By James Hamilton, J.D., LL.M.
The SEC staff has given guidance on a FAQ allowing a company to exclude internal controls related to acquired businesses from the scope of management's assessment of internal controls in the first Form 10-K following the business combination. Steven Jacobs, Associate Chief Accountant, emphasized that judgment is important when applying this exclusion. Specifically, the staff typically expects management's report on internal controls to include controls at all consolidated entities. That said, he continued, the staff understands that it may not be possible to assess the internal controls related to a recently acquired business if there is not adequate time between the consummation date and the assessment date.
In these cases, said the SEC official, management should use its judgment in making the determination as to whether it is possible to complete an effective assessment of the target in light of the timing. If an assessment of the target is clearly possible considering timing and other circumstances, he noted, it may be difficult for the SEC staff to understand how users are best served by excluding it.
In Mr. Jacobs’ view, the staff did not contemplate reverse mergers when responding to the FAQ. However, analogizing to that response, the staff acknowledges that there may not always be adequate time to complete an assessment of the acquirer's internal controls between the consummation date and the assessment date. In those situations, the staff would understand that completing the assessment may be impracticable. The earlier in the year in which the transaction is consummated, he reasoned, the more practicable an assessment may be.
On the question of full blown relief, he observed, one must ask whether any meaningful assessment of what is left over can be done. There are many factors to consider when making that determination. Again, timing becomes an issue. If the transaction occurs early in the year, he reasoned, there may be enough time to fully integrate controls and processes and complete an assessment of the merged entity's internal controls.
However, if the transaction occurs late in the year, it still seems that a meaningful assessment of the legal acquirer's internal controls may be possible. In some mergers, plans to integrate companies may just begin to be formed at the time the merger is consummated and actual integration of employees, systems, processes, and therefore internal controls, may not occur for months.
In these cases, the SEC staff finds it likely that the internal controls for the legal acquirer or issuer would still be in place as of the assessment date and an issuer would be able to conduct an assessment of its internal controls even if it were to exclude the internal controls of the accounting acquirer. This would seem even more likely if management of the legal acquirer stayed on board after the transaction closed leaving entity level controls generally intact as well.