Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

On May 15, 2019, President Donald Trump issued an Executive Order on Securing the Information and Communications Technology and Services Supply Chain. The order provides in part (emphasis added):

The following actions are prohibited:  any acquisition, importation, transfer, installation, dealing in, or use of any information and communications technology or service (transaction) by any person, or with respect to any property, subject to the jurisdiction of the United States, where the transaction involves any property in which any foreign country or a national thereof has any interest (including through an interest in a contract for the provision of the technology or service), where the transaction was initiated, is pending, or will be completed after the date of this order, and where the Secretary of Commerce (Secretary), in consultation with the Secretary of the Treasury, the Secretary of State, the Secretary of Defense, the Attorney General, the Secretary of Homeland Security, the United States Trade Representative, the Director of National Intelligence, the Administrator of General Services, the Chairman of the Federal Communications Commission, and, as appropriate, the heads of other executive departments and agencies (agencies), has determined that:

(i)   the transaction involves information and communications technology or services designed, developed, manufactured, or supplied, by persons owned by, controlled by, or subject to the jurisdiction or direction of a foreign adversary; and

(ii)  the transaction:

(A)  poses an undue risk of sabotage to or subversion of the design, integrity, manufacturing, production, distribution, installation, operation, or maintenance of information and communications technology or services in the United States;

(B)  poses an undue risk of catastrophic effects on the security or resiliency of United States critical infrastructure or the digital economy of the United States; or

(C)  otherwise poses an unacceptable risk to the national security of the United States or the security and safety of United States persons.

The broad prohibition on acquisitions indicates the Executive Order merits consideration in pending or newly initiated M&A transactions involving information and communications technology and related services from foreign governments and persons. Unfortunately, the Executive Order does not appear to include a mechanism where questions of the applicability of the Executive Order can be speedily resolved at this time.

Current SEC reporting requirements establish three different filer statuses that categorizes issuers subject to Exchange Act reporting requirements as non-accelerated, accelerated, and large accelerated filers. Section 404(a) of the Sarbanes-Oxley Act, or SOX, requires almost all SEC reporting issuers, regardless of filer status, to establish and maintain internal control over financial reporting, or ICFR, and have their management assess the effectiveness of their ICFR.

A significant requirement that applies to accelerated and large accelerated filers, but not to non-accelerated filers, is the requirement that accelerated and large accelerated filers have an ICFR auditor attestation. An ICFR auditor attestation requires the independent accounting firm that prepares or issues the issuer’s financial statement audit report to also attest to, and report on, management’s assessment of the effectiveness of the issuer’s ICFR. SOX Section 404(c), however, exempts non-accelerated filers from the ICFR auditor attestation requirement. The Jumpstart Our Business Startups Act also exempted a category of newly public companies referred to as emerging growth companies, or EGCs, from the ICFR auditor attestation requirement.

The ICFR auditor attestation requirement is intended to improve the accuracy and reliability of corporate disclosures. If verified internal controls are in place, it is likely disclosures and financial statements are accurate.   However, the ICFR auditor attestation requirement has long been criticized as a requirement where the costs outweigh the benefits and suppress the number of issuers that would like to conduct an IPO. Others assert the ICFR auditor attestation requirement can divert capital from core business needs of an issuer which are especially burdensome for emerging and growing biotechnology issuers.

The other principal difference between issuers that have different filer status is the deadline for filing Forms 10-K and 10-Q. Non-accelerated filers have more generous filing deadlines, and are required to file a Form 10-Q within 45 days after the end of a quarter and file a Form 10-K within 90 days after year end. In contrast, accelerated filers and large accelerated filers must file their Form 10-Q within 40 days after the end of a quarter while accelerated filers and large accelerated filers have 75 days and 60 days, respectively, after year end to file Form 10-K.

In addition to distinguishing between issuers based on filer status, the SEC has also adopted rules that provide for less onerous reporting requirements for issuers that meet the definition of smaller reporting company, or SRC, which the SEC refers to as scaled disclosure. Historically, the SEC aligned SRC and non-accelerated filer categories, to the extent feasible, to avoid unnecessary complexity. As a result, an SRC generally was not an accelerated or large accelerated filer and did not have to comply with the accelerated or large accelerated filing deadlines or the ICFR auditor attestation requirement. This alignment changed in June 2018 when the SEC adopted amendments to the SRC definition to expand the number of issuers that qualify for scaled disclosure accommodations. The revised SRC definition allows an issuer to use either a public float test or a revenue test to determine whether it is an SRC.

