Member Article

While the SEC’s amendments described in our prior blog post (locatedhere) provide relief to companies in a number of industries – including oil and gas, foreign private issuers, business development companies, and investment funds – we’re taking a closer look at the impact the amendments will have REITs and other real estate companies.

Amendments to the Definition of “Significant Subsidiary” and Generally Applicable Financial Statement Requirements for Acquired Businesses

The “significant subsidiary” definition in Rule 1-02(w) under Regulation S-X includes investment, asset, and income tests that are applied when determining if a subsidiary is deemed significant for the purposes of determining whether separate audited annual and unaudited interim pre-acquisition financial statements of an acquired business must be provided. The SEC materially revised the Rule 1-02(w) investment and income tests. Previously, investment in an acquisition target was compared against the public company's total assets. Under the new versions of the income test, the public company's investment in the acquired property will be measured against the public company's market capitalization (called “aggregate worldwide market value” in the SEC’s release) or, in the absence of market value, the public company's total consolidated assets at the end of its most recently completed fiscal year. The new version of the income test adds a revenue component and revises the net income component to use income or loss from continuing operationsafterincome taxes, instead ofbeforeincome taxes. Public companies with losses, marginal or break-even net income in a recent fiscal year will not have to provide audited financial statements for an acquisition which would otherwise be immaterial to investors. These changes will likely help many public companies in the micro-cap and mid-cap spaces that often operate at a loss for long periods of time.

Rule 3-14: Financial Statements of Real Estate Operations Acquired or to be Acquired

Significance Thresholds. Previously, Rule 3-14 required public companies to file separate financial statements for real estate operations that it had acquired or proposed to acquire. The term “real estate operations” under Rule 3-14 refers to properties that generate revenues solely through leasing, such as offices, apartments, farms, and industrial buildings. As discussed further below, this term now likely also encompasses properties subject to triple net leases. “Real estate operations” excludes the acquisition of properties that generate revenues from operations other than leasing real property, such as nursing homes, hotels, motels, golf courses, auto dealerships, and equipment rental operations. These real estate operations are more susceptible to variations in costs and revenues over shorter periods due to market and managerial factors. S-X 3-05 rather than S-X 3-14 is applicable to the acquisition of these types of businesses.

The financial statement requirement under Rule 3-14 for real estate operations was triggered when an acquired property was individually significant at the 10% level or higher. In some cases, financial statements had to be filed when individually insignificant acquisitions were significant in the aggregate – even if the acquisitions were of unrelated properties. Typically, the public company had to provide audited financial statements for the most recent fiscal year and unaudited financial statements for the most recent interim period, as well as pro forma financial information.

The SEC indicates that the present amendments are intended to align Rule 3-14 with Rule 3-05 where no unique industry considerations warrant differentiated treatment of real estate operations. Accordingly, the amendments to Rule 3-14 increase the significance threshold to 20%, which aligns Rule 3-14 with the 20% significance threshold that applies to acquired, non-real estate businesses under Rule 3-05, and make it clear that the significance tests under Rule 1-02(w) should be used in such calculations. The amendments also align Rule 3-14 with Rule 3-05 by requiring one year of audited financial statements and the most recent interim period for acquisitions above 20% significance. Separate financial statements don’t need to be presented once the operating results of the acquired property have been reflected in the registrant's audited financial statements for nine months or up to one year, depending on significance.

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