III. Guidance About Financial Statement Requirements
A. Financial Statements Of Operating Real Estate Properties Acquired
1. BASIC EXCHANGE AND SECURITIES ACT REQUIREMENTS
Rule 3-14 of Regulation S-X requires that financial statements of each operating real estate property (or group of related properties) acquired that is significant at the 10% level or higher be filed in a Form 8-K and in all transactional filings (registration statements and proxies). The significance test is computed by comparing the registrant's investment in the property to the registrant's total assets at the latest fiscal year-end for which audited financial statements are filed with the Commission. The purchase of real estate by companies engaged in real estate activities is not considered to be an acquisition "in the ordinary course of business" and, therefore, is not excluded from the reporting requirements of Item 2 of Form 8-K.
(Evaluation of significance by comparison to a pro forma balance sheet depicting a subsequent property acquisition is not permitted under Rule 3-14, as it is under Rule 3-05. Also, Rule 3-06 is not applicable to financial statements of real estate properties, although the staff has not required inclusion of financial statements of operating properties acquired from unrelated parties in transactional filings if its operations have been included in the registrant's audited operating results for a period of at least nine months.)
Rule 3-14 imposes the additional requirement in transactional filings to furnish financial statements of operating real estate properties acquired or to be acquired that are individually insignificant, if such acquisitions, in aggregate with other properties, exceed 10% of the registrant's total assets. In certain instances, the staff has granted relief under this requirement whereby omission of audited financial statements of an individually insignificant property that is significant below the 5% level is permitted if: (a) the property is acquired from an unrelated party, (b) descriptive and unaudited summarized financial information about the property is provided and (c) audited financial statements of the substantial majority of all individually insignificant properties acquired or to be acquired are provided.
2. ADDITIONAL REQUIREMENTS APPLICABLE TO "BLIND POOLS"
Registration statements for "blind pool" offerings by real estate companies should include an undertaking to file a sticker supplement during the distribution period describing each property that has not been identified in the prospectus whenever a reasonable probability exists that a property will be acquired, and to consolidate all stickers in a post-effective amendment filed at least once every 3 months. The post effective amendment must include audited financial statements meeting the requirements of Rule 3-14 for all properties acquired. Notwithstanding the filing of sticker supplements or post-effective amendments during the distribution period, an issuer remains subject to the requirements of Form 8-K to report each acquisition of a property that exceeds the 10% significance level, and furnish the financial statements and related pro forma information, unless substantially the same financial information has been filed previously.
After the distribution period, pursuant to its undertaking, the registrant must file (in Form 8-K) audited financial statements of each property upon the commitment of 10% or more (on a cumulative basis) of offering proceeds. While the staff has not objected to the view that the undertaking to provide audited financial statements is not applicable to individually immaterial properties, the staff has objected to the view that a property is insufficiently material to fall within the scope of the undertaking if: (a) it is acquired from a related party, or (b) it exceeds the 5% significance level, or (c) it is one of a group of properties that together aggregate more than 5% and are acquired from a single seller, or whose acquisitions are contingent on one another, or are otherwise related to one another by virtue of location or other material financial or commercial factor.
3. PROPERTIES SUBJECT TO LONG-TERM NET LEASE
If a real estate property will be leased on a long-term basis immediately after its acquisition to a single tenant under a net lease that transfers substantially all of the property's nonfinancial operating and holding costs to the tenant, financial data and other information about the tenant (or other party that guarantees the lease payments) may be more relevant to investors than financial statements of the property acquired. In that case, the financial statements of the property may be omitted from the filing, but pertinent financial data and other information about the lessee or guarantor should be furnished. The staff believes that information should include audited financial statements of the lessee or guarantor if the purchase price of the property exceeds 20% of the greater of total assets or the amount expected in good faith to be raised within the next twelve months pursuant to an effective registration statement. That view is consistent with the guidance furnished in SAB 71 concerning significant credit concentrations. If the lessee or lease guarantor is a public company currently filing reports with the Commission, only summary data need be provided. The disclosure pertaining to a material lessee, including its audited financial statements if the investment exceeds the 20% significance level, should be provided in filings made under both the Securities Act and the Exchange Act.
