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

Overview

On May 21, 2020, the SEC adopted 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 (collectively, the “Amendments”). The Amendments take effect on January 1, 2021, but the SEC is permitting voluntary compliance in the interim. The Amendments were first proposed in 2019; see Goodwin’s alert on the proposed Amendments here. 

The 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 Client Alert focuses primarily on the changes to Rule 3-05 and Article 11 and their related rules and forms. 

HISTORICAL AND PRO FORMA FINANCIALS FOR ACQUIRED OR DISPOSED OF BUSINESSES

To recap, 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, under Rule 3-05, 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”):

Current 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.

The Amendments, described below, update the Investment Test and the Income Test to more closely align the metrics of these respective tests with the overall significance of the acquisition or disposition, according to the SEC.

• Investment Test: Computed by comparing the Registrant’s investment in, and advances to, the acquired business to the average aggregate worldwide market value of all of Registrant’s voting and nonvoting common equity^[1] (“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.
  
  The revised Investment Test also requires that the fair value of contingent consideration (including sales-based milestones and royalties)^[2] be included if required to be recognized under GAAP or IFRS, as applicable. In the event the applicable GAAP or IFRS do not require recognition at fair value, the Registrant must include all contingent consideration, except to the extent the likelihood of payment is remote. On the other hand, assets transferred into the acquired entity that will remain a part of the combined entity following the acquisition are not included.
  
  
• Income Test: The Amendments add an additional revenue component to make the overall test more reflective of the net impact on a Registrant’s financial statements. Under the revised Income Test, a Registrant with recurring annual revenues will use the lower of (i) the revenue component (total annual revenues) and (ii)the net income component, outlined above, when determining the significance threshold.^[3] If the Registrant or acquired entity did not have material revenue in each of the two most recently-completed fiscal years, the Income Test will be based solely on net income or loss from continuing operations, before income taxes.
  
  The Amendments also include 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 amendments to components. 

Summary Illustration: Simplified Revised Significant Test Calculations
Investment Test Investment in/advanced to acquired business -- [divided by] -- Five-day average aggregate worldwide market value of all Registrant's voting and non-voting equality	Income Test Lower of Total annual revenues from acquired businesses -- [divided by] -- Total annual revenues of Registrant and Registrant's share of the business's net income (or absolute value of net loss) from continuing operations, before tax -- [divided by] -- Registrant's net income (or absolute value of net loss) from continuing operations before tax	Asset Test[4] Acquired business' total assets (based on most recent annual financials) -- [divided by] -- Registrant's total assets (based on most recent annual financials)

 

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. Under the Amendments, however, a Registrant will now be permitted 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 but before the date the Registrant must file the financial statements of the acquired business on Form 8-K.

Additionally, the Amendments 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 only the effects of the acquisition or disposition. In other words, Registrants will 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 be limited to the historical financial information of the Registrant and the acquired business, with only Transaction Accounting Adjustments (as described further below), when computing the Significance Tests.

Bright Line Thresholds under the Significance Tests (unchanged)

The Significance Tests include bright-line thresholds to determine “how significant” the acquisition is to a Registrant. The thresholds for acquisitions are as follows, and remain unchanged under the Amendments:

• 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%”)

Amendments to Bright Line Thresholds for Dispositions

In the case of significant dispositions, Rule 11-01 of Article 11 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 currently uses a 10% threshold instead of the 20% threshold outlined above. The Amendments raise the threshold to 20% to mirror the threshold at which an acquisition is deemed significant. Please see the table below for an illustration.

Amendments to Required Historical and Pro Forma Financials for Significant Acquisitions

Under the Amendments, the maximum period is reduced for which historical financial statements of the acquired business are required. The below table describes the current and revised requirements for historical acquired business financial statements and pro forma financial statements:

Significance	Current Requirements	Amended Requirements
< 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% under any of the tests, 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 Amendments, pro forma financial information that depicts the financial impact of the acquired businesses in all material respects is required.

Required Pro Forma Financial Information following Significant Dispositions

Significance (Current)	Significance (Amended)	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, 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.

