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SEC Updates Financial Disclosure Requirements for Fund Acquisitions
The SEC announced updates to its rules and forms that improve financial statement disclosures related to acquisitions and dispositions of business.
On May 21, 2020, the Securities and Exchange Commission (the SEC) announced amendments to its rules and forms that improve financial statement disclosures related to acquisitions and dispositions of businesses. The amendments are designed to enhance the quality of information that investors receive while eliminating unnecessary costs and burdens. Most noteworthy for registered investment companies (RICs), the amendments tailor financial disclosure requirements for acquisitions of investment companies and other types of funds (Acquired Funds) by RICs.
Current Financial Disclosure Requirements
Prior to the SEC’s adoption of the amendments, there were no specific rules or requirements for RICs relating to the financial disclosures in Acquired Fund transactions. Instead, the general requirements in Rule 3- 05 of Regulation S-X (Rule 3-05) and the pro forma financial information requirements in Article 11 of Regulation S-X were applied. Under Rule 3- 05, separate audited annual and unaudited interim financial statements of the Acquired Fund are provided if the acquisition of that fund is “significant” to the registrant. Significance is determined by the application of three tests included in the “significant subsidiary” definition found in Rule 1-02(w) of Regulation S-X: the Investment Test, the Asset Test and the Income Test. The scope of the financial disclosure is then calibrated based on the target fund’s level of significance using a sliding scale approach. Unfortunately, it is often unclear how to apply Rule 3-05 to investment companies.
Enhanced Financial Disclosure Requirements
In its adopting release, the SEC expressly recognized that the rules governing Acquired Fund financial disclosures are not written to reflect the unique characteristics of investment companies. To address this deficiency, the amendments add new Rule 1-02(w)(2) and Rule 6-11 to Regulation S-X (the “New Rules”) specifically tailored for investment companies that, among other things:
- Add a separate definition of “significant subsidiary” in Rule 1- 02(w)(2), based on the current Rule 8b-2 of Regulation S-X (with some modifications), that uses an Investment Test and Income Test, but not an Asset Test
- Add new Rule 6-11 of Regulation S-X to establish financial disclosure obligations for Acquired Funds in the event of an acquisition, including a facts and circumstances test to determine whether a fund acquisition has occurred
- Replace the current pro forma financial disclosures requirement for Acquired Fund transactions with a requirement that RICs provide supplemental financial information about the newly combined entity that it believes would be more relevant to investors
- Revise the financial statement disclosure requirements of Form N-14
In addition to changes specific to investment companies, the amendments also implement significant changes across a number of other rules and forms applicable to acquisitions and dispositions of business development companies, real estate operations, foreign businesses and smaller reporting companies. For example, in Regulation S-X changes are also made to Rules 3-14, 8-04, 8-05, 8-06, and Article 11. Related SEC forms amended include S-11, N-2, 1-A, 8-K and 10-K.
Compliance Date and Early Compliance Option
January 1, 2021, is the mandatory compliance date. Accordingly, acquisitions and dispositions that are probable or scheduled to be consummated after the mandatory compliance date must be evaluated for significance using the New Rules. In addition, initial registration statements and any post-effective amendments filed on or after the compliance date to include either the registrant’s latest audited financial statements in the registration statement or to update the prospectus, must comply with the New Rules. The SEC has said that voluntary early compliance is permitted, provided that the amendments are applied in their entirety from the date of early compliance. Registrants with questions about application of the New Rules in connection with early compliance can contact the SEC staff for additional transition guidance.
Impacted Funds and Next Steps
All RICs that make fund acquisitions significant enough to trigger Rule 3- 05 disclosure requirements would potentially be affected by the amendments. Importantly, the addition of Rule 102(w)(2) affects RICs’ significance determinations and, as a result of those determinations, transaction disclosures filed with the SEC. Most filings for these transactions are on Form N-14, with a limited number on Forms N-1A and N-2.
While the SEC expects the New Rules to assist RICs in making more meaningful significance determinations, the reality is initial determinations under the New Rules may pose unforeseen challenges. Those challenges will include application of the New Rules with limited guidance and lack of precedent. We suggest a proactive approach, starting with the review of acquisition strategies in light of the New Rules. Among other things, we recommend undertaking preliminary significance determination under both Rule 6-11 and Rule 3-05 in consultation with the fund accountant and legal counsel. In certain situations we expect transactions will be significant under Rule 6-11 that would not be deemed such under Rule 305.
Given the option for early compliance, consider on a case-by-case basis when it is preferable to accelerate a transaction to apply the old rules or proceed with a transaction as scheduled, but exercise the option for early compliance and applying the New Rules. Logistically, it may also be prudent to build additional time into transaction calendars to provide sufficient time for analysis of the new requirements in consultation with fund counsel and fund accountants and in preparation of financial disclosures for the first time under the New Rules.
To learn more please contact your Northern Trust representative.