On May 21, 2020, the US Securities and Exchange Commission (SEC) adopted amendments (Amended Rules)1 to financial statement disclosures with respect to business acquisitions and dispositions required by Regulation S-X's Rule 3-05 (Financial Statements of Businesses Acquired or to be Acquired (Rule 3- 05)), Rule 3-14 (Special Instructions for Real Estate Operations to be Acquired (Rule 3-14)), Article 11 on Pro Forma Financial Information (Article 11), and other related rules and forms. The Amended Rules also amended investment companies' financial reporting of acquisitions by adopting a new Rule 6-11 of Regulation S-X (Financial Statements of Funds Acquired or to be Acquired (Rule 6-11)) and revising Form N-14 for financial reporting of acquisitions involving investment companies. The Amended Rules' changes related to investment companies and business development companies are not addressed in this Legal Update.

Through the Amended Rules, the SEC aims to improve the quality of information being made available to investors as to the potential effects of significant acquisitions and dispositions, reduce the complexity and costs to disclose this information and promote capital formation.2

Among the most important amendments contained in the Amended Rules are:

  • revising the investment test and income test used in determining which business acquisition or disposition is considered significant, thereby necessitating the inclusion of target financial statements;
  • updating the required contents and period coverage of the acquired business' financial statements; and
  • creating a new rule to address financial reporting for fund acquisitions by investment companies.

Background

Under the disclosure framework in existence prior to the Amended Rules, when a business combination (other than a real estate operation) involving a registrant has occurred or is probable, the registrant is required by Rule 3-05 to provide separate audited annual, and unaudited interim pre-acquisition, financial statements of that business (Rule 3-05 Financial Statements) if the acquired business is considered to be significant.3 A registrant currently measures significance by applying the 2 Mayer Brown | SEC Amends Business Acquisition and Disposition Disclosure Rules investment, asset and income tests provided in the "significant subsidiary" definition in Regulation S-X's Rule 1-02(w), substituting 20% for the significance threshold. The specified periods of financial information that a registrant must provide depends on the relative significance of the acquisition to the registrant.

Pursuant to Rule 3-14, a registrant that has acquired a significant real estate operation (individually, or more than one in the aggregate) must file separate audited annual and unaudited interim abbreviated income statements (Rule 3- 14 Financial Statements) with respect to such acquired operation. Only one year of Rule 3-14 Financial Statements is required if (i) the real estate operation is not acquired from a related party, (ii) the registrant discloses the material factors considered in assessing the real estate operation and (iii) the registrant indicates it is not aware of material factors that would cause the reported financial information not to be indicative of future operating results. If any of these conditions is not met, the registrant must file three years of Rule 3-14 Financial Statements.

In addition to filing the requisite target historical financial statements, Article 11 also requires a registrant to prepare and file pro forma financial information reflecting the acquisition or disposition. This customarily includes a pro forma balance sheet and pro forma income statements. The pro forma financial information also reflects adjustments to show how the acquisition or disposition might have affected the financial statements had the transaction happened at an earlier time.

Highlights of the Amendments

Below we summarize several of the principal amendments to the existing disclosure framework contained in the Amended Rules.

Investment and Income Tests

In order to determine whether the acquired business' financial statements are required, a registrant must first determine if the acquisition is significant under Rule 3-05. As discussed above, registrants currently measure the significance by using the three tests prescribed by Regulation S-X: the asset test, investment test and income test.

Before the Amended Rules, the investment test considered an acquisition significant if the registrant's investments in the target exceed 20% of the registrant's total assets as of the end of the buyer's most recent fiscal year. In order to closely align the acquisition's economic significance to the registrant where both entities or business are not under common control, the Amended Rules now compare the registrant's investments in and advances to the acquired or disposed business to the aggregate worldwide market value of its voting and non-voting equity (aggregate worldwide market value). The aggregate worldwide market value is the average of the registrant's worldwide market value for voting and non-voting common stock calculated daily for the last five trading days of the registrant's most recently completed month prior to the earlier of either the registrant's announcement date or the acquisition's or disposition's agreement date. This amendment is expressly limited to acquisitions and dispositions. If the aggregate worldwide market value is not available, the registrant would continue to apply the investment test existing before the Amended Rules. Under the Amended Rules, "investments" include the fair value of contingent consideration if required to be recognized at fair value at the acquisition date under US GAAP or IFRS-IASB.

Before the Amended Rules, the income test considered an acquisition significant if the registrant's share of pre-tax income from continuing operations of the target exceeds 20% of its pre-tax income for the most recent fiscal year. To avoid immaterial acquisitions being deemed significant, the Amended Rules revised the income test by adding a new component (revenues less permitted expenses) which allows the deduction of intercompany eliminations from the target's total revenue from continuing operations when the registrant and the acquired business have material revenue in each of the two most recently completed fiscal years, and consider an acquisition significant only if both the existing and the additional components are exceeded. Therefore, when the revenue component of the income test applies, both the revenue and net income components must be exceeded to determine whether a subssidiary is signigicant.

Footnotes

1 A copy of the Amended Rules is available at https://bit.ly/36HKyR1.

2 However, Commissioner Lee pointed out that the Amended Rules will likely facilitate mergers and acquisitions without adequately assessing the risk of insufficient transparency to investors, and risk of increasing economic concentration, See Commissioner Allison Herren Lee, Statement of Financial Disclosures About Acquired and Disposed Businesses, available at https://bit.ly/2XF02Bm.

3 See Target and Pro Forma Financial Statement Requirements for Significant Acquisitions, available at http://bit.ly/2Yfzx45.

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Originally published 29 May, 2020

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