Statement by Commissioner Lee on Financial Disclosures About Acquired and Disposed Businesses

Today [Thursday, May 21, 2020] the Commission amends its rules governing disclosures public companies must provide when they buy and sell businesses. Unfortunately, today’s rulemaking does not adequately address the risks of reduced transparency for investors with respect to this activity, nor does it properly examine the potential effects on competition, particularly in the present economic climate where the risks that arise from overly concentrated markets are heightened.

I want to thank the staff for their hard work on this release. [1] I know it is the product of careful analysis, as well as the incorporation of the policy views of a majority of the Commission. While I may not agree with the final rules on balance, [2] I am, as always, appreciative of the diligence and expertise of the staff. I also note that I do not object to the Commission going forward with this rulemaking in the midst of the ongoing economic and social disruption caused by COVID-19. There has been a lengthy opportunity for public comment, at least nine months of which occurred before the COVID-19 crisis began, and any new obligations imposed by the rules will be delayed by several months.

I am, however, concerned that we would push ahead with a rulemaking that will likely facilitate mergers and acquisitions, or M&A activity, [3] without assessing the costs and risks of such activity in two significant regards: the risk to investors of less transparency regarding the economics of an acquisition, and the risk of increasing economic concentration, which is heightened at present where large companies that are better positioned to weather the current economic conditions may pursue predatory takeovers of smaller, struggling businesses.

Insufficient Transparency

This release, like others under the Disclosure Effectiveness Initiative, asserts that less information will yield better disclosure for investors. [4] It reduces disclosure, asserting that the decreased transparency comes at no cost to investors. [5] For example, the rule drops the requirement to provide up to three years of prior financial statements for significant acquisitions, reducing the maximum required period for financial statements to two years, but maintains that this will result in no significant loss of information. [6] This assertion is not supported by economic analysis [7] or logic. [8] It is a bare assertion in place of the identification and analysis of the costs of our policy choices.

The current COVID-19 crisis and its devastating impact on the financial condition of many companies brings into sharp focus the problems that can arise from a truncated timeframe for analysis of prior financial results. Under the final rule, investors will have (at most) two years of prior financial statements. If one of those years is severely impacted by the COVID-19 crisis, will investors have sufficient information with respect to valuation? How much critical perspective may be lost because of the potentially anomalous period? Climate change risk raises similar concerns. Its effects may create anomalies as sudden and severe shocks to financial results are absorbed. [9]The issue of reduced perspective in the face of anomalous or uncertain financial results [10] is not even identified, much less analyzed in the release.

Increasing Economic Concentration

The release also declines to analyze the risks associated with the economic activity it will facilitate, including the fact that increased M&A activity can lead to greater risks of increased economic concentration. The proposal for this rulemaking failed to identify and analyze certain costs associated with M&A activity, treating it instead as an unqualified benefit. [11]The economic analysis now pivots from its prior position that facilitating M&A activity is a benefit of this rulemaking at all, and no longer contains prior references to facilitating “value-enhancing” acquisitions. [12] Instead it asserts that the new rule will not really affect M&A activity or alter a company’s decision to pursue potential mergers and acquisitions. [13] Thus, the release now reasons, both the costs and the benefits of M&A activity are irrelevant.

This pivot creates a dilemma. If we accept this at face value, it undermines the rationale for the rulemaking. Why are we devoting resources to amending our rules if the effects are so modest?

If on the other hand, the purpose and effect of the rules is to facilitate M&A activity—and that is expressly how they were presented at proposal—then we must identify and weigh the costs of facilitating such activity, which this release expressly declines to do.

And there are costs. For example, increased M&A activity can exacerbate economic concentration—a risk already heightened by current economic conditions—which can harm small businesses and lead to job losses, price increases, and flagging innovation. [14] This release does not engage with these or other costs at all.

In apparent defense of the failure to analyze these costs, the release states that the Commission should not “substitute its judgment” for that of issuers, shareholders, and others as to the merits of an M&A transaction. [15] That statement is fine as far as it goes, but it does not absolve the Commission of its legal obligation, explicitly acknowledged in the release, to consider the impact our rules will have on competition. [16] In fact, directly under the heading “The Effects on Efficiency, Competition, and Capital Formation,” the release touts the benefits of M&A activity, saying “[a]n active mergers and acquisitions market creates efficiencies by transferring inefficiently managed assets to more efficient management or by creating synergies through economies of scale or economies of scope.” [17] That section, however, presents only alleged benefits, making no mention of the potential costs to competition arising from the rules.

