On May 20, 2020, the Securities and Exchange Commission (SEC) amended its rules governing financial information that public companies (sometimes called “registrants”) must provide in connection with significant acquisitions and dispositions (the “Amendments”).1 The Amendments are aimed at improving for investors the financial information about acquired or disposed businesses, facilitating more timely access to capital and reducing the complexity and costs of preparing the required disclosure.
The Amendments will become effective on January 1, 2021. A registrant need not comply with the Amendments until the beginning of its first fiscal year beginning after December 31, 2020, but voluntary compliance is permitted before that date provided that the Amendments are applied in their entirety from the date of early compliance.
The Amendments primarily:
The Amendments also modify the financial information requirements applicable to acquisitions and dispositions of real estate operations and investment companies. Those modifications are beyond the scope of this update. Unless otherwise noted, references in this update to an “Article” or a “Rule” are to the articles and rules included within Regulation S-X, which, among other things, contains rules for preparing and disclosing acquired business historical financial statements and pro forma financial information in connection with significant acquisitions and dispositions.
Whether an acquisition is considered “significant” under Rule 3-05 is currently determined by using the following tests found in the Rule 1-02(w) “significant subsidiary” definition:
The Amendments revise the Investment Test and the Income Test, but do not make substantive changes to the Asset Test.
Investment Test – Use of Aggregate Worldwide Market Value for Acquisitions and Dispositions: The Amendments change the Investment Test from a comparison to total assets to a comparison to market value, when available. Specifically, they change the Investment Test to a comparison of the registrant’s and its other subsidiaries’ investments in and advances to the tested subsidiary to the aggregate worldwide market value of the registrant’s voting and nonvoting common equity, when available, but this change is limited to measuring significance for acquisitions and dispositions. The SEC’s stated reason for the change is that market value is generally more consistent with fair value than total assets, a book value measure. The Amendments require registrants to use the average of aggregate worldwide market value calculated daily for the five trading days of the registrant’s most recently completed month ending immediately before the earlier of the registrant’s announcement date or the agreement date of the acquisition or disposition. The Amendments retained the existing Investment Test (i.e., the comparison to total assets of the registrant and its subsidiaries) for acquisitions and dispositions where the registrant does not have an aggregate worldwide market value and for the additional purposes for which the Rule 1-02(w) significant subsidiary definition is applicable.
Investment Test – Inclusion of Contingent Consideration: The Amendments change the Investment Test to clarify that, for acquisitions, the registrant’s and its other subsidiaries’ “investments in” the tested subsidiary is the consideration transferred, adjusted to exclude the registrant’s and its subsidiaries’ proportionate interest in the carrying value of assets transferred by the registrant and its subsidiaries consolidated to the tested subsidiary that will remain with the combined entity after the acquisition. The Amendments also indicate that the registrant’s and its other subsidiaries’ “investments in” the tested subsidiary must include the fair value of contingent consideration if required to be recognized at fair value by the registrant at the acquisition date under U.S. GAAP or IFRS-IASB, as applicable. If recognition at fair value is not required, however, it must include all contingent consideration, except contingent consideration for which the likelihood of payment is remote. To the extent that unique facts and circumstances may trigger “significance” when financial statements are not reasonably necessary to inform investors, the SEC referred to Rule 3-13, under which the SEC staff may grant relief from financial statement disclosure requirements upon request if the financial information is burdensome to generate and would not result in disclosure of material information.
Investment Test – Other Changes: The Amendments provide that the registrant’s and its other subsidiaries’ “investments in” the tested subsidiary exclude the registrant’s and its other subsidiaries’ proportionate interest in the carrying value of assets transferred by the registrant to the tested subsidiary that will remain with the combined entity after the acquisition. The Amendments also provide that, in a disposition, the registrant’s and its other subsidiaries’ “investments in” the tested subsidiary equal the fair value of the consideration (which includes contingent consideration) for the disposed subsidiary when comparing it to the registrant’s aggregate worldwide market value or, when the registrant has no aggregate worldwide market value, the carrying value of the disposed subsidiary when comparing it to the registrant’s total assets. In addition, the Amendments provide that the Investment Test is met when net book value of the tested subsidiary exceeds 10% of the registrant’s and its subsidiaries’ consolidated total assets or when the number of common shares exchanged or to be exchanged by the registrant exceeds 10% of its total common shares outstanding at the date the combination is initiated for combinations between entities or businesses under common control.
