SEC Proposes Amendments to Rules Governing Financial Disclosures on Material Acquisitions and Dispositions of Businesses

On May 3, 2019, the SEC proposed amendments to, among other things, the financial disclosure requirements in Rule 3-05 of Regulation S-X (“Rule 3-05”), Rule 3-14 of Regulation S-X (“Rule 3-14”) and Article 11 of Regulation S-X (“Article 11”), which relate to the historical and pro forma financial reporting requirements for the acquisition and disposition of businesses^.[1] The proposed amendments are intended to improve the information that investors receive regarding such acquisitions and dispositions and to reduce the complexity and associated compliance costs for SEC-registered companies (each, a “Registrant”). This alert focuses primarily on the proposed changes to Rule 3-05 and Article 11 and their related rules and forms. For a discussion on the proposed amendments to Rule 3-14, please click here.

HISTORICAL AND PRO FORMA FINANCIALS FOR ACQUIRED OR DISPOSED OF BUSINESSES

Under Rule 3-05, when a Registrant makes a significant acquisition it is required to present and file separate audited annual and unaudited interim pre-acquisition financial statements of such acquired business within 75 days of consummating the acquisition (“Rule 3-05 Financial Statements”). Additionally, Article 11 requires that the Registrant present and file unaudited pro forma financial information reflecting the effect of any significant acquisition or disposition, which typically includes a pro forma balance sheet and pro forma income statements (“Article 11 Pro Formas”). In each case, the Registrant is required to present historical financial statements of the acquired business for a number of periods, which is determined by how material the acquisition is to the Registrant based on three tests established by Rule 1-02(w) of Regulation S-X, and are summarized, in their current form, as follows (collectively, the “Significance Tests”):

• Investment Test: Computed by comparing the investment in and advances to the acquired business (which is typically the purchase price) to Registrant’s total assets, based on Registrant’s most recent annual financial statements.
• Income Test: Computed by comparing the Registrant’s share of income from continuing operations of the acquired business, before income taxes, to Registrant’s same measure, based on the most recent respective annual financial statements of each.
• Asset Test: Computed by comparing the proportionate share of the acquired business’ total assets to Registrant’s total assets, based on the most recent respective annual financial statements of each.

Proposed Updates to Components of Significance Tests

In its proposed amendments, the SEC sets forth modifications to the Investment Test and the Income Test, in each case to more closely align the metrics of these respective tests with the overall significance of the acquisition or disposition. The SEC also expressed concern that the existing metrics may not accurately reflect the true value of a Registrant’s assets and may include non-routine items that distort such calculations.

• Investment Test: The SEC proposes that a Registrant instead compare its investment in and advances to the acquired business to the aggregate worldwide market value of all of Registrant’s voting and nonvoting common equity (“Public Float”), rather than its total assets. In the event the Registrant does not have a Public Float, the existing total assets metric would continue to be used when computing the Investment Test.
• Income Test: The SEC proposes (i) adding a new revenue component and (ii) using net income or loss from continuing operations, after income taxes, rather than before income taxes, to make the Income Test more reflective of the net impact on a Registrant’s financial statements. Under the revised Income Test, a Registrant with recurring annual revenues would use the lower of the revenue component and the net income component when determining the significance threshold. If a Registrant does not have recurring annual revenues, the Income Test would be based solely on net income or loss from continuing operations after income taxes. The SEC also proposed a technical change to the Income Test whereby the absolute value of a net loss will be used instead of “zero” for purposes of calculating average net income in certain situations, which the SEC believes will better indicate relative significance.
• Asset Test: No proposed amendments to components.

Under the current rules, a Registrant is required to use the amounts in its most recent 10-K to compute the Significance Tests, even when the most recent 10-K was filed after the acquisition date. In the proposed amendments, however, the SEC would allow a Registrant to choose whether to use its most recent or the prior 10-K, if the most recent 10-K was filed after the consummation of the acquisition. The SEC reasons that this will rectify the current incentive for Registrants to delay filing their 10-K if they do not want to use the amounts contained therein when computing the Significance Tests.

