Related party transactions describe those that are made between two parties with a common interest or pre-existing business relationship.
Understanding related party transactions
Related party transactions are business transactions where the two parties have some established interest or connection. According to the Securities and Exchange Commission (SEC), these transactions include any transaction, arrangement, or relationship in which:
- The company (or any of its subsidiaries) is or will be a participant, and
- Any related party has or will have a direct or indirect interest.
Related party transactions are commonplace since many companies prefer to conduct business with entities they are familiar with. They tend to be prevalent in business affiliates, subsidiaries, shareholder groups, and minority-owned companies.
Note also that such transactions do not have to involve a direct financial payment. They can include:
- Service agreements.
- The receival of goods, services, or property.
- Guarantees.
- Labor – such as volunteers or employees.
- Professional services offered at a discount or for free.
- The transferral of property (including intellectual property), and
- Purchases, sales, or donations.
Are related party transactions lawful?
Related party transactions are lawful and in most cases do not attract the attention of authorities. Sometimes, however, they do result in conflicts of interest where close associates of the company in question receive preferential treatment.
For public companies in the United States, securities regulators ensure that related party transactions are free from conflicts and do not negatively impact shareholder value. These transactions must be disclosed and approved via management consensus or the company’s board of directors.
Enron and related party transactions
Related party transactions were central to Enron’s now infamous 2001 scandal where the company filed for bankruptcy and various executives received prison sentences.
To hide billions in toxic debt from investors and creditors, Enron utilized related-party transactions in conjunction with off-balance-sheet special-purpose vehicles (SPVs). In this example, the related parties distorted the realities of Enron’s accounting and misled the board of directors, audit committee, employees, and the public.
Enron’s financial collapse precipitated the development of the Sarbanes-Oxley Act of 2002. The act clarified new requirements for public companies, their management, and also public accounting firms in the United States. Among these requirements were specific rules to limit conflicts of interest arising from related party transactions.
Charities and related party transactions
Related party transactions often result in many benefits to charities. But these transactions can also cause conflicts or arrangements that are not in the charity’s best interests.
Consider a charity that needs a new website. One of the firms under consideration for the contract is the nephew of the organization’s CEO. This is identified as a related party transaction and potentially a conflict of interest. Managing this process means that:
- The board of the charity is aware of the relationship between the CEO and the web design company.
- The transaction will be noted in a register with enough information to enable the charity to disclose its relationships as per legal requirements.
- The CEO will not be involved in awarding the contract itself, and
- The board will seek out quotes from multiple web design companies before making a decision. This ensures the cost of the website redesign is near market value and does not harm the charity’s financial position.
Key takeaways
- Related party transactions describe those that are made between two parties with a common interest or pre-existing business relationship.
- Related party transactions are lawful and in most cases do not attract the attention of authorities. Sometimes, however, they do result in conflicts of interest where close associates of the company in question receive preferential treatment.
- Related party transactions were central to Enron’s now infamous 2001 scandal where the company filed for bankruptcy and various executives received prison sentences. Enron used these transactions and special purpose vehicles to hide billions of dollars in debt from creditors and investors.
