In 2010, Jay joined Company XYZ, a U.S., New York Stock Exchange-listed company in the computer industry, as its executive vice president and chief operating officer. Prior to joining Company XYZ, in early 2000, Jay had invested in Company AB, a closely-held company located in Bermuda that engineers, designs, and constructs alternative widget technology. Currently, Jay holds a 25 percent equity stake in Company AB.
Company AB recently approached Jay and requested that Jay set up a meeting with Company XYZ’s executive leadership team to discuss ways in which the two companies might collaborate on future initiatives. Jay is excited about the synergies between the two companies and the potential to tap into a market not yet explored. However, the question remains whether the impartiality of Jay’s decision-making in pursuing a business partnership is affected, given Jay’s 25 percent equity stake in Company AB and his position as chief operating officer at Company XYZ. As chief operating officer, Jay has a duty of loyalty and is expected to make business decisions with Company XYZ’s best interest in mind, and to exercise business judgment independent of external influences, such as his personal financial interests.
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What Should Jay Do?
A “conflict of interest” is typically defined when an employee’s private interest interferes or has the potential to interfere with the interests of the company. Generally speaking, companies do not approve of an employee’s financial interest in a business partner if the employee’s job duties in any way relate to working or interacting with that partner. If such a conflict of interest occurs, a company would need to determine whether it is able to make any changes related to the employee’s position or its function, so as to remove the conflict. A waiver of a conflict of interest under a public company’s code of conduct that is granted to any director or executive officer would trigger a Form 8-K filing under Item 5.05, as well as disclosure on the relevant stock exchange within four business days of determination of the waiver.
Under Item 404 of Regulation S-K, a “related party transaction” is defined to be any transaction since the beginning of the last fiscal year or currently proposed, in which the company was or is to be a participant and the amount involved exceeds $120,000, and in which any “related person” had or will have a direct or indirect material interest. (“Related person” includes a company’s directors, executive officers, 5 percent stockholders, director nominee, and immediate family members. See Instruction 1 to Item 404 of Regulation S-K.) Materiality is determined on the basis of the significance of the information to investors in light of all of the circumstances. Several factors should be considered in the materiality analysis, including the relationship of the related person to the transaction, the importance of the interest to the related person, and the amount involved in the transaction. Under the federal securities rules, ownership of over 10 percent of an entity that is a party to the transaction may be a material interest.
A company’s organizational documents, including its board committee charters, code of conduct, and governance guidelines, also help determine the appropriate approval process, approach, and disclosure process related to these types of transactions.
Back to the Hypothetical
Jay contacted Company XYZ’s general counsel to review the matter. The general counsel noted that Company XYZ’s code of conduct provides the disclosure of any potential “conflicts of interest” to the Ethics Committee and/or a member of the Audit Committee. The code of conduct also provides that the Ethics Committee must review disclosure of a “related party transaction” and determine if a waiver of the code is required.
The Ethics Committee at Company XYZ deliberated whether Jay’s investment in a potential business partner would be deemed a conflict of interest. The Ethics Committee reviewed the facts and circumstances including Jay’s role and job responsibilities as chief operating officer. However, despite the potential interference associated with Jay’s job responsibilities at Company XYZ and his pecuniary interest at Company AB, the Ethics Committee concluded that based on Jay’s passive investment in Company AB, as well as the initial stage of the discussions, a waiver at this juncture would be too premature. The Ethics Committee did however outline the precise steps that should be taken to avoid any conflicts of interest that might arise in the discussions, including the absence of Jay from any business meetings between the two companies and disclosure of the potential conflict to Company XYZ’s executive leadership team, as well as its chairman of the board. In addition, the Ethics Committee noted that it would revisit its decision should the discussions elevate to a more definitive business partnership or arrangement between the two companies.
In addition to review and clearance by the Ethics Committee, Company XYZ’s corporate governance guidelines required the Nominating and Corporate Governance Committee to review and approve all “related party transactions.” Accordingly, should a more definitive business partnership develop between the companies into an actual transaction that meet the requirements of a “related party transaction,” the Nominating and Corporate Governance Committee would need to formally approve such transaction.
In terms of disclosure requirements, if the transaction was deemed a “related party transaction,” Company XYZ would be required to include disclosure in its Forms 10-K and 10-Q for as long as such transaction affected the financial statements. (See Financial Accounting Standard 57 and Rule 4.08(k) of Regulation S-X.) Disclosure may also be required in Company XYZ’s registration statements and proxy statements to the extent not previously incorporated by reference.
In sum, when weighing the benefits of a future business strategic partnership, companies should be mindful of the ethics implications and seek to involve all key constituencies to outline a clear roadmap from a legal, board governance, and operational perspective to avoid any potential issues.