When a public company acquires a business or real estate operations, it may or may not have to provide historical financial information about the target in its SEC filings depending on how significant the target is relative to the overall size of the acquiror’s business. SEC rules include various tests based on investments, assets and income to determine the significance of an acquisition. Recently, the SEC modified these rules and tests, which in certain circumstances changes the historical financial information of the target that the acquiror must include in its SEC filings.
Reg. S-X Rule 3-05 applies to financial statements of businesses acquired or to be acquired, other than real estate operations. A registrant’s requirement to present the separate historical financial statements of such a business under Rule 3-05 depends on certain factors, including (1) whether the acquired assets and liabilities meet the definition of a business for SEC reporting purposes, (2) the significance of the acquisition and (3) whether consummation of the acquisition is probable or has recently occurred. The financial statement periods that must be presented are determined on the basis of the highest level of significance for the acquisition, which is assessed by performing the investment, asset and income significance tests provided in Reg. S-X Rule 1-02(w).
Reg. S-X Rule 3-14 applies to real estate operations to be acquired. Rule 3-14 differs from Rule 3-05 in a number of ways, including its requirements that a registrant file only abbreviated income statements for significant acquired or to be acquired real estate operations and that the number of periods to be presented is limited to the most recent fiscal year and interim period, if applicable.
In addition to filing the separate financial statements of an acquired or to be acquired business or the abbreviated income statements of an acquired or to be acquired real estate operation, registrants also need to consider whether they must provide pro forma financial information in accordance with Article 11 of Reg. S-X. Pro forma financial information helps investors evaluate the impact of a significant business acquisition by showing how that acquisition (or acquisitions) might have affected the registrant’s historical financial position and results of operations had the transaction occurred at an earlier date.
On May 20, 2020, the SEC adopted, effective January 1, 2021, amendments to the rules that govern financial disclosures regarding acquisitions and dispositions (the amendments). The amendments include, among other changes: (1) an update to the “significant subsidiary” test in Reg. S-X Rule 1-02(w), and (2) changes to the periods required under Reg. S-X Rule 3-05 for financial statements to be presented for acquired businesses. The 267-page adopting release can be found here. For the SEC’s summary of the changes in the amendments, see pages 9-11 of the adopting release. The amendments are intended to improve the information investors receive regarding acquired or disposed businesses, reduce complexity and costs of preparing the required disclosures, and facilitate timely access to capital.
Revised “Significant Subsidiary” Definition for Registrants Other Than Registered Investment Companies or Business Development Companies
The “significant subsidiary” definition in Rule 1-02(w), which is also included in the defined terms in Securities Act Rule 405 and Exchange Act Rule 12b-2, includes investment, asset, and income tests. These tests are applied when determining if a subsidiary is deemed significant for the purposes of certain Reg. S-X and Reg. S-K requirements as well as certain Securities Act and Exchange Act rules and forms.
The amendments revise the “significant subsidiary” test in Rule 1-02(w) as follows:
- Revised Investment Test. The amendments revise the “investment test” to take into account the aggregate worldwide market value of the registrant’s voting and non-voting common equity (worldwide equity value). Under the amended definition, a registrant must compare its investment in and advances to the business being acquired or disposed of with the registrant’s worldwide equity value. Worldwide equity value is calculated based upon an average of the value for the last five trading days of the most recently completed month prior to the earlier of (1) the announcement date or (2) the date of the agreement for the acquisition or disposition.
- Registrants without Worldwide Equity Value — For registrants without worldwide equity value (i.e., registrants whose common equity is not traded on any market), the revised investment test retains the current approach, in which the registrant determines whether the registrant’s consolidated investment in and advances to the business being acquired or disposed of exceed 10% of the registrant’s total consolidated assets as of the end of the most recently completed fiscal year.
- Treatment of contingent consideration — The amendments require that contingent consideration be included as follows:
- if required by GAAP or IFRS to be recognized at fair value by the registrant at the acquisition date, then it must be included in the registrant’s “investment in” an entity;
- if recognition at fair value is not required, all contingent consideration must be included in the registrant’s “investment in” an entity, other than contingent consideration for which the likelihood of payment is remote.
- Asset Test Is Generally Unchanged. The amended definition of a “significant subsidiary” retains in all material respects the existing “asset test,” except that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the registrant’s and its subsidiaries’ consolidated total assets when computing the asset test.
- Revised Income Test. The amendments add a revenue component that requires a registrant to compare its proportionate share of the revenue of the business being acquired or disposed of to the registrant’s consolidated total revenues from continuing operations, after intercompany eliminations.
- No material revenues — If either the registrant or the business being acquired or disposed of does not have material revenue in each of the last two fiscal years, the revenue component does not apply and the income component, i.e., the current “income test” as revised and clarified by the amendments, will apply.