Proposed Amendments

The SEC held an open meeting on May 9th to issue long-awaited proposed modifications to the filer status definitions. The proposed rule dovetails with the SEC’s similar expansion of the SRC standard adopted in June 2018 and eliminate the requirement under SOX for certain issuers to provide an ICFR auditor attestation.

In particular, the proposed amendments would:

  • exclude from the accelerated and large accelerated filer definitions an issuer that is eligible to be an SRC and had no revenue or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available and therefore eliminate the requirement to provide an ICFR auditor attestation; and
  • adjust the transition thresholds for issuers exiting accelerated and large accelerated filer status.

While the proposed definitional changes are, in the staff’s view, intended to comport with the widely-supported aim of “promot[ing] capital formation for smaller reporting issuers by more appropriately tailoring the types of issuers that are included in the categories of accelerated and large accelerated filers,” the elimination of the ICFR auditor attestation requirement seems likely to be the key gating issue on the path to the Commission’s adoption of final rules.

Disparate Views of SEC commissioners

The Commissioners are well known to hold disparate views on the ICFR auditor attestation requirement and most have previously expressed those views in public statements. And those views were reflected in their respective votes on whether or not to propose the amended rules.

The proposed rules were drafted by the staff at the direction of SEC Chair Jay Clayton who has previously noted his view that the ICFR auditor attestation requirement impacts capital formation. Unsurprisingly, Chair Clayton expressed support for the proposal consistent with his prior views. In his public statement at the open meeting, Chair Clayton highlighted the “proposed rules are aimed at that subset of issuers where the added step of an ICFR auditor attestation is likely to add significant costs and is unlikely to enhance financial reporting or investor protection” and noted that “[t]he proposed amendments are intended to reduce costs without harming investors for certain smaller public companies and, importantly, encourage more companies to enter our public markets.”

Commissioner Hester Peirce’s views on the ICFR auditor attestation requirement align somewhat with Chair Clayton’s, and she also supported the staff’s proposed rules. In connection with the issuance of the rule proposal, Commissioner Peirce noted “I suspect that we also are missing the substantive mark. We are not proposing to exempt all SRCs from [the ICFR auditor attestation requirement}, and the SRCs that are not exempt will continue to receive auditor bills for 404(b). We currently lack the data to provide a clear picture of what the costs of 404(b) compliance are, especially for smaller companies.”

Newly-appointed Commissioner Elad Roisman does not have a history of commenting on the subject but expressed interest in further investigation of the economic impact of the amendments and also voted to release the proposed rules for public comment. Commissioner Roisman noted “I do question, however, whether the benefits of [the ICFR auditor attestation requirement] outweigh the burdens for smaller companies that, even in the absence of [the ICFR auditor attestation requirement], must still establish and maintain ICFR and have their management assess and report on the effectiveness of their ICFR.”

Commissioner Robert Jackson was the sole dissenter amongst the Commissioners and voted against proposing the amendments. Commissioner Jackson has previously stated his opposition to expanded availability of exemptions to the ICFR auditor attestation requirement. In his public statement opposing the newly proposed changes, Commissioner Jackson reached the conclusion that the proposal “has no apparent basis in evidence.” Commissioner Jackson also noted his view that while the proposal would provide the most relief for smaller companies, it is also “equally possible that these are the firms—high-growth companies where the risk, and consequences, of fraud are greatest—where the benefits of the auditor’s presence are highest.”

The future of the newly proposed rules seems likely to hinge upon a similar debate amongst the Commissioners.

Advantages and Disadvantages to Affected Issuers

The SEC estimates the rule proposal, to the extent it relates to elimination of the ICFR auditor attestation requirement, would benefit only 282 issuers. Using a complex analysis, the SEC estimated it would save these issuers $110,000 in audit fees and another $100,000 in non-audit costs. The case can be made however, that these savings are significant for issuers with less than $100 million in revenue and would free up resources for uses such as capital investments or research and development. For the investing public, these cost savings could be offset by potentially less accurate financial reporting when the requirement of an ICFR auditor attestation is eliminated. Also open is the question of whether eligible issuers that eliminate the ICFR auditor attestation will have an increased cost of capital or a somewhat depressed stock price due to investors discounting the reliability of financial reporting for issuers that do not provide an ICFR auditor attestation.

