What Is a Related-Party Transaction?
A related-party transaction is a deal or arrangement between two parties who are joined by a preexisting business relationship or common interest. For example, a contract between a major shareholder of a corporation and that corporation, agreeing that the shareholder's company will renovate the corporation's offices would be a related-party transaction.
Companies often seek to secure business deals with parties with whom they are familiar or have a common interest. Although these types of transactions are legal, they potentially could create a conflict of interest, or lead to another situation that is illegal. So sometimes related-party transactions must be approved by management consensus or the company’s board of directors.
Understanding Related-Party Transactions
In the United States, securities industry regulatory agencies help to ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively.
The Securities and Exchange Commission (SEC) requires that publicly traded companies disclose all transactions with related parties—such as executives, associates, and family members—in their quarterly reports (form 10-Q) and annual reports (form 10-K). As such, many companies have compliance policies and procedures in place for documenting and implementing related-party transactions.
The Internal Revenue Service (IRS) also examines related-party transactions for any conflicts of interest. If it finds conflicts, then the IRS will not allow any tax benefits claimed from the transaction. In particular, the IRS scrutinizes property sales between related parties and deductible payments between related parties.
The Financial Accounting Standards Board (FASB), which establishes accounting rules for public and private companies as well as nonprofits in the United States, has set accounting standards for related-party transactions; some of which include monitoring of payment competitiveness, payment terms, monetary transactions, and authorized expenses.
Although there are rules and standards for related-party transactions, they are difficult to audit. Owners and managers are responsible for disclosing related parties and their interests, but if they withhold disclosure for personal gain, the transactions could go undetected. Transactions with related parties may be recorded among similar normal transactions, making them difficult to distinguish. Hidden transactions and undisclosed relationships could lead to improperly inflated earnings, even fraud.
[Important: Related-party transactions must be reported transparently to ensure that all actions are legal and ethical and do not compromise shareholder value.]
Types of Related Parties and Transactions
The most common types of related parties are business affiliates, shareholder groups, subsidiaries, and minority-owned companies. Related-party transactions can include sales, leases, service agreements, and loan agreements.
Why All Related-Party Transactions Are Conflictual
In large corporate situations, public companies are often minority or majority owned by other entities, which may have similar interests because of business commonalities. In these cases, related-party transactions—such as vendor or supplier relationships for the mutual benefit of both companies—may occur naturally and are not problematic.
- A related-party transaction is an arrangement between two parties that have a preexisting business relationship.
- Some, but not all, related party-transactions carry the innate potential for conflicts of interest, so regulatory agencies scrutinize them carefully.
- Unchecked, the misuse of related-party transactions could result in fraud and financial ruin for all parties involved.
An Example of a Related-Party Transaction: The Enron Scandal
In the infamous Enron scandal of 2001, Enron used related-party transactions with "special-purpose entities" to help conceal billions of dollars in debt from failed business ventures and investments. The related parties misled the board of directors, their audit committee, employees, and the public.
These fraudulent related-party transactions led to Enron's bankruptcy, prison sentences for its executives, lost pensions and savings of employees and shareholders, and the ruin and closure of Arthur Andersen, Enron's auditor, which was found guilty of federal crimes and SEC violations.
From this disaster, however, came the Sarbanes-Oxley Act of 2002, which established new and expanded existing requirements for U.S. public-company boards, management, and public accounting firms, including specific rules that limit conflicts of interest arising from related-party transactions.