Navigating the Waters of the SEC: An M&A Perspective
With Mary Jo White confirmed as Chairman of the SEC, and Paul Beswick named Chief Accountant of the SEC’s Office of the Chief Accountant, the remainder of 2013 will be a period of change at the SEC. Although little is known about their respective potential long-term agendas, in the near term, the SEC will need to complete several delayed rulemaking projects, including those required by the Dodd-Frank and JOBS Acts.
Many companies may be wondering what impact the potential changes at the SEC may have on their potential acquisitions. While there may be some short-term uncertainty at the SEC, there is no shortage of interpretive and regulatory guidance with respect to many deal-related topics. And whether completing a strategic acquisition, or contemplating a possible public debt filing or public exit strategy for a newly acquired portfolio company, understanding the SEC’s “rules of the road” can prove invaluable.
Some questions frequently encountered during a deal process include:
- How many years of financial statements are needed for the deal?
- What kinds of adjustments can I make to the historical financial statements?
- What kinds of performance metrics can be included?
- How long before someone asks about an internal control assessment?
And while answers to some of those questions are part art and part science, below are insights into the answers to those questions, in addition to highlights of some recent rulemaking developments of interest to dealmakers along the way.
Need for the Acquired Company’s Financial Statements
Both private equity investors (PEIs) and strategic buyers alike are frequently faced with the question of how many years of a target’s financial statements are needed for the deal. Public strategic buyers have to comply with SEC Regulation S-X, Rule 3.05 (Rule 3.05), which requires them to provide financial statements for significant consummated or probable business acquisitions. The significant acquisition rule focuses on three principle criteria: the investment test, the asset test and the income test. If any of those tests exceeds a threshold of 20%, at least one year of audited financial statements (and potentially up to three if any of the tests exceeds 50%) will be required. In addition, financial statements for probable acquisitions that exceed a 50% significance threshold will also be required. Note that the significance tests for a foreign target are the same as those for a domestic target. The significance tests must be performed with amounts based on U.S. generally accepted accounting principles (U.S. GAAP). Therefore, results of the foreign target will need to be converted to U.S. GAAP but do not need to be audited (i.e., for the purposes of computing significance tests). In addition, if the foreign target’s financial statements are required as a result of the significance tests, they must be audited in accordance with U.S. auditing standards—either U.S. GAAP or Public Company Auditor Oversight Board standards (depending on the circumstances).
Tip: When purchasing a foreign business that prepares financial statements using local GAAP (i.e., on a comprehensive basis of accounting that is other than U.S. GAAP), a public registrant in the U.S. can file those foreign GAAP financial statements as a means of complying with Rule 3.05 provided that the significance of the target is less than the 30% level. Generally, if greater than 30%, a reconciliation to U.S. GAAP must be provided.¹ In addition, if the foreign target prepares financial statements under IFRS as issued by the IASB, no U.S. GAAP reconciliation is required.
PEIs have a different set of issues, in that the target company’s financial statements typically become the foundation for a “predecessor-black-line-successor” type presentation (assuming that push-down accounting has been applied and therefore a change in basis is reflected in the financial statements) in the event of a “flip”² transaction to register debt in connection with the deal, or an eventual IPO exit. In these situations, because it is considered to be a predecessor, the target is typically required to have three years of audited financial statements and two years of additional unaudited data for purposes of the five-year table of selected financial data.
Tip: During diligence a buyer may identify a potential error in the target financial statements. This “error” may not actually impact the deal valuation or deal multiple (e.g., because the error may not impact cash-flows used to value the business), but identified errors in the target’s historical financial statements can still be a major issue for both PEIs and strategic buyers. The filing of target financial statements in accordance with Rule 3.05 (or in connection with a “flip”) typically comes with a degree of responsibility and potential liability on the part of the buyer with respect to known issues (i.e., they cannot file financial statements that contain known errors). Ferreting out and wrestling down potential accounting issues pre-deal, or prior to close, can provide buyers with ample time to identify and address any issues of filing the target’s financial statements.