Commissioner Jackson noted that the SEC benefits analysis relied on “decade-old data to examine the costs of attestation and makes no serious effort to evaluate the benefits” and offered an alternative analysis. Commissioner Jackson did not offer an alternative costs-saved analysis but provided evidence that in his view demonstrates that since issuers no longer take steps to avoid accelerated filer status then one is entitled to conclude the cost the ICFR auditor attestation is not significant.

As noted, issuers newly qualifying as non-accelerated filers if the rule proposal is adopted will also have extended deadlines to file Forms 10-Q and 10-K. The SEC describes this benefit as modest, noting that some issuers file these reports before the required due date.

Many small cap and newly public companies will continue to confront a perplexing array of SEC rules relating to filer status, SRC status and EGC status, and more particularized rules when transitioning in and out of the categories. The perplexing menu and analyzing costs of choosing a newly available relaxed disclosure regime, or having to comply with a required increased disclosure regime, will likely increase costs for many SEC registrants.

The text of the proposed rule is available here.

C-Suite executives may now have to be accustomed to a new form of adverse publicity to deal with in their crisis management planning – someone making publically available an SEC  whistleblower submission and publicizing the same by blast emails and a press campaign.

In this case, a whistleblower supported by the National Whistleblower Center (NWC) has filed a whistleblower tip with the SEC alleging that Facebook is likely violating securities laws that prohibit publicly-traded companies from misleading shareholders and the public. The anonymous whistleblower’s petition includes what is described by the NWC as a 5-month study of over 3,000 Facebook users expressing support for terrorist organizations.

I assume the whistleblowers convictions are genuinely held, but this looks like a publicity stunt. It’s not illegal, but still a publicity stunt.

Add this to the list of those who want to use the SEC’s communications facilities to grind an ax.  First it was activist investors publishing their manifestos as exhibits to Schedule 13Ds.  Then shareholder proponents began publishing epistles on their shareholder proposals using notices of exempt solicitation.  And now this. If you can’t think of anything else, file a petition for rulemaking and maybe the SEC will post it on their web site.

The NWC claims it is the nation’s leading nonprofit focused on protecting whistleblowers and advocating for laws that encourage and reward their assistance with fighting corruption and other wrongdoing. In addition to assisting with the matter involving Facebook and terror and hate content, NWC claims it is providing support to anonymous whistleblowers that have exposed extensive illegal trafficking of endangered wildlife and stolen antiquities on Facebook and other social media websites.

 

The CFTC’s Division of Enforcement, or DOE, has published its Enforcement Manual (see the link in the upper corner to download the Manual). This is the first issuance of a public Manual by DOE. The Manual provides an overview of the CFTC and DOE, and it establishes certain general policies and procedures that guide the work of DOE staff in detecting, investigating, and prosecuting violations of the Commodity Exchange Act, or CEA and CFTC Regulations.

CFTC Director of Enforcement James M. McDonald noted “The Manual creates no private rights.  And it’s not enforceable in court.  But it is important, we believe, to have clear policies to promote consistency across our Division, which spans multiple offices and teams.  Consistency and transparency as to these procedures should promote fairness, increase predictability, and enhance respect for the rule of law.”

Mr. McDonald also noted “The Manual is divided into eleven different sections, each addressing a different subject matter—ranging from how we generate and process leads, to how we investigate and litigate cases, to how we evaluate applicable privileges and issues of confidentiality.  In addition, the Manual discusses the Division’s Wells process, sets forth how we work in parallel with other civil and criminal agencies, lays out the various aspects of the Division’s self-reporting and cooperation program as well as the various tools we can use to recognize cooperation, and provides an overview of the Commission’s Whistleblower program, among other things.”

The New Civil Liberties Alliance has filed a Motion for Relief from Judgment with the U.S. District Court for the Southern District of New York on behalf of Barry D. Romeril. Mr. Romeril served as the Chief Financial Officer of the Xerox Corporation from 1993-2001.

NCLA has asked the court to remove a gag order placed on Mr. Romeril on June 5, 2003 as part of a Consent Order with the Securities and Exchange Commission (SEC) because it violates the First Amendment of the U.S. Constitution. Despite the passage of nearly 16 years, Mr. Romeril continues to be bound by the gag order provision.  You can find the associated Memorandum of Law here.

