On May 3, 2019, the Securities and Exchange Commission (“SEC”) released newly proposed amendments to the financial disclosure requirements for acquired and disposed businesses and other related rules. The proposals stem from the SEC’s Disclosure Effectiveness Initiative whereby the SEC has been reviewing Regulation S-X and Regulation S-K in an effort to revise the regulations. July 29, 2019 is that last day of the 60-day public comment period following the proposed amendments publication in the Federal Register.
The focus of the proposed amendments is the application of Rule 3-05 of Regulation S-X’s financial statement requirement. Generally, when a registrant acquires a business other than a real estate operation, Rule 3-05 requires the registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business. However, this provision only applies if the acquired business is significant to the registrant. The proposed amendments modify the tests used to determine if a business is significant and align other related regulations to the new Rule 3-05.
The following is a summary of the proposed amendments.
Proposed Amendments to Generally Applicable Financial Statement Requirements for Acquired Businesses
Currently, significance is determined by applying three tests. The proposal seeks to modify two of the tests under Rule 1-02(w) of Regulation S-X, the Investment Test and the Income Test. The Investment Test currently compares the registrant’s investment in and advances to the acquired business to the carrying value of the registrant’s total assets. The new Investment Test will compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide marker value of the registrant’s voting and non-voting common equity. The Income test currently focuses on net income alone. The new Income Test will add a revenue component and simplify the calculation of net income by using income or loss from continuing operations after taxes.
The SEC has proposed to revise rule 3-05 to require up to two years of audited financial statements for significant acquisitions, depending on the relative significance, down from the current maximum of three years.
In the event that a registrant acquires net assets that constitute a business, the SEC has proposed to allow registrants to provide audited financial statements of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and tax expenses) if six conditions have been met.
For an acquisition of a business that includes a significant oil and gas producing activities, the SEC has proposed that Rule 3-05 financial statements include the FASB ASC Topic 932 Extractive Activities – Oil and GAS industry specific financial disclosures. Additionally, the Rule 3-05 financial statements may be audited statements of revenues and expenses that exclude depletion, depreciation and amortization expense, corporate overhead expense, income taxes, and interest expense that are not comparable to the proposed future operation is certain conditions are met.
The SEC has proposed to revise Rule 3-05 and Article 11 to specify that financial statements are required if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by Rule 3-01 of Regulation S-X, or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed. Additionally, the revision would clarify that Rule 3-05 applies when a fair value option is used in lieu of the equity method to account for an acquisition because the required disclosure includes summarized financial information or separate financial statements of the business after the acquisition.
For foreign businesses, the SEC has proposed to modify Rule 3-05 to allow financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to allow foreign private issuers to reconcile their Rule 3-05 financial statements using their home country GAAP to IFRS-IASB instead of U.S. GAAP if they already prepare their financial statements using IFRS-IASB.
For smaller reporting companies, the SEC has proposed to revise Rule 8-04 of Article 8 to direct registrants 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 the financials statements, which would still be prepared in accordance with Rules 8-02 and 8-03.
Proposed Amendments Relating to Rule 3-05 Financial Statements Included in Registration Statement and Proxy Statements
The SEC has proposed to no longer require Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements for a complete fiscal year. Additionally, the Rule 3-05 “major significance” exception will be eliminated.
The SEC has proposed to allow registrants to measure significance using filed pro-forma financial information that only depicts significant business acquisitions and depositions consummated after the latest fiscal year-end for which the registrant’s financial statements are required to be filed for all Rule 3-05 and Rule 3-14 financial statements if certain conditions are met. Additionally, Rule 11-01(b)(1) will be revised to clarify that registrants may not include management’s adjustments when using pro-forma financial information to determine significance.
In the event that multiple insignificant businesses have been acquired or will be acquired, the new Rule 3-05(b)(2)(iv) would require disclosure if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the registrant, for which financial statements are either not required or not yet required, exceeds 50%. However, registrants would be required to provide pro-forma financial information depicting the aggregate effects of all such businesses in all material respects and pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.
