SEC Streamlines Financial Disclosure Requirements Applicable to Business Acquisition and Disposition Transactions

On May 21, 2020, the U.S. Securities and Exchange Commission announced adoption of updates to the financial disclosure requirements of Regulation S-X and related rules applicable to the acquisition and disposition of businesses, including real estate operations. The SEC anticipates that the amendments will result in investors receiving more meaningful financial information regarding business acquisitions and dispositions by reducing the volume of information presented in disclosure documents and focusing financial disclosure on more decision-relevant information. This OnPoint provides a high-level summary of the final rules.

Updates to Significance Tests Applicable to Operating Businesses

The final rules update the significance tests used under Rule 1-02(w) and other SEC rules and forms to improve their application and to assist registrants in making more meaningful significance determinations. Rule 3-05 (Financial statements of businesses acquired to be acquired) under Regulation S-X sets forth the financial statement disclosure requirements of a business acquired or to be acquired by a registrant using a sliding scale tied to the level of significance of the acquisition determined by these tests. Therefore, these amendments will impact the scope of the required financial disclosures in business acquisitions and dispositions.

Rule 1-02(w) contains three significance tests: (1) the “investment test,” (2) the “asset test” and (3) the “income test.” The investment test compares a registrant’s and its other subsidiaries’ investments in and advances to an acquired business to the total assets of the registrant. The asset test compares a registrant’s and its subsidiaries’ proportionate share of the acquired business’s total assets to the total assets of the registrant. The income test compares the registrant and its other subsidiaries’ equity in the income from continuing operations of the acquired business before income taxes, exclusive of amounts attributable to any controlling interests, with the same measure in the registrant’s financial statements. The final rules amend the investment test and the income test, while leaving the asset test substantively unchanged.

As revised, the investment test will compare a registrant’s and its subsidiaries’ investments in and advances to the acquired or disposed business to the registrant’s aggregate worldwide market value, rather than its total assets. The substitution of worldwide market value for total assets is intended to address the current measurement mismatch between a registrant’s investments and advances in a subsidiary, which are typically measured at fair value, and a registrant’s total assets, which are measured at book value. The SEC believes that the use of aggregate worldwide market value in the investment test will provide a more meaningful measure of significance than the current test. If a registrant does not have an aggregate worldwide market value, the investment test will continue to require a comparison of a registrant’s and its subsidiaries’ investments in and advances to the acquired or disposed business to the registrant’s total assets.

The income test will be supplemented to include a new revenue component. Due to its exclusive reliance on net income, the current income test often causes registrants with marginal income or loss in a recent fiscal year to find subsidiaries or acquired or disposed businesses significant where they otherwise would not. The new revenue component of the income test will mitigate this result by comparing a registrant’s and its other subsidiaries’ proportionate share of the tested business’s consolidated total revenues (after intercompany eliminations) to the consolidated total revenues of the registrant. To satisfy the revised income test, the tested business must meet both the net income component and the new revenue component. Under the final rules, however, a registrant may use the lower of the revenue component and the net income component to determine the period for which Rule 3-05 financial statements are required for a business acquisition. If the registrant or acquisition target does not have recurring annual revenues in each of the two most recently completed fiscal years, only the net income component will apply and will be calculated based on the absolute value of the tested business’s consolidated income or loss from continuing operations.

In addition to these changes to the investment test and the income test, the final rules expand the use of pro forma information in measuring the significance of an acquired business. Under Rule 3-05, a registrant is generally permitted to use pro forma, rather than historical, financial information to test significance of a business if the registrant made a significant acquisition after the latest fiscal year-end and filed the required financial statements and pro forma financial information on a Form 8-K. As amended, Rule 3-05 will permit a registrant to measure the significance of an acquired or disposed of business using filed pro forma financial information that depicts only significant business acquisitions and dispositions consummated after the latest year-end for which the registrant’s financial statements are required to be filed, subject to certain conditions. This change is intended increase registrants’ flexibility to determine the relative significance of an acquired or disposed business without delaying or accelerating the filing of pro forma financial information that might occur if such pro forma financial information was required to determine significance.

The final rules also conform, to the extent applicable, the significance tests and thresholds to those used for acquired businesses.

Other Key Changes Applicable to Operating Businesses

In addition to the changes to the significance tests under Rule 1-02(w) described above and the updates specific to investment companies and business development companies (“BDCs”) described below, the final rules will also implement the following changes.