Additionally, the proposed amendments would permit a Registrant that has made a significant acquisition or disposition of a business since the end of its most recently ended fiscal year to use, for the Significance Tests, pro forma financial information about the Registrant that reflects the effects of the acquisition or disposition. In other words, Registrants would be able to substitute the required pro forma financial information (outlined below) from a previous acquisition or disposition during the current fiscal year when computing the Significance Tests for a current acquisition or disposition. Such pro forma financial information must exclude Management’s Adjustments (as described further below) when computing the Significance Tests.

Bright Line Thresholds under the Significance Tests

The Significance Tests include bright-line thresholds to determine “how significant” the acquisition is to a Registrant. The thresholds are as follows:

• all 20% or less (“< 20%”)
• any exceeds 20%, but none exceed 40% (“20%-40%”)
• any exceeds 40%, but none exceed 50% (“40%-50%”)
• any exceeds 50% (“> 50%”)

Proposed Amendments to Bright-Line Thresholds for Dispositions

In the case of significant dispositions, Rule 11-01 of Article 11 (“Rule 11-01”) requires that a Registrant prepare and file pro forma financial information relating to the most recently completed fiscal year and any subsequent interim period for a disposition that meets any of the Significance Tests, but uses a 10% threshold instead of the 20% threshold outlined above. Under the proposed amendments, the threshold would be raised to 20% to mirror the threshold at which an acquisition is deemed significant. Please see the table below for an illustration.

Proposed Amendments to Required Historical and Pro Forma Financials for Significant Acquisitions

In its proposed amendments, the SEC reduces the maximum period for which historical financial statements of the acquired business will be required. The below table describes the current and the proposed revised requirements for historical acquired business financial statements and pro forma financial statements: 

Significance	Current Requirements	Requirements Under Proposed Amendments
< 20%	No historical or pro forma financial statements required	No historical or pro forma financial statements required
20%-40%	(i) Separate audited annual financial statements (“Audited Financials”) for most recent fiscal year (ii) Unaudited financial statements for the interim period of the current fiscal year to the most recent balance sheet date and the comparable interim period of the prior fiscal year (“Interim Financials”) (iii) Unaudited pro forma balance sheet as of the end of the most recent period for which consolidated balance sheet of Registrant is required (“Pro Forma Balance Sheet”) (iv) Unaudited pro forma income statement for Registrant’s most recent fiscal year (“Pro Forma Income Statement”) (v) Unaudited pro forma income statement from the end of Registrant’s most recent fiscal year to the most recent interim date for which a balance sheet is required (“Pro Forma Interim Income Statement”)	(i) Audited Financials for most recent fiscal year   (ii) Unaudited financial statements for only the current year interim period (“Revised Interim Financials”)   (iii) Pro Forma Balance Sheet   (iv) Pro Forma Income Statement (v) Pro Forma Interim Income Statement
40%-50%	(i) Audited Financials for two most recent fiscal years (ii) Interim Financials (iii) Pro Forma Balance Sheet (iv) Pro Forma Income Statement (v) Pro Forma Interim Income Statement	(i) Audited Financials for two most recent fiscal years (ii) Revised Interim Financials. (iii) Pro Forma Balance Sheet (iv) Pro Forma Income Statement (v) Pro Forma Interim Income Statement
> 50%	(i) Audited Financials for three most recent fiscal years (ii) Interim Financials (iii) Pro Forma Balance Sheet (iv) Pro Forma Income statement (v) Pro Forma Interim Income Statement	(i) Audited Financials for two most recent fiscal years. (ii) Revised Interim Financials. (iii) Pro Forma Balance Sheet (iv) Pro Forma Income Statement (v) Pro Forma Interim Income Statement

Although separate financial statements have not been, and will not be, required with regard to acquired businesses with a significance less than 20%, if the total significance of individually insignificant acquisitions exceeds 50%, currently the Registrant must provide financial statements covering at least a substantial majority of the acquired companies for the most recent fiscal year plus the year to date interim period and pro forma financial statements for a year. Under the proposed rules, what would be required would be pro forma financial information that depicts the financial impact of the acquired businesses in all material respects.