In sum, the rules create significant risks arising from reduced transparency for investors and potentially facilitating increased economic concentration, the latter risk being especially acute for small businesses in the current economic conditions. [18] I must respectfully dissent.

Endnotes

1In particular, I would like to thank William Hinman, Patrick Gilmore, Elizabeth Murphy, Luna Bloom, Craig Olinger, Todd E. Hardiman, Jessica Barberich, Steven Hearne, Lindsay McCord, Jennifer Zepralka, Claire Erlanger, and Mark Rakip from the Division of Corporation Finance; Dalia Blass, Alison Staloch, Jenson Wayne, Mark Uyeda, Joel Cavanaugh, Sarah ten Siethoff, and Brian M. Johnson from the Division of Investment Management; S.P. Kothari, Narahari Phatak, Vlad Ivanov, Mengxin Zhao, and Marie-Louise Huth from Division of Economic and Risk Analysis; Marc Panucci, Giles Cohen, Jonathan Wiggins, Duc Dang, Barry Kanczuker, Ryan Wolfe, and Jenifer Minke-Gerard from the Office of the Chief Accountant; and Bryant Morris and Omid Harraf from the Office of the General Counsel.(go back)

2Among other things, the final rules reduce the time period for which companies must provide financial statements for acquired and disposed businesses and increase the circumstances in which companies may provide abbreviated financial information or omit financial statements. See Amendments to Financial Disclosures about Acquired and Disposed Businesses, Final Rule, Rel. No. 33-10786 (May 21, 2020) (Adopting Release), at 37, 42, and 69. The final rules also amend the significance tests, which determine what transactions require disclosure under the rules, to reduce disclosure when a company’s market value exceeds its book value, a circumstance which should trigger greater transparency. See id at 19. The final rules also reflect efforts to update and improve the quality of disclosure, particularly the pro forma information required in connection with these rules. However, one of the key proposed enhancements to the required pro forma disclosures, disclosure of Management’s Adjustments, has been dropped despite investor support for the proposed requirement. See id. at 111; see also Letter from CFA Institute (Nov. 22, 2019) (“[W]e strongly support the proposed changes to the content of pro forma information to include Management’s Adjustments that reflect reasonably estimable synergies and other transaction effects that have occurred or are reasonably expected to occur.”). Overall, the rules err too far on the side of reducing compliance costs at the expense of transparency for investors. (go back)

3The Adopting Release is inconsistent on this point. At places, consistent with the proposal, it suggests the amendments will facilitate M&A activity. See, e.g., Adopting Release at 164 (“The amendments could facilitate merger and acquisition transactions and facilitate an acquiring company’s access to capital.”), 166 (“We believe allowing for abbreviated financial statements in these circumstances will reduce costs for registrants and facilitate the consummation of acquisitions.”), and 183 (“By reducing disclosure burdens for registrants regarding business acquisitions and dispositions, the amendments should facilitate such activities, although, as stated earlier, compliance costs may be a more modest factor when a registrant considers whether to engage in an acquisition or disposition.”). At other places, in a pivot from the proposal, the Adopting Release suggests the final rules will not have a significant effect on M&A activity. See, e.g., id. at 148 (noting costs of complying with disclosure obligations but stating that “we would not expect such costs to alter a decision to pursue a particular transaction”), 151 (“[T]he rules we are amending are relevant to a large number of transactions and businesses but the amendments themselves, beyond their potential cost savings, are not expected to have a significant effect on transactions or businesses more generally.”), and 156 n.447 (noting that “the amendments are highly unlikely to affect whether a transaction proceeds or not”).(go back)

4See Adopting Release at 154 (“The amendments should improve the salience of the information for investors by reducing the volume of information presented about acquired businesses and focusing the disclosures on more decision-relevant information.”). This type of assertion is repeated in other releases that are largely responding to concerns raised by companies about burdens, not concerns raised by investors about volume or complexity of disclosures. See, e.g., Financial Disclosures about Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant’s Securities, Final Rule, Rel. No. 33-10762 (Mar. 2, 2020) (“These proposed amendments [which mostly reduce disclosure] may result in simplified disclosures that highlight information that is material to investment decisions.”); Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, Proposed Rule, Rel. No. 33-10750 (Jan. 30, 2020) (“In combination, the proposed amendments [which proposed to eliminate significant disclosure items] are intended to eliminate duplicative disclosures and modernize and enhance MD&A disclosures for the benefit of investors, while simplifying compliance efforts for registrants.”).(go back)

