INTERNATIONAL PRACTICES TASK FORCE — NOVEMBER 20, 2007
DISCUSSION DOCUMENTS
Discussion Document A — Measuring Assets and Determining Their Location for the Purpose of Performing the Asset Test Component of the Definition of a Foreign Private Issuer
Background: Under Rules 405 of the Securities Act and 3b-4 of the Exchange Act, the definition of a foreign private issuer is as follows:
“…any foreign issuer other than a foreign government except an issuer meeting the following conditions:
More than 50 percent of the outstanding voting securities of such issuer are directly or indirectly owned of record by residents of the United States; and
Any of the following:
- The majority of the executive officers or directors are United States citizens or residents;
- More than 50 percent of the assets of the issuer are located in the United States; or
- The business of the issuer is administered principally in the United States.”
The evaluation of a registrant’s status in relation to the criteria outlined above is a matter of legal interpretation. However, as the asset test involves accounting measurements, accountants may be asked for their views as to its application. While not seeking formal guidance, this document attempts to clarify the Staff’s views on how the asset test may be applied, by providing examples of acceptable methods.
There is no formal guidance on measuring or determining the location of assets in applying the asset test. However, in an article1 that has been widely cited as helpful in applying the foreign private issuer tests, the author indicates, “the SEC staff is frequently asked for guidance in applying the asset test, but has declined to respond, other than to suggest informally that an accounting approach may be an appropriate place to begin.”
The “accounting approach”
Under the accounting approach, in performing the asset test, the company could apply the measurement methodology in the underlying financial statements prepared under US GAAP, or the GAAP used in the primary financial statements if the financial statements are reconciled to US GAAP. This may be the preferred methodology from a practical standpoint, because the company will likely have the systems in place to perform the test regularly. Under the accounting approach, the location of the assets would be the same as that determined in financial reporting for purposes such as segment information.
Alternatives to the accounting approach
There may be a variety of alternatives to using strictly an accounting approach. The following methodologies, to the extent not used in the primary financial statements, may be considered:
Use of fair value for measurement purposes: If a registrant that has all of its operations outside of the U.S. acquires a company with all of its operations inside the U.S., it may record a significant amount of goodwill. As a result, under the accounting approach, a disproportionate amount of assets may be associated with the U.S. operations, relative to the actual fair value of the combined entity. In such a situation, a company may choose to use a full fair value approach, rather than the values stated in its financial statements, for applying the Asset Test. In other words, if company determined the fair value of the assets in the U.S., compared it to the fair value of the assets of the consolidated group and determined that less than 50% of the fair value of the assets were in the U.S., it may conclude that less than 50% of the assets are not in the U.S. even if the amounts under GAAP would indicate that over 50% of the assets were in the U.S.
It should also be noted that, in the above example, if the historical cost basis is used under the GAAP of the primary financial statements, but that GAAP also permits the use of fair values for measuring certain assets, the fair value methodology permitted by that GAAP may be used.
Use of historical cost basis for measurement purposes: If a fair value measurement method is used under the GAAP of the primary financial statements, the historical cost basis permitted by that GAAP may be used for purposes of the asset test.
Use of allocation methodologies that differ from those used for segment disclosure: It is possible that the allocation methodology used in the foreign private issuer asset test may differ from that underlying the presentation of segment assets or entity wide assets on a geographical basis under SFAS 131. Following are examples of such differences:
Cash and cash equivalents — In connection with segment disclosure, the location of cash and cash equivalents may be presented based on where such cash and cash equivalents are kept. Cash and cash equivalents may be kept in the U.S. by a company to fund the U.S. operations. A company might also keep cash in the U.S. as part of an investment decision under a centralized treasury operation where such cash can be transferred to another location easily. It may be reasonable to treat cash and cash equivalents kept in the U.S. to fund U.S operations as located in the U.S. while cash and cash equivalents kept in the U.S. strictly for investment purposes may not be included as asset located in the U.S.
Other financial instruments — In connection with segment disclosure, the location of other financial instruments, such as derivatives, may be the legal or contractual location of such an instrument, which may have little relation to the objective for which the instrument was acquired. The determination of the location of such assets may require evaluation of the facts of the underlying contracts and the reasons for acquiring the instrument.