Required Pro Forma Financial Information Following Significant Dispositions

Significance  (Current)	Significance (Proposed Amendments)	Requirements
< 10%	< 20%	No pro forma financial statements required
> 10%	> 20%	(i) Pro Forma Balance Sheet (ii) Pro Forma Income Statement (iii) Pro Forma Interim Income Statement

Adjustments in Pro Forma Financials under Current Rules

Under Rule 11-02 of Regulation S-X (“Rule 11-02”), Registrants are instructed to reflect in the Article 11 Pro Formas the following adjustments (and no other adjustments):

• Pro Forma Income Statement/Pro Forma Interim Income Statement: Adjustments that are (i) directly attributable to the transaction, (ii) expected to have a continuing impact on the Registrant and (iii) factually supportable. The rules further explain that these should be material, non-recurring charges or credits.
• Pro Forma Balance Sheet: Adjustments that are (i) directly attributable to the transaction and (ii) factually supportable. Adjustments to the Pro Forma Balance Sheet are not required to have a continuing impact on the Registrant because the Pro Forma Balance Sheet is as of the balance sheet date.

Proposed Amendments to Adjustments in Pro Forma Financials

In the proposed amendments, the SEC requires that pro forma financial information include “Transaction Accounting Adjustments” and “Management’s Adjustments,” which would be as follows:

• Transaction Accounting Adjustments: Adjustments that would depict (i) in the case of the Pro Forma Balance Sheet, the accounting for the transaction required by U.S. GAAP or IFRS-IASB (the “Balance Sheet Adjustments”), and (ii) in the case of the Pro Forma Income Statement and the Pro Forma Interim Income Statement, the effects of the Balance Sheet Adjustments assuming such adjustments were made at the beginning of the fiscal year presented. In other words, these adjustments are simply to reflect the application of the required accounting treatment of the significant acquisition or disposition.
• Management’s Adjustments: Adjustments that are limited to giving effect to “reasonably estimable synergies and other transaction effects.” The proposed amendments list as examples closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements, and in each case that have occurred or are reasonably expected to occur.

Registrants would be required to show the Transaction Accounting Adjustments and Management’s Adjustments in  separate columns in the pro forma financial statements, except that if the amount of synergy effects cannot be reasonably estimated, they can be described qualitatively in a footnote.

Registrants would also be required to provide narrative disclosures in explanatory footnotes to the pro forma financial statements in order to “further elicit appropriately balanced disclosure.”  For Management’s Adjustments, the proposed rules require “a description, including the material uncertainty, of the synergy or other transaction effects,” disclosures on underlying assumptions and methods of calculation and other necessary qualitative information to give a “fair and balanced” presentation.

Other Notable Proposed Amendments

Additionally, the proposed amendments would eliminate certain other nuanced requirements on Registrants by:

• permitting Registrants to prepare Rule 3-05 Financial Statements in accordance with IFRS-IASB without reconciling to U.S. GAAP, so long as the acquired business would qualify to use IFRS-IASB if it were a Registrant;
• in the case of acquired components of an entity for which there are no historical financial statements, presenting, instead of balance sheets and income statements required by Rule 3-05, audited statements of assets acquired and liabilities assumed, and statements of revenues and expenses, which exclude certain expenses, such as corporate overhead, interest and income tax expenses;
• no longer requiring Registrants to include Rule 3-05 Financial Statements in registration statements and proxy statements once the acquired business has been reflected in filed, post-acquisition financial statements for a complete fiscal year; and
• no longer requiring Registrants to present Rule 3-05 Financial Statements when an acquisition was of “major significance” (i.e. any of the Significance Tests exceeding an 80% threshold), once the acquired business has been reflected in filed, post-acquisition financial statements for a complete fiscal year.

TAKEAWAYS AND PRACTICE TIPS

Overall Reduction in Disclosure Requirements for Registrants

If adopted by the SEC, the proposed amendments will reduce the quantity and scope of Rule 3-05 Financial Statements and Article 11 Pro Formas that a Registrant must prepare and file. The SEC believes this will facilitate more timely access to capital.