Left unsaid is what Mr. Romeril has to say after lo, these many years,

The Consent purports to permanently forbid him from contesting any of the allegations in the Commission’s Complaint against him, regardless of the accuracy of those allegations or the truth of Mr. Romeril’s remarks. He faces the threat of reopened and renewed prosecution even for truthful speech challenging the allegations. NCLA contends that the Gag Order is a content-based restriction of speech, a forbidden prior restraint, and that it gives the SEC unbridled enforcement discretion by silencing Mr. Romeril in perpetuity.

Six defendants, including Mr. Romerli, agreed to pay over $22 million in penalties, disgorgement and interest without admitting or denying the SEC’s allegations. The SEC’s complaint alleged that the Xeorx executives, including Mr. Romerli, engaged in a fraudulent scheme that lasted from 1997 to 2000 that misled investors about Xerox’s earnings to polish its reputation on Wall Street and to boost the company’s stock price. The scheme involved the use of accounting devices that were not disclosed to investors, many of which violated generally accepted accounting principles. The complaint alleged that the defendants’ fraudulent conduct was responsible for accelerating the recognition of equipment revenues by approximately $3 billion and increasing pre-tax earnings by approximately $1.4 billion in Xerox’s 1997-2000 financial results.

 

The SEC has proposed rule amendments that revise required financial disclosure upon the acquisition and disposition of businesses in M&A transactions. The proposed changes would, among other things:

  • update the significance tests under these rules by revising the investment test and the income test, and conforming the significance threshold and tests for a disposed business;
  • require the financial statements of the acquired business to cover up to the two most recent fiscal years rather than up to the three most recent fiscal years;
  • permit disclosure of financial statements that omit certain expenses for certain carve-out transactions;
  • clarify when financial statements and pro forma financial information are required;
  • no longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for a complete fiscal year; and
  • amend the pro forma financial information requirements to improve the content and relevance of such information; more specifically, these improvements would include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects.

Background

When a registrant acquires a business, Rule 3-05 of Regulation S-X generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it is significant to the registrant (“Rule 3-05 Financial Statements”). Whether an acquisition is significant under Rule 3-05 is determined by applying the investment, asset, and income tests provided in the “significant subsidiary” definition in Rule 1-02(w).

Under the current formulation of the rule, if none of the Rule 3-05 significance tests exceeds 20%, a registrant is not required to file Rule 3-05 Financial Statements. If any of the Rule 3-05 significance tests exceeds 20%, but none exceeds 40%, Rule 3-05 Financial Statements are required for the most recent fiscal year and any required interim periods. If any Rule 3-05 significance test exceeds 40%, but none exceeds 50%, a second fiscal year of Rule 3-05 Financial Statements is required. When at least one Rule 3-05 significance test exceeds 50%, a third fiscal year of Rule 3-05 Financial Statements is required unless net revenues of the acquired business were less than $100 million in its most recent fiscal year. Rule 3-05 Financial Statements are not required once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the registrant for a complete fiscal year, unless the financial statements have not been previously filed or the acquisition is of major significance.

An acquisition is considered to be of major significance when the acquired business is of such significance to the registrant that omission of Rule 3-05 Financial Statements would materially impair an investor’s ability to understand the historical financial results of the registrant; for example, if, at the date of acquisition, the acquired business met at least one of the conditions in the significance tests at the 80% level.

Proposed Amendments to Generally Applicable Financial Statement Requirements for Acquired Businesses

Significance Tests

The SEC proposes to revise the significance tests related to investments and income to improve their application. The investment test compares the registrant’s investment in and advances to the acquired business to the carrying value of the registrant’s total assets. The SEC proposes to revise the investment test to compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (“aggregate worldwide market value”), when available. If the registrant does not have an aggregate worldwide market value, the SEC proposes to retain the existing test.

Currently, the income test focuses on a single component, net income, which can include infrequent expenses, gains, or losses that can distort the determination of relative significance. For registrants with marginal or break-even net income or loss in a recent fiscal year, the use of a net income component by itself can also have the effect of requiring financial statements for acquisitions that otherwise would not be considered material to investors. In these circumstances comparatively small entities may trigger the requirement for Rule 3-05 Financial Statements, which can be costly to prepare.

The SEC proposes to revise the income test by adding a new revenue component and to simplify the calculation of the net income component by using income or loss from continuing operations after income taxes. The SEC expects adding a revenue component would reduce the anomalous results that may occur by relying solely on net income. The SEC believes that this change, along with simplifying these calculations, would reduce complexity and preparation costs without sacrificing material information that investors may need to evaluate these transactions.

