More than 18 months have passed since most registrants to the Securities and Exchange Commission (SEC) began adhering to new revenue recognition rules known as ASC 606, and the change took affect for private companies earlier this year. Meanwhile, the SEC has proposed changes to requirements related to M&A transactions and continued the debate surrounding disclosures related to a company's effect on the environment.
To find out how registrants are handling these complex issues, Toppan Merrill commissioned Mergermarket to speak with three leading experts on SEC disclosure policies for their insights.
Toppan Merrill question: The SEC recently proposed changes to financial disclosures related to acquisitions and divestitures. If this proposal is ultimately adopted, what effect do you think it would have on acquirers and sellers? Could this be a significant benefit? And for shareholders, could this be a major point of controversy? Leading industry experts weigh in...
Andrea Basham, Cleary Gottlieb: Just as background, this rule proposal comes out of the Disclosure Simplification Initiative that began in 2012 with the
JOBS Act. In 2015, Congress then mandated the SEC to look at ways to make disclosure simpler, which was a big shift at the time. And the SEC has done a lot to fulfill that mission.
This particular rule proposal comes out of an SEC concept release responding to the Congressional mandate, and it follows a prior rule proposal also on financial disclosures. Separately, there have been a number of other proposals on more qualitative disclosure mandated by Regulation S-K.
This rule specifically is one that we and our clients really support. For lawyers, acquirers, and targets in an M&A deal, financial disclosure related to the acquisition that will be required down the road is something that frequently ties up negotiations for some period of time. The reason is that when you have a private target that is material or significant to the acquirer, the acquiring company suddenly has an obligation to produce audited, historical financial statements, which the target may never have maintained, and pro forma financial information.
I think the market’s view generally is that investors don’t need the level of detail required by the existing rules and the new proposal is more realistic in balancing investor needs with practical solutions for companies. So this proposal could be really quite impactful from a disclosure burden perspective.
Jeffrey Cohen, Linklaters: I doubt that this change would have any effect on actual M&A activity. That being said, it would be a helpful fix, because what happens a lot of the time is that we wind up needing to complete financial statements and pro formas for acquisitions that are really just not material. You end up with some odd results when you run the tests that determine whether or not you need to file those financial statements.
Basically, there are three tests. First is how much an acquirer is paying relative to their total assets – if that number is over 20%, you have to include the financials and the pro formas. The next test looks at the buyer’s assets compared to the assets they’re acquiring – if that number is over 20%, you need to include historical financials and pro formas. And the third test is basically earnings – specifically, it looks at income from continuing operations before taxes, and compares it to the target’s income.
So if you reach 20% for acquisitions or 10% for dispositions on any of those tests, you have to include at least one year of historical financials of the target and one year of pro formas. And that can cause all kinds of difficulties in terms of timing and expense. In some cases, you have to get the cooperation of the target before you've closed the deal, which can be difficult. So there are lots of practical issues with doing it.
And what happens sometimes is that the tests have odd results. I think most people's instinct would be to look at acquisitions by revenue – as in, how much is the buyer’s revenue relative to the target’s revenue? Because the income test involves income rather than revenue, if there is a one-time expense, that can put a weird spin on the test, and if you have losses, that also puts a weird spin on it. So what happens very often is that we get surprising results.
The SEC proposal would change the procedure so that the income test would only apply if you also trip the revenue test. That means that as long as revenue doesn't exceed 20%, you don't have to worry about the income test.
The upshot of this proposal is that at the margins, there would definitely be fewer situations in which you trigger this requirement. That's a good thing in many respects. It saves people money and time.
From the SEC's point of view, it’s also good because what sometimes happens when we trip that test and are about to do a debt deal is that we switch to doing a 144A deal instead of a registered deal. And that’s fine for us, but the SEC doesn't like it from a policy point of view, because they believe it's better that transactions be regulated.
Amisha Shrimanker Kotte, Jones Day: This proposal has been well-received by issuers. The SEC is focusing on a principles-based approach and here they are easing the financial disclosure burden that comes with certain acquisitions and dispositions, while at the same time providing investors the material information they would want to have when a transaction at that level occurs. These changes essentially help both parties.
One of the most beneficial aspects of the proposal would be the elimination of the requirement to provide a third year of audited financial statements for acquired businesses. This is something we’ve discussed with a number of clients over the years, and that information is generally considered to be stale and not really beneficial for shareholders. These financials can also be rather difficult and costly to prepare if you have a private target. This would be a welcome change for companies generally, since it would certainly ease the compliance burden.
Other changes would actually take into account how companies are impacted in a transaction, and reflect the relative economic impact of an acquisition on filers. If you're a company that has low net income, you may hit a significance threshold under some of the tests just because of your low net income. The SEC has taken that into account in the proposal so that such companies with unique factors fall under a new definition of significance, allowing them to not have to provide unnecessary additional disclosure.
Overall, this proposal is viewed positively. The staff looks to have reflected on a number of issues that filers have raised over the years about these requirements, and has added in desired changes.