SEC Amendments to financial disclosures save money at the expense of investors

On May 21, the SEC published its final rule regarding Amendments to Financial Disclosures about Acquired and Disposed Businesses. While the feedback submitted during the comment period was generally positive and supportive of the proposed amendments, in our view the rule could have negative consequences for investors.

The amendments principally pertain to revisions to (i) Rule 3-05 of Regulation S-X, which requires a registrant to disclose certain subsidiary financial statements upon the acquisition or disposal of a “significant” subsidiary by the registrant, and (ii) Rule 1-02(w) of Regulation S-X, which sets forth a number of tests to determine what makes a subsidiary “significant.” Whether and what type of financial statements are required under Rule 3-05 depends on the size of the acquired or disposed business relative to the registrant under the significance tests. The three significance tests contained in the definition of “significant subsidiary” in Rule 1-02(w) of Regulation S-X are generally as follows:

• The investment test compares the value of the investments in and advances to the acquired business by the acquiror (i.e. the purchase price) to the total assets of the acquiror. Under the final rule, the metric used to measure the size of the registrant is changed from total assets to its “aggregate worldwide market value,” which is the market value of the registrant’s voting and non-voting common equity. Additionally, the amendments provide that “investments in and advances to” the acquired business include contingent consideration (e.g., potential earn-out payments conditioned upon achievement of certain post-closing milestones).

• The income test compares the income from continuing operations of the acquired business to the income from continuing operations of the registrant, each before taxes. The final rule adds a second component to this test, which compares the acquired business’s consolidated total revenues from continuing operations to consolidated revenues of the registrant for its most recent fiscal year.

• The asset test, which examines the value of the acquired business’s total assets relative to the total assets of the registrant, was not substantively revised by the amendments.

Under Rule 3-05, if none of the percentages obtained by applying each of the significance tests outlined above exceed 20% (meaning that the target business is less than 20% of the size of the registrant), then no separate financial statements of the target business are required to be disclosed in connection with the transaction. Under the prior rule, up to three years of financial statements may be required if any of the significance tests exceed 50%. Following the effectiveness of the amendments, however, the maximum number of years of financial statements required is reduced from three years to two years for transactions where any of the significance tests exceed 40%.

According to its May 21 press release, the SEC’s purported goal of the rule is to “improve for investors the financial information about acquired and disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure.” Commentators largely agree that the changes do achieve the SEC’s goal in reducing the complexity and cost to prepare disclosures. Nevertheless, we do not believe the revised rule actually improves the financial information available to investors; rather, these amendments may actually impair investors’ ability to monitor the performance of particularly risky or underperforming transactions.

In fact, two SEC commissioners raised public concerns regarding the reduction in disclosure. When the amendments were first proposed in May 2019, Commissioner Robert J. Jackson Jr. cautioned in a public statement that they ignored acquisitions intended not to create “synergies” or economies of scale, but instead to “extract private benefits at investor expense.” Specifically, the change in the investment test to use the market value of the registrant instead of the value of its audited assets may inappropriately exclude significant acquisitions by registrants whose book value is significantly different from its market value (e.g., when a registrant is highly leveraged). These transactions, Commissioner Jackson asserted, “are the mergers that are more likely to be bad deals—precisely the type of mergers for which we should require the most transparency.”

Commissioner Allison Herren Lee similarly dissented with respect to the approval of the final rule. In a statement on May 22, 2020, she noted that the “rulemaking does not adequately address the risks of reduced transparency for investors” with respect to mergers and acquisitions. Commissioner Lee highlighted that the reduction in the periods of financial statements required relating to particularly significant acquisitions from three to two years is not supported by “economic analysis or logic” and that the justification that such reduction does not materially impact the information received by investors is a “bare assertion in place of the identification and analysis of the costs of [the SEC’s] policy choices.” Particularly in times of great economic volatility, like the current global coronavirus pandemic, a reduction in financial data available to investors may present an inaccurate picture of an acquired business’s performance.

We agree with the concerns raised by Commissioners Jackson and Lee. While we believe that the amendments will reduce time and cost to registrants, we are skeptical that the disclosure reductions will have a net-neutral or net-positive benefit to investors. Institutional investors are generally sophisticated parties with the experience and resources to accurately interpret financial disclosures. The purported simplification of the disclosures is unlikely to materially benefit such investors in their ability to interpret the performance of their investments.

In reducing the amount and types of financial disclosures required following a significant acquisition or disposition, the SEC rolls back investors’ ability to monitor management following a transaction that does not benefit stockholders. While the SEC ought to be commended for its efforts to modernize and simplify its regulatory requirements, such efforts in this instance come at a potentially meaningful cost to stockholders, the very parties the SEC consistently intends to protect.

The views and opinions expressed in this publication are those of the authors and do not purport to reflect the views or opinions of VLP Law Group LLP. 