Under the proposed amendments, the income test would require that, where the registrant and its consolidated subsidiaries and the tested subsidiary have recurring annual revenue, the tested subsidiary must meet both the new revenue component and the net income component. In this case, the registrant would use the lower of the revenue component and the net income component to determine the number of periods for which Rule 3-05 Financial Statements are required.

Where a registrant or tested subsidiary does not have recurring annual revenues, the revenue component is less likely to produce a meaningful assessment and therefore only the net income component would apply. To reduce inconsistent results in these circumstances, the SEC also proposes revising the income test to use the average of the absolute value of net income when the existing 10% threshold in Computational Note 2 to Rule 1-02(w) is met and the proposed revenue component of the income test does not apply.

The SEC also proposes to revise the net income component calculation so that it is based on income or loss from continuing operations after income taxes. Income tax is a recurring and often material line item. Further, the current calculation, which is based on income from continuing operations before income taxes, may require additional calculations for components of net income that are presented on a post-tax basis with the result that a registrant may not be able to use amounts directly from the financial statements. Instead, the proposed amendments refer to income or loss from continuing operations after income taxes, which would permit a registrant to use line item disclosure from its financial statements, simplifying the determination. The SEC is also proposing to clarify the net income component by inserting a reference to the absolute value of equity in the tested subsidiary’s consolidated income or loss from continuing operations, which the SEC believes will mitigate the potential for misinterpretation that may result from inclusion of a negative amount in the computation.

The SEC proposes to calculate net income and average net income using absolute values. For net income, the SEC believes this modification would serve to clarify that the test applies when a net loss exists, and is to be used when either the tested subsidiary or the registrant, but not both, has a net loss. For average income, the SEC proposal differs from current staff interpretation, which indicates that “zero” should be used for loss years in computing the average. The SEC believes calculating average net income using the absolute value of the loss or income amounts for each year and then calculating the average would make the average income test more indicative of relative significance.

In addition, proposed Rules 3-05(b)(3) and 11-01(b)(3) will also clarify that the Income Test may be determined using the acquired business’s revenues less the expenses permitted to be omitted by proposed Rules 3-05(e) and 3-05(f) if the business meets the conditions in those proposed rules.

Audited Financial Statements for Significant Acquisitions

Currently Rule 3-05 Financial Statements may be required for up to three years depending on the relative significance of the acquired or to be acquired business. The SEC proposes to revise Rule 3-05 to require up to two years depending on the relative significance. Accordingly, the SEC proposes eliminating the requirement to file the third year of Rule 3-05 Financial Statements for an acquisition that exceeds 50% significance.

The SEC also proposes to revise Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period. This proposed revision would eliminate the need to provide a comparative interim period when only one year of audited Rule 3-05 Financial Statements is required.

Financial Statements for Carve-Out Transactions

Registrants frequently acquire a component of an entity, such as a product line or a line of business contained in more than one subsidiary of the selling entity that is a business as defined in Rule 11-01(d) but does not constitute a separate entity, subsidiary, or division. These businesses may not have separate financial statements or maintain separate and distinct accounts necessary to prepare Rule 3-05 Financial Statements because they often represent only a small portion of the selling entity. In these circumstances, making relevant allocations of the selling entity’s corporate overhead, interest, and income tax expenses necessary to provide Rule 3-05 Financial Statements for the business may be impracticable.

The SEC proposes to permit registrants to provide audited financial statements of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest, and income tax expenses) if certain conditions are met.

Timing and Terminology of Financial Statement Requirements

The SEC proposes revising Rule 3-05 and Article 11 to clarify when financial statements and pro forma financial information are required, and to update the language to take into account concepts that have developed since adoption of the rules over 30 years ago. Specifically, the proposed amendments would specify that financial statements are required if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by Rule 3-01 of Regulation S-X, or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed. The SEC also proposes to clarify that Rule 3-05 applies when the fair value option is used in lieu of the equity method to account for an acquisition because the disclosure required by U.S. GAAP on a post-acquisition basis, and related requirements in Rules 4-08(g) and 3-09, includes summarized financial information or separate financial statements of the business after the acquisition.

The SEC further proposes replacing the term “furnish” with “file” throughout Rule 3-05 and Article 11 to make clear that the information required by Rule 3-05 and Article 11 must be filed with the SEC, as the SEC believes that, at the time of adoption, the use of the term “furnished” in Rule 3-05 and Article 11 was not intended to mean that those disclosures were “not filed.”