Income Test – Revenue Component: The Amendments revise the Income Test to add a revenue component to reduce the result that registrants with marginal or break-even net income or loss in a recent fiscal year may be more likely to have tested subsidiaries deemed significant where they otherwise would not. The SEC noted this anomalous result is particularly relevant where it would require separate audited annual and unaudited interim pre-acquisition financial statements of a business if it is significant to the registrant. To satisfy the Income Test under the Amendments, the tested subsidiary must meet both the revenue component and the net income component when the revenue component applies. For purposes of Rule 3-05, the tested subsidiary may use the lower of the revenue component and the net income component to determine the number of periods for which financial statements under Rule 3-05 are required. The new revenue component compares a registrant’s and its other subsidiaries’ proportionate share of the tested subsidiary’s consolidated total revenues (after intercompany eliminations) to such consolidated total revenues of the registrant for the most recently completed fiscal year. The Amendments modify the description of the tested subsidiary’s consolidated total revenue to clarify that consolidated total revenue refers to consolidated total revenue from continuing operations (after intercompany eliminations).
Income Test – Recurring Annual Revenue: The Amendments provide that the revenue component of the Income Test does not apply if either the registrant and its consolidated subsidiaries, on the one hand, or the tested subsidiary, on the other hand, did not have material revenue in each of the two most recently completed fiscal years. The SEC believes this change should allow registrants to determine more easily whether the revenue component applies and, when it does apply, will clarify that all revenues must be included.
Income Test – Use of Absolute Values: The Amendments also provide clarity on the net income component of the Income Test by inserting references to the absolute value of equity in the tested subsidiary’s consolidated income or loss from continuing operations, which the SEC believes will mitigate the potential for misinterpretation that may result from inclusion of a negative amount in the computation. The Amendments also adopt the use of absolute values for calculating average income when the revenue component does not apply and the registrant’s calculated income for the most recent fiscal year is at least 10% lower than the average of such amounts for each of its last five fiscal years.
Income Test – Additional Clarifications and Simplifications: The Amendments revise Rules 3-05(b)(3) and 11-01(b)(3) to clarify that the Income Test may be determined using the acquired business’s revenues less the expenses permitted to be omitted by new Rules 3-05(e) and 3-05(f) if the business meets the conditions in those rules (as described below in this update) and make additional nonsubstantive changes to the net income component in order to simplify the description of the test.
The Amendments revise Rule 3-05 to require up to two years of separate audited financial statements of a significant acquired business, a reduction from the current requirement of up to three years. Under revised Rule 3-05, if none of the significance tests exceeds 20%, then no audited financial statements are required; if any of the significance tests exceeds 20%, but none exceed 40%, then audited financial statements for the most recent fiscal year are required; and, if any of the significance tests exceeds 40%, then audited financial statements for the two most recent fiscal years are required. Explaining this change, the SEC observed that three-year-old audited financial statements, due to their age, are less likely to indicate the current financial condition, changes in financial condition and results of operations of the acquired business.
For acquisitions where a significance test exceeds 20%, but none exceeds 40%, the Amendments changed Rule 3-05 to require unaudited financial statements of a significant acquired business for the “most recent” interim period specified in Rules 3-01 and 3-02 rather than “any” interim period. This change eliminates the need to provide a comparative interim period when only one year of audited financial statements is required. The SEC stated that requiring a comparative interim period when there is no requirement for a corresponding comparative annual period would have limited utility for investors and imposes an additional burden on registrants to prepare such information. For acquisitions where any of the significance tests exceeds 40%, financial statements for comparative interim periods will continue to be required.
The SEC reminded registrants that, regardless of the number of years presented, a registrant must provide any further material information that is necessary to make the required statements not misleading.
The Amendments add Rule 3-05(e) to allow registrants to provide audited abbreviated financial statements in the form of statements of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if the acquired business meets the following conditions:
Additionally, if the acquired business meets the above conditions for use of abbreviated financial statements, the Amendments require such abbreviated financial statements to be presented in accordance with the following parameters:
The Amendments do not address “carve-out financial statements” derived from the financial statements of a larger parent company as issues relating to carve-out financial statements may require unique judgments that the SEC believes are best addressed on the basis of their unique facts and circumstances through the SEC staff consultation process.