Enter the JOBS Act
In 2012, President Obama signed into law the JOBS Act, intended to lighten the load on emerging growth companies (EGCs). Defined as a company with less than $1 billion in revenue,³ less than $700 million in market cap and not more than $1 billion in non-convertible debt issued over a rolling previous three-year period, an EGC can retain EGC status for up to five years—provided none of these thresholds are exceeded. The JOBS Act provides an EGC with several reporting accommodations. For example, EGCs would be allowed to present only two years of audited income statements (instead of the normal three) as well as be allowed to omit the additional three years of unaudited data typically required to complete the five-year selected financial table in an initial public offering. This is potentially big news both in terms of time and cost savings for PEIs and their portfolio companies. In addition, the SEC would not object to the EGC presenting only two years of Selected Financial Data as required under item 301 of Reg. S-K.
Cost and time savings for EGCs may also come in the form of relief from the requirement to obtain an external audit of their internal control over financial reporting (ICFR). EGCs, however, must continue to evaluate and assert the effectiveness of their ICFR. An EGC also benefits from a provision in the JOBS Act that allows it to adopt new or revised financial accounting standards on the basis of effective dates applicable to private companies (i.e., nonissuers) “if such standards apply to companies that are not issuers.”
Tip: A portfolio company of a PEI that issues debt in a 144A filing and then registers that debt via an S-3/S-4 “flip” is not eligible for the reduced financial statement requirements included in the JOBS Act for EGCs. This reduction is limited to registration statements for the initial public offerings of common equity securities. However, as a public debt filer only, it is automatically exempt from the auditor attestation standards because of its limited float.
Tip: Private companies have typically instituted put and call provisions on stock-based compensation awards in an attempt to limit the number of shareholders and keep that number below the 500 shareholder threshold. Because the JOBS Act raises that threshold to 2,000 shareholders in addition to providing an exemption for securities offered to employees under stock- based compensation arrangements,⁴ portfolio companies may consider alternate uses of cash instead of being potentially constrained to repurchasing their own shares.
Inclusion of Pro Forma Financial Statements and Non-GAAP Information
For private equity companies, exempt offerings to institutional investors under Rule 144A of the Securities Act of 1933 remain a popular alternative to both (i) financings registered with the SEC and (ii) other private placements. Historically, however, Rule 144A debt filings have been followed shortly thereafter by a public registration of the underlying debt on Form S-3/S-4. Accordingly, when considering the information presented in a 144A filing, it is quite commonplace for practitioners to consider and apply the SEC’s rules on pro forma adjustments to a 144A filing. Those SEC rules, outlined in Article 11 of Regulation S-X, require that pro forma adjustments be limited to those events that are: directly attributable to the transaction, expected to have a continuing impact on the registrant and factually supportable.
Tip: In an M&A environment, where buyers are frequently moving quickly and have limited access to information or personnel of the target company, application of the SEC’s pro forma rules is often not as straightforward as one might think. Consider the following examples highlighted by the SEC at the 2011 AICPA Conference:⁵
- A pro forma adjustment to eliminate compensation expense related to a 14% reduction in a target’s work force after the acquisition would not meet the “factually supportable” criterion because the “termination is not limited to compensation expense” for the terminated employees (i.e., the corollary impacts of the workforce reduction on revenues and compensation of other employees is not known).
- A pro forma adjustment that eliminates a goodwill impairment charge in the historical financial statements of the target would not meet the “directly attributable” criterion because it is unrelated to the current year acquisition that is the subject of the pro formas.
Application of the three criteria noted above often results in the exclusion of cost savings or certain other nonrecurring charges on the face of the pro forma financial statements, even though the company may have included similar adjustments in its valuation model or financial projections.
In lieu of “adjusted pro formas,” underwriters and lawyers may often request the inclusion of other non-GAAP disclosures (such as EBITDA and adjusted EBITDA) as part of the deal summary that appears in the front section of a 144A filing (i.e., “in the box”), or elsewhere in the document. However, Rule 144A offerings are exempt from many of the SEC’s rules and regulations including Regulation G and Regulation S-X, Item 10(e) that govern the use of non-GAAP financial measures. As a result, companies are often requested to comply such rules in a Rule 144A offering (i) to assist an investor’s understanding of the non-GAAP financial measures and (ii) in anticipation of subsequently registering the securities with the SEC. For example, these rules, as interpreted by the SEC’s Division of Corporation Finance in its Compliance and Disclosures Interpretations (C&DI),⁶ prohibit adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring when the nature of the charge (or gain) is such that it is reasonably likely to recur within two years or where a similar charge (or gain) existed within the previous two years.
