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A public company and its shareholders (although certain of such transactions must be reported on Form 4, pursuant to Rule 16a-3(f)). To the extent that an exemption exists from the reporting requirements of Section 16(a) in respect of any transaction in a security, the short-swing profit recapture provisions of Section 16(b) likewise do not apply to such transaction (see Rule 16a-10). Rule 16a-10 does not apply in the reverse; an exemption from the short-swing profit recapture provisions of Section 16(b) does not automatically provide an exemption from the reporting requirements of Section 16(a). An insider must file Form 4 with the SEC and with each national securities exchange on which any security of the company is listed within 10 days of the end of each month in which any reportable change in position occurs with respect to any security as to which it has a direct or indirect pecuniary interest. Every transaction during such month must be reported, even if acquisitions and dispositions during such month even out. For purposes of beneficial ownership, a person can be deemed to own beneficially not only securities owned directly by such person but also securities underlying derivative instruments convertible into or exchangeable for securities. For example, the holder of an option convertible into securities within 60 days will be deemed, for the purposes of Section 13(d) (and determining a person’s status as an insider under Section 16(a)), to indirectly beneficially own the underlying securities, whether or not the option has been exercised. Thus, derivative securities owned by an insider that are, within 60 days, convertible into or exercisable for more than 5% of a security will create a reporting obligation under Section 13(d) with respect to the underlying securities. If such derivative securities are, within 60 days, convertible into or exercisable for more than 10% of a security, such holder will also be deemed an insider of the company of such security subject to the reporting obligations under Section 16(a). 7.5 Related party transactions Cleary Gottlieb Steen & Hamilton LLP It is not uncommon, pre-IPO, for the company to do business informally with family members or without giving due consideration to whether certain transactions are done on an arm’s-length basis. Once the company conducts its IPO, however, it needs to be careful about so-called “related party transactions” because they can present potential or actual conflicts of interest and create the appearance that decisions are based on considerations other than the best interests of the company and its stockholders. Definition: The SEC defines a “related party transaction” as: • any individual or series of transactions, including any financial transaction, arrangement or relationship; • in which the company participates; • where the amount involved exceeds $120,000; and • in which any related person had or will have a direct or indirect material interest. A “related person” includes: • any director or executive officer of the company; • any nominee for director, if the information is being provided in a proxy statement; • any beneficial owner of more than 5% of any class of the company’s voting securities; and • any immediate family member of the people listed above (i.e., any child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brotherin-law or sister-in-law of such people) and any person. other than a tenant or employee, sharing the household of such people. Reasons for concern: The company should care about related party transactions for a number of reasons: • It makes good business sense—Related party transactions may involve terms that are not as competitive as might otherwise be achieved, preventing the company from best accomplishing its financial or strategic goals. • Some related party transactions are prohibited—Under the securities laws, the company is prohibited from making loans to directors or executive officers. Any such loans would have to be unwound prior to the company’s IPO. Other related party transactions can cause a director not to be considered independent for service on the company’s compensation or audit committee for tax or securities law purposes. • Stockholders care—Related party transactions signal a possible conflict of interest to investors. They can call into question whether the company puts the best interests of the company and its stockholders first, tarnishing the legitimacy of management and damaging valuation of the company’s securities. • The SEC cares—The SEC considers disclosure regarding related party transactions as integral to a materially complete picture of financial relationships with the company. As a result, securities regulations require detailed disclosure on these transactions in proxy statements, annual reports and registration statements, including Form S-1. The disclosure must cover such information as the name of the related person and the basis on which the person is a related person, the related person’s interest in the transaction with the company, the approximate dollar value of the transaction and any other information regarding the transaction that is material to investors in light of the circumstances of the particular transaction. • Stock exchanges care—The listing rules of the various stock exchanges require the company to think carefully about related party transactions. For example, under NASDAQ rules, an independent body of the company’s board of directors must conduct ongoing review and oversight of all related party transactions for potential conflict-ofinterest situations. Similarly, the NYSE recommends a similar process and also 78 NYSE IPO Guide
