News

New SEC interps regarding Reg S-K, Item 404, Transactions with Related Persons, Promoters and Certain Control Persons

News Brief
March 15, 2007

By Cydney Posner

The SEC has posted some new interps regarding Reg S-K, Item 404, Transactions with Related Persons, Promoters and Certain Control Persons. These interps replace the Item 404 interps in the July 1997 Telephone Interp Manual and March 1999 Supplement. Quite a few of these interps are restatements of prior interps. Notably, however, the new interps do not include any version of the old interp under former Item 404(b), which permitted nondisclosure of transactions between a company and a third party with which a director was affiliated, even if the value of the transactions exceeded the threshold of $60,000 (now $120,000), as long as the relationship was solely a business relationship that did not afford the director any special benefits and the amount involved did not exceed five percent of either the company's or the third party's consolidated gross revenues (the disclosure threshold under former Item 404(b)). Some commentators had hoped that the SEC would retain the interp, even in the absence of Item 404(b), as a way to inform the definition of "indirect material interest." Unfortunately, the interp did not survive in any form, with the result that the scope of disclosure for directors has been substantially expanded.

Item 404 —General Guidance

  • If a public company that is current in its Exchange Act reports files a Form S-1 that does not incorporate information by reference, the company does not have to provide Item 404(a) disclosure for fiscal years ending before December 15, 2006 if the company already provided Item 404 disclosure for these years under the old rules in an SEC filing. The company does not need to "restate" Item 404(a) disclosure under the new rules if the disclosure was previously reported under the old rules.
  • In contrast, a company filing an S-1 for an IPO (or a Form 10 to register a class of securities under the Exchange Act), must provide Item 404(a) disclosure pursuant to the new rules for the period specified in Instruction 1 to Item 404, even for fiscal years ending before December 15, 2006.

