Thought Leadership  •  November 02, 2023

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Acquisitions and Dispositions: SEC Rule 3-05

In 2020, the Securities and Exchange Commission (SEC) modified the rules for disclosing acquisitions and dispositions, which are part of SEC Rule 3-05. The changes were intended to simplify financial reporting for matters including corporate property dispositions. This guide covers the changes to SEC Rule 3-05, including final amendments and the all-important Rule 3- 05 significance test. Read on to discover what's new and why these changes were made.

What Is SEC Rule 3-05?

First, a refresher: What is SEC Rule 3-05, and why does the SEC care about information disclosures during acquisition?

Rule 3-05 requires any registered entity that wants to acquire a business to provide audited annual financial statements and other types of financial reporting.

Before the rule change, companies were required to:

  • Submit a single year's audited financial statement if the significance test results fell between 20% and 40%
  • Submit two years of audited financial statement if the significance test results fell between 40% and 50%
  • Submit three years of audited financial statement for significance test results over 50%

The SEC's final ruling explains the reasons for these changes. Specifically, the changes are intended to improve for investors the financial information about acquired or disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure.

Final Amendments to Rule 3-05 and 3-14

The most notable changes to Rule 3-05 and Rule 3-14, a related rule that targets real estate entities specifically, involve the income test and investment test.

Under the final version of the rule:

  • The investment test will rely on the entity’s aggregate worldwide market value, when possible.
  • The income test will use a lower measure than in the previous rule.
  • The amount of annual financial statements required is a maximum of two most fiscal years.
  • In certain cases, including for some IPOs, financial statements may no longer be required.
  • Abbreviated financial statements can be used in certain circumstances than before, without the need to officially request permission from the SEC.
  • The reporting threshold for disposition is raised to 20%.

Updates to Significance Tests

The updates to the significance tests are among the largest changes regarding Rule 3-05 financial statements, so it's worth unpacking what's changed in greater detail.

The Investment Test

Under the previous version of the Rule, the investment test compared the entity's investment in the target company with its total assets. This formula was helpful and simplistic.

The investment test approved under the final rule requires the entity to compare its investment in the target company with the aggregate worldwide market value of its equity (both voting and non-voting shares), averaged over the final five days of the month before the registrant's announcement of the deal.

Thus, if the deal was announced on September 7, the investment test would look to the last five trading days of August to make the decision.

What happens when an entity has no aggregate worldwide market value? In that case, the old investment test would be used instead.

The Income Test

The previous income test looked at net income for the target and the acquiring company. Since the previous version of the test omitted business expenses and other variables, results were sometimes skewed.

The new income test looks at the target company's revenue as compared to the acquiring entity's revenue for the two preceding fiscal years.

New entities may not have a lengthy track record of revenue, in which case the former calculation (based on net income only) shall be used.

Significance Threshold for Dispositions

When a company disposes of an asset through sale, shareholder distribution, split-off, split-up or other means, the disposition must be reported on a Form 8-K if it exceeds a stated threshold. The former threshold for reporting a disposition was 10%.

As mentioned above, the threshold for dispositions increased to 20% with the rule change. This adjustment brings the threshold for disposition in line with that used to consider acquisitions.

Pro Forma Financial Information

Pro forma financials were not allowed under the old version of Rule 3-05, but there are a few accepted use cases under the new guidelines.

Under the amendments, companies can use pro forma instead of historical data when acquisitions were performed in the previous year and already filed the target company's historical and pro forma statement using the 8-K Form at the time.

Companies can also use pro forma data for significant dispositions made in the preceding year and filed the relevant financial information on an 8-K, as required. Pro forma data can be used when determining significance testing for an IPO.

Companies that submit pro forma data to satisfy the significance test must continue to use pro forma data until their next annual report is filed.

While at first glance it seems as though the SEC made a lot of changes, ultimately the new acquisition and disposition rules make financial reporting easier. Once companies adjust to the new process, they will ultimately find that required financial reporting is less time-consuming and a better fit for their M&A proceedings.


Marcie Clark

Global Director, Filing and Compliance Services, DFIN