Under its Disclosure Effectiveness initiative, the SEC’s Division of Corporation Finance is in the process of reviewing  disclosure requirements for public companies to consider ways to improve it for the benefit of investors and the companies themselves.

Pursuant to this, the SEC has recently published a request seeking public comments on the effectiveness of Regulation S-X which deals with financial disclosures of the entities other than the company (such as acquiree company results, guarantor, affiliate details etc) in the company’s financial reports.

By asking for comments, the SEC has clearly indicated that it is starting to dig deeper into the reports for information accuracy. While the focus so far has been on information pertaining only  to  the registrant, it seems that the SEC is now beginning to look at gathering information regarding the company’s business transactions with other entities too.

As the last day for requesting comments is soon approaching, here is my take on the rules on which the SEC is seeking inputs.This post will help you  understand the usability of the rules in question and judge their significance in overall disclosure effectiveness.

The Regulation S-X: Basic Premise

Let’s step back a little - Why do companies need to report to the SEC on financial information of other companies that they deal with?

Simply put, the answer lies in empowering users of financial information with all the facts and data they need to make a knowledgeable decision. It is essential for investors and analysts to evaluate the complete financial soundness of the entities that they are investing in or researching on.

Regulation S-X is a prescribed regulation that lays down the specific format and content that registrants/companies need to follow for reporting their financial statements, notes and schedules as part of:

a)      registration statements under the Securities Act of 1933 and

b)      registration statements under section 12, annual or other reports under sections 13 and 15(d) and proxy and information statements under section 14 of the Securities Exchange Act of 1934; except as otherwise specifically provided in the forms.

c)      registration statements, annual reports and shareholder reports filed under the Public Utility Holding Company Act of 1935 and likewise

d)      the Investment Company Act of 1940

Key Rules under Regulation S-X

The Regulation’s rules 3-01 to 3-20 govern the examination, form and content of financial statements, including the basis of consolidation and the schedules to be filed. The SEC is seeking public comments on possible disclosure changes primarily related to the following requirements in Regulation S-X.

1.   Rule 3-05: Financial statements of businesses acquired or to be acquired

2.   Rule 3-09: Separate financial statements of subsidiaries not consolidated and 50 percent or less owned persons

3.   Rule 3-10: Financial statements of guarantors and issuers of guaranteed securities: registered or being registered

4.   Rule 3-16: Financial statements of affiliates whose securities collateralize an issue registered or being registered

The SEC wants to evaluate how the above-mentioned rules are helping investors make investment and voting decisions and also understand what difficulties registrants face in preparing and presenting these disclosures.

Who is required to comply with these rules?

Domestic registrants that do not qualify as smaller reporting companies or emerging growth companies.

Rules Demystified

Let us now see what registrants need to disclose under these rules.

1.        Rule 3-05: Disclosure regarding financial statements of businesses acquired or to be acquired

A business acquisition can result in a change in the following for a company (acquirer)

1)   Financial condition

2)   Results of operation

3)   Liquidity

4)   Change in management

Any change in the above as a result of acquisition is a vital piece of information for the acquirer’s investors. Therefore there is a need to disclose financial statements of the acquiree company’s business prior to the acquisition. That way, investors know the financial health and soundness of the acquiree company and also the impact of such acquisition on the registrant’s future line of business.

The SEC is seeking input on how and to what extent the information on the disclosures of the acquiree financial results is useful to investors.

My Take: Acquistions have a major impact on the registrant, both at the organizational level as well as on the balance sheet/overall financials of the company. Details of the acquiree company in terms of proforma results can be of immense use to investors, bringing in greater transparency regarding future business performance. For the registrant, the level of difficulty in preparing these documents will not be a huge overhead as they themselves look at this information before acquiring. The acquiree company has to provide the entire information to the registrant before acquisition


2.        Rule 3-09: Separate financial statements of subsidiaries not consolidated and 50 percent or less owned persons

A registrant owning 50 percent or less of an entity is generally required to provide:

1)   Separate audited or unaudited annual financial statements of the investee if it is significant or exceeding the 20% threshold

2)   Summarized balance sheet and income statement information on an aggregate basis for all investees (significance exceeding 10%) disclosed in the notes to the registrants’ financial statements

An equity-based investee can have a significant impact on a registrant’s business. SEC recognizes the fact that when an investee is not a consolidated one, it may not be subject to the same disclosure requirements as the registrant or its subsidiaries. There could be a differences on account of the accounting methods, accounting standards, fiscal year end, currencies in which financial statements are reported etc. Due to these differences the financial statements of the registrant cannot be reconciled with  that of the investee/s. The SEC is therefore seeking input on the ways and means to improve the usefulness of this summarized financial information.

My Take: As listed above, there are several disclosure reporting challenges that registrants face while reporting information on equity-based investees..Hence, the difficulty and costs involved in preparing such reports is high. However, summarized report submission on all the investees instead of individual reports can help cut the cost and time while providing relevant information to investors.


3.        Rule 3-10 :Financial statements of guarantors and issuers of guaranteed securities: registered or being registered

Rule 3-10 specifies that ‘A guarantor of a registered security is an issuer because the guarantee of a security is a separate security.’ Therefore there is a need for both the issuers of guaranteed registered securities and guarantors of the registered securities to file their own audited annual or unaudited interim financial statements.

The rule also provides certain exemptions to a registrant that raises capital using certain means such as:

·        an offering of its own securities guaranteed by one or more of its subsidiaries; or

·        an offering of securities by its subsidiary that it guarantees and, sometimes, that one or more of its other subsidiaries also guarantees

Also if the subsidiary issuers or guarantors meet certain conditions, the parent company can provide disclosures in its own annual and interim consolidated financial statements. Upon fulfilling certain conditions, the parent company can also disclose details of the guarantor subsidiary details in the condensed financial information footnote which would consist of all main line items of the financial statements, results of operations and cash flow statement.

The SEC is seeking input to evaluate the usefulness of this information and know what other information could be relevant from an investor’s point of view.

My Take: Again, there is enormous amount of time and cost involved in reporting details as required by rule 3-10. Therefore there is a need to revisit this rule in understanding what information is important from an investor’s perspective and to simplify the reporting as per the condensed consolidated financial information.


4.        Rule 3-16: Financial statements of affiliates whose securities collateralize an issue registered or being registered

Rule 3-16 requires a ‘registrant to provide separate annual and interim financial statements for each affiliate whose securities constitute a substantial portion of the collateral for any class of securities registered or being registered as if the affiliate were a separate registrant’.

In the event of default by the registrant, it is important from an investor’s perspective to understand the extent to which affiliates would meet their commitment. The SEC is seeking input on whether the disclosure requirements of the rule impacts or influences the structure of collateral arrangements and what other information could be useful for investors.

My Take: Practically speaking, the provision of collateral arrangements may limit the amount of collateral provided. Secondly, there could be lot of confusion arising in case of parent and multiple subsidiary collateral arrangements in terms of order of fulfilling commitment.


Other Requirements

The SEC is encouraging all interested users to actively participate and provide comments related to financial information about entities, or portions of entities, other than a registrant.

In the ‘request for comment’ letter, the SEC has provided an example of Rule 3-14, Special Instructions for Real Estate Operations to be Acquired, on which they are requesting comments. The SEC is also seeking inputs on the following:

·        What other rules and forms should be considered for review?

·        In what areas and topics can we improve disclosure of information? Should they be in machine readable format and how  can technology play a vital role in providing meaningful and useful data to investors?

·        Are there alternative ways of presenting information? - Which disclosures would require summarized information and which ones would require detailed information.

In essence, the SEC’s  request for comments is a great opportunity for all those who have anything to do with a regstrant’s financial information, be it  data analytics, research houses or preparers themselves. This can prove to be a platform to contribute views, opinions and requirements to the SEC as to what information in a registrant’s financial report  influences the  decision making process comparing it against the cost and efforts involved in getting that information.