A public company and its shareholders requires listed companies to adopt a code of business conduct and ethics for directors, officers and employees that address conflicts of interest. • Auditors care—Auditors are obligated to have sufficient understanding of the company’s business activities to assess whether the company’s disclosures on related party transactions are adequate. Accounting requirements dictate certain disclosures about related party transactions. Audit rules set forth specific auditing procedures on how to determine the existence of related parties and transactions with them, how to examine identified related party transactions and how to respond to management’s representations that a transaction was consummated at arm’s length. These audit procedures are quite detailed and can involve a review of the company’s board minutes, proxy information and other material filed with the SEC, stockholder listings and other potential sources of information. How to deal with the issue: The company should develop policies and procedures for the review, approval or ratification of related party transactions. Clear policies are essential to provide directors and officers with guidance on related party transactions and how the company will deal with them. Although the securities laws do not mandate the specific features of the policy, they require disclosure of it in certain filings and suggest that it may be appropriate to include the following: • Types of transactions covered by the policies and procedures—The company should consider what makes most sense given its business requirements, corporate structure and operating style. Also, it pays to be aware of “hot-button” issues when describing the types of transactions covered. For example, the SEC is especially sensitive about transactions involving family members, so the company may consider developing a nepotism policy. • Standards to be applied pursuant to the policies and procedures—Policies should hold all related parties to the same standards as third parties. Although there may be situations where a limited market makes it difficult to establish what the terms and manner of settlement of a particular transaction would be with a third party, the company should nevertheless attempt to set forth objective business criteria against which the related party transaction can be reviewed. • The persons (or groups of persons on the board of directors or otherwise) who are responsible for applying such policies and procedures—The company should consider the board committee responsible for administering the policy. Usually the audit committee is charged with this task, but it may also make sense for the nominating and corporate governance committee to be responsible for matters relating to directors. Also, the company should establish when the responsible persons will review related party transactions. Although subsequent review may be acceptable, best practice mandates prior review. In order to enable board members or delegates to make informed advance decisions on related party transactions, company procedures need to ensure that the information presented to them is sufficient in scope and quality: • Sources of information—The first source of information should be the related parties themselves. For example, an annual questionnaire distributed to directors and officers should capture basic information about transactions between directors and officers, their family members and the company. Furthermore, directors and officers should have an ongoing obligation to inform the company in advance of any potential related party transaction and to provide updates of parties related to them, their employment and relationships with charitable organizations. The company may also consider instituting independent information-gathering procedures, which may include periodic review of news articles or Internet searches. • Application of information—The company may consider developing a related party master list to be distributed, with any updates, to the relevant members of management such as the CFO and business unit and department leaders responsible for purchasing or selling. The company may also develop a “watch list” of potentially related persons, using the sources of information described above to check whether their status changes. Tasks: In preparing for the IPO, the company and its lawyers should do the following: • Review both existing related party arrangements and any plans for new ones as soon as possible. Consider the impact of such arrangements on disclosure and governance standards. • Identify arrangements between officers, insiders and their close relatives on the one hand, and the company on the other; these arrangements will generally have to be disclosed. • Confirm that the compensation committee approves all elements of compensation paid to executive officers. Compensation exceeding $120,000 paid to executive officers must be disclosed if not approved (or recommended for approval) by the compensation committee or a group of independent directors performing that function. • Unwind loans to directors and officers before the initial IPO registration statement is filed with the SEC. • Develop written related party transaction policies and procedures. If the company already has a code of conduct or other policies addressing this issue, it may be preferable to integrate related party transactions policies with such existing policies. Although the securities laws do not require that policies and procedures be in writing, best practice mandates written policies. 7.6 Share ownership mechanics Morrow & Co., LLC (a) Types of share ownership Shareholders can be divided into two broad groups: “registered” holders and “beneficial” holders. A registered holder NYSE IPO Guide 79
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