Definition of a business: the sum of the parts

A European example of a disagreement about what constitutes a business

In numerous recent posts, I’ve looked at issues arising from extracts of enforcement decisions recently issued by the European Securities and Markets Authority (ESMA) (for more background see here). I came late to this party though, because ESMA had actually issued similar summaries on thirteen previous occasions. Who knew? Well, I suppose someone must have. Anyway, having mostly exhausted the potential of the most recent batch, I thought I’d look back at previous editions for other matters of ongoing relevance, starting with the 13th.

Here’s an issue that often comes up in practice, frequently requiring discussions with regulators:

  • “The issuer operates in the shipping industry and owns vessels for transportation of cars and other rolling cargoes. In June 2010 the issuer acquired all the shares in Company B from Company A. Company B owned all the shipping industry investments of Company A. These investments consisted of shares in holding companies (Entities C1 – C4, owned 100% by Company B) that owned shares in single purpose companies (Entities D1 – D4, owned by C1 – C4 respectively, with different ownership percentages). The single purpose companies each owned and operated one or two shipping vessels.
  • There were no employees in Company B or its subsidiaries. At the acquisition date, there were only limited activities related to managing the respective companies; other activities were outsourced. All the employees in Company A were employed by a management company that was a sister company of Company B and was not part of the transaction (‘management company’). The management company was a matrix organization where the employees handled several investments areas. Three employees in the management company were offered and accepted employment in the issuer as part of the transaction.
  • The companies owning the vessels (D1 – D4) had an agreement with the management company concerning assistance with chartering and purchase and sale of vessels. The management company used a shipbroker to assist the company with: marketing of the vessels, entering into new charter agreements and serving customers. The broker assisted in purchases and sales of the vessels. Technical management was outsourced from the vessel owning entities to the management company until autumn 2009 and subsequently outsourced to an independent third party company.
  • The issuer accounted for the transaction as an asset acquisition. The consideration paid and related transaction costs were recognized as the acquisition price of the vessels.
  • The issuer argued that the vessels were only passive investments and that Company B did not own a business consisting of processes, since all activities regarding commercial and technical management were outsourced to either the management company or to an independent third party company. Consequently, the acquisition was accounted for as if the vessels were acquired on a stand-alone basis.”

The elements of a business

The enforcer (as ESMA likes to term it) disagreed with this finding, considering that the acquired group of entities had all the necessary attributes of a business: inputs, processes and outputs. On the key matter of the outsourcing arrangements, the report says this: “IFRS 3 Appendix B11 states that whether a seller operated a set of assets and activities as a business or whether the acquirer intends to operate it as a business is not relevant in evaluating whether a particular set is a business. Accordingly, it was not relevant that the seller had outsourced some activities (e.g. management services for which fees were paid) to a third party as a market participant could chose to conduct and manage the integrated set of assets and activities as a business. Consequently, the acquisition included all the elements that constitute a business, in accordance with IFRS 3.” As a result, the entity restated its statements, reducing the amounts assigned to the vessels and recognizing a goodwill amount, among other changes.

In plain language terms, I suppose the point is that when you buy a business, you’re always buying something that’s worth more than the sum of its parts. If you just acquire an asset – whether it’s a motor vehicle or a property or a patent – then it’s irrational, in theory at least, to pay more than the identifiable fair value of the asset itself (by themselves, after all, assets can’t do anything to generate wealth – they need to be integrated into some kind of structure or system). In a worst case, if there’s no way of demonstrating how the asset’s individual potential to generate cash flows justifies what was paid for it, then maybe the carrying value’s instantly impaired. But a business, by comparison, has its own identity and momentum: it’s figured out how to rub pieces together and create fire (albeit, for some businesses, not a very strong fire). And you might willingly and rationally pay more for that demonstrated capacity than you would to separately acquire the identifiable elements (the excess being what we call goodwill). By the same token, in a regulatory context, historical financial statements of an acquired business may have some predictive value, because there’s at least some continuity between its past and its future. But historical financial statements of an asset would be meaningless, even if one could construct them, because there’s no reason to think there’ll be any necessary similarity in how the asset is used from one owner to the next.

As ESMA’s example illustrates, if something’s a business by its nature, you can’t get out of that through clever structuring. Well, I should rephrase that – you shouldn’t be able to. I guess I wouldn’t put too much money on it that no one ever does…

The opinions expressed are solely those of the author

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