With all the excitement surrounding the new executive compensation disclosure rules, the SEC’s recent amendments to the requirements for disclosing related person transactions have received less attention. As companies delve deeper into these new requirements, many are discovering that they must change their processes, policies and procedures in order to identify and address any potentially problematic transactions and relationships on a timely basis. 

Item 404 of Regulations S-K and S-B contains the SEC’s requirements for disclosing company transactions with “related persons,” which include the company’s directors, director nominees, executive officers, 5% shareholders, and their respective immediate family members.  Effective for disclosure for fiscal years ending on or after December 15, 2006, the SEC revised Item 404 to make the disclosure requirements more principles-based and to broaden both the class of persons and the types of transactions and relationships requiring disclosure.  In particular, the SEC collapsed into a single, comprehensive requirement now contained in Item 404(a), the detailed requirements previously contained in paragraphs (a), (b) and (c) of Item 404 and the related instructions.

            As amended, Item 404(a):

  • Takes a broad approach to the scope of covered transactions, including any financial transaction, arrangement or relationship in which the related person has a direct or indirect material interest, including indebtedness or guarantees (thus, extending the requirement to disclose related person indebtedness to 5% shareholders);
  • Extends to any transaction or proposed transaction in which the company is a “participant,” even if the company is not technically a “party” to it;
  • Extends the disclosure requirements to transactions involving a person who was, at any time during the last fiscal year, a director, director nominee, executive officer, or their respective immediate family members, even if the person was not such a related person at the time of the transaction;
  • Revises the definition of “immediate family member” to include stepchildren, stepparents and any other person (other than a tenant or employee) sharing the household of a related person; and
  • Increases the dollar threshold for disclosure of a related person transaction from $60,000 to $120,000.

Item 404(a) provides some guidance about transactions or relationships that need not be disclosed.  Item 404(a) does not require disclosure of executive and director compensation that is disclosed under Item 402 of Regulations S-K and S-B.  In addition, a person is not deemed to have a direct or indirect material interest in a transaction because of their relationship with an entity that engages in a transaction with the company if that person’s interest arises only from being a director or limited partner of, or having a less than 10% ownership interest in, the entity involved in the transaction.

In addition, Item 404(b) of Regulations S-K and S-B was amended to require companies to disclose whether they have a policy or procedures for the review, approval or ratification of related person transactions and whether the policies or procedures are in writing.  Companies must describe the material features of these policies and procedures, which may include the types of covered transactions, the standards to be applied, the persons responsible for applying the policies and procedures and, if the policies and procedures are not in writing, how such policies and procedures are evidenced. Companies must also describe any transaction required to be disclosed under Item 404(a) that was not subject to review under the company’s policies and procedures and any instances in which the company did not follow its policies and procedures.

Companies should consider taking the following actions to address the new requirements:

  • Update D&O questionnaires.  The annual D&O questionnaire should be updated to elicit the information needed to comply with the new requirements of Item 404(a) described above. The questionnaire should also be revised to eliminate questions relating to old Item 404(b) and (c).  Item 404(a) provides rules for determining transaction values, which depend on a variety of factors.  As a result, companies may wish to solicit information on all possible transactions involving executive officers, directors, nominees and their immediate family members without regard to amount.  Companies may wish to mirror for executive officers the types of open-ended questions often contained in “independence questionnaires” for independent directors.
  • Adopt a written policy for approving related person transactions.  Companies without a written policy in place for reviewing and approving related person transactions should adopt one.  Companies may have a “conflict of interest” transaction policy in their code of ethics; however, these policies should be reviewed to determine whether they will be sufficient to identify and address transactions or relationships now required to be disclosed under Item 404(a), as well as applicable stock exchange listing standards.
  • Adopt categorical standards for director independence.   Item 407 of Regulations S-K and S-B consolidates and builds on existing disclosure requirements regarding director independence and corporate governance.  Item 407 provides a new requirement that companies disclose, by category or type, any transactions, relationships or arrangements considered by the board when determining the independence of a director that have not otherwise been disclosed under Item 404(a).  Companies that have adopted categorical standards for determining the independence of directors under the NYSE’s corporate governance listing standards will find this disclosure to be consistent with processes and disclosures already in place.  Companies that have not adopted clear categorical standards for types of transactions, relationships or arrangements that are not deemed to be material or affect the independence of their directors may find it more difficult to comply with the new Item 407 disclosure requirement.
  • Develop a “watch list” of potentially related persons.  A company’s ability to determine whether transactions or relationships have been identified on a timely basis for review and approval may require development of a “watch list” for potentially related parties (including immediate family members).  Such a “watch list” may require the company to solicit information from directors and executive officers now, well in advance of D&O questionnaires related to the annual Form 10-K and proxy statement preparation process.
  • Confirm that the compensation committee approves all elements of compensation paid to executive officers.   Compensation exceeding $120,000 paid to executive officers is required to be disclosed under Item 404(a) if not disclosed pursuant to Item 402 or approved (or recommended for approval) by the compensation committee or a group of independent directors performing that function.  Stock exchange listing requirements generally require compensation committee approval (or recommendation) of compensation paid to all executive officers, but companies should make sure that all elements have been so approved.
  • Review the status of compensation committee members under Rule 16b-3 and Section 162(m). The broader scope of Item 404(a) may require companies to disclose transactions with outside directors that were not previously required to be disclosed.  An outside director with a transaction or relationship now required to be disclosed under Item 404(a) may no longer qualify as a “non-employee director” for purposes of Rule 16b-3 or as an “outside director” for purposes of IRC Section 162(m). Companies should review the status of all outside directors to determine their eligibility to serve on the compensation committee.