The Amendments add Rule 3-05(f) to codify existing practice by companies with oil- and gas-producing activities by requiring disclosures under FASB ASC Topic 932 Extractive Activities – Oil and Gas for a significant acquired business that includes “significant oil- and gas-producing activities” (as defined in the FASB ASC Master Glossary), which may be presented as unaudited supplementary information for each full year of operations presented for the acquired business. Additionally, the financial statements required under Rule 3-05 may consist of only audited statements of revenues and expenses that exclude depreciation, depletion and amortization expense, corporate overhead expense, income taxes and interest expense that are not comparable to the proposed future operations if: (1) substantially all of the revenues of the business are generated from oil- and gas-producing activities and (2) the qualifying conditions and presentation requirements for abbreviated financial statements are met and related footnote disclosures are provided.
The Amendments include changes to update the terminology in and clarify various SEC rules and forms, including amendments to Rule 3-05 and Article 11 to clarify when separate financial statements of a significant acquired business and pro forma financial information are required by:
The Amendments modify Rule 3-05(c) to permit foreign private issuers that prepare their financial statements using IFRS-IASB to reconcile financial statements required under Rule 3-05 for foreign businesses prepared using home country GAAP to IFRS-IASB rather than U.S. GAAP. The Amendments also add Rule 3-05(d) to permit financial statements required under Rule 3-05 of an acquired business that is not a foreign business but would qualify as a foreign private issuer if it were a registrant to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP or, if the registrant is a foreign private issuer that prepares its financial statements using IFRS-IASB, to be prepared on a basis other than U.S. GAAP or IFRS-IASB and reconciled to IFRS-IASB or U.S. GAAP. In circumstances where the registrant presents its financial statements in U.S. GAAP, the pro forma financial information reflecting the acquisition must continue to be presented in U.S. GAAP. The SEC explained that it made these changes to increase the consistency between the basis of accounting used by acquired businesses and foreign private issuers and to permit acquired businesses and registrants to avoid unnecessary costs, such as one-time presentations of U.S. GAAP reconciling information where such information would not be material to investors.
The Amendments revise Rule 8-04 to refer to Rule 3-05 for the requirements relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Rules 8-02 and 8-03. The SEC believes these revisions should ease compliance burdens and clarify the application of rules for smaller reporting companies and issuers relying on Regulation A by focusing them on the provisions of Rule 3-05. The Amendments also expressly permit smaller reporting companies and issuers relying on Regulation A to omit historical acquired business financial statements if the acquired business has been included in the registrant’s results for either nine months or a complete fiscal year, depending on significance, as more fully described below in this update.
As revised, Rule 8-04 continues to require up to two years of acquired business historical financial statements and expressly permits smaller reporting companies to omit such financial statements if the acquired business has been included in the registrant’s results for a complete fiscal year. The Amendments also add references to Rule 8-04 in Rule 3-06 and to Rule 3-06 in Article 8, as proposed, to expressly permit smaller reporting companies to file audited financial statements covering a period of nine to 12 months to satisfy the requirement for filing financial statements for a period of one year for an acquired business.
The Amendments also provide that a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days before the date of the relevant final prospectus or prospectus supplement, rather than 74 days before the effective date of the registration statement as under current Rule 8-04(c)(4).
The Amendments modify Rule 3-05 to eliminate the requirement to include financial statements required under Rule 3-05 for a significant acquired business in registration statements and proxy statements once the acquired business has been included in a registrant’s audited post-acquisition results for nine months if any of the significance tests exceeds 20% but none exceed 40% (i.e., when one year of audited financial statements are required for the acquired business) or for a complete fiscal year if any of the significance tests exceeds 40% (i.e., when two years of audited financial statements are required for the acquired business). The Amendments also eliminate the requirement to include financial statements required under Rule 3-05 in registration statements or proxy statements when they have been previously filed but the acquired business is of major significance.
The Amendments expand the circumstances in which a registrant may use pro forma financial information for significance testing by permitting registrants to measure significance using filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the registrant’s financial statements are required to be filed, so long as the registrant has filed the financial statements required by Rule 3-05 for any such acquired business and the registrant has filed pro forma financial information required by Article 11 for any such acquired or disposed business. When determining significance, the pro forma financial information must be limited to the applicable amounts that combine the historical financial information of the registrant and the acquired business and Transaction Accounting Adjustments (as described below in this update). In addition, the pro forma financial information used to measure significance may only give effect to the subsequently acquired or disposed of business and may not give effect to Autonomous Entity Adjustments (as described below in this update), Management’s Adjustments (also as described below) or other transactions, including the use of proceeds from an offering. Once a registrant uses pro forma financial information to measure significance, however, it must continue to use that approach to measure significance until it files its next annual report on Form 10-K.
