The Minefield of Related-Party Transactions

Among the accounting scandals that wrecked Wall Street titans like Enron, WorldCom, Adelphia, and Tyco (NYSE: TYC  ) , one of the recurring themes was an all-too-cozy relationship between management and directors and the business that they did. Aside from the outright fraud that was allegedly rampant at many of these companies, so-called "related party transactions" proved to be a major problem. These deals were supposedly conducted at arm's length but ultimately benefited several of the principals involved.

Whether it was loans to directors, lucrative consulting contracts, or real estate deals involving executives, directors, or their family members, the point was the same: The company was using shareholders' resources to favor insiders.

Not all related-party transactions are illegal -- nor even most of them. A 2004 study by RateFinancials found that 40% of all companies in the S&P 500 have some kind of related-party transaction. For example, the general contractor for Gap (NYSE: GPS  ) store construction is owned by the brother of the company's chairman. It's not illegal, but it introduces a potential for conflicts of interest.

Large corporations aren't the only ones engaging in these types of deals. I would imagine it's more prevalent in smaller businesses, since they're generally less covered by analysts, and a family owned and -operated business will necessarily have closer ties. The desire and opportunity to use a known party will be greater. While there can be benefits to such arrangements, such as the level of trust involved when dealing with familiar people, the chance for that closeness to also become a problem grows, too. The line between using a familiar face and exploiting shareholders' resources for personal gain becomes very wide and very gray.

For example, what should investors in Aaron Rents (NYSE: RNT  ) think about the company spending $890,000 last year so that the company president's two sons could become race-car drivers? Or that the firm will be spending as much as $1 million to that end this year?

Sometimes, related-party transactions aren't quite so over-the-top; they often have a seemingly legitimate business relationship. Wireless network developer Wireless Facilities (Nasdaq: WFII  ) announced it was withdrawing from the dicey Mexican market and selling its subsidiaries there. Yet the company they were selling to was a new business created by one of the founders and former CEOs of Wireless Facilities, who would be receiving $18 million. And those subsidiaries? They were run by another brother of the company founders.

Again, there is nothing to suggest that these transactions were anything but aboveboard. Yet they introduce an air of favoritism, not to mention the suspicion of conflicts of interest. The Fool's Bill Mann raised a stink a while back about Parlux (Nasdaq: PARL  ) and its relationship with E Com Ventures (Nasdaq: ECMV  ) , which was owned by Parlux's CEO. A lot of the perfumery's revenue was tied up with the affiliate, and the CEO seemingly stood to benefit most.

The SEC took a brief look at related-party transactions after the accounting scandals, but only addressed one aspect of the plethora of ways that insiders can benefit themselves at shareholders' expense. The SEC ultimately barred companies from making loans to management, since generous and ultimately forgiven loans were a large part of the downfall of WorldCom and Adelphia.

At one time, all related-party transactions had been banned, but that was seen as overly restrictive, and the SEC lifted its prohibition against such deals. Now the SEC needs to step in again, creating a proper definition to divide legitimate transactions from inappropriate ones.

For us investors, it's difficult to separate the two. Wireless Facilities' proxy statements report numerous related-party transactions over the years, including loans and consulting-services payments to and from directors and management. However, those statements all include boilerplate stating that the deals were arm's-length, approved by "disinterested" members of the board of directors.

When I discover such transactions when looking for a company in which to invest, I tend to dig deeper into management's integrity. How many deals are there? Have they grown over time? Are there details provided for the transactions, as well as justifications beyond the typical verbiage that the terms of these deals are just as good as those with unrelated third parties? A dearth of information may mean that management just doesn't care.

If I can't find sufficient validity in these deals, I'll walk away from investing in the company. With so many other worthy investment possibilities, why step into a minefield? Develop your own cozy relationships with companies that don't need to fritter away shareholder resources on favored friends and relatives.

Gap is both aMotley Fool Stock AdvisorandMotley Fool Inside Valuepick, and the reformed Tyco is also an Inside Value selection. Whatever your investing style, the Fool hasa newsletter for you.

Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.

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