Earlier this year, the Securities and Exchange Commission updated its requirements to provide financial information about acquisitions and dispositions of businesses and real estate operations, the first time that these requirements had been comprehensively addressed in over 30 years. The amendments impact disclosure in current reports under Form 8-K, which are filed by reporting companies, as well as disclosure in certain transaction filings (registration statements, proxy statements and prospectuses).
In addition to changes to the content and presentation of financial disclosure under Regulation S-X, the amendments are intended to raise the threshold when determining whether acquisitions and dispositions are significant for purposes of triggering financial disclosure. The amendments – of particular interest to real estate investment trusts (“REITs”) – clarify that the investment test under Rule 1-02(w) is to be used to measure the significance of transactions in real estate operations. The amendments also more closely align the financial disclosure requirements for acquisitions of real estate operations under Rule 3-14 with those applicable to acquisitions of other businesses under Rule 3-05.
The amendments will be effective on January 1, 2021, but voluntary compliance is permitted in advance of the effective date as long the registrant complies with the amendments in their entirety.
As the Commission explains in the press release accompanying the final amendments, when a registrant acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the registrant.
Rule 3-14 of Regulation S-X addresses the unique nature of real estate operations and requires a registrant that has acquired a significant real estate operation to file financial statements with respect to such acquired operation.
In addition to the historical financial statements required under Rule 3-05 or 3-14, Article 11 of Regulation S-X requires registrants to file unaudited pro forma financial information relating to the acquisition or disposition. Pro forma financial information typically includes a pro forma balance sheet and pro forma income statements based on the historical financial statements of the registrant and the acquired or disposed business, including adjustments to show how the acquisition or disposition might have affected those financial statements.
Changes to Significance Tests for Acquisitions and Dispositions
The significance of an acquisition or disposition is measured using the investment, asset and income tests under the “significant subsidiary” definition in Rule 1-02(w) of Regulation S-X, Securities Act Rule 405 and Securities Exchange Act Rule 12b-2. The amendments revise the investment test and the income test, but no substantive revisions were made to the asset test. Furthermore, the amendments clarify that only the investment test should be used for real estate operations.
The amendments, among other things, update the significance tests by:
The amendments also modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required by:
In terms of periods to be presented, the amendments require the financial statements of the acquired business to cover no more than the two most recent fiscal years, though three years of historical financial statements for a target company still could be required in a transaction subject to a shareholder vote.
Changes Specific to Real Estate Operations
Certain amendments that specifically affect real estate operations are summarized below. Where they are referenced, “Rule 3-14 Financial Statements” refer to separate audited annual and unaudited interim abbreviated income statements with respect to such real estate operations.
“Real estate operation” is defined as “a business that generates substantially all of its revenues through the leasing of real property,” with the term “substantially” being dependent on the specific facts and circumstances.
The amendments clarify that a real estate operation is a “business” as that term is used in Article 11 for purposes of pro forma financial disclosure.
The significance threshold for individual acquisitions and dispositions is the 10 percent significance threshold in Rule 1-02(w).
Due to the nature of a real estate operation, staff interpretations have sought to focus registrants on the investment test in Rule 1-02(w), adapted to compare the registrant’s and its other subsidiaries’ “investments in” the real estate operation, including any debt secured by the real properties that is assumed by the registrant, to the registrant’s total assets at the last audited fiscal year end when determining “significance” under Rule 3-14.
The significance threshold for individual acquisitions and dispositions of real estate operations aligns with the 20 percent threshold for businesses in Rule 3-05.
New Rule 3-14(b)(2) requires the use of the investment test in Rule 1-02(w) to determine the significance of the acquisition or disposition of a real estate operation. The new rule requires a registrant to compare its (and its other subsidiaries’) investments in and advances to the tested subsidiary to the aggregate worldwide market value of the registrant’s voting and non-voting common equity, when available.
If the registrant’s significance test is based on total assets (vs aggregate worldwide market value), consistent with the old rule, the test should be adapted to compare the registrant’s and its other subsidiaries’ “investments in” the real estate operation, including any debt secured by the real properties that is assumed by the registrant, to the registrant’s total assets as of the end of the most recently completed fiscal year.
The significance test for blind pool offerings by non-traded REITs is codified to compare the registrant’s and its other subsidiaries’ “investments in” the real estate operation to the sum of: (1) The registrant’s total assets as of the date of the acquisition, and (2) The proceeds (net of commissions) in good faith expected to be raised in the registered offering over the next 12 months.
Registrants must aggregate consummated and probable acquisitions since the date of the most recent audited balance sheet that are less than 20 percent significant, and if the significance of the aggregated group exceeds 50 percent:
The amendments also update current reports on Form 8-K, with more specific requirements on acquisitions and dispositions of real estate operations. The amendments:
We expect that the foregoing amendments will result in additional staff guidance as well as substantial revisions to the Commission’s Financial Reporting Manual, including sections of the Manual that address real estate operations.
1 The Commission notes that, in some circumstances, accountants might need to perform additional work to meet the “reasonable investigation” and “reasonable care” due diligence standards of the Securities Act in order to provide negative assurance to underwriters on the combined pro forma financial information.