The SEC’s Small Business Capital Formation Advisory Committee voiced its support for the Commission’s proposal to amend Regulation S-X’s financial disclosure requirements relating to acquisitions and dispositions of business. However, the committee also recommended that the Commission explore revising its proposal in certain respects, including whether the proposed column for pro-forma management adjustments should be mandatory or optional.
Proposed amendments. The Commission voted to approve the proposed amendments in May. Currently, Rule 3-05 of Regulation S-X requires that a registrant that acquires a significant business other than a real estate operation must provide separate audited annual and unaudited interim pre-acquisition financial statements of that business (acquisitions of real estate businesses are subject to a separate rule). The number of years of financial information that must be provided depends on the relative significance of the acquisition to the registrant and is determined by a “significance test.” Whether an acquisition is “significant” is determined by one of three tests: the investment test, the asset test, or the income test. The proposed amendments would revise (1) the investment test to align more closely with the economic significance of the acquisition to the acquiring company; and (2) the income test by adding a new revenue component to the current net income component. The proposed amendments would also expand the use of pro forma financial information in measuring significance.
While the Commission’s vote on the proposal was unanimous, Commissioner Robert Jackson expressed concern that the proposal treats acquisitions as an “unalloyed good” instead of a tool that can be used by executives to “build empires,” even if giving management more domain is not in investor interests.
Presentation. The committee heard from two speakers on how the proposal could impact small businesses and investors: Matthew B. Swartz, a partner at Pillsbury Winthrop Shaw Pittman LLP; and Bill Korn, CFO of MTBC, Inc., a healthcare technology company that is an emerging growth company and a smaller reporting company. Both speakers applauded the SEC’s proposal but offered ways they thought it could be improved.
Swartz, who said he counsels mostly on small- and middle-market companies, discussed how the proposed changes look from the selling company’s point of view. According to Swartz, when a middle-market company is looking to sell, it considers price as a factor in deciding which buyer has the most compelling offer. However, the selling company will also consider factors relating to the certainty of closing the deal, such as whether the buyer actually has the money and its reputation and speed to close. The seller will also consider special requirements, such as foreign buyers’ compliance with CFIUS rules and whether it will be subject to providing audited financial statements.
Swartz broke down the general types of acquirors into four categories: private companies, private equity funds, small public companies, and large public companies. According to Swartz, small public companies seeking to acquire a business face a greater risk of not closing because they are more likely than large public companies to meet one of the significance tests, which would require the filing of a Rule 3-05 audited financial statement. Obtaining audited financial statements imposes costs and delays on the business, leading to uncertainty as well as the small company bidder being less competitive compared to larger public companies and private equity funds, Swartz explained. These factors make smaller public companies less appealing as acquirors and also inhibits their ability to grow by acquisition when targets prefer other buyers.
While the proposed changes will make small public companies more competitive acquirors, they would still be at a disadvantage to other buyers, Swartz said. The SEC can improve the proposal by placing more emphasis on detailed pro-forma information and explanations. When a company seeks to acquire another, audited financial statements are not as relevant as other information, Swartz explained. Instead, the company wants to know what the combined business would look like, which would involve a greater emphasis on detailed pro-forma information, Swartz advised. He also recommended studying the financial due diligence of successful private equity funds which do not always require audited financial statements.
Korn offered the perspective of a buying company, noting that MTBC has completed 15 acquisitions over the past six years, eight of which required MTBC to file audited financial statements under Rule 3-05 (or Rule 8-04 for smaller reporting companies). Like Swartz, Korn said that when he talks to investors and analysts, they never ask him about the 3-05 financials—they want to know how an acquisition will affect the company, including revenue, profit, and cash flow in future years.
Korn said the proposed changes are welcome, but he described some tweaks the SEC can make to the proposal to make it more useful to smaller companies. The SEC should eliminate the repeated filing of Rule 3-05/8-04 financials by allowing Forms 8-K to be incorporated in future registration statements, he advised. He also encouraged the SEC to allow carve-out or partial financial statements for asset purchases and eliminating intangibles and goodwill from prior acquisitions because they just get eliminated once the acquisition is complete.
He also advised using the aggregate worldwide market value for the investment test and including the value of all equity, not just common equity, in the test. If preferred stock has a valuation, it should be relevant to the investment test, according to Korn.
Finally, he would allow pro-forma information to include management adjustments in a way that doesn’t complicate the auditors comfort letter. Doing so would make pro-forma financial statements more relevant in many cases, he added.
Discussion. There was broad support for the SEC’s proposal by committee members, with some echoing the presenters’ suggestions for revision. Jeffery M. Solomon, CEO of Cowen, Inc., said that his company has a whole team to evaluate the three significance tests because they are so complicated. He noted that the three tests are part of the regulation because it needs to encompass all industries, but wondered if a market capitalization test would be better because it is “industry-agnostic.” Robert Fox of Grant Thornton disagreed, observing that that the three tests are needed because if a pure market cap test was adopted, IT and biotech companies would object since they frequently buy pre-revenue companies.
Some committee members expressed concern about the proposal’s provision that management’s adjustments be presented through a separate column in the pro-forma financial information after the presentation of the combined historical statements and transaction accounting adjustments. Carla Garrett, corporate partner at Potomac Law Group, noted that she had been general counsel at a smaller reporting company that had made several acquisitions and “that last column would have scared me to death” as general counsel. Even if subject to a safe harbor, she said that the acquiring company making outright disclosures about, for example, what facilities will close or how many employees will be laid off, could be inadvisable because even if anticipated at the start of the acquisition phase, the company may decide that it is not necessary, but it has already been disclosed in a public document, she cautioned.
Sara Hanks, CEO and co-founder of CrowdCheck, Inc., spoke about the impact of the rules on Regulation A companies and implored the Commission to give these companies a break. She observed that she has been in situations where there was an acquisition of a small company by an even smaller company, and the pro-forma rules in these situations are “just fantasy.” After going through rounds of comments and fine-tuning the eliminations in the pro-forma statement, all it results is an enormous bill from the accountants, according to Hanks.
Recommendation. The committee voted to support the Commission’s proposal, while recommending that it consider the following:
- Continue to look at Regulation A companies and how they are treated under the proposed rules; and
- Further look at disclosures of management’s adjustments, including whether synergies and the pro-forma column should be mandatory, optional, or not included at all.