5[See Adopting Release at 157-58 (“We also acknowledge that one objective of the amendments is to reduce unnecessary disclosure and as a result, in some cases, the amendments will reduce the amount of information provided. However, we do not believe that there will be a reduction in the disclosure of information that is material to investors. We anticipate that the amendments will generally result in disclosure that is more salient and that any potential loss of information will be mitigated by a registrant’s obligation under Rule 4-01(a) of Regulation S-X to include such further material information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”)./ref]

[ref no=6]The release provides that “in limited cases” the reduced timeframe could result in some loss of information to investors, but that limited loss would be “partially mitigated” by the general requirement not to make misleading statements in disclosures. See id. at 164. Stopping short of providing a misleading picture is too low a bar for calibrating these disclosures.(go back)

7The economic analysis does not determine the extent to which, or even whether, the third year of financial statements has value for investors, stating “To the extent that information from three years prior might be less relevant to investors’ analysis of an acquisition, we believe the benefits from the reduction in disclosure burden and audit costs justify investors’ loss of the incremental value of the third year of financial information.” Seeid. at 163-64 (emphasis added). This essentially amounts to a statement that if the incremental value is low, we believe that its loss is outweighed by reduced costs to issuers. This is not economic analysis about the effects, or likely effects of the rule. It is an unsupported hypothesis. This construction appears elsewhere in the release and leaves an incomplete picture of the likely economic effects of our rules. See, e.g., id. at 163 (“To the extent that the amendments to the significance tests capture more significant businesses and acquisitions and fewer insignificant ones, they may directly benefit investors by improving the overall salience of the information disclosed to them.”) and 178 (“[I]nvestors may gain important insights to the extent a registrant chooses to disclose Management’s Adjustments.”).(go back)

8The release asserts that the third year is “less likely to be indicative of the current financial condition . . . of the acquired business.” See id. at 37. This is certainly true, just as the second year is less likely to be indicative of current financial condition than the first. The question, of course, is not how does the third year compare to the second or first in terms of its value, but rather what is the value to investors of having three years of financial information vs. two? This question is not addressed.(go back)

9Physical risks, liability risks, and transition risks associated with climate change could each affect a company’s financial stability with little or no warning. See Mark Carney, Breaking the Tragedy of the Horizon—Climate Change and Financial Stability (Sept. 29, 2015) (identifying each of these risks and noting that, even in 2015, there had “already been a few high profile examples of jump-to-distress pricing because of shifts in environmental policy or performance”); see also Governor Lael Brainard, Why Climate Change Matters for Monetary Policy and Financial Stability (Nov. 8, 2019) (discussing the potentially devastating economic effects of climate change, noting some have described the PG&E bankruptcy as “the first climate bankruptcy”); National Oceanic and Atmospheric Administration, National Centers for Environmental Information, U.S. Billion-Dollar Weather and Climate Disasters (2020), https://www.ncdc.noaa.gov/billions/ (“The U.S. has sustained 265 weather and climate disasters since 1980 where overall damages/costs reached or exceeded $1 billion (including CPI adjustment to 2020). The total cost of these 265 events exceeds $1.775 trillion . . . In 2020 (as of April 8), there have been 2 weather/climate disaster events with losses exceeding $1 billion each to affect the United States. The 1980–2019 annual average is 6.6 events (CPI-adjusted); the annual average for the most recent 5 years (2015–2019) is 13.8 events (CPI-adjusted).”).(go back)

10It is often asserted that the longer term effects on businesses of climate risk are uncertain and hard to predict or quantify. See, e.g., Sara Harrison, “Companies Expect Climate Change to Cost Them $1 Trillion in 5 Years,” Wired (June 4, 2019) (“[S]ome [climate-related] risks are hard[] to calculate. How much will changing weather patterns in the midwest alter crop yields or harm pollinators? And how will that ultimately figure into the bottom line? Companies also have blind spots. A corporation might do a good job of assessing risks to its own physical infrastructure, but might not apply that same scrutiny to its supply chain.”). This too elevates the significance of providing more information on actual prior results.(go back)

11See Commissioner Robert J. Jackson, Jr., Statement on Financial Disclosures about Acquired and Disposed Businesses (May 3, 2019) (“I’m concerned that the proposal treats mergers as an unalloyed good—ignoring decades of data showing that not all acquisitions make sense for investors.”).(go back)

