SEC Final Amendments On Disclosures For Registered Debt Offerings
Writing a blog once a week during a time when almost daily events are publish-worthy means that some topics will be delayed, at least temporarily. Back in March, the SEC adopted final amendments to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed rule changes were published in the summer of 2018 (see HERE).
The amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The SEC also created a new Article 13 in Regulation S-X, renumbered Rules 3-10 and 3-16 to Rules 13-01 and 13-02, and made conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.
As stated in the SEC press release on the new rules, the amended rules focus on the provision of material, relevant, and decision-useful information regarding guarantees and other credit enhancements, and eliminate prescriptive requirements that have imposed unnecessary burdens and incentivized issuers of securities with guarantees and other credit enhancements to offer and sell those securities on an unregistered basis. The amendments are intended to improve disclosure and reduce the SEC registration-related compliance burdens for issuers. It is hoped that the rules will encourage registered debt offerings over unregistered offerings and thus improve disclosures and protections for investors.
The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.
Under the Securities Act, a guarantee of a debt is a separate security requiring either registration, with audited financial statement, or an exemption from registration upon its offer or sale. Rule 3-10 of Regulation S-X requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements and that the subsidiary be 100% owned. If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.
The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.
The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.
To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.
When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.
The amendments streamline the current structure, which has differing criteria depending on which exemption is being relied upon to unify all criteria. The amendments broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the eligibility requirements to rely on the exception are met and the parent company includes specific financial and non-financial disclosures about those subsidiaries.
The amended rule will:
(i) Allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned;
(ii) Replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis;
(iii) New non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities;
(iv) Permit disclosures to be provided outside the footnotes of the parent’s audited and interim unaudited financial statements in the registration statement covering the offering and in the Exchange Act reports thereafter;
(v) Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, provided however, if the acquisition is significant, summarized financial information must be provided; and
(vi) Reduce the time in which additional Alternative Disclosure must be made to the period for which the issuer and guarantors have Exchange Act reporting obligations instead of the entire period that the guaranteed securities are outstanding.
To be eligible to rely on the exception, the following conditions must be met:
(i) The consolidated financial statements of the parent company have been filed;
(ii) The subsidiary or guarantor is a consolidated subsidiary of the parent;
(iii) The guaranteed security is debt or debt-like; and
(iv) One of the following issuer and guarantor structures is applicable: (a) the parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or (b) a consolidated subsidiary issues the security or co-issues the security with one or more other consolidated subsidiaries of the parent company, and the security is guaranteed fully and unconditionally by the parent company.
Importantly, as noted, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subjects the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
The new rules include conforming amendments to also apply to the Rule 8-01 of Regulation S-X dealing with smaller reporting companies and Forms 1-A, 1-K and 1-SA to apply to Regulation A issuers.
Current Rule 3-16 requires a company 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. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.
The amendments replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security. The amended financial and non-financial disclosures are included in new Rule 13-02.
The level of disclosure is based on materiality and would include certain line items of the balance sheet and income statement of the affiliate. Where more than one affiliate provides collateral, financial information can be included on a consolidated rather than individual basis. However, when information is applicable to one or more, but not all, affiliates, it will need to be separated out. For example, when one or more affiliates separates trades, it would need to be clear which affiliate trading market information is being provided for.
In addition, the amendment changes the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.
Furthermore, the amendments 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 financial and non-financial disclosures to the extent material, eliminating numerical thresholds. The rule leans towards materiality with the need to determine information is immaterial for it to be omitted.