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What is a Related Party Transaction?

Mary McMahon
By
Updated May 16, 2024
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A related party transaction is a business-related transaction conducted between two parties that have a relationship with each other. This relationship gives one party the transaction control or influence over the other. Such transactions are legal, but they can create conflicts of interest and there are certain circumstances where they will not be allowed. Companies that are publicly traded are required to disclose related party transactions on their financial statements.

For companies with a legal requirement to disclose, a related party transaction can occur between a company and a major shareholder, officer, director, or family member of any of the previous. Special relationships are enjoyed between companies and people in all of these classes. Companies usually assemble panels to make decisions about proposed related party transactions to determine whether or not a transaction is legal and justifiable.

Things considered when making a decision about a related party transaction include the benefit to the company, as well as the other party, along with the value of the transaction and the nature of the transaction. If the company suspects that a conflict of interest may be created, such as when it is prepared to contract with a vendor in a related party transaction without considering prices at other vendors, it will not go through with the transaction. Likewise, if transactions appear to be illegal business practices, the company will not move forward. Companies also want to avoid scandals and thus, may opt to vote down a proposed transaction even if it is legal, if they feel that people may suspect impropriety.

If the panel determines that a related party transaction is legal and in the best interests of the company, it can give the approval for the transaction to be conducted. There are certainly cases where a related party transaction offers the best deal for the company and is beneficial for shareholders as well. Information about the transaction is recorded in accounting notes on the company's books so that people reviewing financial statements can clearly understand the nature of the transaction.

Companies without reporting requirements are free to engage in related party transactions. Small businesses often take advantage of deals offered by people with whom they enjoy relationships, and return the favor by hiring and promoting these people. These practices are sometimes criticized, especially in small communities where it can be difficult to break into certain areas of the business community as a result of entrenched habits and practices.

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Mary McMahon
By Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a SmartCapitalMind researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

Discussion Comments

By parkthekarma — On Oct 15, 2011

I don't have a problem with this kind of transaction in a privately held business. They put the money and time into it, they can do business with people of their own choosing.

In a public company, however, shareholders have to really take a look at the business relationships of their company. This can be really hard if the company is large, because it will have so many different transactions going on. You have to be on the lookout for "sweetheart deals" where the principals are making money at the expense of the shareholders, and possibly also inflating the stock price.

This happened at a former employer of mine. They cut a backroom deal with another company to sell goods and services to each other in such a way that they basically just passed the same money (and it was millions of dollars) back and forth. One of the companies was public, and their stock shot up on the false numbers. Thousands of shareholders, many of them employees, ended up holding the bag when they got caught and the stock tanked.

By Nepal2016 — On Oct 14, 2011

The extreme example of this is a family business. These types of businesses can be really hard for a non-relative to get hired, and definitely to get promoted.

I used to work as a computer technician, and one of our customers was a small, high-end industrial machinery sales place. They didn't have more than about 40 employees or so, but more than half the managers had the same last name as the company. They also did a lot of their business with a supplier owned by another relative. It was next to impossible for anyone not part of the family to get a serious promotion or become part of their supply chain.

There is nothing wrong with this. In fact, it's admirable (and rare) these days to take care of your own. But it is something to keep in mind when deciding where to work.

By winslo2004 — On Oct 14, 2011

This kind of transaction is really common in real estate, which makes sense. Especially in small towns and upscale communities, the society can be somewhat closed. Someone with connections can network effectively and get the house sold. This can also ease any reservations the homeowners may have about selling their house to an outsider.

Real estate is the perfect business for this, because selling and buying a house is such a personal transaction. It makes sense to use someone you know and trust. They industry is not subject to SEC or other regulation, so there is no ethical problem.

Mary McMahon

Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a...

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