About a year ago, the SEC brought several enforcement proceedings targeting shortcomings in related party transactions disclosures, including by Lyft. The action provides a reminder that Item 404(a) is broadly construed to require a description of transactions since the beginning of the registrant’s last fiscal year in excess of $120,000 in which it was or is to be a participant, and in which a related person had or will have a direct or indirect material interest. When the cases came out, I added related party transactions to my (very long) list of topics worthy of a blog and now is the time.
Item 404 of Regulation S-K sets forth the related party disclosure obligations for domestic companies that must be included in various periodic reports and registration statements under the Securities Exchange Act of 1934 (“Exchange Act”) and in registration statements under the Securities Act of 1933 (“Securities Act”). Foreign private issuers can comply with Item 404 by providing the information required by Item 7.B of Form 20-F plus any additional information required by its home jurisdiction – which I will cover in next week’s blog.
Item 404 – Related Party Transactions
Item 404(a) requires disclosure of any transaction, since the beginning of the company’s last fiscal year, or any currently proposed transaction, in which the company was or is to be a participant and the amount involved exceeds $120,000, and in which any related person had or will have a direct or indirect material interest. As discussed below, the term “participant” is broadly interpreted and is not limited to being an actual party to a transaction.
Disclosure includes:
- The name of the related person and the basis on which they are related.
- The related person’s interest in the transaction with the company, including their position(s) or relationship(s) with, or ownership in, a firm corporation or other entity that is a party to or has an interest in the transaction.
- The approximate dollar value involved in the transaction.
- The approximate dollar value of the amount of the related person’s interest in the transaction, which must be computed without regard to the amount of profit or loss.
- In the case of a debt transaction, the amount involved in the transaction must include the largest aggregate amount of principal outstanding during the disclosure period, the amount outstanding as of the latest practicable date, the amount of principal paid during the disclosure period, the amount of interest paid during the disclosure period, and the rate or amount of interest payable on the debt.
- Any other information regarding the transaction or related person that is material to investors in light of the circumstances of the particular transaction.
SEC interpretations specifically require disclosure of an agreement by the company with a related person to repurchase shares from the related party’s estate with the proceeds of a life insurance policy paid for the by company where the value of the repurchase would be in excess of $120,000.
Related Person
Item 404 defines a “related person” as any person in the following categories during the disclosure period: (i) any director or executive officer of the company (this does not include directors or executive officers of wholly owned subsidiaries unless they are otherwise a related party); (ii) any nominee for director where the disclosure is in a proxy or information statement relating to the election of such nominee; or (iii) any immediate family member of a director or executive officer of the company or of a director nominee where the disclosure is in a proxy or information statement (immediate family member includes any child, stepchild, parent, stepparent, spouse sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, and any person (other than a tenant) sharing the household of the director, executive officer or director nominee). Immediate family member does not include prior family members following a divorce.
Item 404 also defines a “related person” as any person in the following categories when a related party transaction occurred or existed: (i) any 5% or greater shareholder; or (ii) any immediate family member of a 5% or greater shareholder (immediate family member includes the same as listed above). SEC C&DI clarifies that if the transaction occurs prior to the person becoming a 5% shareholder it does not need to be disclosed unless: (i) the transaction is continuing (such as through ongoing payments) after the person becomes a 5% shareholder; or (ii) results in the person becoming a 5% shareholder.
Participant
Item 404 does not define, provide instructions on, or otherwise give guidance as to the meaning of “participant” in a related party transaction and as such we must look to the rule release, SEC enforcement actions and other judicial proceedings. The word “participant” was intentionally used, as opposed to “party to” a transaction to broadly encompass subsidiaries and activities in support of a transaction, whether or not the company is a party.
Being a participant encompasses situations where the company benefits from a transaction but is not technically a contractual party to the transaction. In response to concerns that the concept of a “participant” might be too broad and far-reaching, the SEC offered the following example of a case where disclosure might be required even if the company is not a contractual party: “[d]isclosure would be required if a company benefits from a transaction with a related person that the company has arranged and in which it participates, notwithstanding the fact that it is not a party to the contract.”
In practice, the SEC has interpreted the term “participant” very broadly. As noted in the introduction to this blog, the SEC recently brought an enforcement proceeding against Lyft for failing to disclose a related party transaction where the company helped negotiate a contract and asked for, and received, certain provisions in the contract even though it was not a direct party. The SEC determined that Lyft’s involvement made it a “participant” to the transaction. The particular contract involved the sale of shares by one shareholder to an SPV affiliated with a director. Lyft did not have a material interest in the contract. The case, and other recent proceedings, remind practitioners to take a close look at the facts and circumstances of a transaction to determine if the company could be considered a participant.