B. Financial Statements of Businesses Contributed to Joint Venture
A registrant and another party may each contribute businesses to a Newco (or "joint venture"), receiving in exchange an equity interest in the combined company. In this transaction, the registrant is giving the other party an interest in a formerly consolidated business in exchange for an equity interest in the other party's business.
Instruction 2 to Item 2 of Form 8-K specifies that dispositions and acquisitions effected through exchange transactions each be reported under that Item. The Item specifies separate thresholds for determining when each of those transactions is significant. The significance of the disposition and acquisition should be evaluated separately in determining whether pro forma information about the disposition (and receipt of an equity investment) is required, and whether audited financial statements of the business contributed by the other party are required.
Pro forma financial statements should be furnished to reflect the effects of a disposition of a controlling interest in a business if the business is a "significant subsidiary" exceeding the 10% level under the tests in Rule 1-02(w) of Regulation S-X. Retention of an equity interest in the business (or the newly combined businesses) does not alter that requirement.
The acquisition of an interest in a business to be accounted for using the equity method is deemed the acquisition of a business. Therefore, if the interest in the joint venture will be accounted for using the equity method, financial statements of the business or businesses contributed by the other party may be required under Rule 3-05 of Regulation S-X. The asset, investment and pretax earnings tests of Rule 1-02(w) should be based on the acquired percentage of the other party's business compared to the registrant's historical financial statements (without adjustment for the related disposition of the business contributed by the registrant to the joint venture). Whether or not the transaction is accounted for at fair value, the investment test should be based on the fair value of the consideration given up or the consideration received, whichever is more reliably determinable.
If reporting of both the disposition and the acquisition are required by Form 8-K, a registrant may be unable to present a pro forma income statement depicting the joint venture formation because financial statements of the business contributed by the other party are not available. Those financial statements and related pro forma financial statements need not be filed until 75 days after the transaction is consummated. Pro forma financial statements depicting a significant disposition are required to be filed within 15 business days of the disposition. In these circumstances, the initial Form 8-K reporting the transaction should include a narrative explanation of the effects of the disposition, quantified to the extent practicable, with complete pro forma information depicting the effects of the exchange of interests furnished at the time that the audited financial statements of the acquired business are filed.
C. Financial Statements for Acquired Oil & Gas Producing Properties
The acquisition of a working interest in oil and gas producing properties is deemed to be the acquisition of a business for purposes of Rule 3-05 of Regulation S-X and Form 8-K. If it is not practicable to obtain complete audited financial statements with respect to an acquired oil and gas property, we will not waive the requirement to furnish financial information. However, we will accept audited statements of revenues and direct operating expenses for the necessary periods as determined by the level of significance. A footnote should explain the omitted historical expenses and the reasons for the omission. If the type and amounts of omitted expenses are known or reasonably available on an unaudited basis they should be disclosed in an unaudited footnote.
The supplementary disclosures described in paragraphs 10 through 17 and 30 through 34 of SFAS 69 should be furnished pursuant to Item 302(b) of Regulation S-K. Where prior year reserve studies were not made, we will accept the reserves computed for prior years using only production and new discovery quantities and valuation, in which case there will be no "revision of prior estimates" amounts. The registrant may develop these disclosures based on a reserve study for the most recent year, computing the changes backward. The method of computation should be disclosed in a footnote.
We believe that in all cases it is necessary to present information as of the latest year-end on reserve quantities and the future net revenues associated with those quantities. However, SAB Topic 2:D.Question 5 states that "the staff will consider, on a case-by-case basis, granting exemptions from (i) the disclosure requirements for year to year reconciliations of reserve quantities, and (ii) the requirements ... for a summary of oil and gas producing activities and a summary of changes in the net present value of reserves. For instance, the staff may consider requests for exemptions in cases where the properties acquired ... are fully explored and developed, particularly if the management of the emerging company has not been involved in the exploration and development of such properties."
