Equity Investments and Regulation S-X Rule 3-09

Bill S. Preston, Esq, General Counsel of So-Crates, Inc. is back on the line. This time, he is telling you that the company has discovered that it has been looking at some of its investments, and has concluded that they may have grown more significant than previously. He’s worried that separate financials may be required for those investments, and if so, wants to know if relief is available to avoid a totally bogus journey.
Background

Regulation S-X Rule 3-09 generally requires the inclusion of separate audited financial statements for significant investments -- that is, an entity which is owned 50% or less -- that are accounted for under the equity method. We discuss the significance tests in our co‑branded publication with KPMG on financial statement requirements, but in broad outline they evaluate significance on the following two tests:

  • whether the amount of the issuer’s (and its other subsidiaries’) investment in and advances to the investee exceeds 20% of the total assets of the issuer and its subsidiaries on a consolidated basis as of the end of the most recently completed fiscal year (Test 1); and
  • whether both (where applicable) the equity of the issuer (and its other subsidiaries) in: (i) the pre-tax income from continuing operations and (ii) the consolidated total revenues from continuing operations (after intercompany eliminations) of the equity investee exceeds 20% of such income and revenue of the issuer and its subsidiaries on a consolidated basis for the most recently completed fiscal year (Test 2).

If either of the above tests is met, separate financial statements of the investee must be filed. (For equity investees at the 10%-20% level, summary financial information may be required under S-X 4-08(g).) See also Section 2410 of Corp Fin’s Financial Reporting Manual.
What is a “50% or less owned person?”

According to Section 2405.3 of the Financial Reporting Manual, the SEC Staff interprets this “to refer to an investment accounted for using the equity method (even if voting ownership exceeds 50%).” Note as well that the financial statements required by Rule 3-09 are for annual periods; Rule 3-09 does not require separate interim financial statements. Bear in mind, though that S-X Rule 10-01(b)(1) requires certain summarized interim income statement information for significant investees.

When must S-X 3-09 financials be filed?

In certain circumstances, S-X Rule 3-09(b) permits additional time to provide the required separate financial statements after the registrant files its Form 10-K. If the registrant is an accelerated filer but the investee is not an accelerated filer, the required financial statements may be filed as an amendment to the 10-K within 90 days after the end of the registrant’s fiscal year, or within six months after the end of the registrant’s fiscal year if the investee is a foreign business. If the fiscal year of any investee ends after the date of filing the registrant’s 10-K (or within 60, 75 or 90 days before the date of the filing for registrants that are large accelerated filers, accelerated filers or non-accelerated filers, respectively), the required financial statements may be filed as an amendment to the 10-K within 60, 75 or 90 days (depending on the filing status of the investee) after the end of such investee’s fiscal year. If the investee is a foreign business, the financial statements may be filed as an amendment to the 10-K within six months after the end of the investee’s fiscal year.

So-Crates’s investment looks like it trips S-X 3-09. Is relief from the SEC Staff available?

Maybe. According to Section 2020.1 of the Financial Reporting Manual “if after performing the required significance tests a registrant believes that the tests specify periods beyond those reasonably necessary to inform investors, the registrant may make a written request to CF‑OCA to waive one or more years of financial statements.”

If you need to submit such a waiver, let’s talk.

The waiver request will go to the Corp Fin Office of the Chief Accountant (not to be confused with the SEC’s Office of the Chief Accountant). Each case is different, of course, but you might begin with an outline hitting the following points:
background setting the scene -- describe the results of the company’s periodic review and the requirements of S-X 3-09, and perhaps set forth why the significance trigger is anomalous or will not continue;

  • why the company seeks relief from providing financial statements, including number of investments, estimates that are unable to be verified in a sufficient timeframe, etc.);
  • analysis, such as the nature of the investments at risk of meeting the 20% threshold, any uncertainties and cost estimates;
    requested relief, such as waiver of all or some of the requirements and, perhaps, an offer to increase disclosure in another area, such as in the Company’s S-X Rule 4-08(g) disclosure; and
  • appendix (if applicable) showing the company’s calculations and anything else supporting the Company’s conclusions that the investments are not a concern to investors

Be prepared for the SEC Staff to condition a waiver on the specific facts and circumstances in the waiver request letter. It is important to carefully consider and vet the facts and descriptions in the letter and to continue to monitor the investment in question for any additional facts or changes to those facts and circumstances.