Transaction
Item 404 defines a “transaction” to include, but not be limited to, any financial transaction, arrangement or relationship, or any series of transactions, arrangements or relationships.
Amount of Transaction
The amount involved or dollar value of a transaction includes: (i) in the case of a lease or other transaction providing for periodic payments or installments, the aggregate of all periodic payments or installments due on or after the beginning of the company’s last fiscal year, including any optional payments due during or at the conclusion of the lease or other transaction; and (ii) in the case of a debt transaction, the largest aggregate amount of all indebtedness outstanding at any time since the beginning of the company’s last fiscal year and all amounts of interest payable on it during the last fiscal year.
Determining value requires aggregating related transactions or series of transactions. For example, when a company negotiates a transaction, such as a lease, with an unrelated person, but a related person receives a commission on such transaction, the value of the lease would be included in determining whether the related party disclosure threshold is triggered as the commission is directly related to the lease.
Moreover in the case of a debt transaction, the following items may be excluded from the calculation of the amount of debt and need not be disclosed: (i) amounts due from the related person for purchases of goods and services subject to usual trade terms, for ordinary business and travel expense payments and for other transactions in the ordinary course of business; and (ii) amounts involved in debt transactions with a 5% or greater shareholder or their immediate family.
In the case of a debt transaction where the lender is a bank, saving and loan association, or broker dealer extending credit under the Federal Reserve Regulation, and the loans are not disclosed as past due, nonaccrual or troubled debt restructurings in the company’s financial statements, the company may disclose (if true) that the loans: (i) were made in the ordinary course of business; (ii) were made on substantially the same terms, including interest rate and collateral, as those prevailing for comparable third parties loans at the time (third parties must be true unrelated third parties); and (iii) the loans did not involve more than the normal risk of collectability or have other unfavorable features.
SEC C&DI clarify that unexercised, in the money options, are valued by determining the difference between the fair market value of the securities underlying the options and the exercise or base price of the options. Use of the Black-Scholes or binomial option pricing method also would be appropriate, provided that such use and the underlying assumptions are clearly disclosed and the value thus calculated is greater than zero and is otherwise reasonably related to the unrealized gain.
Employment and Compensation Transactions
The instructions to Item 404 provide that disclosure of an employment relationship or transaction involving compensation with an executive officer solely relating to such employment relationship need not be disclosed under Item 404 if: (i) the compensation is disclosed under Item 402 – executive compensation; (ii) the executive officer is not an immediate family member and the compensation would have been reported under Item 402 if the person was a named executive officer during the time that Item 402 disclosure is required, and the compensation is approved by the compensation committee or similar group of independent directors; or (iii) the transaction involves the recovery of erroneously awarded compensation (see HERE for more on the clawback rules).
SEC guidance notes that related party disclosures would be required where the child of a related person works for the company, makes in excess of $120,000, and is not otherwise disclosed in Item 402.
Indirect Material Interest
A person that has a position or relationship with a firm, corporation or other entity that engages in a transaction with a company, will not be deemed to have an indirect material interest in the transaction if: (i) the interest arises only from such person’s position as a director of the other entity; (ii) the interest arises only from the direct or indirect ownership by such person of less than 10% equity interest in the other entity; (iii) the interest arises from both a position as a director and a less than 10% equity interest; or (iv) the interest arises only from such person’s position as a limited partner in a partnership and their interest in the partnership is less than 10% and the person is not a general partner and does not hold other positions with the partnership.
Other Disclosure Exclusions
A related party disclosure need not be provided if: (i) the transaction rates or charges are determined by a competitive bid; (ii) the transaction involves the rendering of services as a common or contract carrier, or public utility, at rates or charges fixed in conformity with law or governmental authority; (iii) the transaction involves services as a bank depository, transfer agent, registrar, trustee under a trust indenture or similar services; or (iv) the interest of the related person arises solely from the ownership of a class of equity in the company and all holders of that class of equity receive the same benefits on a pro rata basis.
A company would not be able to avail itself of the competitive bid exclusion if the related party’s bid was not the lowest and most competitive bid. Further, the competitive bid exclusion requires that the company use formal competitive bidding procedures and not just informally solicit a few bids.
