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As previously reported in this Cooley PubCo post, on May 21, the SEC adopted final amendments to the financial disclosure requirements for the acquisition and disposition of businesses. One change relating to the use of abbreviated financial statements stands out as a welcome reform for public or pre-public biopharma and life sciences companies. Historically, if a public company wanted to purchase (or exclusively license) a product or development program that constituted a business under SEC guidance (commonly referred to as a “carve-out transaction”) and that carve-out transaction was significant, the buyer would have to seek an exemption from the SEC in order to file abbreviated audited financial statements for the acquired “business” in lieu of full carve-out financials. The new rules permit buyers to file abbreviated financial statements in these types of carve-out transactions without prior SEC consent, as long as certain criteria are met. Eliminating the need to obtain this relief from the SEC will save buyers time and legal and accounting expense. More importantly, the new rules may better position a buyer in an auction process where the buyer needs to know that it will be able to satisfy its SEC filing obligations if its bid prevails. Under the current rules, a potential buyer is often forced to choose among several less than ideal options in an auction process, whether it be (i) seeking permission from the seller to request the SEC exemption on a contingent basis during the process, (ii) including a contingency in its bid for obtaining this SEC relief or (iii) accepting the risk that it might not be able to satisfy the financial statement requirements and become non-compliant with SEC filing requirements (therefore losing S-3 eligibility). Buyers will still need to make arrangements with sellers for the preparation and audit of the abbreviated financial statements and the allocation of the expense. A more detailed explanation of the financial statement requirements for these types of carve-out transactions—under the current and new rules—is set forth below.
Historical Requirements and Process for Carve-Out Transactions
Rule 3-05 and Article 11 of Regulation S-X require the inclusion of financial information with respect to the acquisition or disposition of a “business,” as defined in Rule 11-01(d) of Regulation S-X. While the acquisition of a subsidiary or business unit of another organization is presumed to indicate that a business has been acquired, other forms of acquisition may also involve a “business.” In fact, our experience shows that the SEC rarely agrees to treat an acquisition of assets (or an exclusive license that may be substantially similar to an asset acquisition) as something other than the acquisition a “business.” For example, acquisitions of commercial drugs are generally treated as acquisitions of “businesses.” As a result of the expansive nature of the definition, public company buyers are often required to file full carve-out financials with the SEC despite only having acquired a single asset or group of assets (or exclusively licensing an asset or group of assets). Carve-out financials typically mean full GAAP financials of the acquired “business,” excluding the continuing operations retained by the seller. In many of these carve-out transactions, the seller has not historically maintained separate books and records for the assets being sold—making it immensely burdensome, if not impossible, to prepare the required financials. As a result, buyers often have sought relief from the SEC to permit the filing of abbreviated financial statements in lieu of full carve-out financial statements. Historically, the SEC staff could—but was not required to—grant that relief. This relief-seeking exercise has been used regularly in our life sciences practice, where buyers have purchased or licensed single drug products or a line of drug products from large pharmaceutical sellers, who rarely maintain separate financials for those assets given the size of the assets compared to the overall size of the seller. We note that the new rules do not change the requirements for carve-out financial statements for carve-out acquisitions that do not qualify for the abbreviated financial statements.
Understanding the New Rules
The new rules alleviate some of the difficulty faced by registrants involved in carve-out transactions by permitting the use of abbreviated financial statements without prior SEC approval if certain conditions are met, including:
- The acquired business consists of part of the selling entity
- No separate historical financial statements were ever prepared for the acquired business
- The acquired business represents 20% or less of the total assets and total revenues (both after intercompany elimination) of the selling entity on a consolidated basis for its most recently completed fiscal year
Under the new rules audited abbreviated financial statements must include:
- A balance sheet statement of assets acquired and liabilities assumed
- A statement of comprehensive income comprised of a statement of revenue and direct expenses which does not omit selling, distribution, marketing or general and administrative expense or research and development expenses (exclusive of corporate overhead, interest and income tax expense)
- Notes to the abbreviated financials with the following additional disclosures:
- Type of omitted expenses and rationale for omission;
- Explanation of why it would be impractical to prepare financials with the omitted expenses
- Description of how abbreviated financials are not indicative of financial condition or results of operation going forward due to omitted expenses
- Information about the acquired business’s operating, investing and financing cash flows, to the extent available
The rules do not go into effect until January 1, 2021, but early adoption is permitted so long as the amendments are adopted in their entirety. Given the number of improvements in the amendments, we would expect most registrants who are working on one or more business acquisitions to take advantage of this early adoption option.