Yesterday, the SEC voted to propose new amendments to Rules 3-10 and 3-16 of Reg S-X intended to streamline the financial disclosure rules related to registered debt offerings that involve guaranteed or collateralized securities. The proposed amendments to Rules 3-10 and 3-16 are “intended to provide investors with material information given the specific facts and circumstances, make the disclosures easier to understand, and reduce the costs and burdens to registrants.” Chair Jay Clayton is quoted in the press release as having “seen firsthand instances in which an issuer did not pursue SEC registration of a debt offering that included a subsidiary guarantee or pledge of affiliate securities as collateral because of the costs and, in particular, time burdens of these rules….The proposed rules are intended to make the disclosures easier for investors to understand and to encourage these offerings to be conducted on a SEC-registered basis.”
Rule 3-10 addresses when a filing must include financial statements for a subsidiary that issues securities guaranteed by the parent or for a subsidiary that guarantees the parent’s securities. Rule 3-16 addresses when an affiliate’s financial statements are required if the affiliate’s securities are used to collateralize the registrant’s debt securities. The proposal would also relocate part of Rule 3-10 and all of Rule 3-16 to new Rules 13-01 and 13-02 in Article 13 of Reg S-X. The vote was taken without an open meeting, as the proposal was removed from the original agenda of the open meeting held last week.
Because a guarantee of a debt security is considered a separate security, unless it is exempt, the offer and sale of the guarantee must be registered. In addition, the issuer of the guarantee can become subject to Exchange Act reporting as a result of the registration. Under current Rule 3-10, with five exceptions, every issuer of a registered security that is guaranteed and every guarantor of a registered security must file the financial statements required under Reg S-X. These five exceptions allow a subsidiary issuer or guarantor to omit its separate financial statements and to avoid Exchange Act reporting if, among other conditions—including the parent’s providing prescribed alternative disclosures for as long as the securities are outstanding—it is 100% owned by the parent and the guarantee is “full and unconditional.” Separate requirements apply to newly acquired subs and guarantors.
Rule 3-10 is based on the “overarching principle” that “investors in guaranteed debt securities rely primarily on the consolidated financial statements of the parent company and supplemental details about the subsidiary issuers and guarantors when making investment decisions.” The proposed amendments continue to adhere to that principle, the release indicates, but eliminate some detail considered unnecessary and burdensome, and provide more flexibility.
The proposed amendments would simplify the exercise by providing only a single set of eligibility criteria that would apply to all issuer and guarantor structures (instead of five sets of criteria for five exceptions) and include the requirements for the proposed alternative disclosures together in proposed Rule 13-01.
More specifically, the amendments would:
- require that the financial statements of the subsidiary issuer or guarantor be consolidated in the parent’s consolidated financial statements rather than requiring that it be 100% owned by the parent;
- replace “Consolidating Information” (described by commenters as complex to provide) with summarized financial information of the issuers and guarantors (which may be presented on a combined basis), and reduce the number of periods required to be 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 alternative disclosures to be provided outside of the parent’s financial statements (where they must be audited and subject to XBRL tagging) in registration statements covering the guaranteed debt securities, as well as in periodic reports required to be filed during the fiscal year in which the first bona fide sale of the subject securities is completed;
- require financial statement footnote disclosure of the proposed alternative disclosures, however, in periodic reports beginning with the parent’s Form 10-K for the fiscal year when the sale of securities was completed;
- eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors; and
- require the proposed alternative disclosures only for so long as the issuers and guarantors have an Exchange Act reporting obligation with respect to the guaranteed securities rather than for so long as the guaranteed securities are outstanding.
There are also a number of proposed detailed changes to other conditions for omission of the financial statements of the subsidiary issuer or guarantor. Notably, however, the release indicates that the “proposed amendments are not intended to reduce the types of entities or structures that would be able to rely on the proposed new Rule 3-10.”
Current Rule 3-16 requires a registrant to provide separate annual and interim financial statements for each affiliate the securities of which constitute a “substantial portion” of the collateral for any class of securities registered or being registered. “Substantial portion” is determined by comparing the highest amount or value of the affiliate’s securities to the principal amount of the registered securities; if the highest amount or value equals or exceeds 20% of the principal amount of the registered securities for any fiscal year, Rule 3-16 financial statements are required for that affiliate, even though the affiliate is not considered a registrant. If the 20% threshold is not met, no disclosure is required at all.
The same overarching principle as applied in connection with the amendments to Rule 3-10 likewise applies in the context of debt collateralized by affiliates’ securities under Rule 3-16. That is, because the “pledge of collateral is a residual equity interest that could potentially be foreclosed upon only in the event of default and almost always relates to an affiliate whose financial information is already included in the registrant’s consolidated financial statements,” the SEC believes that, in most cases, separate affiliate financial statements would not be material. Among other things, the proposed amendments would:
- replace the existing requirement to provide separate financial statements for each affiliate the securities of which are pledged as collateral (and equal or exceed the threshold) with a requirement to provide specific financial and non-financial disclosures about the affiliate and the collateral arrangement as a supplement to the consolidated financial statements of the registrant that issues the collateralized security;
- permit the proposed financial and non-financial disclosures to be located in filings in the same manner as described above for the disclosures under Rule 3-10 related to guarantors and guaranteed securities; and
- replace the “substantial portion” test with a materiality test; that is, instead of requiring disclosure only when the pledged securities meet or exceed the 20% threshold, require the proposed financial and non-financial disclosures in all cases, unless they are immaterial to holders of the collateralized security. However, the registrant would be required to disclose the omission of financial disclosures and the reasons why the disclosures were not material.
The amendments would also require disclosure of any additional material information about the collateral arrangement and each affiliate whose security is pledged as collateral. Although she voted in favor of issuing the proposal, Commisioner Kara Stein still had a few reservations. See this PubCo post.