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August 6, 2018 Download PDF
On July 24, the SEC proposed rules (available here) amending and simplifying the financial disclosure requirements of Rule 3-10 of Regulation S-X for guarantors and issuers of guaranteed securities registered with the SEC and of Rule 3-16 of Regulation S-X for affiliates whose securities collateralize registered securities. The proposed rules are intended to focus disclosures in the context of registered debt offerings on material information, make the disclosures easier to understand, reduce the cost of compliance and encourage potential issuers to offer guaranteed or collateralized securities on a registered basis or on a private basis with registration rights, thereby affording investors protections they may not be provided in “Rule 144A-for-life” offerings.
The proposed rules result from an ongoing evaluation of the SEC’s disclosure requirements pursuant to the Disclosure Effectiveness Initiative, a broad-based staff review of the SEC’s disclosure requirements mandated by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). As part of that evaluation, in September 2015, the SEC issued a request for comment seeking feedback on, among other things, the financial disclosure requirements for acquired businesses, affiliated entities, and guarantors and issuers of guaranteed securities.
If adopted, the proposed rules would amend portion of Rule 3-10, and relocate part of Rule 3-10 and all of Rule 3-16 to new Article 13 of Regulation S-X.
Rule 3-10 / Proposed Rule 13-01
Rule 3-10 of Regulation S-X requires annual audited and unaudited interim financial statements to be filed for all issuers and guarantors of securities registered with the SEC, with exceptions. Guarantors are subject to these requirements since, under the Securities Act, a guarantee of a debt or debt-like security is itself a separate security, with implications under both the Securities Act and under the Exchange Act. These exceptions are available for individual subsidiaries of a parent company when the subsidiary is 100% owned by the parent company and each guarantee is “full and unconditional.” The exceptions also generally require that the parent company provide potentially burdensome condensed consolidating financial information regarding guarantor and non-guarantor subsidiaries in its financial statements. If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted and the subsidiary may avoid public reporting under the Exchange Act if the parent company continues to provide these disclosures in its periodic reports for so long as the guaranteed securities are outstanding. In addition, for recently acquired subsidiaries that are considered “significant,” the rule requires the filing of pre-acquisition audited financial statements.
In the proposing release, the SEC notes that the existing disclosure requirements may involve unnecessary detail and may pose undue compliance burdens. Accordingly, while the SEC has retained the overarching principle that investors purchasing guaranteed debt securities would be best served if they rely primarily on the consolidated financial statements of the parent company and supplemental details about the subsidiary issuers and guarantors, amended Rule 3-10 and proposed Rule 13-01 would provide simplified eligibility criteria that must be met in order to omit separate subsidiary issuer or guarantor financial statements. Among other things, the proposed amendments would:
- replace the condition that a subsidiary issuer or guarantor be 100% owned by the parent company with a condition that it be consolidated in the parent company’s consolidated financial statements;
- replace condensed consolidating financial information with less burdensome summarized financial information (as defined in Rule 1-02(bb)(1) of Regulation S-X) of the issuers and guarantors, which may be presented on a combined basis, and reduce the number of periods presented;
- expand the qualitative disclosures about the guarantees and the issuers and guarantors;
- eliminate quantitative thresholds for disclosure and require disclosure of additional information that would be material to holders of the guaranteed security;
- permit the proposed disclosures to be provided outside the footnotes to the parent company’s financial statements in the registration statement covering the offer and sale of the subject securities and any related prospectus, and in certain Exchange Act reports filed shortly thereafter;
- require that the proposed disclosures be included in the footnotes to the parent company’s financial statements for annual and quarterly reports beginning with the annual report for the fiscal year during which the first bona fide sale of the subject securities is completed;
- eliminate the requirement to provide pre-acquisition financial statements of recently-acquired subsidiary issuers and guarantors; and
- require the proposed financial and non-financial disclosures for as long as the issuers and guarantors have an Exchange Act reporting obligation with respect to the guaranteed securities rather than for as long as the guaranteed securities are outstanding.
The proposed amendments would require summarized financial information only as of, and for, the most recently completed fiscal year and year-to-date interim period, if applicable.
