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Related Party Transactions
Can Be an Investment Red Flag

By Art Berkowitz and Richard Rampell
August 29, 2002.

What is the difference between these two scenarios?

 The president of your local homeowner's association hiring his brother-in-law to do the maintenance for the organization.
 Enron's Michael Kopper running the partnerships Enron had set up to remove assets and debt off of their books.

Maybe not as much as you think. They are both what accountants call related-party transactions. And both examples ended up in litigation.

Related-party transactions are close relationships between entities or individuals. They aren't necessarily wrong, but because of their delicate nature and the risk of abuse or fraud, they must be carefully scrutinized and usually fully disclosed.

As an investor, you want corporate disclosures to provide a clear and fair picture of the entity's net worth, operations, and cash flow. Related party transactions are important because they have the potential for distorting that information.

The Financial Accounting Standards Board (FASB) Statement No. 57 requires that financial statements include disclosures of material related-party transactions. It goes on to say that if the relationship could result in significant differences from those that would have been obtained if the enterprises were autonomous, the nature of the control relationship shall be disclosed even though there are no transactions between the enterprises (emphasis added).

Many in the accounting profession have interpreted this to mean that the concept of materiality when applied to related-party transactions has a different meaning. If the relationship has the potential to distort the financial information, it should be disclosed, whether or not there are material amounts involved.

This week, Michael Kopper became the first Enron official to plead guilty 1 to illegal activities since the Enron scandal began late last year. Enron's Board of Directors in their investigative report 2 (you need Adobe Acrobat 3 to read the report) stated that they were not aware of Kopper's role in the partnerships. A thorough reading of the related party transaction footnote in the Enron financial statements would give the investor little information to be able to interpret the impact of that relationship. In her famous whistleblower memo 4 , Sherron Watkins cited inadequate explanation of the related party transactions.

But it's not just high-profile cases like Enron that attract lawyers and the lawmen. It is not unusual to find homeowner's associations enmeshed in litigation due to undisclosed related party transactions, too.

Whether you are an investor, analyst, banker, a partner in a small entrepreneurial activity, or a homeowner, you still need to know if the information provided to you represents the true picture of the entity.

There are two major issues related to these transactions:

 Are they proper activities for the organization to be participating in.
 Are they properly disclosed to those who might need (or even want) that information?

Recent corporate scandals involving Enron, Adelphia, and Tyco demonstrate the potential for abusive activity in related party transactions. Companies have used related entities and ambiguous disclosures to hide debt as well as billions of dollars in self-serving transactions. Even when the transactions appear fair to the stockholders, it is difficult, if not impossible, for those who provide the oversight function to know all the implications of the relationship. FASB No. 57 states, "Transactions involving related parties cannot be presumed to be carried out on an arm's length basis."

Enron set up a procedure to examine the fairness of transactions and hired a Big Five accounting firm, other than its main auditor, Arthur Andersen, to review the fairness of those transactions. It still didn't work!

FASB No. 57 goes on to say "Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm's length transactions unless such representations can be substantiated."

The 2000 Enron financial statement actually used that exact phrase!

Whether Arthur Andersen went too far in permitting such disclosures may not be as important as the dangers demonstrated by the very nature of related party transactions.

What does that mean for investors like you and me? We need to watch related party transactions carefully. If we can't determine the nature of the related party transactions, that might be a red flag. Who knows if revenue or expenses that are currently the responsibility of some other individual or entity might some day fall on us? The Adelphia scandal 5 is one example where the related-party transactions came home to roost.

The second major issue is disclosure. In our original example of the homeowner's association, the president may not have felt the need to disclose the relationship because his brother-in-law was doing the maintenance for less than any one else. So how did that transaction end up in litigation?

What one person might perceive as an innocent and perhaps even beneficial relationship, might be viewed by others as an abuse of power. Ask yourself if you would have a problem disclosing the information to the board or even have it printed on the front page of the local newspaper. If you are hesitant because it might be misinterpreted, tell everyone. If you are hesitant to tell others about the relationship, perhaps it should not even be considered.

In light of all the recent corporate scandals, we need to ask if the present related party disclosure rules go far enough. We don't think they do.

Here are some suggestions:

 Disclose the relatives of management who are on the payroll, including what they do for the company.
 Disclose transactions with vendors who are related to management.
 Disclose management transactions with investment bankers who do business with the company (certain investment bankers have been offering key executives 6 hot IPOs in exchange for the company's investment banking business).

The next time your organization or company is thinking of doing business with a board member's relative, you might want to think about how that decision will be viewed by others two or three years down the road.


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