May 10, 2019

SEC Proposes Amendments to Financial Disclosures in M&A

Cydney Posner

This morning, once again without an open meeting—whatever happened to government in the sunshine?—the SEC  voted to propose amendments intended to improve the disclosure requirements for financial statements relating to acquisitions and dispositions of businesses.  According to the press release, the proposed changes are designed to “improve for investors the financial information about acquired and disposed businesses; facilitate more timely access to capital; and reduce the complexity and cost to prepare the disclosure.”  The proposal will be open for public comment for 60 days.

The proposed amendments affect Rules 3-05 and Article 11 of Reg S-X, as well as related rules and forms.  Under Rule 3-05, acquiring companies must provide separate audited annual and unaudited interim pre-acquisition financial statements of the acquired business, with the number of years required determined on the basis of the relative significance of the acquisition. Article 11 applies to pro forma financial statements, and requires the company to file unaudited pro forma financial information with regard to the acquisition or disposition, including adjustments that show how the acquisition or disposition might have affected the historic financial statements. (The proposal also applies to rules and forms related to real estate businesses and investment companies, not discussed in this post.)

Among other things, the proposed changes would make the following changes:

Significance test. Currently, to determine the significance of an acquisition (and therefore the extent of the financial disclosure), under Rule 3-05, companies apply prescribed investment, asset and income tests set forth in the “significant subsidiary” definition in Rule 1-02(w). The proposal would revise the significance tests by modifying the investment test and the income test. The new investment test would “compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (‘aggregate worldwide market value’), when available.” The new income test would reduce the frequency of anomalous results that occur from relying solely on the net income component by requiring that “the tested subsidiary  meet both a new revenue component and the net income component.” It would also require use of after-tax income. The changes would also expand the use of pro forma financial information in measuring significance, and conform the significance threshold and tests for a disposed business.

Number of years.  Currently, if none of the significance tests exceeds 20%, no Rule 3-05 financial statements are required.  Between 20% and 40%, financial statements are required for the most recent fiscal year and any required interim periods; between 40% and 50%, a second fiscal year is required, and over 50%, a third fiscal year is required (unless net revenues of the acquired business were less than $100 million in its most recent fiscal year).  The proposal would reduce the number of years of required financial statements for the acquired business from three years to two years for an acquisition that exceeds 50% significance. In addition, the proposal would revise Rule 3-05 “where a significance test measures 20%, but none exceeds 40%, to require financial statements for the ‘most recent’ interim period specified in Rule 3-01 and 3-02 rather than ‘any’ interim period.”

Acquisition of component of entity. Where the acquisition is of a component, such as a product line or a line of business spread across more than one sub or division, but constitutes a “business” as defined in Rule 11-01(d),  the proposal would eliminate the need to make some allocations of corporate overhead, interest and income tax expenses by permitting the omission of certain expenses for these types of acquisitions if required conditions are satisfied.

Clarifications. The proposal would also revise “Rule 3-05 and Article 11 to clarify when financial statements and pro forma financial information are required, and to update the language to take into account concepts that have developed since adoption of the rules over 30 years ago.”

Individually insignificant acquisitions.   Currently, if the aggregate impact of “individually insignificant businesses” acquired since the date of the most recent audited balance sheet exceeds 50%, the company must include in a registration statement or proxy statement audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired, as well as related pro forma financial information as required by Article 11. The proposal would 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, among other things, requiring “pro forma financial information depicting the aggregate effects of all such businesses in all material respects and pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.”

International acquisitions. The proposal would modify Rule 3-05 to permit financial statements “to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to permit foreign private issuers that prepare their financial statements using IFRS-IASB to provide Rule 3-05 Financial Statements prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP.”

Omission of financial statements. Currently, Rule 3-05 financial statements are not required once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the acquiring company for a complete fiscal year, unless the financial statements have not been previously filed or, when previously filed, the acquired business is of major significance. Under the proposal, financial statements would no longer be required in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition company financial statements for a complete fiscal year, thus eliminating the requirement to provide financial statements when they have not been previously filed or when they have been previously filed but the acquired business is of major significance.

