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E-MailDavid A. Katz, Trevor Norwitz and Victor Goldfeld, are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell Lipton memorandum.
The SEC recently proposed amendments to its financial disclosure requirements relating to business acquisitions and dispositions. In general, the proposals reflect a welcome comprehensive review and update, balancing the need for providing relevant information to investors with the costs and burdens of disclosure requirements. Among other things, the proposed amendments would:
- revise the “significance” tests used to determine whether and which financial statements of a target business need to be filed by the registrant, including by (1) using market capitalization rather than total assets for the denominator in the “investment” test (notably, this may increase the number of transactions that meet the test because it is based on equity rather than enterprise value) and (2) adding a new revenue component to the “income” test;
- eliminate the need to include financial statements for certain periods required under the current rules; and
- raise the significance threshold for dispositions from 10% to 20%, matching the current significance threshold for acquisitions.
One aspect of the proposed rules, however, raises potential issues that appear to be at odds with current practices. Article 11 of Regulation S-X currently precludes inclusion of pro forma adjustments for the potential effects of post-acquisition actions expected to be taken by management. As explained in the SEC Division of Corporation Finance’s Financial Reporting Manual, “highly judgmental estimates of how historical management practices and operating decisions may or may not have changed as a result of that transaction” are “considered a projection and not an objective of S-X Article 11.” The proposed amendments would replace the existing pro forma adjustment criteria with, among other things, “Management’s Adjustments” that would include “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 proposed rules would require, for each Management’s Adjustment, “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 proposed rules would require “that qualitative information necessary for a fair and balanced presentation of the pro forma financial information also be provided.”
We believe that mandating synergy disclosure in pro forma financial statements should be approached with caution and may be problematic. The SEC Staff indicated that the proposal is motivated by the desire to make pro forma financial statements more useful and to hold issuers more accountable for their synergy estimates. This may be commendable, but pro formas are an imperfect vehicle for communicating synergy predictions for many reasons, including the timing disconnect, the fact that synergies are not always a material element of transactions, and the practical reality that synergy targets identified upon transaction announcements are inherently uncertain and based on limited information exchanged during due diligence. Whether or not the disclosures would be considered “forward looking statements,” every transaction is different and such disclosures would potentially be speculative and subject to abuse or unfair criticism, particularly in contested situations, and could create potential liability concerns. Transactions present a wide variety of synergy opportunities, which may include cost savings or revenue opportunities, and may involve the incurrence of costs to achieve them, or potentially offsetting dis-synergies. Parties may have sufficient confidence to disclose a target (or range) of an aggregate amount of anticipated synergies, but not to identify the specific financial statement line items that would be affected by the synergies. Moreover, run-rate synergies often are only expected to be achieved after a period of years, making it difficult to clearly communicate synergy expectations through pro forma financial statements for historical periods. Management’s Adjustments likely would increase the time needed for accountants to review the pro formas, which often are the gating item for filing a registration statement with the SEC.
After careful review, the SEC may determine that the current requirements—in which disclosures of anticipated synergies are constrained, from a legal perspective, by general antifraud rules, and, from a practical perspective, by the fact that investors hold management teams accountable based on their ability to achieve stated synergy targets—are the appropriate framework for communicating synergy expectations rather than mandating that they be reflected in pro forma financial disclosures.
