The US Securities and Exchange Commission (SEC) has adopted improvements to the rules requiring separate target financial disclosures when SEC-reporting companies make ‘significant’ acquisitions or disposals.
The changes are effective from 1 January 2021 but voluntary early compliance is permitted provided such compliance is as to all the amendments.
SEC rules require SEC-reporting companies to include separate financials for the acquired or disposed of entity (and related pro forma financial information), where such entity is ‘significant’ to the reporting company, in periodic reports and registration statements.
Among other things, the changes aim to reduce the incidence of anomalous findings of significance. In such cases, reporting companies generally seek relief from the SEC from the requirement to file separate financial information, a process which can be time consuming and uncertain.
One goal of the changes is to reduce the need to apply for such waivers by tweaking the significance tests.
In many exempt transactions by non-SEC reporting companies, such as those under Rule 144A, such companies seek to comply with these rules by analogy to the extent possible as a benchmark for meeting the Rule 10b-5 disclosure standard.
However, such compliance is time consuming and costly, and can be difficult to justify, particularly if sophisticated home country jurisdictions would not impose analogous requirements in the same situation.
Because these SEC rules can be difficult to comply with for such exempt transactions from a practical perspective, this relaxation of the financial disclosure requirements can make it easier for companies to come to a view on the extent to which they would seek to comply.
UK significance tests
In the UK, the Listing Rules (LR) administered by the UK’s Financial Conduct Authority (FCA) also use a concept of significance to determine the appropriate level of disclosure for acquisitions and disposals by premium-listed companies on the London Stock Exchange.
LR 10 classifies transactions by size according to four different percentage ratios, known as class tests. These are:
- gross assets of the acquired entity divided by gross assets of the listed company;
- profits (pre-tax) attributable to the acquired entity divided by the profits of the listed company;
- consideration paid for the acquired entity divided by the aggregate market value of all ordinary shares of the listed company; and
- gross capital of the acquired business divided by gross capital of the listed company
Where any percentage ratio is 25 per cent or more, the transaction is Class 1 and prior shareholder approval is required for the transaction together with formal notification and an explanatory circular for shareholders. Where any percentage ratio is 5 per cent or more but less than 25 per cent, the transaction is class 2 and only formal notification is required.
These class tests for measuring significance are also used in a primary issuance context to determine whether an acquisitive company seeking a premium London listing meets the track record requirement that its financial statements included in a prospectus represent at least 75 per cent of its business for the past three years.
In other markets, for example, European high yield issuance and listings outside the UK (but marketed in the US to qualified institutional buyers under Rule 144A) where there may be no local jurisdiction formal significance test, the question of whether separate target financials are required to be included in the prospectus can be more pressing.
As a result, it is helpful to have an understanding of the changes the SEC has adopted. There are many aspects to the changes but here we focus on one aspect – the significance tests.
SEC changes on significance
The SEC rules have three tests – investment, income and assets tests – that are used to determine significance.
The amendments modify and update the investment and income tests while the asset test remains generally unchanged. They also expand the use of pro forma financial information in significance testing and conform the significance threshold and tests for disposals to that for acquisitions.
For M&A transactions, the investment test is revised to compare the fair value of the purchase consideration to the aggregate worldwide market value of the acquiring company’s voting and non-voting common stock.
Where no market value is available, the current metric, total assets of the acquiring company, is used. This change broadly aligns the SEC’s investment test with its LR 10 counterpart, the consideration test.
The biggest changes are to the income test. Currently, the income test compares the pre-tax income of the acquired entity to the pre-tax income of the acquiring company; and this is similar to its LR 10 counterpart.
The changes revise the income test to add a revenue component. Where both entities have revenue, the acquired entity must meet both the revenue and the income component.
The comparison yielding the lower significance outcome determines the level of disclosure required. Where either the acquiring company or the acquired entity lacks material annual revenue in each of the two most recently completed fiscal years, only the income component applies.
The SEC’s changes are generally welcome as they show some sensitivity to the realities of the corporate world, for example, where loss-making tech companies with large market capitalisations seek out acquisitions of smaller businesses at high valuations.
We believe the revisions should have the effect of requiring target company financial statements in fewer instances when the acquisition is not, in practice, significant.
By contrast, in the UK, the market relies on the FCA’s power of derogation to manage anomalous results from its class tests.