by Cydney Posner
The SEC is requesting comment on certain Reg S-X rules as part of its Disclosure Effectiveness Project. The request relates specifically to the financial disclosure requirements in Reg S-X that require public reporting companies to provide financial information about entities other than the reporting company — acquired businesses, subsidiaries not consolidated and 50 percent or less owned persons, guarantors and issuers of guaranteed securities, and affiliates whose securities collateralize registered securities. Comments are due within 60 days after the request for comment is published in the Federal Register.
Generally, the SEC is seeking comment on how well the requirements identified below inform investors and how investors use the disclosures to make investment and voting decisions, as well as the challenges faced by companies in satisfying these requirements and potential changes that should be made to these requirements, particularly in light of the issues noted below. The rules under the microscope are:
- Rule 3-05, Financial Statements of Businesses Acquired or to be Acquired;
- Rule 3-09, Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons;
- Rule 3-10, Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered; and
- Rule 3-16, Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered.
Rule 3-05 requires a company that has acquired a business to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it is significant to the company, with the extent of disclosure depending on the relative size of the acquisition. Among the issues the SEC raises with regard to Rule 3-05 are current restrictions on pro forma adjustments that can prohibit companies from reflecting many significant changes expected from acquisitions, such as workforce reductions and facility closings, which are generally too uncertain to meet the criteria for adjustment. In addition, there is no pro forma information for comparative prior periods and the information is unaudited. Further, investors must often wait 75 days for the historical and pro forma financial statements. The SEC also notes that the Rule’s tests employ bright-line percentage thresholds that do not permit the use of judgment. Moreover, there is a disparity between the accounting rules and Reg S-X in the definition of what constitutes a “business” acquired for purposes of these tests: a “business” under Reg S-X focuses primarily on “whether the nature of the revenue-producing activity of the target will remain generally the same as before the transaction”; under applicable accounting standards, the focus is on “whether the target is an integrated set of activities and assets that is capable of being conducted and managed by a market participant for the purpose of providing a return.”
Rule 3-09 requires a company that owns 50 percent or less of an entity (“Investee”) to provide separate audited or unaudited annual financial statements of the Investee if it is significant. In addition, Rule 4-08(g) of Reg S-X requires disclosure in the financial statement notes of summarized balance sheet and income statement information on an aggregate basis for all Investees only if a Rule 3-09 test or an additional asset test exceeds 10% for any individual Investee or combination of Investees. However, the financial statements presented may use different accounting standards, fiscal year ends, and/or reporting currencies and therefore may be difficult to reconcile with the company’s financial statements. In addition, the aggregation of Investees in summarized financial information may also make it difficult to reconcile, impairing an investor’s ability to discern the impact of significant Investees. Similar to Rule 3-05, Rule 3-09 uses bright-line tests and does not permit the use of judgment.
Rule 3-10 provides certain exemptions, commonly used in parent-sub and sub-parent guarantees of securities, from the requirement that both issuers and guarantors of registered securities file their own audited annual and unaudited interim financial statements (since a guarantee of a security is a separate security). Under Rule 3-10, if specified conditions are satisfied — primarily that the subsidiary must be “100% owned” by the parent and the guarantees must be “full and unconditional” — the parent can provide alternative disclosures in its own annual and interim consolidated financial statements in lieu of providing separate financial statements for each subsidiary issuer and guarantor. Whether the company can then provide alternative abbreviated narrative disclosure or must provide alternative more detailed condensed consolidating financial information depends on satisfaction of other conditions. The SEC notes, however, that the alternative disclosure is “detailed and unique.” Even if alternative disclosure is permitted, in a registration statement, the parent may still need to provide pre-acquisition financial statements of significant, recently acquired subsidiary issuers/guarantors. In addition, the 100% ownership requirement means that alternative disclosure is not available for subsidiaries that are organized in jurisdictions requiring directors to own a small number of shares. Similarly, the requirement that a guarantee be “full and unconditional” means that alternative disclosure is not available when guarantees become enforceable only after the passage of some time period after default.
Rule 3-16 requires a company to provide separate annual and interim financial statements for each affiliate whose securities constitute a substantial portion of the collateral for any class of securities registered as if the affiliate were a separate registrant. The SEC notes that this requirement applies even though the collateral pledge is not a separate security. Companies have also expressed to the staff that the financial statements can be confusing. In addition, the percentage test applied to determine whether the collateral is a substantial portion is another bright-line test, made more difficult to apply when the market value of the securities, in the absence of a public market, may not be available.