US reporting companies that are planning or have completed a significant acquisition of a business may be required to file separate target financial statements and related pro forma financial statements under Rule 3-05 and Article 11 of Regulation S-X. The specific US Securities and Exchange Commission ("SEC") rules and financial reporting obligations triggered by a significant acquisition can be quite complex, requiring careful evaluation by an acquiring company. These rules may also impact the ability of registrants to access the capital markets in a timely fashion, affecting the ability to offer securities in a registered offering, the proceeds of which would be used to fund the acquisition or to register securities to be used as consideration for the acquisition.

This note discusses the SEC's financial reporting and disclosure requirements triggered by a company's significant business acquisition. We outline key concepts and practice points helpful in determining if an acquisition is significant, which financial statements of the target are required to be included in the registrant's SEC filing or offering document, what related pro forma financial information is required, when and how these target and pro forma financial statements are to be filed or updated, and relevant market practice considerations.

We have updated this note to reflect the relevant amendments ("amendments") adopted by the SEC on May 21, 2020, to Rule 3-05 and Article 11 of Regulation S-X and related rules.1 These amendments go into effect on January 1, 2021, although early adoption by companies is permitted as long as the amendments are applied in their entirety. In this note, we refer to existing Rule 3-05 and Article 11 of Regulation S-X and related rules as the "current rules" or "existing rules," and we refer to the amended rules as the "new rules"; when we refer to or cite a rule without mentioning the words "current," "existing," or "new," this means that the existing rule remains the same and is unchanged by the amendments. For brevity, we do not discuss the various other rules specifically applicable to investment companies, real estate operations, or smaller reporting companies.

Overview

In general, Rule 3-05 requires the filing of separate pre-acquisition, or historical, financial statements when the acquisition of a significant business has occurred or is probable. This means that the acquiring company must obtain separate audited annual and unaudited interim pre-acquisition financial statements of the target or business it acquires, if such business or acquisition is "significant" to the acquiring company. "Significance" is determined and measured by applying three significance tests prescribed by the SEC rules. The more significant an acquisition is, the more onerous the requirements relating to financial information of the target (e.g., years of historical annual audited financial statements required). In addition, a registrant must also present pro forma financial statements that give effect to the acquisition, in compliance with Article 11. As a general rule, the registrant must file these target and pro forma financial statements within 75 days after an acquisition is consummated, with a Current Report on Form 8-K. However, a registrant that registers or offers securities may need to provide these financial statements much earlier and include these in the relevant SEC filing or offering document; for instance, in its registration statement, prospectus supplement or merger proxy statement, as applicable. Furthermore, while these rules technically only apply to SEC filings and registered offerings, market practice has evolved such that practitioners, in general, substantially adhere to them in the context of exempt offerings.

Rule 3-05 and Article 11 of Regulation S-X should be read and understood in conjunction with "Topic 2: Other Financial Statements Required" and "Topic 3: Pro Forma Financial Information" of the Financial Reporting Manual ("FRM")2 of the SEC's Division of Corporation Finance ("Corp Fin").

Threshold Questions

In determining whether Rule 3-05 financial statements will be required in connection with an acquisition, the first order of business is to ask two threshold questions: (1) Do the assets and liabilities acquired or to be acquired by the registrant constitute a "business?" and (2) Has the transaction been consummated or is it "probable?"

Is the Target a "Business"?

The SEC prescribes a "facts and circumstances" analysis to determine whether an acquisition constitutes the acquisition of a "business," rather than of just assets.3 The focus of the inquiry is whether there is sufficient continuity of operations so that disclosure of prior financial information is material to an understanding of future operations. There is a presumption in Rule 11-01(d) of Regulation S-X that a separate entity, subsidiary, or division is a "business" for Rule 3-05 purposes. However, a lesser component of an entity, such as a product line, also may be considered a business. In evaluating whether a component of an entity can be considered a business, Rule 11-01(d) requires registrants to consider (1) whether the nature of the revenue-producing activity of the component will remain generally the same as before the transaction and (2) whether the facilities, employee base, distribution system, sales force, customer base, operating rights, production techniques, or trade name of the component will remain with the component after the transaction.

Moreover, the SEC rules treat a group of related businesses as a single business for these purposes. Under Rule 3-05(a)(3), businesses shall be deemed to be related if they are under common control or management or their acquisitions are dependent on each other or a single common event or condition.4 Finally, FRM paragraph 2010.1 cautions that what constitutes a "business" for SEC reporting purposes (e.g., the Rule 11-01(d) definition applicable to a Rule 3-05 analysis) may be different from what constitutes a "business" for accounting purposes (e.g., under US GAAP).

Is the Transaction "Probable"?

Rule 3-05 applies not only when an acquisition has been consummated (e.g., the business combination has closed), but also when an acquisition is "probable." The term "probable" is not defined in Rule 3-05. However, FRM paragraph 2005.4 provides that the assessment of "probability" requires consideration of all available facts and that an acquisition is probable where the registrant's financial statements alone would not provide adequate financial information to make an investment decision. In practice, factors that may be considered to determine whether an acquisition is "probable" include the following: (i) a signed definitive agreement; (ii) a binding letter of intent; (iii) approval from the board of directors or shareholders of the seller and target companies; (iv) submission of transaction terms to regulatory authorities for approval; (v) receipt of required third-party approvals or consents material to the transaction; (vi) incurrence of financial penalties if acquisition is not consummated; and (vii) a public announcement of the acquisition. If the acquisition by the registrant is an acquisition of a "business" and such acquisition has been consummated or is probable, then the next query to be made in order to determine whether target financial statements are required is whether such acquisition is significant.

Significance Tests: Is the Acquisition "Significant?"

Registrants measure significance by using each of the three tests prescribed under the SEC rules: the asset test, investment test, and income test. These tests are based on the definition of a "significant subsidiary" under Rule 1-02(w) except that, for Rule 3-05 purposes, the 10% minimum threshold in Rule 1-02(w) is replaced by a 20% minimum threshold. For Rule 3-05 purposes, an acquisition is considered "significant" if it exceeds 20% on any of the three tests. The significance tests compare features of the acquired business (i.e., acquisition purchase price, the target's assets, pre-tax income (and revenue under the new rules)) to the registrant buyer and measure these relationships as a percentage. These significance tests, under the current rules and under the new rules, are illustrated in the tables below. Per FRM paragraph 2015.2, as a general rule, one should use and compare the most recent pre-acquisition annual financial statements of the target with the registrant buyer's most recent pre-acquisition consolidated annual audited financial statements to perform these tests.

Footnotes

1 See adopting release, SEC Release No. 33-107861 (May 20, 2020), available at https://www.sec.gov/rules/final/2020/33-10786.pdf.

2 The FRM, last updated on July 1, 2019, is available at https://www.sec.gov/files/cf-financial-reporting-manual.pdf.

3 See Rules 3-05 (a)(2) and 11-01(d). All rule references in this note are to Regulation S-X unless otherwise indicated.

4 See also FRM Section 2015.12

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Originally published 7 July 2020.

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