In addition, Rule 3-05 requires “financial statements prepared and audited in accordance with this regulation.” Consistent with current practice, the proposed amendments to Rule 3-05 would clarify that references to “this regulation” include the independence standards in Rule 2-01 unless the business is not a registrant, in which case the applicable independence standards would apply.

As another clarification, the SEC proposes to replace references to “business combination” with the term “business acquisition” to make clear that Rule 3-05 and Article 11 are not limited to “business combinations” as that term is used in U.S. GAAP and IFRS-IASB. The term “business combination” is defined by reference to the term “business,” which has developed differently under U.S. GAAP and IFRS-IASB from that term as defined in Rule 11-01(d). Because “business acquisition” also encompasses a “combination between entities under common control,” the proposed amendments would also replace this term in Rule 3-05 and Article 11.

Consistent with current practice, the proposed amendments would further provide that a registrant may continue to determine significance using amounts reported in its Form 10-K for the most recent fiscal year when the registrant has filed its Form 10-K after the acquisition consummation date, but before the date the registrant is required to file financial statements of the acquired business on Form 8-K. The SEC proposes to permit rather than require use of the more recent Form 10-K in this circumstance to avoid creating an incentive for registrants to delay the filing of their Form 10-K.

The proposed amendments would also replace the term “majority-owned” as used in Item 2.01 of Form 8-K with the term “subsidiaries consolidated,” as that term more accurately conveys which subsidiaries are required to be included in the registrant’s financial statements.

Omission of Rule 3-05 Financial Statements for Businesses That Have Been Included in the Registrant’s Financial Statements

Current Rule 3-05(b)(4)(iii) generally permits Rule 3-05 Financial Statements to be omitted once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the registrant for a complete fiscal year. However, Rule 3-05 Financial Statements are required to be included when they have not been previously filed or when the Rule 3-05 Financial Statements have been previously filed, but the acquired business is of major significance to the registrant.

The SEC is proposing to no longer require Rule 3-05 Financial Statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements for a complete fiscal year. This change would eliminate the requirement that Rule 3-05 Financial Statements be provided when they have not been previously filed or when they have been previously filed but the acquired business is of major significance.

Pro Forma Financial Information

Adjustment Criteria and Presentation Requirements

The pro forma financial information described in Article 11 of Regulation S-X must accompany Rule 3-05 Financial Statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all registrants.

Article 11 provides that the only adjustments that are appropriate in the presentation of the pro forma condensed statement of comprehensive income are those that are:

  • directly attributable to the transaction,
  • expected to have a continuing impact on the registrant, and
  • factually supportable.

The pro forma condensed balance sheet, on the other hand, reflects pro forma adjustments that are directly attributable to the transaction and factually supportable, regardless of whether the impact is expected to be continuing or nonrecurring because the objective of the pro forma balance sheet is to reflect the impact of the transaction on the financial position of the registrant as of the balance sheet date.

The SEC proposes to revise Article 11 by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and present the reasonably estimable synergies and other transaction effects that have occurred or are reasonably expected to occur. The proposed adjustments would be broken out into two categories:

 

  • “Transaction Accounting Adjustments”; and
  • “Management’s Adjustments.”

Transaction Accounting Adjustments would depict:

  • in the pro forma condensed balance sheet, the accounting for the transaction required by U.S. GAAP or IFRS-IASB; and
  • in the pro forma condensed income statements, the effects of those pro forma balance sheet adjustments, assuming the adjustments were made as of the beginning of the fiscal year presented.

The Transaction Accounting Adjustments are intended to reflect only the application of required accounting to the acquisition, disposition, or other transaction. The SEC believes the Transaction Accounting Adjustments would link the effects of the acquired business to the registrant’s audited historical financial statements while the Management’s Adjustments would provide flexibility to include forward-looking information that depicts the synergies and other transaction effects identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given.

Management’s Adjustments would be required for and limited to synergies and other effects of the transaction, such as closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements, that are both reasonably estimable and have occurred or are reasonably expected to occur. The SEC believes it is appropriate to require disclosure of synergies and other transaction effects in these circumstances in order to provide investors insight into the potential effects of the acquisition and the post-acquisition plans expected to be taken by management. Limiting Management’s Adjustments to those that are reasonably estimable and that have occurred or are reasonably expected to occur will serve to define the population of effects subject to inclusion in pro forma financial information. While not all information is appropriate for reflecting an adjustment in the pro forma financial information, some information where the synergies and other transaction effects are not reasonably estimable would still be important to investors. The SEC believes that any information necessary to give a fair and balanced presentation of the pro forma financial information should be provided to investors. Thus, the SEC proposes to require registrants to additionally provide qualitative disclosure of such information in the explanatory notes to the pro forma financial information to further elicit appropriately balanced disclosure.

