SEC adopts amendments to required financial disclosures for acquisitions and dispositions of business

On May 21, 2020, the US Securities and Exchange Commission (SEC) announced the approval of a final rule adopting amendments to certain of its rules and forms related to the disclosure of financial information regarding acquired or disposed business. Among other changes, the amendments impact longstanding SEC rules relating to (1) the definition of “significant” subsidiaries, (2) requirements to provide financial statements for “significant” acquisitions, and (3) revisions to the formulation and usage of pro forma financial information.

In its press release announcing the adoption, the SEC stated that the amendments are “intended to assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant, and improve the financial disclosure requirements applicable to acquisitions and dispositions of businesses, including real estate operations and investment companies.”

The amendments will become effective January 1, 2021. However, public companies can utilize the new rules on a voluntary basis effective immediately so long as they adopt the amendments in their entirety (ie, selective use of the new rules is not permitted).

BACKGROUND

Under Rule 3-05 of Regulation S-X, public companies that acquire businesses deemed “significant” within the meaning of the rules are generally required to provide separate audited annual and unaudited interim pre-acquisition financial statements of the acquired business, with the number of years of financial information that must be provided varying based on the relative significance of the acquisition. In addition, under Article 11 of Regulation S-X, public companies may be required to file unaudited pro forma financial information, including pro forma balance sheet and pro forma statement of operations data, relating to certain acquisitions or dispositions. Similar rules exist for “smaller reporting companies” (Rule 8-04 of Regulation S-X) and companies engaged in real estate operations (Rules 3-14 and 8-06 of Regulation S-X).

OVERVIEW OF THE AMENDMENTS

The SEC’s final rule amends the financial disclosure requirements under Regulation S-X for acquisitions and dispositions of businesses, including real estate operations, the significance tests required in connection with determining whether financial information is required and certain rules applicable to investment companies and business development companies.

Significance tests

Under applicable SEC rules, including Rule 1-02(w) of Regulation S-X, an acquisition will be deemed “significant” if it exceeds certain thresholds under any of three different tests: the investment test, the asset test, and the income test. The amendments update the significance testing process by modifying (1) the investment test to compare the investment in the target business against the reporting company’s “aggregate worldwide market value of the registrant’s voting and non-voting common equity,” when available, instead of its total assets as of the prior year-end and (2) the income test to add a revenue component to the test instead of just comparing the reporting company’s net income against the target business’s net income. The amendments do not substantively change the asset test.

The amendments also raise the applicable thresholds for a disposed business to 20% from 10% to be consistent with the thresholds applicable to an acquired business. 

Investment test

As revised, the investment test compares a reporting company’s “investments in” a tested business against either the reporting company’s consolidated total assets as reported on its latest audited balance sheet or its aggregate worldwide market value. For purposes of the test, the reporting company will measure “aggregate worldwide market value” on a daily basis over the last five trading days of the company’s most recently completed month ending prior to the earlier of the announcement date or agreement date of the acquisition or disposition.

The new test only applies to determining significance for purposes of acquisitions and dispositions (e.g. the existing asset test will still be required for other significance determinations, including measuring the significance of equity method investments) and companies that do not have an aggregate worldwide market value will be required to continue to use the existing investment test. The final rule also clarified what constitutes an “investment” in a tested business, including by requiring the inclusion of the fair value of contingent consideration in certain circumstances.

Income test

As revised, the income test requires that a reporting company compare both its revenue and its net income against the tested business’s revenue and net income. Where both the reporting company and the tested business have had material revenue in each of the two most recently completed fiscal years, a tested business would have to exceed the applicable thresholds under both the revenue component and the net income component in order to be deemed “significant.”

If a business meets both components, the reporting company may utilize the lower of the revenue component and the net income component for purposes of determining the number of periods for which financial information is required. If either of the businesses has not had material revenue in each of the two most recently completed fiscal years, only the net income component would apply.

Although the SEC had initially proposed to modify the definition of net income to calculate income or loss from continuing operations after income taxes, in its final rule the SEC determined to retain the existing definition, which calculates income or loss from continuing operations before income taxes.

Number of years of required historical financial information

In addition to modifying the significance tests, the final rule also (1) eliminate the requirement that reporting companies provide three years of audited financial statements of the acquired business be provided when the business exceeds 50 percent significance and (2) update the requirements for acquired businesses that are between 20 percent and 40 percent significance to eliminate the need to provide comparative interim period financial statements. Under both the prior rules and the amended rules, financial statements are not required if an acquired business does not exceed 20 percent significance under any applicable test.

As amended, financial information would be required as follows:

Under the final rule, reporting companies also may omit historical financial statements from registration statements and proxy statements for businesses that (i) are between 20 percent and 40 percent significance after results from the acquired business have been included in at least nine months of reported financial results and (ii) exceed 40 percent significance, once the business has been included in the reporting company’s post-acquisition results for a complete fiscal year.

Pro forma financial information

The final rule amends the requirements for presenting pro forma financial information to replace the existing adjustment criteria with three new categories of adjustments:

• Transaction Accounting Adjustments. Adjustments to reflect only the application of required accounting to the acquisition or disposition, linking the effects of the acquired business to the registrant’s audited historical financial statements;
• Autonomous Entity Adjustments. Adjustments to reflect the operations and financial position of the registrant as an autonomous entity when the registrant was previously part of another entity; and
• Management’s Adjustments. Adjustments to provide reporting companies with the flexibility to include forward-looking information that depicts the “synergies and dis-synergies” identified by management in determining to consummate the transaction for which pro forma effect is being given.

Although the SEC originally proposed requiring “Management’s Adjustments,” the final rule provides that Management’s Adjustments are optional. Only “Transaction Accounting Adjustments” and “Autonomous Entity Adjustments” are required. If presented, Management’s Adjustments are subject to a number of conditions, including presentational and disclosure requirements, intended to ensure they are presented consistently and in a manner that would not be misleading to investors.

Other changes

In addition to the changes noted above, the final rule, among other things:

• Modifies the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required by eliminating historical financial statements for insignificant businesses and expanding the pro forma financial information to depict the aggregate effect in all material respects;
• Permits disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
• Permits the use of, or reconciliation to, International Financial Reporting Standards, as issued by the International Accounting Standards Board, in certain circumstances;
• Aligns Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
• Makes corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X, which will also apply to issuers relying on Regulation A;
• Creates rules and forms more specifically tailored for investment companies and business development companies.

CONCLUSION

The final rule represents a substantial change to the SEC’s reporting and disclosure requirements with respect to business combinations. The amendments are intended to reduce the burdens on companies, but the changes are significant, so we encourage you to contact your DLA Piper relationship attorney or the authors if you have any questions.

This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.