The SEC and the Courts’ Cooperative Policing of Related Party Transactions
Posted: 2 Sep 2013
Date Written: September 1, 2014
A transaction between a corporation and its director or officer (a “related party transaction”) presents conflicts of interest that could harm, or alternatively, could also benefit the corporation. To sort beneficial related party transactions from detrimental ones, the current legal regime relies on both ex ante screening and ex post litigation. Disclosure plays an essential role in both stages. Based on a set of hand-collected data on actual disclosures from Fortune top fifty companies, this Article casts doubt on the effectiveness of the current regulation of related party transactions. The ambiguity of the federal securities regulations leaves too much room for manipulation. An approving committee of each company exercises considerable discretion not only over which proposed transactions to approve, but also over which transactions to disclose to its shareholders and what information to include in the disclosures. In the context of state corporate law, uncertainty exists in fiduciary duty of loyalty litigation regarding when and whether a court should bypass the fairness test and apply the business judgment rule to a related party transaction that satisfies certain safe harbor conditions, such as approval by disinterested directors. This Article proposes a fix by linking the strategic disclosure problem to the question of the applicable standard of review in fiduciary duty of loyalty litigation. To that end, the court should consider a disclosure under federal securities law as a strong signal of fairness of the disclosed transaction and be more willing to apply the business judgment rule rather than the fairness test in state duty of loyalty litigation. Potential benefits of the proposal include creating better incentives to disclose related party transactions, giving litigants more predictable rules, and allowing for richer accumulation of disclosure data over time, thus providing better guidance to companies and market participants in distinguishing between beneficial and harmful related party transactions.
Keywords: related party transactions, conflicts of interest, duty of loyalty, disclosures, independent directors, Item 404
JEL Classification: K22
Suggested Citation: Suggested Citation