K which requires the disclosure of relationships considered by the board but deemed not to result in a loss of director independence.  See Item 407(a)(3)("For each director and nominee for director that is identified as independent, describe, by specific category or type, any transactions, relationships or arrangements . . . that were considered by the board of directors under the applicable independence definitions in determining that the director is independent.Perhaps the same rule should apply to related party transactions.").  The latter requirement would at least allow shareholders to know that the board had in fact considered the relevant related party transaction.