- Interplay of existing income test and new revenue component — If the revenue component of the revised income test applies, the business being acquired or disposed of must meet both the revenue and income components.
- Use of absolute values — The amendments clarify that, when determining the income component, a registrant should use the absolute value of its equity in the pre-tax income from continuing operations of the business being acquired or disposed of.
- Expanded Use of Pro Formas Allowed. The amendments expand the circumstances in which registrants may use pro forma financial information to calculate the significance of a business acquired after its prior fiscal year end. Existing rules permit such use of pro forma financial information if the registrant filed Rule 3-05 financial statements and pro forma financial information related to the acquisition on Form 8-K, which effectively precludes the availability of this relief in initial registration statements. The amendments permit the use of pro forma financial information in calculating significance if:
- the registrant has filed the financial statements and pro forma financial information required by Rule 3-05 (or Reg. S-X Rule 3-14) and Reg. S-X Rule 11-01, respectively, for the acquisition, and
- the registrant continues to use pro forma amounts to determine significance for acquisitions and dispositions through the filing date of its next Form 10-K.
Revised “Significant Subsidiary” Definition for Registrants That Are Registered Investment Companies or Business Development Companies
Registered investment companies and business development companies, or BDCs, are required to use the Rule 1-02(w) significant subsidiary tests when applying Rule 3-05. The Rule 1-02(w) tests, however, are not tailored to the operations and accounting of investment companies or BDCs, and they are based on financial measures not commonly reported by these companies. In addition, the Rule 1-02(w) significance tests differ from the definition of “significant subsidiary” provided in Rule 8b-2 under the Investment Company Act of 1940, or the 1940 Act. To rectify these issues, the amendments add a separate definition of “significant subsidiary” for investment companies and BDCs in Rule 1-02(w)(2) and make changes to Rule 8b-2 to incorporate the new definition. The new definition eliminates the asset test for investment companies and BDCs, and makes them subject to investment company-specific versions of the investment test and income test:
- Investment Test. A subsidiary is significant if the value of investments in and advances to the business being acquired or disposed of exceeds 10% of the value of the registrant’s total consolidated investments as of the end of the most recently completed fiscal year.
- Income Test. A subsidiary is significant if the absolute value of the sum of (a) investment company income from dividends, interest and other income, (b) net realized gains and losses on investments and (c) net change in unrealized gains and losses on investments from the business to be acquired or disposed of in the most recently completed fiscal year exceeds:
- 80% of the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year; or
- 10% of the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year and the investment test described above is satisfied at the 5% level (instead of 10%);
provided that, if the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year is at least 10% lower than the average of the absolute value of such amounts for each of its last five fiscal years, the registrant may compute both conditions of the income test using the average of the absolute value of such amounts for the registrant and its consolidated subsidiaries for each of its last five fiscal years.
The new investment test is similar to the existing investment test but uses a comparison of the value of the registrant’s total investments rather than total assets to focus the significance determination on the impact to the registrant’s investment portfolio as opposed to including other non-investment assets. The new income test seeks to better reflect the impact of the business being acquired or disposed of on an investment portfolio by including net realized gains and losses and the net change in unrealized gains and losses, in addition to investment income.
Revisions to Reg. S-X Rule 3-05 – Financial Statements of Businesses Acquired or to be Acquired
The changes to Rule 3-05:
- Shorten from three to two years as the maximum time periods for which historical financial statements for an acquired business will be required.
- Specifically allow abbreviated financial statements when a registrant acquires a portion of an existing business (consisting of less than 20% of the assets and revenues of the seller), subject to satisfaction of certain conditions, and provides the presentation requirements for such abbreviated financial statements. Note – the amendments do not address the use of carve-out financial statements; these should continue to be addressed with SEC Staff pursuant to Reg. S-X Rule 3-13 relief.
- Modify Rule 3-05(b)(4)(iii) to provide that financial statements of an acquired business need not be presented once the operating results of the acquired business have been reflected in the audited consolidated financial statements for a period of nine months (if 20%-40% significance) or 12 months (if greater than 40% significance).
- Eliminate the current requirement to provide audited financial statements and pro forma financial information with respect to a substantial majority of insignificant acquisitions when a registrant has made multiple insignificant acquisitions that are over 50% significant in the aggregate, and replace that with a requirement to provide pro forma financial information depicting the aggregate effects of all such businesses in all material respects.
- Note – when determining the aggregate effect of the investment test for individually insignificant acquisitions, registrants should combine businesses acquired and real estate operations acquired.
