Public companies are required to disclose related party transactions in their filings with the Securities and Exchange Commission (SEC) in order to inform investors of potential conflicts of interest. The disclosure requirements apply to transactions exceeding an amount of $120,000 in which the company is a participant and a related person has a material interest. The disclosure rules for related party transactions are set forth in Item 404 of Regulation S-K, a regulation under the Securities Act of 1933 that details public company reporting requirements.

Related persons are defined under Item 404(a) of Regulation S-K to include directors, director nominees, executive officers, or shareholders with a 5% or greater ownership stake in the company. The related persons definition also captures the immediate family members of these individuals. An immediate family member is defined broadly to include any spouse, child, stepchild, parent, stepparent, sibling, mother-in-law, father-in-law, daughter-in-law, son-in-law, sister-in-law, or brother-in-law.

Related party transactions falling under the scope of Item 404 must be disclosed since the beginning of the company’s previous fiscal year in a company’s Form 10-K annual report or proxy statement. For SEC registration statements, disclosure of related party transactions is required for the previous three fiscal years.

Item 404(d) contains special requirements for smaller reporting companies. A company qualifies as a “smaller reporting company” if it meets one of two criteria: (i) has a public float of less than $250 million or (ii) it has less than $100 million in annual revenues and a public float of less than $700 million. Under Item 404(d), smaller reporting companies are required to disclose related party transactions for the past two fiscal years, regardless of whether the information is included in a registration statement, annual report, or proxy statement.

Related party transactions are only required to be disclosed if the related person has a “material interest” in the transaction. Materiality is defined based on the standards set forth in two Supreme Court cases, TSC Industries v. Northway and Basic, Inc. v. Levinson. These cases state that the materiality of a related party transaction depends on the significance of the information to a reasonable investor’s investment decision based on the particular facts and circumstances involved. In other words, there must be a substantial likelihood that a misrepresentation or omission of the information would have been viewed by a reasonable investor as altering the total mix of information.

There have been a number of SEC enforcement cases for inadequate disclosures about related party transactions. For example, the ride-hailing company Lyft agreed to pay a civil penalty to the SEC to settle allegations that it failed to disclose a related party transaction in its Form 10-K annual report for 2019. The SEC’s order claimed that a Lyft director arranged for a shareholder to sell its shares to an investment vehicle. The director subsequently arranged for another shareholder to purchase the shares from the investment vehicle. The director received millions of dollars in compensation for his role in facilitating the transaction. The SEC claimed that the director was a related party in the transaction, given his material compensation and board position, and that Lyft was a participant in the transaction and received material benefits.

In order to avoid potential violations of the SEC disclosure rules under Item 404, public companies should regularly review their Related Party Transaction Policy and make sure that key individuals at the company fully understand the disclosure requirements. Directors, director nominees, and executive officers should also be made aware of the fact that they have an affirmative obligation to inform the company of potential related party transactions.