Use of pro forma for significance test.  Currently, a company may use pro forma, rather than historical, financial information if the company “made a significant acquisition subsequent to the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K.” The proposal would “expand the circumstances in which a registrant can use pro forma financial information for significance testing,” allowing companies, for all filings, to “measure significance using filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the registrant’s financial statements are required to be filed,” subject to satisfaction of specified conditions.

Pro forma financial information. Currently, pro forma financial information typically includes a pro forma balance sheet and pro forma income based on the historical financial statements of the acquiring company and the acquired or disposed business. Pro formas generally include “adjustments intended to show how the acquisition or disposition might have affected those financial statements had the transaction occurred at an earlier time.” In addition, the existing pro forma adjustment criteria “preclude the inclusion of adjustments for the potential effects of post-acquisition actions expected to be taken by management, which can be important to investors.” The proposal would “revise Article 11 by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and present the reasonably estimable synergies and other transaction effects that have occurred or are reasonably expected to occur.”  More specifically, the proposal would allow inclusion of “disclosure of ‘Transaction Accounting Adjustments,’ reflecting the accounting for the transaction; and ‘Management’s Adjustments,’ reflecting reasonably estimable synergies and transaction effects.” In particular, “Management’s Adjustments would be required for and limited to synergies and other effects of the transaction, such as closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements, that are both reasonably estimable and have occurred or are reasonably expected to occur.” The proposal would also revise Rule 11-01(b) to raise the significance threshold for the disposition of a business from 10% to 20%.

Smaller reporting companies. The proposal would make corresponding changes to the smaller reporting company requirements in Article 8 of Reg S-X.


While Commissioner Robert Jackson voted for the proposal, it was apparently not without some hesitation. In his statement, Jackson acknowledged that “the proposal provides several necessary updates to our rules. But I’m concerned that the proposal treats mergers as an unalloyed good—ignoring decades of data showing that not all acquisitions make sense for investors. Thus, while I vote to open this proposal for public comment, I urge investors to help us engage more carefully and critically with longstanding evidence that corporate insiders use mergers as a means to advance their private interests over the long-term interests of investors.”

To Jackson, M&A has both benefits and costs: “Some acquisitions create important efficiencies; others allow managers to build empires and extract value from investors. Our disclosure rules should give investors the tools to tell the difference.”  While creating economies of scale and efficiencies are positive effects, “research has long shown that they can also be used by executives to build empires, even if giving management more domain is not in investor interests.” He advocates that the disclosure rules should require more post-closing information to facilitate accountability, which would make “management more likely to pursue only those mergers that make long-term sense for investors.”  In his view, the shift in the methodology for determining “significance” from audit asset value to market value of equity  “could result in less disclosure about acquisitions made by companies whose market value is significantly different from their book value. The evidence shows that those are the mergers that are more likely to be bad deals—precisely the type of mergers for which we should require the most transparency That’s especially true in light of evidence suggesting that managers prefer to hide information about underperforming mergers in order to avoid accountability to investors.”

In addition, Jackson took issue with the release’s economic analysis, which he viewed as “one-sided,” going “on at length about the benefits of rolling back certain disclosures. But it says nothing about the foundational theory or evidence showing that mergers also come with substantial agency costs. The failure to grapple with these costs suggests that our regulatory choices reflect one-sided advocacy rather than sound economic analysis.” As an example, he observed that the analysis discussed the merger premium for the target, but “ignores the other half of this well-known equation: that acquiring companies’ stocks tend to take a hit upon the announcement of a merger. Looking at the performance of the combined company, which is more logically—and economically—sound, shows that many mergers are not in investors’ long-term interests,” as evidenced, he suggests, by more recent research not addressed in the analysis.

Cydney Posner

Counsel, Cooley LLP

Cydney S. Posner is special counsel in Cooley’s public companies group. Her practice concentrates on corporate counseling in connection with SEC reporting and compliance, corporate governance and general corporate matters. She has also represented both issuers and underwriters in numerous public offerings primarily for emerging growth companies, including companies in the internet and high technology, life sciences and consumer retail sectors. In addition, she has represented companies in mergers, tender offers and other change-of-control transactions, going-private transactions and private placements.