Review, Approval or Ratification of Related Party Transactions
Item 404(b) requires disclosure of the company’s policies and procedures for the review, approval or ratification of related party transactions that are required to be reported under Item 404(a) as described above. Item 404(b) provides a non-exclusive list of examples of the types of information that may be included in policies and procedures including: (i) types of transactions; (ii) standard to be applied; (iii) persons or groups on the board or otherwise who are responsible for applying such policies and procedures; and (iv) a statement as to whether the policies and procedures are in writing or how otherwise evidenced.
Item 404(b) also requires the disclosure of any transactions required to be reported under Item 404(a) since the beginning of the company’s last fiscal year where a company’s policies and procedures did not require review, approval or ratification of the transaction, or where the policies and procedures were not followed.
An Item 404(b) disclosure is not required if the transaction occurred before the related person was a related person as defined in Item 404(a) as described above, and the transaction did not continue when the person became a related person.
Item 404(b) disclosure is required even when there are no reporting Item 404(a) related party transactions to disclose.
Promoters and Certain Control Persons
Item 404(c) provides for additional disclosures related to promoters and certain control persons when a company is filing a Form S-1 under the Securities Act or a Form 10 under the Exchange Act. In particular Item 404(c) requires that a company disclose the following if they have had a promoter at any time during the past five fiscal years:
- The names of the promoters, the nature and amount of anything of value (including money, property, contracts, options or rights of any kind) received or to be received by each promoter, directly or indirectly, from the company and the nature and amount of any assets, services or other consideration therefore received or to be received by the company; and
- As to any assets acquired or to be acquired by the company from a promoter, disclose the amount at which the assets were acquired or are to be acquired and the methodology followed or to be following in determining such amount, and the identity of the persons making such determination and their relationship, if any, with the company or any promoter. If the assets were acquired by the promoter within two years prior to the transfer to the company, also disclose the cost thereof to the promoter.
In addition, Item 404(c) requires the company to disclose the same information as to any person who acquired control of a company that was a shell, or that was part of a group of two or more persons that agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of the shell company.
Smaller Reporting Companies
As is often the case, smaller reporting companies (“SRCs”) have different related party disclosures and a different threshold triggering disclosure obligations. For a refresher on the definition of an SRC see HERE. Although SRC disclosures are usually scaled back, in the case of related party transactions, an SRC generally has additional disclosure obligations. The only scaled back item is that an SRC need not provide the 404(b) information related to the review, approval or ratification of transactions with related parties.
Item 404(d) provides that an SRC must report the six items required by Item 404(a) listed above where the dollar amount involved exceeds the lesser of $120,000 or 1% of the average of the SRC’s total assets at year end for the last two completed fiscal years. An SRC is obligated to disclose the information required for promoters and control persons, to the same extent as non-SRC filers. As an additional disclosure an SRC must disclose all parents, the basis of control, and as to each parent, the percentage of voting securities owned or other basis of control by its immediate parent, if any.
The instructions to Item 404(d) add that where an SRC engages in an underwritten offering and a related party is the principal underwriter or a controlling person or member of a firm that was or is to be a principal underwriter, the SRC must disclose any underwriting discounts or commissions. Moreover, an SRC disclosure obligation includes the current fiscal year and the prior fiscal year.
Extended Disclosure in Registration Statements
Where the related party disclosure is included in a Securities Act or Exchange Act registration statement, the time period for disclosure is extended to include the current fiscal year and last two preceding fiscal years. An exception to this extended time period is where the disclosure is incorporated by reference in an S-4.
NYSE and Nasdaq Rules
Nasdaq Rule 5630 requires that the audit committee or another independent body of the board of directors conduct an appropriate review and oversight of all related party transactions for potential conflict of interest situations on an ongoing basis. Related party transactions include any transactions required to be disclosed by Item 404 or, for an FPI, Item 7.B of Form 20-F.
Section 314 of the NYSE Listed Company Manual requires a company’s audit committee or another independent body of the board of directors conduct a reasonable prior review and oversight of all related party transactions. Further, the NYSE requires that the committee prohibit transaction if it determines the transaction is not consistent with the interests of the company and its shareholders. Related party transactions include any transactions required to be disclosed by Item 404 or, for an FPI, Item 7.B of Form 20-F.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony, Linder & Cacomanolis
A Corporate and Securities Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony, Linder & Cacomanolis, PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALC legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including the American Red Cross for Palm Beach and Martin Counties, Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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