Benefit to Registrants With Significant Internally-Developed Assets

In the case of buy-side Registrants that are “asset-light” companies or have significant internally-developed assets, such as intellectual property, the proposed amendments will reduce the likelihood that a transaction would, solely due to the technical computation inputs, be deemed material under the Significance Tests. For example, a tech or life sciences Registrant may have a substantial Public Float but hold substantial internally-developed assets that are reflected at cost on the Registrant’s balance sheet. Under the revised Investment Test, the Registrant would instead be able to rely on its Public Float when computing the significance of the acquisition.

Addition of Revenue Component to Income Test to Benefit Registrants in Certain Industries

Because Registrants will take the lower of the revenue comparison and net income comparison when computing the Significance Tests, Registrants that have significant revenues but net losses will likely compute more Registrant-favorable Income Test results than under the current rules. For example, many valuable companies in the tech and life sciences industries show net losses on their income statements but considerable revenues, which the current rules do not take into account. Under the proposed amendments, such Registrants would be less likely to trigger the Income Test component of the Significance Tests because they will have the benefit of comparing their revenues with those of an acquired business.

Registrants With “Loss Years” No Longer Penalized Under the Income Test

By revising the required treatment of a net loss from “zero” to the absolute value of the loss when computing the Income Test, the proposed rules will be more accommodating to Registrants that have suffered a net loss in a given year. This will reduce the likelihood of a “gotcha” result under the Income Test.

“Estimable Synergies” are Likely to Introduce Obstacles in Practice

By limiting Management’s Adjustments to “reasonably estimable” synergies, the proposed rules may cause confusion in practice. Registrants may find it difficult to satisfy the “reasonably estimable” standard for such integration items within 75 days of closing the transaction. For others, there may be significant unknowns or contingent obligations that are too difficult to estimate. While Registrants can explain such matters in qualitative disclosures, such uncertainties could lead to difficulties for the teams charged with performing the Management’s Adjustments.

Publicly disclosing expected synergies, particularly in a separate column of the Article 11 Pro Formas, is also likely to draw the focus of plaintiffs in stockholder litigation. If the anticipated synergies are substantially greater than the premium above market being paid in the transaction, target company stockholders may be more likely to sue. On the other hand, if the anticipated synergies are not achieved, the Registrant’s stockholders may also be more likely to sue. The SEC disclosed in a footnote that it would create an expanded “safe harbor” for failures to achieve estimated synergies, but that will not prevent suits that (i) accuse directors of breaches of fiduciary duty by approving transactions on the basis of faulty expectations and/or (ii) challenge the validity of stockholder approvals based on proxy materials that contained estimated synergies that were not achieved or that differ from later estimates. Even absent stockholder lawsuits, the markets may react negatively to a Registrant’s failure to achieve estimated synergies.  

The Proposed Rule Changes are Likely to be Modified

The proposed rule changes are subject to public comments. There is a substantial likelihood that, as a result of the public comments, the final rules will differ in material respects from the proposed revised rules. This is almost always the case with regard to rules proposed by the SEC.

Registrants Should Consult With Counsel When Evaluating an Acquisition or Disposition Under Rule 3-05 and Article 11

Closing a significant acquisition or disposition can be a big task for even the largest Registrant, so Registrants should make the most of the available assistance of counsel and work through the Significance Tests and related requirements while the transaction is fresh in the heads of the deal team. With proper planning, Rule 3-05 and Article 11 compliance can be built into the deal team’s closing and post-closing checklist so that the 75-day deadline does not sneak up on the Registrant. It is important to remember that the preparation of Rule 3-05 Financial Statements and Article 11 Pro Formas can be time-consuming and require the assistance of counsel, accountants and outside auditors.

^[1] The proposed amendments were in response to the SEC’s September 2015 Request for Comment on the Effectiveness of Financial Disclosures About Entities Other Than the Registrant, which is outside of the scope of this Client Alert.

As always, the Goodwin team is available to answer any questions you have.