12[For example, discussing disclosure obligations, the proposal stated that “such disclosure requirements impose costs on registrants that could deter them from engaging in, or diminish the benefits associated with, acquisitions that are value enhancing, for example, where the acquirer has to negotiate for information that may be costly and burdensome for the acquiree to prepare and provide.” See Amendments to Financial Disclosures about Acquired and Disposed Businesses, Proposed Rule, Rel No. 33-10635, at 119 (May 3, 2019) (Proposing Release). The same discussion in the Adopting Release now reads as follows: “Disclosure requirements also impose costs on registrants that may seek to engage in acquisitions or dispositions. In particular, such costs could diminish the benefits associated with an acquisition or disposition; however, we would not expect such costs to alter a decision to pursue a particular transaction.” See Adopting Release at 148. Similarly, the proposal stated: “This reduced compliance burden also may encourage registrants to engage in more potentially value-enhancing mergers and acquisitions than they otherwise would engage in without the proposed amendments.” See Proposing Release at 118. The Adopting Release now reads: “The reduction in compliance costs could in theory facilitate increased acquisition or disposition activity by registrants. However, registrants engage in acquisitions and dispositions for a variety of business reasons, and, as a general matter, their evaluation of the advisability of acquisitions and dispositions often involve cost and benefit considerations much greater than compliance cost considerations. See Adopting Release at 147./ref]

[ref no=13]See Adopting Release at 156 (“We acknowledge that there are a significant number of acquisitions that prove to be value-decreasing for the acquirer. However, as discussed above, the amendments are unlikely to affect whether a registrant engages in an acquisition or disposition . . . .”).(go back)

14See Amanda Fischer, Washington Center for Equitable Growth, “Rescuing small businesses to fight the coronavirus recession and prevent further economic inequality in the United States” (Apr. 14, 2020) (“Small businesses, consumers, and workers suffer from rising concentration and consolidation by big firms . . . What’s worse is that economic crises are particularly hard on small businesses, providing a dire warning for policymakers as they grapple with the coronavirus recession.”); Bill Baer, Brookings Institution, “Why we need antitrust enforcement during the COVID-19 pandemic” (April 22, 2020) (noting that “[o]ur sudden but necessary shutdown has put business of all sizes at risk of permanent closure” with the effect that “many markets are going to become more concentrated,” which poses risks of “long-term adverse consequences on innovation, quality, and price”); see also Marc Jarsulic, Ethan Gurwitz, Kate Bahn, and Andy Green, Center for American Progress, “Reviving Antitrust: Why Our Country Needs a Progressive Competition Policy” (June 29, 2016) (“Concentration-increasing mergers, many of which have gone unchallenged by antitrust authorities, have too often been followed by increased prices. Moreover, there have been few challenges to unilateral actions to expand or preserve market power by those who have it.”); Bruce A. Blonigen and Justin R. Pierce, “Evidence for the Effects of Mergers on Market Power and Efficiency,” Working Paper 22750, National Bureau of Economic Research (Oct. 2016) (examining mergers and acquisitions in the manufacturing industry and finding that mergers increased average markups but did not enhance productive efficiency); Colleen Cunningham, Florian Ederer, and Song Ma, “Killer Acquisitions” (April 19, 2020), https://ssrn.com/abstract=3241707 (arguing that “incumbent firms may acquire innovative targets solely to discontinue the target’s innovation projects and preempt future competition” and finding that such acquisitions tend to “bunch” just below the threshold for antitrust scrutiny).(go back)

15See Adopting Release at 157.(go back)

16See id. at 148-49 (“Section 2(b) of the Securities Act, Section 3(f) of the Exchange Act, and Section 2(c) of the Investment Company Act require the Commission, when engaging in rulemaking where it is required to consider or determine whether an action is necessary or appropriate in the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. Additionally, Section 23(a)(2) of the Exchange Act requires us, when adopting rules under the Exchange Act, to consider, among other things, the impact that any new rule would have on competition and not to adopt any rule that would impose a burden on competition that is not necessary or appropriate in furtherance of the Exchange Act.”).(go back)

17See Adopting Release at 183-84. If, as asserted, this rulemaking will not affect M&A activity, then this statement is entirely irrelevant as an economic justification. On the other hand, if the rules will affect M&A activity, then this analysis is incomplete as it presents potential benefits without a corresponding discussion of costs.(go back)

18See Baer, supra note 14 (“Economists see small businesses as particularly vulnerable, and the CARES Act only begins to address the problem.”).(go back)