Rule 3-14 Financial Statements of Real Estate Operations Acquired or to be Acquired
The SEC has proposed amendments to Rule 3-14 to make Rule 3-14 consistent with the proposed amendments to Rule 3-05. Additionally, Rule 3-14 will be amended to define a real estate operation as “a business that generates substantially all of its revenues through the leasing of real property,” mandate that registrants use a modified investment test to determine significance, and specifically require Rule 3-14 Financial Statements for the most recent year-to-date interim period prior to the acquisition.
For smaller reporting companies, the proposed revision to Rule 8-06 will direct registrants to proposed Rule 3-14 for the requirements relating to financial statement disclosures of real estate operations acquired or to be acquired, while still permitting smaller reporting companies to rely on the form and content for annual and interim financial statements provided in Rules 8-02 and 8-03.
For blind pool offerings, the SEC has proposed to add Rule 3-14(b092)(iii) to Rule 3-14 to provide that significance for blind pool offerings shall be computed by comparing the registrant’s investment in the real estate operation to the sum of: (1) the registrant’s total assets as of the date of the acquisition, and (2) the proceeds (net of commissions) in good faith expected to be raised in the registered offering over the next 12 months.
Pro-Forma Financial Information
The SEC has proposed to revise the Article 11 pro-forma adjustment criteria with simplified requirements broken down into two categories: (1) Transaction Accounting Adjustments and (2) Management’s Adjustments. Additionally, Management’s Adjustments would be required to be presented through a separate column in the pro-forma financial information after the presentation of the combined historical statements and Transaction Accounting Adjustments.
The SEC has also proposed to revise the Rule 11-01(b) significance threshold for the disposition of a business from 10% to 20%, to make it consistent with Rule 3-05, along with conforming the significance tests, to the greatest extent possible.
For smaller reporting companies and issuers relying on Regulation A, the SEC has proposed to revise Rule 8-05 to require that the preparation, presentation, and disclosure of pro-forma financial information substantially complies with Article 11. Additionally, the new Rule 8-05 would require the presentation of pro-forma financial information whenever the conditions in Rule 11-01 exist, which would require smaller reporting companies and issuers relying on Regulation A to provide pro forma financial information whenever it is material to investors, regardless of the nature of the underlying transactions.
Amendments to Financial Disclosures About Acquisitions Specific to Investment Companies
The SEC has proposed to add new Rule 1-02(w)(2) to create a separate definition of significant subsidiary for investment companies in Regulation S-X, which would use an investment test and an income test but not an asset test. The proposed Investment Test would be a modified version of the existing Investment Test, so that the comparison would be to the value of the registrant’s total investments rather than total assets. The proposed Income Test would include, in the numerator, the following amounts for the most recently completed pre-acquisition fiscal year of the tested subsidiary: (1) investment income; (2) the net realized gains and losses on investments; and (3) the net change in unrealized gains and losses.
The SEC has also proposed to change the significance threshold for the income test in Rule 1-02(w) as it applies to investment companies. A subsidiary will be significant under the proposed amendment if the test yields a condition of greater than either (1) 80% by itself or (2) 10% and the investment test for investment companies yields a result of greater than 5%.
The SEC has proposed to add a new Rule 6-11 to require only one year of audited financial statements for fund acquisitions, down from the current one to three year requirements of Rule 3-05. To determine whether financial statements of a fund acquired or to be acquired must be provided under proposed Rule 6-11, the conditions specified in the definition of significant subsidy under proposed Rule 1-02(w)(2) would be applied.
The SEC has proposed to remove the requirement to provide pro-forma financial information for investment company registrants in connection with fund acquisitions. The new Rule 6-11(d) would require that investment companies provide supplemental information about the newly combined entity that would include: (1) a pro-forma fee table, setting forth the post-transaction fee structure of the combined entity; (2) if the transaction will result in a material change in the acquired fund’s investment portfolio due to investment restrictions, a schedule of investments of the acquired fund modified to show the effects of such change and accompanied by narrative disclosure describing the change; and (3) narrative disclosure about the material differences in accounting policies of the acquired fund when compared to the newly combined entity.
The SEC has also proposed to amend Form N-14 so that its disclosure requirements are consistent with the disclosure requirements of the proposed Rule 6-11.
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About Maxwell Michael
Maxwell Michael's practice is focused on shareholder merger and securities litigation. Maxwell is an associate in Faruqi & Faruqi, LLP's New York office.