• Revise Rule 3-05 to reduce the maximum period of required historical financial statements of an acquired or to be acquired business from three years to two years for an acquisition that exceeds 50% significance.
• Permit disclosure of abbreviated financial statements for carveout transactions where the target business did not maintain separate financial statements, subject to certain presentation and disclosure requirements. To qualify to use abbreviated financial statements, the acquired component of an entity must have constituted 20% or less of the entity’s total assets and total revenues (both after intercompany eliminations) as of and for the most recent fiscal year.
• Permit the use of, or reconciliation to, International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (as opposed to U.S. GAAP) in certain circumstances involving the acquisition of a foreign business.
• No longer require a registrant to file separate acquired business financial statements once the business has been included in the registrant’s post-acquisition audited annual financial statements for either nine months (for acquisitions that exceed 20% significance but do not exceed 40% significance) or a complete fiscal year (for acquisitions that exceed 40% significance). Under existing Rule 3-05, an acquired business’s financial statements may be omitted by a registrant when the operating results of the acquired business have been reflected in the audited consolidated financial statements for a complete fiscal year. Under the current rule, however, if Rule 3-05 financial statements for the acquired business have not been previously been filed, they must be provided by the registrant even if the acquired business has been included in the post-acquisition audited results of the registrant. 
• Modify and enhance the required disclosure for the aggregate effect of individually insignificant acquisitions for which financial statements are not required or are not yet required. The amendments continue to require pro forma financial information showing the aggregate effect of all acquisitions that collectively exceed 50% significance, but provide that historical financial statements will only be required for those businesses whose individual significance exceeds 20%. Under the current rules, if a series of acquisitions exceeds 50% significance, a registrant must file the historical audited financial statements for those businesses constituting the mathematical majority of the group (i.e., businesses constituting more than 50% of the relevant test on which the businesses were determined to be significant in the aggregate) in addition to the pro forma financial statements.
• Clarify the application of Rule 3-14 (Special instructions for real estate operations to be acquired) regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements.
• Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist to standardize the requirements for acquired businesses overall while retaining the industry specific disclosure necessary for investors.
• Amend the pro forma financial information requirements of Article 11 of Regulation S-X by replacing the pro forma adjustment criteria with simplified requirements to present the accounting for the transactions in three columns: (1) a “Transaction Accounting Adjustments” column (adjustments required to account for the transaction under U.S. GAAP or IFRS); (2) an “Autonomous Entity Adjustments” column (for spinout transactions); and (3) an optional “Management Adjustments” column to show synergies and related forward-looking transaction effects (that have “a reasonable basis” and are necessary for a “fair presentation”).
• Clarify when financial statements and pro forma financial information are required, and update the language used in in the SEC’s rules to take into account concepts that have developed since adoption of the rules. Among other things, the final rules amend Rule 3-05 and Article 11 of Regulation S-X to (1) specify that financial statements are required if an acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by Rule 3-01 (Consolidated Balance Sheets), or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed and (2) provide that a registrant may continue to determine the significance using amounts reported in its annual report on Form 10-K for the most recent fiscal year when the registrant has filed its annual report Form 10-K after the closing date of the applicable acquisition, but before the date the registrant is required to file the target’s financial statements on Form 8-K.
• Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X.

Updates Specific to Investment Companies and BDCs

In addition to the changes described above, the final rules contain specific updates applicable to financial reporting for investment companies registered under the Investment Company Act of 1940, as amended (the “1940 Act”) and BDCs. In particular, the final rules (1) add a definition of “significant subsidiary” to Regulation S-X that is specifically tailored for investment companies and BDCs, (2) establish a new Rule 6-11 of Regulation S-X which will govern financial reporting for fund acquisitions in lieu of Rule 3-05 and (3) eliminate the pro forma financial information requirement for investment companies.

Investment companies and BDCs are currently required to use the significant subsidiary tests in Rule 1-02(w) when determining required disclosures for fund acquisition and disposition transactions. The final rules create a new “significant subsidiary” test applicable to investment companies and BDCs based on Rule 8b-2 of the 1940 Act. Unlike the significance test under Rule 1-02(w) and consistent with Rule 8b-2, the new significant subsidiary test for investment companies and BDCs has only two prongs: (1) an investment test and (2) an income test. The SEC has determined that an asset test is generally not meaningful when applied to investment companies. The new investment test for investment companies and BDCs will compare a registrant’s and its other subsidiaries’ investments in and advances to the tested subsidiary with the value of the registrant’s total investments, rather than the registrant’s worldwide market value (or total assets if no such worldwide market value exists) under Rule 1-02(w), as amended. The new income test applicable to investment companies and BDCs compares the total investment income of the tested subsidiary with the total investment income of the parent and its consolidated subsidiaries, consistent with Rule 8b-2, but includes any net realized gains and losses and net change in unrealized gains and losses in the calculation.

The adoption of new Rule 6-11 will govern the financial information required in fund acquisitions in lieu of Rule 3-05. Among other things, Rule 6-11 will require financial statements for the periods described in Rule 3-18 (Special provisions as to registered management investment companies and companies required to be registered as management investment companies) under Regulation S-X if the acquired fund is subject to Rule 3-18 and only one year of audited financial statements for other fund acquisitions (as opposed to up to two years, under the amended Rule 3-05), and will require interim and supplemental financial information at certain significance levels. Importantly, Rule 6-11 will require a fund to include in its disclosure documents the schedule of investments required by Article 12 of Regulation S-X for an acquired or to be acquired fund.

Finally, Rule 11-01, which currently requires a company to furnish pro forma financial information when a significant business acquisition has occurred or is probable, has been replaced for investment companies and BDCs. Instead, under the new rules, an investment company or BDC will be required to present the following information:

• A pro forma fee table, setting forth the post-transaction fee structure of the combined entity;
• If the transaction will result in a material change in the acquired fund’s investment portfolio due to investment restrictions, a schedule of investments of the acquired fund that shows the impact of such change and includes narrative disclosure describing the change; and
• Narrative disclosure about material differences in accounting policies of the acquired fund when compared to the newly combined entity.

In connection with these changes, the final rules also amend Form N-14 (Registration Statement under the Securities Act of 1933, as amended, for investment companies and BDCs) to, among other things, include financial statement requirements consistent with new Rule 6-11. 

Effectiveness and Transition

Registrants will be required to comply with the final amendments beginning with the registrant’s fiscal year beginning after December 31, 2020. Voluntary compliance will be permitted in advance of the effective date provided that the new rules are applied in their entirety from the date of early compliance.

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