Trade receivables — In connection with segment disclosure, the location of trade receivables may be determined by the location of the business unit that has made the related sale. However, another factor that might be considered is the location of the debtor.
Cost method investments and equity method investees — In connection with segment disclosure, the location of cost method investments and investments in equity method investees may be determined by the location of the entity that owns the shares of the investee. However, it is possible that the location of the business operations of the investee has little relation to the location of the entity that owns its shares. In such cases, the location of the investee’s operations may be considered.
Other tangible assets — In connection with segment disclosure, the location of tangible assets may be determined by where they are physically located. However, there may be circumstances under which a portion of the value of tangible assets is allocated to a location other than where the asset is physically located. For example, computer hardware might have software embedded in it. The hardware may be used in one location while the software might be used by several locations. Some companies may have an information system housed in one location, but being used by multiple countries. In these situations, it may be reasonable to allocate the value of the assets according to their use.
Intangible assets — In connection with segment disclosure, the location of an intangible asset may be the location of the entity that holds the asset. However, if an intangible asset such as brand, patent or trademark is used in more than one country, a company might allocate the value of the asset to countries where it is used, in proportion with revenue or some other rational measure of the use of the asset.
It is possible that in applying the above alternative methodologies to the use of the accounting approach, a registrant may use a GAAP other than that used in preparing the primary financial statements. For example, a company that presents its financial statements under US GAAP for purposes of filing its Form 20-F, but reports its results in its home country GAAP locally, may use home country GAAP for its asset test.
It should be noted that while the Commission’s rules are silent as to how frequently a company needs to perform the asset test, in a no-action letter issued in 19932, the Staff indicated that the test should be performed, at a minimum, on a quarterly basis, but also upon the occurrence of certain transactions. From a practical standpoint, therefore, the use of a methodology other than the accounting approach may result in significant incremental effort on a quarterly basis.
Additionally, once a registrant has selected a methodology in performing the asset test, it should be applied on a consistent basis, unless a clear change in circumstances warrants a reassessment.
The Task Force seeks the Staff’s confirmation that it is unlikely to object to a particular measurement or allocation methodology, including those outlined above, as long as it is rationally based and rigorously applied, without considering in advance what the likely result will be.
SEC Staff Response: The staff agrees with the Task Force’s view. With respect to the frequency of testing described in the third-to-last paragraph above, the staff notes that when the recently adopted Foreign Issuer Reporting Enhancements (SEC Release 33-8959) become effective in late 2008, foreign private issuers will be required to test their status only once per year.
Discussion Document B — Financial Statement Requirements in Form 8-K After a Foreign Company Completes a Reverse Acquisition of a U.S. Public Shell Company
Background:
- A foreign company is completing a reverse acquisition of a U.S. domestic registrant shell company.
- To effect the reverse acquisition, a Form S-4 was filed with statements of the foreign company (accounting acquirer) in home-country GAAP reconciled to U.S. GAAP in compliance with Item 18.
- A Form 8-K will be filed upon consummation of the transaction.
Issue: Related to the Form 8-K that will be filed upon consummation of the merger in the above fact pattern, questions that often arise include:
- Within how many days after the consummation of the merger is the Form 8-K due?
- What GAAP should be used to prepare the financial statements of the foreign company (accounting acquirer) included in the Form 8-K?
Discussion: To address these questions, issuers often refer to guidance in the SEC Staff Training Manual and the SEC Staff’s outline (that is, the International Financial Reporting and Disclosure Issues in the Division of Corporate Finance). Relevant excerpts (emphasis added) from these publications are as follows:
SEC Staff Training Manual, Exhibit B, Reverse Acquisitions.
Form 8-K
- 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.
- 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 75 days from the date the acquisition was consummated to furnish the required information.SEC Staff Training Manual, Topic 6 (Foreign Private Issuers and Foreign Businesses), Chapter III (Requirement for Reconciliation to US GAAP), Item A.4
- "Backdoor" listings by foreign companies
- Foreign companies sometimes obtain a "backdoor" listing through a reverse acquisition with a U.S. public shell. Even though substantially all of the operations are conducted outside of the U.S., the registrant would not be considered a foreign private issuer.
- To facilitate timely reporting, the staff would not object if the financial statements included in the Form 8-K are prepared using a foreign GAAP, provided a reconciliation to U.S. GAAP that complies with Item 18 of Form 20-F is provided.