The Amendments modify Rule 3-05 to require registrants to provide pre-acquisition historical financial statements in registration statements and proxy statements only for those acquired businesses whose individual significance exceeds 20%. Previously, when the aggregate impact of “individually insignificant businesses” acquired since the date of the most recent audited balance sheet of the registrant exceeded 50%, registrants were required to include audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired in a registration statement or proxy statement, meaning registrants were required to provide audited historical pre-acquisition financial statements for individually insignificant acquisitions.
The Amendments also require registrants to provide pro forma financial information depicting the aggregate effects of all individually insignificant businesses in all material respects when the aggregate impact of individually insignificant businesses acquired since the date of the most recent audited balance sheet of the registrant exceeds 50% significance. Previously, registrants were only required to include pro forma financial information for an acquisition for which financial statements under Rule 3-05 were required. The Amendments also revise Rule 11-01(c) to clarify that the exception to permit the exclusion of pro forma financial information when separate financial statements of the acquired business are not included in the filing will not apply where the aggregate individual impact exceeds 50% significance. In making these changes, the SEC acknowledged that auditors might have a more difficult time providing comfort letters to underwriters in offerings because the historical financial statements for individually significant businesses that will need to be included in pro forma financial information will not have been reviewed or audited. The result is that auditors might need to perform additional work to give comfort to underwriters in these circumstances.
Historically, Article 11 provided that the only adjustments that were appropriate in the presentation of pro forma statements of comprehensive income were those that were directly attributable to the transaction, expected to have a continuing impact on the registrant and factually supportable. Pro forma balance sheets, in contrast, reflected pro forma adjustments that were directly attributable to the transaction and factually supportable (regardless of whether the impact was expected to be continuing or nonrecurring). The Amendments modify Article 11 to replace the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given. The revised pro forma adjustment criteria are broken out into the following three categories:
The Amendments also contain the following conditions relating to the form of presentation of Management’s Adjustments:
Because Management’s Adjustments involve forward-looking statements, the Amendments explicitly provide that any forward-looking information will be expressly covered by the forward-looking statement safe harbor provisions of Rule 175 under the Securities Act of 1933 and Rule 3b-6 under the Securities Exchange Act of 1934.
The Amendments also require explanatory notes to the pro forma financial information to disclose revenues, expenses, gains and losses, and related tax effects that will not recur in the income of the registrant beyond 12 months after the transaction. In addition, the amendments require that pro forma financial information must be appropriately labeled; each transaction for which pro forma effect is required must be presented in a separate column; and, if the pro forma financial information includes another entity’s statement of comprehensive income, that financial information must be brought up to within one quarter, if practical.
Rule 11-01(a)(4) requires pro forma financial information to be included upon the disposition of a significant portion of a business if the disposition is not fully reflected in the registrant’s financial statements. Under the Amendments, Rule 11-01(b) was modified to raise the significance threshold for disposition of a business from 10% to 20%, which is consistent with the threshold at which an acquired business is significant under Rule 3-05, and to conform, to the extent applicable, the tests used to determine significance of a disposed business to those used to determine significance of an acquired business.
The Amendments revise Form 8-K and Article 8 to require smaller reporting companies to provide pro forma financial information in connection with the disposition of a significant business in Form 8-K and, in certain cases, in registration statements and proxy statements when the disposition occurs during or after the most recently completed fiscal year.
In addition, the Amendments revise Rule 8-05 to require that the preparation, presentation and disclosure of pro forma financial information by smaller reporting companies substantially comply with Article 11. This change will also apply to issuers relying on Regulation A because Form 1-A refers to Rule 8-05. Due to this change, in certain circumstances, smaller reporting companies and issuers relying on Regulation A will need to include pro forma financial information for two years when the transaction will be retrospectively reflected in the historical financial statements of smaller reporting companies and issuers relying on Regulation A for all periods presented as required by GAAP.
In addition, Rule 8-05 was amended to require the presentation of pro forma financial information when the conditions in Rule 11-01 exist, which will require smaller reporting companies and issuers relying on Regulation A to provide pro forma financial information for significant acquisitions and dispositions in certain roll-up transactions when such presentation is necessary to reflect the operations and financial position of the registrant as an autonomous entity.
1 See Amendments to Financial Disclosures about Acquired and Disposed Businesses, SEC Release No. 33-10786. The amendments were proposed in Release No. 33-10635 (May 3, 2019).