Tip: The prohibition on eliminating or smoothing for certain items and denoting them as “non-recurring” in an adjusted EBITDA calculation was a prohibition on the use of the caption “non-recurring,” for items that do not meet the definition of non-recurring rather than making the specific adjustment. Most items can be adjusted for, provided they receive an appropriate title and meet the requirements of Regulation G and Regulation S-k, Item 10(e).⁷
An exception to this general prohibition exists, however, if the non-GAAP measure is essential to an investor’s understanding of a registrant’s financial condition (e.g., a debt covenant calculation), and the adjustment is a required part of the calculation of the non-GAAP measure.⁸ As a result, the presentation of “adjusted” non-GAAP measures (e.g., adjusted EBITDA or debt compliance EBITDA) is often limited to those amounts directly tied to and defined by an underlying debt covenant, under the premise that such information is, in fact, critical to a reader of a 144A debt filing.
Tip: While including non-GAAP information in an SEC filing may be allowed in situations where it is tied to a debt covenant and the debt covenant is material to an investor’s understanding of the registrant’s liquidity, an auditor may be requested to provide comfort over such amounts. However, an auditor’s willingness to give comfort will depend on the nature of the non-GAAP financial measure and its components. For example, if the debt covenant calculation of adjusted EBITDA includes undefined cost savings (and such amounts cannot be traced to the underlying books and records of the registrant), auditors may not be willing to provide comfort. In these situations, filers may wish to consider including detailed descriptions of the build-up of the non-GAAP financial measure, as the auditors may be able to provide comfort on certain components of the calculation even if they are unable to provide comfort on the entire non-GAAP amount.
Tread lightly, however, as the C&DIs were not intended as a signal that “anything goes,” a message that the SEC staff reinforced at the 2011 AICPA Conference when it stated that the SEC staff has noticed a return in the types of non-GAAP financial measures that prompted the SEC to adopt the final rules on the use of non-GAAP financial measures. At the 2012 AICPA Conference, the staff reiterated its position that a registrant should not present misleading non-GAAP financial measures. The SEC staff further indicated that the following items should not be excluded from non-GAAP financial measures: 1) expenses that are necessary to run the business and 2) the largest expenses that are necessary to generate the registrant’s revenues.
On July 13, 2012, the SEC issued its final staff report summarizing the staff’s analysis and observations related to the work plan that the SEC initiated in February 2010 to evaluate the implications of incorporating IFRSs into the financial reporting system for U.S. companies. The report emphasizes that the SEC has not made “any policy decision as to whether [IFRS] should be incorporated into the financial reporting system for U.S. issuers, or how any such incorporation, if it were to occur, should be implemented.” Further, the report indicates that before making a decision, the SEC should further analyze and consider “the fundamental question of whether transitioning to IFRS is in the best interests of the U.S. security markets generally and U.S. investors specifically.” The report does not include any timetable for this effort. The staff is currently awaiting further instructions from the Commission.
1. The reconciliation requirements differ depending on if the target is defined as “foreign business” or a “foreign private issuer”. A buyer should consult with its SEC counsel in determining whether a target meets either of these definitions.
2. A “flip” transaction typically occurs with the initial issuance of debt in a 144A filing, followed by a “flip” of that debt to registered debt via the filing of a subsequent registration statement with the SEC Staff on Form S-3/S-4.
3. Total annual gross revenue means as presented on Income Statement under U.S. GAAP or IFRS for the most recently completed fiscal year.
4. It is not presently clear whether the exemption survives post-termination of employment, but if not, the exemption becomes somewhat non-substantive.
5. AICPA National Conference on SEC and PCAOB Developments.
6. The Division of Corporation Finance issued a set of C&DIs in January 2010 that are intended to provide registrants with more “flexibility” regarding the use of non-GAAP information, which, in SEC staff’s opinion, had swung too far in the opposite direction (i.e., items were being excluded from filings that could be useful to investors) as of result of the SEC staff’s previous interpretations.
7. For additional information, see C&DI Question 102.03.
8. See C&DI Question 102.09, for more information.