- The first Form 10-K and any registration statement should include financial statements prepared using U. S. GAAP for all periods presented, including those prior to the reverse acquisition. Financial statements in a foreign GAAP reconciled to U.S. GAAP would not be acceptable.
SEC — International Financial Reporting and Disclosure Issues in the Division of Corporate Finance, (November 1, 2004) section VI. — Issues Encountered in Reconciliations to US GAAP/Business Combinations/Financial Statement Requirement after a Reverse Acquisition.
A number of foreign companies have obtained a listing in the US by merging into a nonoperating US public shell company whose securities are already registered with the Commission. The transaction is typically accounted for as a “reverse recapitalization.” Notwithstanding that substantially all of the registrant’s operations after the merger will be conducted outside of the US, the registrant is not a foreign private issuer and must comply with the rules applicable to US public companies. Accordingly, the registrant must file a Form 8-K containing financial statements of the foreign company within 75 days of the merger. To facilitate the initial filing of the foreign company’s statements, the staff will not object if the financial statements included in the 8-K are prepared in accordance with a foreign GAAP, but reconciled to US GAAP in accordance with Item 18 of Form 20-F. However, the first Form 10-K following the merger, and any registration statement, should include financial statements prepared in accordance with US GAAP for all periods presented, including those periods prior to consummation of the reverse recapitalization. Financial statements in a foreign GAAP reconciled to US GAAP would not be acceptable.
SEC Rule Release 33-8587
In July 2005, the SEC published its final rule, Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies (“Rule Release 33-8587”). The new rule requires substantially more disclosures, on a timely basis, when a public shell company ceases to be a shell company (e.g., the acquisition of more than nominal assets; the acquisition of an operating business, including a reverse merger or back-door registration). In addition, the rule prohibits a public shell company from using Form S-8, and prohibits a former public shell company from using Form S-8 until 60 days after it files the specified disclosures. These rules target regulatory problems that the SEC had identified where shell companies have been used as vehicles to commit fraud and abuse their regulatory processes.
Pursuant to these rules, the SEC requires that the surviving entity file its report on Form 8–K within four business days after completion of the transaction that it is required to report. The SEC believes the timeframe is appropriate because shell companies and their counsel control the pace and timing of these transactions. Given the concerns unique to shell company transactions, the SEC believes shell companies should complete a transaction that is required to be reported only when they can timely provide investors with adequate information to make informed investment decisions.
Under the new rules, the financial statements of the accounting acquirer of a shell company must be filed within four business days and must be equivalent to that required in a Form 10 Exchange Act registration.
Discussion:
Issue 1 — With respect to a foreign company obtaining a “backdoor” listing through a reverse acquisition of U.S. public shell company, the new rules shortened the time period to file the 8-K (i.e., 4 days). However, a preparer relying on the guidance in the SEC — International Financial Reporting and Disclosure Issues in the Division of Corporate Finance, (November 1, 2004) could inappropriately interpret that guidance to provide 75 days from the date of the merger to file the financial statements by amendment to the 8-K. Therefore, to some, it is unclear as to whether the accommodation to timing is still granted by the SEC Staff.
Issue 2 — Rule Release 33-8587 is silent with respect to the acceptability of the foreign company (accounting acquirer) filing home-country GAAP reconciled to U.S. GAAP in the 8-K. Some believe that considering the SEC’s intent with respect to Rule Release 33-8587 and the preparer and counsel control of timing of the transaction that the accommodation to provide home-country reconciled to U.S. GAAP should be discontinued. Others are not troubled by the foreign company (accounting acquirer) continuing to be able to use home-country GAAP reconciled to U.S. GAAP in the Form 8-K.
With respect to both issues, the Task Force believes that the SEC Staff should update the publications mentioned above so as to avoid confusion in practice amongst preparers and their counsels.
Proposed Task Force Recommendation: Considering the SEC’s intent with respect to Rule Release 33-8587 and that the financial statements of the accounting acquirer (i.e., foreign company) become the primary financial statements of the registrant and will have to be prepared in accordance with U.S. GAAP, the Task Force recommends that the SEC Staff update the SEC — International Financial Reporting and Disclosure Issues in the Division of Corporate Finance, (November 1, 2004) mentioned above as follows:
- The registrant must file a Form 8-K containing financial statements of the foreign company within 4 business days of the merger.
