Securities Regulation and Corporate Governance

​On May 3, 2019, the Securities and Exchange Commission announced (available here) proposed changes to existing disclosure requirements in connection with acquisitions and dispositions of businesses.  The proposed rules (available here) are intended to: (1) improve financial disclosures regarding the acquisition and disposition of businesses, (2) facilitate more timely access to capital, and (3) reduce the complexity and compliance costs related to such disclosures.

The proposed rules, if adopted, would represent a modest but welcome change for registrants that are involved in M&A activity.  A registrant is required to file financial statements of the target business and pro forma financials of the registrant if the acquisition is deemed “significant" under one of three tests set forth in Rule 1-02(w) of Regulation S-X: an investment test, an asset test and an income test.  At times, these tests have resulted in a technical requirement to prepare and file financial statements of an acquired business even when the acquisition may not be material under other applicable analysis, such as when there is an anomaly in financial results in a particular year.  Registrants have also struggled with providing three years of audited financial statements for target businesses that are not subject to SEC reporting requirements.  Although the Staff has frequently granted waivers that alleviate this burden on a showing of cause, the proposed rules would significantly reduce the circumstances in which the time-consuming and uncertain waiver request process is undertaken.  The proposed amendments to the significance tests are intended to reflect more accurately the relative significance to the registrant of the acquired business.

The following is a summary of some of the key changes proposed by the SEC:

Proposed Changes to Significance Tests

• Revise the “Investment Test" under Rule 1-02(w) to compare the investment in, and advances to, the acquired business against the aggregate worldwide market value of the registrant's voting and non-voting common equity, including shares held by affiliates, measured as of the last day of the registrant's most recent fiscal year, as opposed to the existing carrying value of the registrant's total assets (unless the registrant has no such equity value (such as a pre-IPO registrant), in which case the existing asset-based test would continue to apply);
• revise the “Income Test" under Rule 1-02(w) to add a new revenue component and to simplify the calculation of the net income component by using income or loss from continuing operations after income taxes, requiring financial statements only if the registrant meets both components of the test (and only for the number of years required by the lower of the two tests), with the goal of reducing the likelihood that marginal or break-even net income or loss in a recent fiscal year will distort the significance analysis for otherwise immaterial acquisitions;
• expand the circumstances in which a registrant can use pro forma, rather than historical, financial information for significance testing, with the goal of reducing circumstances in which pro formas are required for immaterial acquisitions; and
• conform the significance threshold for a disposed business from 10% to 20%, conforming to the lowest significance threshold for acquisitions.
  
  Proposed Changes to Time Periods Required and Related Disclosures
• Reduce from three to two years the financial statements required for the acquired business when the relative significance exceeds 50% under any measure, and to require only the most recent interim period (omitting the comparative prior interim period) when relative significance does not exceed 40% under any measure;
• expand the circumstances in which separate acquired business financial statements can be omitted once the business has been included in the registrant's post-acquisition financial statements for a complete fiscal year; and
• modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required.
  
  Other Proposed Amendments
• Permit the use of IFRS-IASB without reconciliation to U.S. GAAP, and to permit the use of IASB-reconciled home county IFRS, in certain circumstances;
• align Rule 3-14 (for acquisitions of real estate operations) with Rule 3-05, where no unique industry considerations exist;
• amend the pro forma financial information requirements, including disclosure of “Transaction Accounting Adjustments" reflecting the accounting for the transaction, and “Management's Adjustments" reflecting reasonably estimable synergies and transaction effects;
• include a definition of significant subsidiary that is tailored for investment companies; and
• include a new Rule 6-11 and amend current Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.

The changes to the significance tests will affect other disclosures not related to acquisition financials, notably the identification of significant subsidiaries listed in an exhibit to a company's Form 10-K.  Similarly, as representations and warranties in purchase agreements and underwriting agreements often cover “Significant Subsidiaries" by reference to Rule 1-02(w), their scope of coverage may be impacted by these changes.

The proposal will have a 60-day public comment period following its publication in the Federal Register.  Comments may be submitted (1) via the internet at http://www.sec.gov/rules/other.shtml; (2) via e-mail to rule-comments@sec.gov (with “File Number S7-05-19" included on the subject line); or (3) via mail in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.  All submissions should refer to File Number S7-05-19.

***

Special appreciation to Rodrigo Surcan for his contribution to this post.