Foreign private issuers would continue to be subject to Rule 3-10 and would also be required to comply with proposed Rule 13-01. A foreign private issuer that prepares its financial statements on a basis other than U.S. GAAP or IFRS as issued by the International Accounting Standards Board would not be required to reconcile its supplemental financial disclosure to U.S. GAAP. However, the parent company would be required under proposed Rule 13-01(a)(5) to disclose any other quantitative or qualitative information that would be material to a decision to invest in the guaranteed security.
The proposed amendments are not intended to reduce the types of entities or structures that would be able to rely on proposed Rule 3-10, and the SEC expects that issuer and guarantor structures that are currently eligible under existing Rule 3-10 would continue to be so.
Rule 3-16 / Proposed Rule 13-02
Rule 3-16 requires a registrant to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. To determine whether the affiliate securities constitute a “substantial portion” of the collateral, the greater of the principal amount, par value, book value or market value of the affiliate securities is compared to the principal amount of the securities being offered, and if it equals or exceeds 20% of the principal amount of the securities being offered, separate financial statements of the affiliate are required. While the importance of the collateral to an investor may vary widely from situation to situation, the existing rule requires full, audited financial statements for the affiliate in all circumstances when the “substantial portion” threshold is met.
In the proposing release, the SEC notes that while it believes that information about an affiliate whose security is pledged as collateral is material for an investor to consider potential outcomes in the event of foreclosure, separate financial statements of each such affiliate are not material in most situations. As a result, among other things, proposed Rule 13-02 would:
- replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with financial and non-financial disclosures about the affiliate and the collateral arrangement as a supplement to the consolidated financial statements of the issuer that issues the collateralized security;
- permit the proposed financial and non-financial disclosures to be located outside the financial statements in Exchange Act reports required to be filed during the fiscal year in which the first bona fide sale of the securities is completed; and
- replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered with a requirement to provide the proposed financial and non-financial disclosures in all cases, unless they are immaterial to holders of the collateralized security.
As noted in the proposing release, the preparation of separate affiliate financial statements for affiliates whose stock or other securities are pledged to secure registered securities can be onerous and time-consuming. As a result, issuers often avoid registered secured note offerings entirely and issue “Rule 144A-for-life” debt securities (which are never registered). Other issuers issue registered secured notes (often in registered “A/B exchange offers”) but structure their collateral packages to exclude pledges of affiliate capital stock or other securities or specifically release an affiliate’s securities from collateral if and when their inclusion would trigger the provision of separate financial statements of such affiliate (a “Rule 3-16 Exclusion”). Rule 3-16, as modified by the proposing release, because it dramatically reduces the amount of disclosure that an issuer would be required to produce as a result of a pledge of capital stock or other securities would likely encourage issuers to consider issuing registered debt securities that are secured by a pledge of affiliate capital stock or other securities. Nevertheless, the requirement to provide additional financial and non-financial disclosures if such disclosures would be “material” to a holder of the relevant debt security may give such issuers some pause, due to uncertainty as to the content of such disclosures and as to the determination of what is “material” to such holders.
Furthermore, the amendment to Rule 3-16 may affect a number of issued and outstanding registered debt securities that have a Rule 3-16 Exclusion. The typical Rule 3-16 Exclusion provides that capital stock or other securities of an affiliate will be excluded from the collateral:
“…to the extent that such capital stock or other securities can secure the notes without Rule 3-16 of Regulation S-X (or any other law, rule or regulation) requiring separate financial statements of such affiliate to be filed with the SEC (or any other governmental agency)…”
As a result, if Rule 3-16 is modified as provided in the proposing release, many Rule 3-16 Exclusion provisions will no longer operate to exclude capital stock and other securities of affiliates, since Rule 3-16 will no longer require the provision of “separate financial statements.” As a result, holders of such debt securities that are subject to a Rule 3-16 Exclusion may discover that their debt securities are now secured by additional capital stock and other securities of affiliates as a result of the adoption of the modified Rule 3-16. Issuers that are currently relying on the Rule 3-16 Exclusion would be required to evaluate whether the additional financial and non-financial disclosures about the affiliate and the collateral arrangements would be necessary because they are “material” to holders of the collateralized security.
Comments are due 60 days after publication of the proposed rule in the Federal Register.
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