How the SEC’s Amendments to Financial Disclosures for Acquisitions Affect High-Yield Bond Offerings

On May 21, the Securities and Exchange Commission (SEC) adopted amendments to its rules governing financial disclosures relating to acquisitions and dispositions of businesses. Following review and consideration of public comments, the amendments were ultimately adopted largely as initially proposed on May 3, 2019. These adopted amendments will have a significant impact on financial disclosures in high-yield bond offering materials, both in the case of public offerings and back-end exchange offers, that are registered under the Securities Act of 1933, as amended (Securities Act), and in the more common “Rule 144A-for-life” private offerings, as market participants typically seek to comply in all material respects with the disclosure requirements applicable to offerings registered under the Securities Act. The adopted amendments will become effective on Jan. 1, 2021, although filers may voluntarily comply with the new rules before the effective date.

A discussion of the adopted amendments most relevant to high-yield bond offerings is set forth below.

Liberalization of Income Statement Pro Forma Adjustments

Under the previous SEC rules, a pro forma income statement could include only adjustments to historical results that were directly attributable to the relevant transaction, expected to have a continuing impact on the issuer, and factually supportable.

The adopted amendments replace the existing adjustment criteria with simplified standards to show the application of required accounting to the transaction and to provide management the option to show “synergies and dis-synergies” for which pro forma effect is being given (such as closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements that have occurred or are reasonably expected to occur). Such synergies and dis-synergies adjustments may be included if, in management’s opinion, they would “enhance the understanding of the pro forma effects of the transaction.”

Some of the most significant differences in the new standards are:

• The elimination of the “directly attributable” requirement.
• The effective change from a “factually supportable” standard to a “reasonably expected to occur” standard.
• Explicit endorsement of the inclusion of “synergies and dis-synergies” in “reasonably estimable” adjustment amounts.

While the SEC encourages synergies and dis-synergies adjustments, it recognizes that they may not always be appropriate; so it places certain conditions on their use. These conditions are related to the basis for presenting them, and are most notably:

• There should be a “reasonable basis” for each adjustment.
• The adjustments should be presented as if existing as of the beginning of the fiscal year of the relevant historical financial statement presented.
• The pro forma financial statement should reflect all adjustments that are, in the opinion of management, necessary for a “fair statement of the pro forma financial information presented,” including a statement from management to that effect.

The adopted amendments further require disclosure of the basis for and material limitations of each such adjustment, including:

• Material assumptions and uncertainties.
• To the extent material, an explanation of the method of calculation.
• An estimated time frame for achieving the synergies and dis-synergies of the adjustment.

The exact contours of permissible income statement synergies and dis-synergies adjustments will be established over time through the consultative and review processes of the staff of the SEC and, as a practical matter, the policies of the accounting firms in providing comfort. Nonetheless, it is safe to say that the adopted amendments will result in the inclusion of many synergies adjustments that are currently included in loan syndication materials but not high-yield bond offering memoranda.

Modification of the ‘Investment Test’ and the ‘Income Test’

The SEC requires audited and unaudited financial statements for the acquired business if it is considered “significant” to the issuer. The SEC measures “significance” as a percentage on a sliding scale by applying the following tests: the “investment test,” the “asset test” and the “income test.” An acquired business is significant if it exceeds a certain threshold under any one of the three tests, with greater disclosure required as the issuer exceeds greater thresholds. The amendments adopt changes to the investment test and income test, but do not change the asset test (the issuer’s proportionate share of the acquired business’s total assets to issuer’s total assets).

Under the previous investment test, the issuer’s investment or proposed investment in the acquired business was compared to the issuer’s total assets. Under the adopted amendments, if the issuer has publicly traded equity, such investment would be compared to the aggregate market value of all classes of the issuer’s common equity.

Under the previous income test, the acquired business’s income from continuing operations before taxes, as well as extraordinary items and the cumulative effect of changes in accounting principles, is compared to that of the issuer. The adopted amendments include an alternative revenue test (comparing the acquired business’s revenue to that of the issuer’s) pursuant to which the acquired business would need to exceed both the revenue and net income thresholds to be significant, with the lower percentage of the two tests determining whether and for how many years audited financial statements of the acquired businesses would be required to be presented. As adopted, however, the revenue component applies only to the extent that both the issuer (including its consolidated subsidiaries) and the acquired business have “material revenue” in each of the two most recently completed fiscal years.

Elimination of Third Year of Audited Statements of Acquired Businesses

Under the previous SEC rules, the requirement for an issuer to present audited financial statements for a business that has been or is likely to be acquired was based on whether the acquired business meets at least a 20% significance level under any of the investment, income or asset tests provided in the “Significant Subsidiary” definition in Rule 1-02(w) under Regulation S-X: one year of audited financial statements if a 20% level under any test is met, two years if a 40% level is met and three years if a 50% level is met. The adopted amendments, as proposed, eliminate the requirement to provide three years of audited financial statements where the relative significance of the acquired business exceeds 50%. In the case of an acquired business whose significance exceeds 20% but does not exceed 40%, the adopted amendments eliminate the requirement for prior-year comparative interim financial statements.

Omission of Acquired Business Financial Statements

Under the previous SEC rules, acquired business financial statements were required to be presented even after the acquired business has been reflected in the issuer’s financial statements for a complete fiscal year, if the acquired business is of “major significance” (i.e., significant at the 80% level) or the financial statements have not been previously filed with the SEC. Under the adopted amendments, the acquired business’s financial statements would no longer be required to be presented after the acquired business has been reflected in the issuer’s financial statements for a full fiscal year. Additionally, the adopted amendments permit the omission of pre-acquisition financial statements for acquired businesses that exceed 20% but do not exceed 40% significance after the acquired business has been reflected in the issuer’s financial statements for nine months.

Elimination of Carve-Out Acquisition Allocations

Under the previous SEC rules, in carve-out acquisitions, financial statements for the acquired business typically require an allocation of the seller’s corporate overhead, interest and income tax expenses. The adopted amendments permit issuers to prepare audited financial statements of assets acquired and liabilities assumed and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses), subject to certain qualifying conditions, most notably:

• Total assets and revenue (in each case, after intercompany eliminations) of the acquired business constitute 20% or less of the seller and its consolidated subsidiaries.
• The acquired business was not a separate entity or business during the periods for which financial statements would be required.
• Separate financial statements have not previously been prepared.
• The acquired business did not maintain “distinct and separate accounts” necessary for financial statements.

Additionally, the adopted amendments require that notes to the financial statements include additional disclosures, such as the type of and reason for omitted expenses and an explanation of the impracticability of providing separate financial statements.

Modification of Treatment of Individually Insignificant Acquisitions

Under the previous SEC rules, if the aggregate significance of individually insignificant businesses exceeds or would exceed 50%, issuers must present audited financial statements covering at least the mathematical majority under the relevant triggered tests of the acquired businesses. The adopted amendments now require audited financial statements and pre-acquisition historical financials only for acquired businesses whose individual significance exceeds 20%. However, the adopted amendments also expand the pro forma financial statement requirement to reflect the aggregate effects of all individually insignificant businesses regardless of significance, rather than reflect those that represent such mathematical majority.