Disclosure Reform, the SEC, and Related Party Transactions: The Case of Wal-Mart (Part 1)

We have spent some time on this Blog discussing problems associated with the definition of "independent" director used by the stock exchanges and state courts.  My article on the definition employed by Delaware and the problems associated with it, is here.  Today and tomorrow we will examine another aspect of this issue, the disclosure of related party transactions.   

Item 404 of Regulation S-K provides for the disclosure of any transaction or series of transactions involving the company and exceeding $120,000 in which a director, executive officer or immediate family member has a "direct or indirect material interest."  Material interest is "determined on the basis of the significance of the information to investors in light of all the circumstances."  Exchange Act Release No. 54302A (August 29, 2006).  The SEC recently amended Item 404 to increase the dollar threshold of transactions implicated by the disclosure provision from $60,000 to $120,000.  See Exchange Act Release No. 54302A (August 29, 2006).

This was one of the first SEC disclosure requirements that involved the intersection between disclosure and substantive behavior.  The information requires the disclosure of information that can implicate the duty of loyalty under state law and reveal possible bias or favoritism by the fiduciary.  See In re Disney, Exchange Act Release No. 50882 (admin proc Dec. 20, 2004)("Item 404 extends to transactions and relationships involving members of the families of directors and executive officers because shareholders should have information concerning transactions and arrangements that might appeal to the natural human inclination to look favorably upon a family member's employer. Such information is intended to help a shareholder to assess the director's or officer's performance and suitability to hold his or her position.").  Related party transactions were one of the first categories of disclosure required by the Commission in an effort to improve substantive standards of behavior by officers and directors.  That topic is discussed in greater detail in my article here. 

The provision is clear enough when determining a "direct" material interest.  These typically involve payments from the company directly to the fiduciary.  In those circumstances, a company need only compute the total value of the transaction (to determine whether it exceeds $120,000) and ascertain whether whether the fiduciary receives a material portion of the amount.        

In the case of "indirect" payments, however, the task is more difficult and the reach of Item 404 less clear.  These types of transactions typically arise where the company enters into a contract with another entity and the fiduciary or family member has some type of connection to that entity, whether through employment or ownership.  See Exchange Act Release No. 54302A (August 29, 2006)("For example, under amended Item 404(a) disclosure is required if an executive officer had a material indirect interest in an indebtedness transaction . . .  between the company and another entity due to that executive officer's ownership interest in the other entity.").  A person will not be deemed to have an "indirect material relationship" by virtue of serving as a director or owning less than 10% of the entity.  Beyond that, Item 404 provides little guidance on these "indirect" benefits.

Where the family member owns the entity, the payments from the company will generally give rise to an indirect interest.  See In re Sweeney, Exchange Act Release No. 24888 (admin proc Sept. 9, 1987)(company did not disclose transaction with another entity involving more than $1 million that was owned by brother of executive officer).  The same is true where the family member controls the operations of the entity.  See In re Warner, Exchange Act Release No. 45441 (admin proc Feb. 13, 2002)(company made payments to entity where CEO's son "operated" the entity).  In the former circumstance, the family member benefits from the payment through ownership.  In the latter, the family member is in a position to direct the benefits. 

Where the officer, director or family member merely has an employment (or independent contractor) relationship with the supplier or vendor, the treatment is more problematic.  In those circumstances, the family member does not ordinarily receive compensation based upon the transaction or hold a position that enables can be used to direct the benefits.  In general, therefore, these types of relationships do not need to be disclosed. 

There are two problems with this approach.  First, with or without evidence of a direct connection between the transaction and the family member or fiduciary, shareholders would often want to know about it.  To the extent a supplier or vendor hires the children of a director or executive officer, it could still suggest favoritism or a conflict of interest, even if the children obtained no "direct or indirect" material benefit benefit from the transaction.  Second, a director, executive officer or family member may sometimes obtain an indirect material benefit as a result of a relationship with a supplier or vendor but the board may have incorrectly determined otherwise, either as a result of error or lack of disclosure by the benefiting individual. 

Tomorrow we will discuss this in the context of recent allegations regarding Wal-Mart and the employment relationship of the president and CEO's son.