New Reg. S-X Rule 6-11 – Acquisition Financial Statements for Fund Acquisitions
The amendments also introduce new Reg. S-X Rule 6-11 to specifically cover financial reporting in the event of a fund acquisition. Investment companies and BDCs must use Rule 6-11 instead of Rule 3-05 when a fund acquisition occurs or is probable to occur. The determination of whether a fund has been acquired or will be acquired is evaluated in light of the facts and circumstances involved, including whether an action will result in the acquisition by the registrant of all or substantially all of the portfolio investments held by another fund.
Rule 6-11 requires only a single year of audited financial statements, aligning with the financial reporting obligations under Reg. S-X Rule 3-18, which allows investment companies to file only one year of audited financial statements in registration statements. Investment companies and BDCs are required to file separate financial statements for acquired funds as follows:
- If neither of the significance tests (investment test and income test) is satisfied at the 20% level, financial statements and supplemental information are not required.
- If either significance test is satisfied at the 20% level, financial statements for the most recent fiscal year and the most recent interim period must be filed, as well as certain supplemental financial information.
- If the aggregate impact to an investment company or BDC of acquired funds and probable acquisitions causes either significance test to be satisfied at the 50% level, financial statements for the most recent fiscal year and the most recent interim period must be filed for each such fund, as well as certain supplemental financial information.
Separate financial statements of the acquired funds are no longer required once the portfolio investments of the acquired fund have been reflected in the acquiring investment company or BDC’s most recent audited balance sheet.
Revisions to Reg. S-X Rule 3-14 – Special Instructions for Real Estate Operations to Be Acquired
The changes to Rule 3-14:
- Conform many of the Rule 3-14 requirements to those of Rule 3-05 by:
- Increasing the significance threshold from 10% to 20%.
- Eliminating the current requirement to include three years of historical financial statements if the property is acquired from a related party.
- Removing the requirement to include Rule 3-14 financial statements once the acquired real estate operation is reflected in post-acquisition financial statements for nine months.
- Requiring significance to be tested with the investment test, with “investment in” a property required to include debt to be assumed.
- Codify existing staff guidance for registrants that are engaged in “blind pool” offerings, typically non-traded real estate investment trusts, or REITs. A registrant that is a non-traded REIT historically has applied adapted significance tests that permit it to compare its investment in an acquired real estate operation with (1) its total assets as of the date of acquisition, plus (2) the proceeds (net of commissions) in good faith expected to be raised in the registrant’s offering over the next 12 months. In addition to codifying these adapted significance tests, the amendments extend the use of the adapted significance tests to Rule 3-05 acquisitions by these registrants.
Changes for Smaller Reporting Companies and Issuers Relying on Regulation A – Article 8 of Regulation S-X – Financial Statements of Smaller Reporting Companies
The amendments revise Reg. S-X Rule 8-04 to refer to Rule 3-05 for the requirements relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for those financial statements, which should continue to be prepared in accordance with Reg. S-X Rules 8-02 and 8-03. The SEC stated in the adopting release that these revisions should ease compliance burdens and clarify the application of the rules for smaller reporting companies and issuers relying on Regulation A by focusing them on the more complete and better understood provisions of Rule 3-05. The amendments also expressly permit smaller reporting companies and issuers relying on Regulation A to omit historical acquired business financial statements if the acquired business has been included in the registrant’s results for either nine months or a complete fiscal year, depending on significance.
Financial Statements for the Acquisition of a Business That Is the Subject of a Proxy Statement or Registration Statement on Form S-4
Generally, the amendments do not affect the financial statements related to the acquisition of a business that is the subject of a proxy statement or registration statement on Form S-4. In certain circumstances, however, application of the amended significance tests may affect whether the financial statements of a subject business that is not an Exchange Act reporting company are required to be included in such a proxy statement or registration statement.
Effective Date and Transition Provisions
As noted above, the amendments are effective January 1, 2021. Voluntary early compliance is permitted, so long as registrants comply with the amendments in full. For an acquisition or disposition for which an Item 2.01 Form 8-K has been filed or is required to be filed before January 1, 2021 (or earlier, if voluntarily adopted before January 1, 2021), but for which the Rule 3-05 financial statements and Article 11 financial information is not required to be filed until after January 1, 2021 (or the earlier voluntary adoption date), the registrant must file the financial statements and pro forma financial information as required by the rules in effect as of the date the Item 2.01 Form 8-K was required to be filed.
The above is only a summary of some of the changes in the amendments, and you should contact one of the authors or your primary Nelson Mullins contact for specific advice as you consider an acquisition or disposition.
 The term “fund” includes any investment company as defined in Section 3(a) of the 1940 Act including a BDC, or any company that would be an investment company but for the exclusions provided by Sections 3(c)(1) or 3(c)(7) of the 1940 Act, or any private account managed by an investment adviser.