Amendments to Adjustments in Pro Forma Financials

Under the Amendments, adjustments to pro forma financial information are limited to (i) “Transaction Accounting Adjustments”, (ii) “Autonomous Entity Adjustments” and (iii) “Management’s Adjustments,” which are as follows[1]:

• Transaction Accounting Adjustments: Adjustments that 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.
  
  
• Autonomous Entity Adjustments: Adjustments that are necessary to reflect the operations and financial position of the Registrant as a standalone, autonomous entity if the Registrant was previously part of another entity.
  
  
• Management’s Adjustments: Optional adjustments, at management’s discretion, depicting the “synergies and dis-synergies” if “such adjustments would enhance an understanding of the pro forma effects of the transactions” and provided that certain conditions are met. These conditions include that (i) there is a reasonable basis for each such adjustment, (ii) the adjustments be limited to the effect of such on the historical financial statements that form the basis of the pro forma statement of comprehensive income, as if the synergies and dis-synergies existed as of the beginning of the fiscal year presented and (iii) the pro forma financials reflect all Management’s Adjustments that are, in management’s opinion, necessary to a fair statement of the pro forma financial information (and that if synergies are presented then dis-synergies also be disclosed).^[6]

Registrants will be required to show the Transaction Accounting Adjustments and Autonomous Entity Adjustments in separate columns in the pro forma financial statements, and must also include explanatory notes describing each adjustment, any material uncertainties, material assumptions, calculations and such other information “necessary to give a fair and balance presentation of the pro forma financial information.”

Management’s Adjustments, on the other hand, must be presented in the explanatory footnotes to the pro forma financial statements in the form of reconciliations, but the SEC notes that this will allow for flexibility to include forward-looking information pursuant to the applicable safe harbor provisions for forward-looking statements.

Other Notable Amendments

Additionally, the Amendments eliminate certain other nuanced requirements on Registrants by:

• Permitting Registrants to prepare Rule 3-05 Financial Statements in accordance with IFRS-IASB (or reconciling home country GAAP to 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 for debt not assumed by the Registrant 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 (or in the case of acquisitions that are 20%–40% for nine months); 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.

TAKEAWAYS AND PRACTICE TIPS

Overall Reduction in Disclosure Requirements for Registrants

The Amendments 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, but at minimum we expect the Amendments to reduce compliance costs for Registrants.

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 IP, the Amendments 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 will 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 Amendments, such Registrants will 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 Amendments are 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.

Management Adjustments Limited to Synergies and Dis-Synergies are Likely to Introduce Obstacles in Practice

By limiting Management’s Adjustments to synergies and dis-synergies, the Amendments may cause confusion in practice. Registrants may find it difficult to satisfy the applicable conditions for inclusion of 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.

Publicly disclosing expected synergies or dis-synergies, even if in the footnotes of the Article 11 Pro Formas, is also likely to draw the focus of plaintiffs in stockholder litigation notwithstanding the applicability of safe harbor provisions for forward-looking statements. 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 or dis-synergies are greater than anticipated, the Registrant’s stockholders may also be more likely to sue. The Amendments avail Management’s Adjustments to the safe harbor provisions under Rule 175 of the Securities Act and Rule 3b-6 of the Exchange, 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 or by underestimating dis-synergies.

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.

As always, please reach out to your regular Goodwin contact with any questions or to continue the discussion.

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^[1] In the proposed amendments, the SEC only addressed Transaction Accounting Adjustments and Management’s Adjustments, but acknowledges in the commentary to the Amendments that Autonomous Entity Adjustments were previously to be included in the proposed amendments under the Management’s Adjustments.

^[2] In the proposed amendments, the SEC limited Management’s Adjustments to adjustments that are limited to giving effect to “reasonably estimable synergies and other transaction effects”

^[3] Computed based on the last five trading days of the last completed month prior to the deal signing/announcement.

^[4] No change.

^[5] In the proposed amendments, the SEC permitted exclusion of sales-based milestones and royalties from the Investment Test, when not required to be recognized at fair value under GAAP or IFRS, but reversed course in the Amendments.

^[6] Under the proposed amendments, the Income Test would have used income or loss from continuing operations after income taxes, instead of before, but the SEC reversed course in the Amendments and retained before income taxes.