SEC amends financial disclosure requirements

Overview

The US Securities and Exchange Commission (the “SEC”) on 21 May 2020 adopted amendments to the financial disclosure requirements for acquisitions and dispositions of businesses by public reporting companies in the United States (“registrants”). The amendments were first proposed in May 2019 and were adopted largely as proposed.

The amendments are intended to streamline the financial disclosure requirements in connection with business combination transactions, improve the financial information available to investors about acquired or disposed businesses, and reduce the complexity and costs to prepare the disclosure.

Under the existing rules, the extent of financial disclosure required in connection with acquisitions and dispositions of businesses by registrants is determined based on the significance of the transaction to the registrant, using three tests set forth in the definition of “significant subsidiary” in the SEC‘s Regulation S-X, which are commonly referred to as the “investment test”, the “asset test” and the “income test”. The application of these tests to particular transactions, and the calculations under the tests, are often technical and complex and sometimes produce anomalous results.

Under the existing rules:

• the “investment test” generally compares the size of the registrant’s investments in and advances to the acquired or disposed business to the assets of the registrant;
• the “income test” generally compares the pre-tax income of the acquired or disposed business to the pre-tax income of the registrant; and
• the “asset test” generally compares the assets of the target to the assets of the registrant.

These three tests are retained in the rules as amended, although the SEC had adopted significant changes to the “investment test” and the “income test” that are intended to reduce the likelihood of anomalous results and assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant. The SEC has also amended the rules to clarify the application of the requirements to real estate operations and registered investment companies, and to codify disclosure requirements for acquisitions of significant oil and gas producing activities.

While the Regulation S-X rules do not by their terms apply in the context of Rule 144A or US private placement offerings of securities, in practice the rules provide important substantive guidance to US counsel, who are often called upon to advise issuers and underwriters as to the materiality of financial statements of acquired or disposed businesses in the context of the preparation of offering documents for issuers with significant acquisitions or dispositions that are either probable or have been completed. Accordingly, the amendments provide useful guidance to counsel involved in Rule 144A and other US private placement offerings.

Background

When an SEC registrant acquires a significant business (other than a real estate operation), Rule 3-05 of Regulation S-X generally requires the registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. The number of years of audited financial information that must be provided depends on the relative significance of the acquisition to the registrant. Under the existing rules, a registrant is required to provide audited financial statements of an acquired business for three years, if significance exceeds 50%, for two years, if significance exceeds 40%, or for one year, if significance exceeds 20% (with the level of significance determined based on the highest outcome of the three significance tests). Similarly, Rule 3-14 requires a registrant that has acquired a significant real estate operation to file financial statements with respect to the acquired operation.

Article 11 of Regulation S-X also requires registrants to file unaudited pro forma financial information relating to the acquisition or disposition. Pro forma financial information typically includes a pro forma balance sheet and pro forma income statements based on the historical financial statements of the registrant and the acquired or disposed business, including adjustments to show how the acquisition or disposition might have affected those financial statements.

Amendments to rules applicable to all registrants

The amendments adopted by the SEC will, among other things:

• update the significance tests in Rule 1-02(w) of Regulation S-X and related rules by:

  • revising the “investment test” to compare the registrant’s investments in and advances to the acquired or disposed business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity, when available (and otherwise retaining the existing investment test, in which case the comparison is to the registrant’s total assets);

  • revising the “investment test” to generally include contingent consideration in the calculation of the registrant’s investments in and advances to the acquired or disposed business;

  • revising the “income test” by adding a revenue component to the existing pre-tax income test – as a result, the revised “income test” generally would not be met unless two separate calculations each exceed the applicable threshold: (i) pre-tax income of the acquired business divided by pre-tax income of the registrant and (ii) revenue from continuing operations (after intercompany eliminations) of the acquired business divided by registrant revenue;

  • note that the revenue component of the “income test” does not apply where either the registrant or the acquired business did not have material revenue in the two most recently completed fiscal years, in which case only the pre-tax income component would be used in the income test;

  • expanding the use of pro forma financial information in measuring significance; and

  • conforming, to the extent applicable, the significance threshold and tests for disposed businesses to those used for acquired businesses.

• amend the definition of “significant subsidiary” to provide a definition that is specifically tailored for investment companies;

• eliminate the requirement for historical financial statements for insignificant businesses, and expand the pro forma financial information to depict the aggregate effect in all material respects of all acquisitions for which financial statements are not required;

• require the audited financial statements of the acquired business to cover no more than the two most recent fiscal years (whereas under the existing rules, financial statements of an acquired business at the 50% significance level were required for the three most recent fiscal years);

• retain the requirement to present financial statements for an interim period subsequent to the most recent annual financial statements, but only require the comparative interim period from the prior year to be presented if two years of annual financial statements are required to be presented;

• permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity (for example, when an acquisition target is a carved-out entity);

• no longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;

• clarify the application and scope of Rule 3-14 regarding real estate operations with respect to:

  • the determination of significance;

  • the need for interim income statements; and

  • special provisions for blind pool offerings.

• amend the pro forma financial information requirements to improve the content and relevance of pro forma financial information; in particular, the amendments replace the existing pro forma adjustment criteria with simplified requirements to show:

  • “Transaction Accounting Adjustments”, reflecting only the application of required accounting to the transaction;

  • “Autonomous Entity Adjustments” reflecting the operations and financial position of the registrant as an autonomous entity if the registrant was previously part of another entity; and

  • optional “Management’s Adjustments” depicting synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given if, in management’s opinion, such adjustments would enhance an understanding of the pro forma effects of the transaction and certain conditions related to the basis and the form of presentation are met.

Additional amendments to rules applicable to “foreign private issuers” and acquisitions of foreign businesses

In addition to the amendments applicable to acquisitions and dispositions by all registrants, the SEC adopted additional amendments intended to reduce the burden of complying with the rules in connection with acquisitions by foreign private issuers and acquisitions of foreign businesses.

With respect to the application of the rules to non-US registrants that are “foreign private issuers”, the SEC amended the rules in order to increase the consistency between the basis of accounting used by acquired businesses and foreign private issuers, as well as to permit acquired businesses and registrants to avoid unnecessary costs, such as one-time presentations of the U.S. GAAP reconciling information where such information would not be material to investors.

Specifically, the SEC adopted amendments to:

• permit foreign private issuers that prepare their financial statements using IFRS-IASB to reconcile financial statements of foreign businesses prepared using home country GAAP to IFRS-IASB rather than U.S. GAAP, because this will provide more comparable information and better facilitate analysis of the financial statements;

• permit acquired company financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify as a foreign private issuer if it were a registrant. In circumstances where the registrant presents its financial statements in U.S. GAAP, the pro forma financial information reflecting the acquisition will continue to be required to be presented in U.S. GAAP; and

• permit an acquired business that would qualify as a foreign private issuer if it were a registrant to reconcile to IFRS-IASB rather than U.S. GAAP when the registrant is a foreign private issuer that uses IFRS-IASB.

Effective date

The rule amendments will be effective January 1, 2021, with voluntary compliance permitted in advance of the effective date provided that public companies adopt the amendments in their entirety.

A copy of the adopting release is here