- The financial statements of the foreign company (accounting acquirer) included in the 8-K should be prepared in accordance with a U.S. GAAP.
Furthermore, the Task Force believes these actions will protect investors by deterring fraud and abuse in the U.S. securities markets through the use of reporting shell companies.
SEC Staff Response: The staff agrees with the Task Force’s view.
Discussion Document D — Monitoring Inflation in Certain Countries
Background: At the March 2003 meeting of the Task Force, it was noted that it would be helpful to be more proactive in assessing the inflationary status of countries. As a result, it was agreed that a mechanism be developed for proactively monitoring the inflationary status of countries. That approach and the related assumptions used by the Task Force are described below:
Approach
The Task Force agreed to regularly consider the inflationary status of a number of countries for the purpose of determining whether they were highly inflationary as defined in FASB Statement 52. It was agreed that inflation rates be monitored regularly (monthly to the extent possible) in order to identify cases where the Task Force could discuss a country’s inflationary status. Based on the cumulative inflation information, countries would be categorized as follows:
- Countries that are clearly highly inflationary (i.e., that have cumulative inflation approaching or exceeding 100%).
- Countries with increasing cumulative inflation rates that should be monitored.
- Countries that are clearly not highly inflationary (i.e., with sufficiently low cumulative inflation).
Assumptions
The following assumptions were developed as a means of screening countries in order to determine whether the Task Force should discuss their inflationary status:
- Inflation rates used would be based on a consumer price index, unless otherwise noted. Where an index other than the CPI is used, the Task Force would need to discuss the appropriateness of the index.
- Inflation information would be derived from the “International Financial Statistics” on the IMF website. In cases where information is not provided to the IMF, local sources would be used (e.g., country central bank data).
- Countries with cumulative inflation rates not exceeding a certain level, say 70%, generally would not be considered highly inflationary based on quantitative factors alone. However, qualitative factors ultimately would be considered pursuant to EITF Topic D-55, as deemed necessary by the Task Force.
- Countries with cumulative inflation rates between 70% and 100% would be assessed for highly inflationary status given recent trends, based on the guidance in EITF Topic D-55. For example, in cases where the cumulative rate has declined below 100%, is that decline “other than temporary”? Or, in cases where the inflation rate has been increasing, is the cumulative rate at a level that “approximates” 100%? In addition, countries with a significant increase in inflation during the current period would be monitored.
In certain cases inflation information is not updated regularly. In such cases the following was agreed:
- Where a country was previously considered highly inflationary (i.e., the last known cumulative inflation rate previously exceeded or approached 100%), presume that still highly inflationary.
- Where a country was previously not considered highly inflationary (i.e., the last known cumulative inflation rate did not previously exceed or approach 100%), deduce the current inflation rate necessary in order to exceed 100% (the “deduced rate”). The deduced rate would be calculated solely for the purpose of determining whether or not the Task Force should analyze a particular country’s inflationary status. The ultimate determination of that status would depend on all relevant facts and circumstances.
- If deduced inflation rate for the current period(s) exceeds a certain level, say 30%, then presume that not highly inflationary unless the deduced rate is consistent with the trend in recent known periods.
- If deduced inflation rate does not exceed a certain level, say 30%, then presume highly inflationary unless the deduced rate is not consistent with the trend in recent known periods.
The Task Force agreed that qualitative factors also should be considered. The Task Force noted that the existence of objective and verifiable evidence would be necessary for a country to no longer be considered highly inflationary.
Task Force Recommendation:
Countries considered highly inflationary
The Task Force concluded that the following countries should be considered highly inflationary through December 31, 2007:
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Angola* |
Myanmar |
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Zimbabwe | |
* The Task Force agreed that Angola would come off highly inflationary status as of the first period beginning after December 31, 2007. | |
Regarding the Dominican Republic, which came off highly inflationary status in 2007, the Task Force agreed that registrants may change status as of the first period beginning after March 15, 2007, if practicable, but no later than the first period beginning after September 15, 2007.
Countries on the highly inflationary “watch list”
The following countries are on the Task Force’s inflation “watch list”:
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Eritrea |
Guinea |
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Haiti |
Venezuela |
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Iran |
Zambia |
SEC Staff Response: The Staff agrees with the Task Force recommendation.