New Related-Party Disclosure To Trip Cos.?

With the Securities and Exchange Commission’s new disclosure rules taking effect next month, companies need to pay particular attention to changes to the disclosures they will have to make about related-party transactions, experts warn.

As a result of these new rules, observers note that stockholders will have greater visibility into the existence of relationships between directors and companies.

“These are not new concepts, but companies need to be aware so they don’t get tripped up on it,” says Ronald Mueller, a partner at law firm Gibson, Dunn & Crutcher.

In particular, companies ought to pay close attention to disclosures required under the new Item 407 of Regulation S-K and revised Item 404 of the same regulation.

What 407(a) Will Do

Under the new Item 407(a) of Regulation S-K, companies now will be required to disclose any transactions or relationships with directors—even immaterial ones—that were considered by the board in determining “independence.” That small change has the potential to “significantly expand” disclosure relating to director independence, notes Lisa Kunkle, partner at the law firm Jones Day.

Kunkle

“It could theoretically go so far as to require the disclosure of immaterial transactions such as retail purchases by directors of company products, depending on how a company structures its policies,” she says.

Whether companies will have to disclose more depends on the company and the board, and whether any relationships actually exist. “Some companies may not have any relationships at all with board members, or may already prohibit them,” Kunkle says.

For some companies, Mueller says, the new rules will bring a greater level of attention to this area, both internally and externally. He notes that the elimination of Item 404(b) of Regulation S-K—which previously was the SEC’s independence standard—also means the loss of an SEC interpretation under that item that said that the types of relationships covered under 404(b) didn’t have to be analyzed separately under 404(a).

“This is one of the big issues we’re advising companies to raise with their directors so directors are aware of the heightened disclosure and scrutiny that will arise from their relationships,” he explains. “The effect of the new rules is to say that there’s no de minimus disclosure threshold.”

Companies will do the same independence assessment they’ve always done under stock exchange-listing standards, he says, “but they’ll also have look at them with eye toward whether the relationship should be disclosed under 404(a) or referred to under 407.”

Julie Bell, a lawyer with the firm Hogan & Hartson who previously served as special counsel in the SEC’s Division of Corporate Finance, says issuers had voiced concerns about the “potential for extensive detail about these types of transactions” when the rule was first proposed. That prompted the SEC to add a proviso in the final version saying companies can disclose the relationship or transaction by “specific category or type,” allowing for more generic disclosure.

Bell

Still, Bell says, the instruction to 407(a)(3) says the specific category or type of transaction must be provided “in sufficient detail so that the nature of the transaction is ‘readily apparent,’ which seems to somewhat undercut the proviso.” Bell calls the language “a backdoor” to get additional disclosure relating to directors’ related-party transactions with the company via 404(a).

Kunkle says the SEC may be trying to simplify confusion surrounding the use of “categorical independence standards” to avoid disclosure, by requiring disclosure of all relationships and transactions considered when determining independence.

Under New York Stock Exchange independence rules, companies must identify independent directors and disclose the basis for a board’s determination that a director relationship with the company isn’t material. The rules allow companies to adopt categorical independence standards, and, as long as a director meets those standards, the disclosure of specific relationships isn’t required.

Kunkle says some companies have adopted categorical standards designed only to meet the minimum criteria established by the NYSE, to avoid disclosure of all relationships with directors ultimately determined to be independent. However, she notes that the exchange has “indicated that it may not be appropriate for a company to categorically claim a director as per se independent if he or she meets the bright-line independence standards established by the NYSE.”

Will Shareholders Start To Second Guess Director Independence?

Experts note that a corporate concern about the new disclosure is that it will lead to second-guessing by shareholders about director independence.

“This seems like a way to give shareholders the ability to judge in their own minds whether a director is independent,” Bell says. “It may also give them the ability to second-guess board independence determinations.”

REMINDER

The deadline for complying with the SEC’s new and amended rules is fast approaching.

Companies must comply with these disclosure requirements in Form 8-K disclosures for triggering events that occur on or after Nov. 7, 2006, and in Forms 10-K and 10-KSB for fiscal years ending on or after Dec. 15, 2006. Companies other than registered investment companies must comply with these disclosure requirements in Securities Act registration statements and Exchange Act registration statements (including pre-effective and post-effective amendments), and in any proxy or information statements filed on or after Dec. 15, 2006 that are required to include Item 402 and 404 disclosure for fiscal years ending on or after Dec. 15, 2006. Registered investment companies must comply with these disclosure requirements in initial registration statements and post-effective amendments that are annual updates to effective registration statements on Forms N-1A, N-2 (except those filed by business development companies) and N-3, and in any new proxy or information statements, filed with the SEC on or after Dec. 15, 2006.

Source

SEC’s Final Rules On Related-Party Disclosures (Page 2)

Another worry, Mueller says, is “that this will be aggravated even more in a litigation context.” For example, if a company discloses that three directors were on a special committee, plaintiffs’ lawyers or reporters might “cast aspersions on whether those three directors are objective enough to serve on that committee if they have business dealings with the company,” he says.

To prevent that, he says, companies may want to consider having procedures in place to identify on a real-time basis during the year these related party transactions, not wait until the end of the year when they’re preparing their proxy.

Mueller

“They need to monitor for them during the course of the year both for disclosure and for independence purposes, and it can be a messy issue because of the extension of the rules applying to family members,” Mueller says. “We’ve heard some corporate secretaries say they’re following the wedding announcements in the New York Times to watch in case a director’s child gets married and the ‘immediate family’ otherwise expands.”

Kunkle says companies should re-examine all relationships and transactions between them and their directors and be prepared to disclose them, but adds that they may want to filter out “ordinary-course transactions,” such as retail purchases of company products, that might not be appropriate for director-level considerations.

“If a company adopts—in their related-party policy or elsewhere—a filter so that the board isn’t considering immaterial relationships in its independence determinations, disclosure of those relationships may not be required,” under 407(a), Kunkle says.

Bell advises companies to be cautious. In addition to reviewing transactions to determine whether they need to be disclosed under 404(a), “they also have to keep documentation of all relationships that were considered by the board because they may have to be disclosed under Item 407(a)(3).”

Bell says the rule confusion is “continued evidence that the devil is in the details on the new disclosure requirements. As companies get in the weeds on the requirements, there may continue to be surprises.”