The SEC also proposes to include presentation requirements for Management’s Adjustments. The presentation requirements would provide 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. Similarly, the SEC proposes that per share data be presented in two separate columns. One column would present the pro forma total depicting the combined historical statements with only the Transaction Accounting Adjustments, and the second column would present the combined historical statements with both the Transaction Accounting Adjustments and Management’s Adjustments.

To clarify the required disclosure in the explanatory notes accompanying the pro forma financial information, the SEC proposes to add requirements based on existing rules, practice, and staff interpretation that would require disclosure of:

  • revenues, expenses, gains, and losses, and related tax effects which will not recur in the income of the registrant beyond 12 months after the transaction;
  • total consideration transferred or received, including its components and how they were measured. If total consideration includes contingent consideration, the proposed amendments would require disclosure of the arrangement(s), the basis for determining the amount of payment(s) or receipt(s), and an estimate of the range of outcomes (undiscounted) or, if a range cannot be estimated, that fact and the reasons why; and
  • information about Transaction Accounting Adjustments when the initial accounting is incomplete.

For each Management’s Adjustment, the SEC proposes to require:

  • a description, including the material uncertainties, of the synergy or other transaction effects;
  • disclosure of the underlying material assumptions, the method of calculation, and the estimated time frame for completion;
  • qualitative information necessary to give a fair and balanced presentation of the pro forma financial information; and
  • to the extent known, the reportable segments, products, services, and processes involved; the material resources required, if any; and the anticipated timing.

For synergies and other transaction effects that are not reasonably estimable and will not be included in Management’s Adjustments, the SEC additionally proposes to require that qualitative information necessary for a fair and balanced presentation of the pro forma financial information also be provided.

Significance and Business Dispositions

Rule 11-01(a)(4) provides that pro forma financial information is required upon the disposition or probable disposition of a significant portion of a business either by sale, abandonment, or distribution to shareholders by means of a spin-off, split-up, or split-off, if that disposition is not fully reflected in the financial statements of the registrant. Rule 1-02(w) uses a 10% significance threshold, not the 20% threshold used for business acquisitions under Rules 3-05 and 11-01(b). When a registrant determines that it has an acquisition or disposition of a significant amount of assets that do not constitute a business, Item 2.01 of Form 8-K uses a 10% threshold for both acquisitions and dispositions to require disclosure of certain details of the transaction.

The SEC proposes revising Rule 11-01(b) to raise the significance threshold for the disposition of a business from 10% to 20%, to conform to the threshold at which an acquired business is significant under Rule 3-05. The SEC also proposes conforming, to the extent applicable, the tests used to determine significance of a disposed business to those used to determine significance of an acquired business. This change would be consistent with the symmetrical treatment in Form 8-K provided to acquisitions and dispositions of assets that do not constitute a business.

In this action, anonymous whistleblower John Doe filed a Petition for a Writ of Mandamus Directed to the Securities and Exchange Commission to Compel Agency Action that has been Unreasonably Delayed in the United States Court of Appeals for the District of Columbia Circuit.

With respect to the action in which the whistleblower submitted a tip, the SEC published a notice of recovery on January 31, 2017. According to the petition, petitioner submitted a timely claim for an award on April 27, 2017, two years ago. The petitioner has heard nothing since other than a boilerplate letter acknowledging that the SEC received his claim.

The petition discloses that contemporaneously with the noted petition, counsel for petitioner is filing a similar petition against the SEC for unreasonable delay in processing a different claim for an SEC whistleblower award on behalf of another SEC whistleblower.

This is not the first time this has happened.  In 2015, a similar petition for a writ of mandamus regarding the SEC’s unreasonable delay in making a preliminary determination regarding a right to an award regarding a different enforcement matter was filed. The court ordered the SEC to respond to that petition. The SEC instead issued the preliminary determination that the petition sought, and the court dismissed the petition as moot.

According to the petition, the SEC does not disclose its delays in issuing preliminary determinations on whistleblower award claims in its Annual Reports to Congress or anywhere else. However, the petitioner believes the SEC’s recent statements and actions indicate that the agency’s delays are substantial, and that the SEC has sought with increasing vigilance to avoid disclosing the magnitude of its delays.