D. Financial Statements in Hostile Takeover Situations
In registration statements that require financial statements of a company other than the registrant (such as when the registrant acquires or will acquire another entity), the audit report of the target's independent accountants must be included in the registration statement. The consent of the target's auditor to the inclusion of its report in the registration statement is required pursuant to Rule 436 of Regulation C.
A registrant offering its own securities in a hostile exchange offer for the target's stock may seek and not be able to obtain the target's cooperation in providing either its audited financial statements or the target auditor's consent to the use of its report in the required registration statement. In this situation, the registrant should follow the guidance in SAB Topic 1A. If the target is a public company, SAB Topic 1A requires that any publicly filed financial information of the target, including its financial statements, be included in the registrant's filing or incorporated by reference into, and therefore made a part of, that filing.
The acquirer/registrant should use its best efforts to obtain the target's permission and cooperation for the filing or incorporation by reference of the target's financial statements, and the target auditor's consent to the inclusion of its report on the financial statements. At a minimum, a registrant is expected to write to the target requesting these items and to allow a reasonable amount of time for a response prior to effectiveness of the filing. The target may, however, fail to cooperate with the registrant.
Under Rule 437 of Regulation C, a registrant may request a waiver of the target auditor's consent by filing an affidavit that states the reasons why obtaining a consent is impracticable. The affidavit should document the specific actions taken by the registrant to obtain the cooperation of the target for the filing of its financial statements as well as the efforts made to obtain the target auditor's consent. As stated in SAB Topic 1A, the staff should request copies of correspondence between the registrant and the target evidencing the request for and the refusal to furnish financial statements.
If the registrant uses its best efforts but is still unsuccessful in obtaining the target's permission and cooperation on a timely basis, the staff will generally agree to waive the requirement to include or incorporate by reference the target auditor's audit report, but not the target's financial statements. If target financial statements are incorporated by reference into the acquirer's registration statement from the target's public filings, disclosure should be made that, although an audit report was issued on the target's financial statements and is included in the target's filings, the auditor has not permitted use of its report in the registrant's registration statement. The auditor should not be named. Any legal or practical implication for shareholders of either the registrant or the target of the inability to obtain the cooperation of the target or consent of the target's auditor should be explained. No disclosure in the registration statement should expressly or implicitly purport to disclaim the registrant's liability for the target's financial statements. In the event that circumstances change, for example, if the deal turns friendly, the registration statement should be amended to include the audited financial statements and the auditor's consent required by the form.
E. Third Party Credit Enhancements
Third party credit enhancements differ slightly from guarantees. A guarantee running directly to the security holder is a security within Section 2(1) of the Securities Act and must be covered by a Securities Act registration statement filed by the guarantor, as issuer. A third party credit enhancement is an agreement between a third party and the issuer or a trustee that does not run directly to the security holders. A party providing credit enhancement generally is not a co-issuer. However, if an investor's return is materially dependent upon the third party credit enhancement, the staff requires additional disclosure about the credit provider. The disclosure must provide sufficient information on the third party to permit an investor to determine the ability of the third party to fund the credit enhancement. In most cases, the disclosure of the third party's audited financial statements presented in accordance with generally accepted accounting principles would be required. However, if such financial statements are not available, statements prepared under statutory standards may be acceptable (e.g., statutory financial statements of insurance companies serving as credit enhancers).
The staff considers the following factors in assessing the sufficiency of the disclosure in this area: (1) the amount of the credit enhancement in relation to the issuer's income and cash flows; (2) the duration of the credit enhancement; (3) conditions precedent to the application of the credit enhancement; and (4) other factors that indicate a material relationship between the credit enhancer and the purchaser's anticipated return.
