Related-party transaction disclosures aren’t always obvious

Related-party transactions are often easy to spot:  the company is on one side of a contract, and a director or officer, or a company they control, is on the other side. But some transactions are less obvious.

The SEC recently brought a settled proceeding against John D. Schiller, Jr., the former CEO of Energy XXI Ltd., a now-defunct Nasdaq-listed issuer, for failing to disclose millions in personal loans from companies that did business with EXXI or the owners of those companies. According to the complaint, Schiller sought multi-million dollar loans to avoid margin calls on his highly leveraged stock portfolio. In exchange for the loans, Schiller allegedly arranged for EXXI to direct additional business to those vendors, often on terms that were disadvantageous to EXXI.

In the SEC’s view, EXXI should have disclosed these contracts and the loans as “related-party transactions” under Item 404 of Regulation S-K. Item 404(a) requires disclosure of “any transaction … in which the registrant 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.”

At first blush, neither the vendor contracts nor the loans to Schiller would appear to qualify as related-party transactions. The vendor contracts were between EXXI and an unrelated vendor; there was no allegation that Schiller served as a director or officer of any vendor or that he had any ownership interest in any vendor. The loans were between the vendors (or their owners) and Schiller; EXXI was not a party to the loans and (other than Schiller) was apparently unaware of the loans.

According to the complaint, these contracts constituted “related-party transactions” under Item 404 because “[a]s a result of the loans, Schiller had a material interest in the vendors’ business with EXXI because he received the loans in exchange for future EXXI business or favorable terms of business to the vendors.” In other words, the reportable “transaction” is the undocumented quid pro quo of the CEO’s promise of future business from EXXI in exchange for the personal loans. As CEO, Schiller had the apparent authority to commit EXXI to direct future business to the vendors (a commitment he ultimately fulfilled); the fact that no one else at EXXI was aware of the transaction did not excuse EXXI’s failure to report the transaction.

The key takeaway from this proceeding is that the SEC will read Item 404 expansively, interpreting the terms “transaction,” “interest” and “participant” in a manner that favors more disclosure, rather than less. When crafting directors’ and officers’ questionnaires, public companies should be certain to include broadly-worded questions that seek to elicit the full scope of directors’ and officers’ relationships with third parties with which they do business. Without knowing all the facts surrounding these relationships, public companies may reach the wrong conclusion about the disclosures they should make.

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