SEC Proposes Sweeping Amendments to Financial Disclosures Required in M&A Transactions – But at least one SEC Commissioner already hints at objections

On May 3, 2019, the U.S. Securities and Exchange Commission proposed significant amendments to its rules and forms covering financial statement disclosure requirements relating to acquisitions and dispositions of businesses by SEC registrants including public companies.  The proposed changes have the potential for focusing required disclosures on more decision-relevant information for investors, shortening the time period needed for registrants to prepare disclosures necessary to access the capital markets, and generally reducing registrant compliance costs. Among the proposed changes are: reducing the number of years of financials statements required for an acquired business; revising the “significance” tests applicable to business acquisitions and dispositions; and updating the pro forma financial information requirements (including simplifying the requirements to account for synergies and other transaction effects).  The release also contains a number of proposals applicable to oil and gas businesses, acquired real estate operations, investment companies (including business development companies) and to smaller reporting companies. The proposing release is available here.

Although voting to open the proposal for public comment, SEC Commissioner Jackson expressed significant reservations with the cost-benefit analysis of the changes. In prepared remarks (available here) he stated his belief that the proposal “ignores evidence on how corporate insiders use mergers to extract private benefits at investor expense,” and urged commenters to come forward with ways in which the proposal can be improved that would “reflect a more balanced perspective about the implications of mergers and acquisitions for ordinary investors” and to provide “ideas about how this proposal can be improved in ways that will empower investors to hold executives accountable — particularly for those mergers that harm investors over the long run.”

The proposal will be subject to a 60-day public comment period following its publication in the Federal Register.

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When a registrant acquires a business, 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 (“Rule 3-05 Financial Statements”). Up to three years of financial information may be required, depending on the relative significance of the acquired business as determined by applying the investment, asset and income tests provided under Rule 1-02(w) of Regulation S-X (the “Rule 1-02(w) Significance Tests”).

Additionally, a registrant that acquires or disposes of a business is also generally required to file unaudited pro forma financial information relating to the acquisition or disposition as prescribed by Article 11 of Regulation S-X. The pro forma financial information is based on the historical financial statements of the registrant and the acquired or disposed business (including adjustments intended to show how the acquisition or disposition might have affected those financial statements), and typically includes a pro forma balance sheet as of the end of the most recent period for which a consolidated balance sheet of the registrant is required and pro forma income statements for the registrant’s most recent fiscal year and for the period from the most recent fiscal year end to the most recent interim date for which a balance sheet is required. Pro forma financial information for an acquisition is required at the 20% significance threshold and at the 10% significance threshold for a disposition.

Certain Proposed Amendments

The proposed changes would, among other things:

  • Require that the Rule 3-05 Financial Statements of an acquired business cover only up to the two most recent fiscal years, rather than up to the three most recent fiscal years as required under the current rules;1
  • Update the Rule 1-02(w) Significance Tests by
    • Revising the investment test to compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity when available, or otherwise retain the existing test;2 and
    • Revising the income test to add a revenue component3 and to simplify the calculation of the net income component;
  • Update the Article 11 pro forma financial information requirements by
    • Raising the significance threshold for which pro forma financial information for a disposition of business would be required from 10% to 20%, to conform to the significance threshold at which pro forma financial information for an acquired business would be required; and
    • Replace the existing pro forma adjustment criteria with simplified requirements to depict the accounting of the transaction as well as the reasonably estimable synergies and other transaction effects that have occurred or are likely to occur;4 and
  • No longer require Rule 3-05 Financial Statements of an acquired business in registration statements and proxy statements once the business has been included in the registrant’s post-acquisition financial statements for a complete fiscal year.5

Certain Other Proposed Areas Considered for Amendment

The proposing release includes a number of other amendments to the current financial information disclosure requirements, including:

  • Amending Rule 3-05 and Article 11 to clarify when financial statements and pro forma financial information are required, and to update the language to take into account concepts that have developed since adoption of the rules over 30 years ago;
  • Revising the disclosure requirements for individually insignificant acquisitions;
  • Amending and codifying certain financial statement reporting practices applicable to businesses that include oil and gas producing activities;
  • Revising the financial statement requirements of real estate operations acquired or to be acquired to align with those of Rule 3-05 where no unique industry considerations exist;
  • Amending the financial disclosure requirements concerning acquisitions by investment companies, including business development companies;
  • Permitting in certain circumstances Rule 3-05 Financial Statements to be prepared in accordance with IFRS as issued by the IASB without reconciliation to U.S. GAAP; and
  • Making corresponding changes to and simplifying the disclosure requirements applicable to smaller reporting companies and issuers relying on Regulation A.
Endnotes    (≈ returns to text)

  1. The proposed amendments would eliminate the requirement to file the third year of Rule 3-05 Financial Statements for an acquisition that exceeds 50% significance. The amendments would also eliminate the need to provide comparative prior year interim period financial statements when only one year of audited Rule 3-05 Financial Statements is required.
  2. Currently, the investment test compares the registrant’s investment in and advances to the acquired business to the carrying value of the registrant’s total assets. The SEC believes that using the registrant’s aggregate worldwide market value would align the investment test more closely with the economic significance of the acquisition to the registrant.
  3. Currently, the income test focuses on a single component – net income – which can include infrequent expenses, gains or losses that can distort the determination of relative significance.  Additionally, for registrants with marginal or break-even net income or loss in a recent fiscal year, the use of a net income component by itself can also have the effect of requiring financial statements for acquisitions that otherwise would not be considered material to investors. In such circumstances a relatively small entity could trigger the requirement for Rule 3-05 Financial Statements. The SEC expects that adding a revenue component will reduce the skewed results that may occur by relying solely on net income, and that simplifying the calculations will reduce complexity and preparation costs.
  4. The proposing release notes that the existing pro forma adjustment criteria are not clearly defined nor easily applied and, in practice, can yield inconsistent presentations for similar fact patterns. Moreover, the existing adjustments also preclude the inclusion of adjustments for the potential effects of post-acquisition actions expected to be taken by management. Under the amended rules, pro forma adjustments would be broken down into two categories: (i) Transaction Accounting Adjustments intended to reflect only the application of required accounting to the acquisition or disposition; and (ii) Management’s Adjustments which would provide flexibility to include forward-looking information that depicts the synergies and other transaction effects identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given. Management’s Adjustments would include such synergies and transaction effects as closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements, and would be limed to those synergies and effects that are both reasonably estimable and have occurred or are reasonably expected to occur.
  5. Current Rule 3-05(b)(4)(iii) generally permits Rule 3-05 Financial Statements to be omitted once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the registrant for a complete fiscal year. However, Rule 3-05 Financial Statements are required to be included, even if the acquired business is included in post-acquisition audited results, (i) when they have not been previously filed – this typically arises with initial registration statements – or (ii) when the Rule 3-05 Financial Statements have been previously filed, but the acquired business is of major significance to the registrant – Rule 3-05 provides an example of an acquired business that met at least one of the significance tests at the 80% level at the date of acquisition – which could result in Rule 3-05 Financial Statements of the acquired business to be continued to be provided regardless of whether post-acquisition activities have diminished the relative significance of the acquired business.