F. Reverse Acquisitions — Reporting Issues
Commission rules do not address directly a registrant's reporting obligations in the event that it acquires another entity in a transaction to be accounted for as a reverse acquisition. For accounting purposes, the acquiree is treated as the continuing reporting entity that acquired the registrant. The staff believes the reports filed by the registrant after a reverse acquisition should parallel the financial reporting required under GAAP -- as if the acquiree were the legal successor to the registrant's reporting obligation as of the date of the merger. To comply with Exchange Act requirements, the registrant should assure that its filings with the Commission result in timely, continuous reporting, with no lapse in periods presented in the financial statements and no audited period exceeding 12 months. The staff believes this may be accomplished in either of two ways, depending on whether the registrant intends to report after the merger based on its previous fiscal year or is adopting the fiscal year of the "accounting acquirer."
In any case, a Form 8-K should be filed not later than 15 days after the consummation of the reverse acquisition. That Form 8-K should note under the appropriate Form 8-K item number any intended change in independent accountants and changes in fiscal year end from that used by the registrant prior to the acquisition. Most typically, registrants adopt the fiscal year and auditor of the accounting acquirer, but that is not necessary.
The Form 8-K reporting the acquisition should contain financial statements of the accounting acquirer (the legal acquiree). Those financial statements thereafter become the financial statements of the registrant pursuant to GAAP. Audited financial statements of the accounting acquirer for the three most recently completed fiscal years should be included; or two years, if the registrant was eligible to use S-B forms and effected that election in its initial filing in the fiscal year in which the merger occurred. (However, if the accounting acquirer would not be eligible to use S-B forms itself, the staff would deem the registrant ineligible to use S-B forms in any filing made subsequent to the consummation of the transactions.) Unaudited interim financial statements of the accounting acquirer for any interim period and the comparable prior year period, and pro forma information depicting the effects of the acquisition, should be included in the Form 8-K. If the financial statements of the accounting acquirer are not available, the registrant has up to 60 days from the date the Form 8-K was initially filed to furnish the required information.
If the registrant elects to adopt the fiscal year of the accounting acquirer, the staff believes no transition report is necessary. Periodic reports for periods ending prior to the consummation of the merger should be filed as they become due in the ordinary course of business. Commencing with the periodic report for the quarter in which the merger was consummated, reports should be filed based on the fiscal year of the accounting acquirer. Those financial statements would depict the operating results of accounting acquirer, including the acquisition of the registrant from the date of consummation.
If the registrant intends to continue to report using the fiscal year-end of the legal acquirer, periodic reports for periods ending prior to the consummation of the merger should be filed as they become due in the ordinary course of business. In addition, the registrant ordinarily should file a transition report on Form 10-K containing the audited financial statements of the accounting acquirer for the necessary transition period (generally, from the end of the legal acquiree's most recently completed fiscal year to the next following date corresponding with the end of a fiscal year of the legal acquirer). The transition report is due 90 days after the consummation of the acquisition. The Form 10-Q for the combined entity should be filed within 45 days after the end of the quarter.
G. Accountants' Refusals to Re-issue Audit Reports
Some accounting firms have adopted risk management policies that lead them to refuse to re-issue their reports on the audits of financial statements that have been included previously in Commission filings. In some cases, accountants whose reports on acquired businesses were included in a registrant's Form 8-K have declined to permit that report to be included in a registrant's subsequent registration statement. In other cases, accountants have declined to reissue their reports on the registrant's financial statements after the registrant engaged a different auditor for subsequent periods. The Commission's staff is not in a position to evaluate the reasons for an accountant's refusal to re-issue its report and will not intervene in disputes between registrants and their auditors. Moreover, the staff will not waive the requirements for the audit report or the accountant's consent to be named as an expert in filings. If a registrant is unable to re-use the previously issued audit report in a current filing, the registrant must engage another accountant to re-audit those financial statements. A registrant that is unable to obtain either re-issuance of an audit report or a new audit by a different firm may be precluded from raising capital in a public offering.
When registrants engage an accountant to perform audit services, they should consider the need for the accountant to re-issue its audit report in future periods. It may be appropriate to address in the audit services contract the registrant's expectations regarding the use of the audit report in filings that it or its successors may make under either the Exchange Act or the Securities Act and the circumstances under which the accountant may decline to reissue its report.