The petition states the SEC has obfuscated its delays by redacting information necessary to match its preliminary determinations with the corresponding Notice of Covered Action. The SEC justifies these redactions based on a purported duty to protect a whistle blower’s identity according to the petition.

In a wide ranging derivative action, a Facebook shareholder has filed a 193 page complaint in the Delaware Court of Chancery alleging three Facebook directors sold a total of $1.5 billion of stock while in possession of inside information.  Specifically, the complaint alleges that at the time of the stock sales Facebook faced a looming crisis over privacy concerns and that the value of Facebook equity shares did not reflect such “inside information.” According to the complaint, when the directors sold their respective shares of Facebook stock, Facebook had been aware of the activities of Cambridge Analytica and the other misconduct referred to in the complaint.

Other allegations in the complaint include:

  • Defendants violated Section 14(a) of the Exchange Act and SEC Rule 14a-9 by causing Facebook to issue proxy statements that failed to disclose the Cambridge Analytica incident, or the seriously deficient internal controls and privacy policies that Facebook maintained which caused Facebook to violate user privacy laws and damage Facebook’s reputation.
  • Facebook’s board, including all of the individual defendants, caused Facebook to issue and file with the SEC materially misleading proxy statements soliciting their vote against various matters proposed by shareholders.
  • Defendants also violated Section 14(a) of the Exchange Act and SEC Rule 14a-9 by causing Facebook to issue proxy statements soliciting approval of compensation packages, failing to disclose the Cambridge Analytica incident which caused serious harm and damages to Facebook or the seriously deficient privacy policies that allowed it to occur.
  • With full knowledge of the exfiltration and unauthorized use of user data and the undisclosed deviation of its policies described in the complaint, the Facebook board authorized Facebook to repurchase $6 billion of its own shares of common stock.

It is important to note that no court has ruled any of the allegations in the complaint are proper or true or state a cause of action or that the defendants took any improper actions.

Nasdaq has proposed a rule change that will require companies listing in connection with a Regulation A+ offering to have a minimum operating history of two years at the time of the approval of the initial listing application.

Citing to the Longfin SEC enforcement action, the rule notes that Nasdaq has observed problems with certain Regulation A companies. The rule filing indicates Nasdaq believes that companies seeking to list in conjunction with a Regulation A offering are generally less mature companies with less developed business plans than other companies seeking to list. In addition, Nasdaq believes that the Regulation A offering process may not adequately prepare companies for the rigors of operating a public company and satisfying the SEC and Nasdaq’s reporting and corporate governance requirements.

The rule filing also indicates Nasdaq staff has adopted heightened review procedures for companies applying to list on Nasdaq in connection with an offering under Regulation A.

Nasdaq believes that this proposed requirement will help assure that companies have more established business plans and a history of operations upon which investors can rely. In addition, the proposed operating history requirement will help assure that the company has been able to fund the initial phase of its operations. Further, Nasdaq believes that these more seasoned companies are more likely to be ready for the rigors of being a public company, including satisfying the SEC and Nasdaq’s reporting and corporate governance requirements.

According to this announcement, Blockstack expects to be the first SEC Regulation A+ qualified token offering.

I’m not touting or endorsing the potential Blockstack offering. But viewing from the outside in, there’s a good chance they’re right.

They are backed by a bona-fide VC firm that appears to want to devote the resources to do it right. Blockstack expects to spend $1,500,000 with a good Silicon Valley law firm to get it done.

You can find the offering circular here. The Form 1-A was initially submitted confidentially to the SEC, and you can find responses to what appears to be the first round of comments here.

There is also this nifty analysis by Blockstack’s law firm which addresses the following points:

  • Miners are not broker-dealers though they receive fees for recording transactions
  • Neither Blockstack nor miners need to register as transfer agents or clearing agencies
  • Neither the Blockstack network nor browser extension are required to register as an exchange or ATS
  • No Blockstack entity is a money transmitter or money services business
  • Blockstack is not eligible to conduct this 1-A offering without engaging the services of a registered transfer agent
  • Transactions of Stacks Tokens to pay fees on the Blockstack network do not violate Regulation M
  • Blockstack does not meet the definition of “investment company” under the Investment Company Act of 1940 because the Tokens will be “non-securities” in Blockstack’s hands

It looks like Blockstack initially requested confidential treatment of the above analysis but I’m guessing it was shot down because where is the competitive harm?