On May 3, 2019, the SEC proposed amendments to its rules and forms which would revise the disclosure requirements for financial statements relating to acquisitions and dispositions of businesses. We believe that most aspects of the proposed amendments, if adopted in current form, are thoughtful revisions to existing rules and will be beneficial to public companies, although we believe that a couple of aspects of the proposed amendments noted below may bear reconsideration by the SEC.
Key aspects of the proposed amendments include the following:
- Updating the significance tests by:
- increasing the significance threshold for a disposed business (triggering the requirement to file pro forma financials) from 10% to 20% (mirroring the existing percentage threshold for acquired businesses).
- revising the “income test” in the definition of “significant subsidiary” under Regulation S-X, particularly to include a revenue as well as (after-tax) income component to such test, which will eliminate anomalies existing under the current rules (which do not include a revenue component) when a registrant has net income close to zero and a filing may be triggered even where a registrant is much larger than an acquired or disposed company.
- revising the “investment test” in the definition of “significant subsidiary” under Regulation S-X, including to provide that the purchase price in an acquisition or disposition (which is the numerator in such test) will be compared to the equity value of the registrant rather than (as under the current rules) to the book value of the total assets of the registrant.
- expanding the use of pro forma financial information in measuring significance, which may provide added flexibility to registrants in determining significance under certain circumstances.
- Revising the periods of audited financial statements of an acquired company to be filed in acquisitions and the associated percentage thresholds, including to require financial statements of the acquired business to only cover the two most recent fiscal years rather than the three most recent fiscal years where significance exceeds 50%.
- Eliminating the requirement to include separate historical financial statements of an acquired company following such time that such financial results have been included in the consolidated financial statements of a registrant for a complete fiscal year, which revision may be particularly beneficial in the IPO context.
- Amending certain aspects of the existing pro forma financial information requirements, as discussed below.
With respect to the revisions to the denominator of the investment test, the SEC has proposed to change the denominator in the test from the total assets of the registrant and its subsidiaries to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (when the common equity is traded on a market). However, while we understand the SEC’s efforts to revise the denominator to a metric more reflective of fair value, we believe that the equity value of a registrant alone will not be a reasonable approximation of the fair value of the registrant in certain circumstances where a registrant has a significant amount of leverage. As a result, we suggest the denominator in the revised investment test should take into account the value of the outstanding indebtedness of the registrant. We have submitted a comment letter to the SEC suggesting that the indebtedness of a registrant be taken into account in connection with determining the fair value of a company in the denominator of the investment test (such as through providing that the denominator in the investment test would be the greater of the equity value or enterprise value of a registrant).
With respect to the amendments to the pro forma financial information requirements, the proposed adjustments contemplate two forms of pro forma adjustments, (1) transaction accounting adjustments, which would reflect the accounting for an acquisition, disposition or other transaction under GAAP; and (2) management adjustments, which would require adjustments for synergies and other impacts of the acquisition or disposition that are reasonably estimable if such events have occurred or are reasonably expected to occur (in contrast, the SEC’s current rules do not contemplate adjustments for post-closing actions expected to be taken by a registrant). Moreover, qualitative disclosure would be required under the proposed rules for any such effects that are not reasonably estimable. These revisions would include a forward-looking component in pro forma adjustments, which has the potential to broaden the liability exposure of registrants when preparing such management adjustments. It remains to be seen the extent to which the SEC will revisit this forward-looking component given these liability concerns.
Following the SEC’s receipt of comments on the proposed rules (which are due by July 29), the Staff will process and review the public responses prior to promulgating final rules. We will provide an update to this post at such time that the SEC has promulgated final rules.