Item 404(a) —Transactions with related persons

  • Disclosure is not required of related-person transactions with five percent shareholders that occur prior to the date the person became a five percent shareholder if the transaction concluded before the person became a five percent shareholder. However, disclosure would be required for transactions that occurred prior to the shareholder's becoming a five percent shareholder if the transaction:
    • was continuing (such as through the ongoing receipt of payments) after the date the person became a five percent shareholder; or
    • resulted in the person's becoming a five percent shareholder.
  • For purposes of determining whether the $120,000 threshold of Item 404(a) has been met, a company should value unexercised, in-the-money stock options 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 use of the model and the underlying assumptions are clearly disclosed and the value calculated is greater than zero and is otherwise reasonably related to the unrealized gain.
  • Instruction 4.c.ii. to Item 404(a) provides an exclusion for certain bank or broker loans that are made on substantially the same terms as "comparable loans with persons not related to the lender." The term "persons not related to the lender" means persons with no relationship at all to the lender other than the lending relationship, such as regular customers. Employees are considered related to the lender by virtue of their employment relationship.
  • The term "any immediate family member," as used in Item 404, is defined to include, among others, mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and sisters-in-law and stepchildren and stepparents. For purposes of this item, these relatives are deemed to be:
    • only those persons who are currently related to the primary reporting person (e.g., a person who is divorced from a director’s daughter would no longer be a son-in-law whose transactions must be reported); and
    • only those persons who are related by blood or step relationship to the primary reporting person or his spouse (e.g., the sister of a director’s spouse is considered a sister-in-law for purposes of this item; the sister’s husband, however, is not considered a brother-in-law for purposes of this item).
  • A is an officer and director of Y corporation, a wholly owned subsidiary of registrant X. A is not an officer or director of X and holds only a nominal amount of X’s shares. Y does business in an amount in excess of $120,000 with B, A’s brother. That relationship need not be disclosed in X’s reports under Item 404(a), since A is not a "related person" under the definition in Instruction 1 to Item 404(a).
  • A corporation enters into a lease in an amount substantially in excess of $120,000 with a lessor completely unaffiliated with the corporation. The lease, however, is negotiated through a related person specified in Instruction 1 to Item 404(a), who is paid a commission that is less than $120,000 by the lessor for those services. Since the amount of that person’s commission is dependent upon the value of the lease, that person is considered to have an interest in the lease transaction, and the transaction, together with the commission, should be reported if the interest is determined to be a direct or indirect material interest.
  • Instruction 7.a. to Item 404(a) provides an exception from disclosure for transactions where rates or charges are determined by competitive bids. To qualify for the exclusion, the procedure used must involve the formal procedures normally associated with competitive bidding situations, such as specifications established for the transaction being bid upon as well as indications of the basis upon which a bid was accepted.
    • The instruction would not permit non-disclosure of an equipment lease transaction between a company owned by a director of a reporting company and the reporting company simply because the reporting company solicited proposals from other unrelated persons and selected the director’s company only after an internal analysis of the available terms. The procedure did not otherwise involve the formal procedures normally associated with competitive bidding situations.
    • Y, the President and a director of Z Corporation, a supplier of the registrant, is a member of the registrant’s board of directors. The registrant solicited bids from Z and various other companies on a supply contract involving an amount in excess of the $120,000 threshold of Item 404(a). The registrant plans to award the contract to Z, even though this supplier did not submit the lowest bid in what purportedly was a competitive bidding contest. Under these circumstances, the registrant cannot take advantage of the exclusion in Instruction 7.a. for competitive bidding situations.
  • A contract between a reporting company and the fund manager of the company’s pension plan, who is also a more than five percent beneficial owner under Rule 13d-3, should be disclosed under Item 404(a) where the amount involved in the contract exceeds $120,000.
  • If a director's child is employed by the registrant and receives annual compensation exceeding $120,000, which compensation is not reported under Item 402 since the child is not an NEO or other officer or director, the registrant must disclose the child’s compensation under Item 404(a) as a transaction in which the director has a material interest.
  • An agreement by a company with a related person to repurchase company shares from the related person’s estate upon death with the proceeds of a life insurance policy paid for by the company should be disclosed pursuant to Item 404(a).
  • In connection with a move of company headquarters, a company purchased and resold the homes owned by all affected employees. The price paid was determined by an independent appraiser. The company was permitted by the staff to disclose under Item 404(a) only the general features of the program (including how the price was determined) and the total amount spent by the company on the program.
  • Item 404(a) requires disclosure of nonaccrual, past due, restructured and potential problem loans from banks, savings and loan associations or broker-dealers extending credit under Federal Reserve Regulation T. Instruction 4.c. of Item 404(a) refers to Industry Guide 3, Statistical Disclosure by Bank Holding Companies, for determining if loans are nonaccrual, past due, restructured or potential problem loans. Guide 3 requires disclosure of loans in these categories at the end of each "reported period." In a proxy statement, therefore, where the reported period is the last fiscal year, only those loans which were in these categories at the end of the last fiscal year are required to be reported.
  • A parent and its subsidiary are both Exchange Act reporting companies. Some of the executive officers of the parent may receive a portion of their compensation from the subsidiary corporation.
    • If an executive spends 100% (or near 100%) of his or her time for the subsidiary but is paid by the parent, then the compensation paid by the parent has to be reported in the executive compensation table of the subsidiary.
    • If, however, an allocation of the monies paid by the parent would be necessary because the executive officer splits time between the parent and the subsidiary, the payments made by the parent need not be included in the subsidiary’s executive compensation table.
    • In the event that the subsidiary pays a management fee to the parent for use of the executives, disclosure of the structure of the management agreement and fees would have to be reported under Item 404.
    • Compensation paid by the subsidiary to executives of the parent company must be included in the parent’s executive compensation table if such payments are paid directly by the subsidiary. If the payments are part of a management contract, disclosure of the structure of the management agreement and fees would have to be reported under Item 404.

Item 404(b) —Review, approval or ratification of transactions with related persons

  • A company must include disclosure regarding policies for the review, approval or ratification of related-person transactions under Item 404(b)(1) even when the company does not have to report any transactions under Item 404(a). The disclosure would discuss the policy that would apply if there were 404(a) transactions to report.

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