New Rules Could Help Companies That Have Registered or Are Considering Registering Guaranteed or Collateralized Debt Securities
On March 2, 2020, the Securities and Exchange Commission (SEC) adopted certain rule amendments to simplify and modernize the financial disclosure requirements for registered offerings of guaranteed and collateralized debt securities, in an attempt to relieve some of the cost and burden of compliance. The current Rule 3-10 of Regulation S-X (which governs when a filing must include financial statements for a subsidiary that either issues securities guaranteed by the parent or guarantees the parent’s securities) and Rule 3-16 of Regulation S-X (which governs when separate financial statements are required for an affiliate whose securities collateralize the registrant’s debt securities) are burdensome and have caused many companies to use exemptions from registration (typically Rule 144A) when offering guaranteed or collateralized securities. The SEC provides in its press release that the “changes are intended to both improve the quality of disclosure and increase the likelihood that issuers will conduct debt offerings on a registered basis.” These amendments may cause issuers of guaranteed or collateralized debt securities to re-evaluate whether to pursue a registered offering when accessing the capital markets and will provide some relief to certain existing registered debt issuers.
Current rules 3-10 and 3-16 will be amended, renumbered, and placed within the new Article 13 in Regulation S-X. The amendments will be effective on January 4, 2021, but voluntary compliance will be permitted in advance of the effective date.
The following is a brief summary of each of the existing rules and certain of the significant changes to the rules. In addition, the appendix to the SEC release summarizes the amendments on a side-by-side comparison basis (see pages 250-265 of the release).
Rule 3-10 of Regulation S-X
Current Rule 3-10(a) states that, in general, every issuer of a registered security that is guaranteed and every guarantor of a registered security must file its own audited annual and unaudited interim financial statements. However, the rule also sets forth five exceptions that conditionally allow the parent company to provide certain abbreviated disclosures that cover the subsidiary issuer or guarantor in lieu of the separate financial statements (“Alternative Disclosures”), which commonly are highly detailed, condensed consolidating financial information rather than brief narrative descriptions. Additionally, pursuant to Rule 12h-5, each guarantor or issuer subsidiary in any such qualifying transaction is exempt from the separate, ongoing Exchange Act reporting obligations otherwise applicable to a registrant, but the parent company is required to provide the Alternative Disclosures in its annual and quarterly periodic reports for as long as the guaranteed securities are outstanding. All of the five exceptions in Rule 3-10 require that (i) the subsidiary issuer and guarantor be “100% owned” by the parent company; and (ii) each guarantee be “full and unconditional.”
The amendments to Rule 3-10 make it easier to meet the exceptions to providing separate financial statements, and they permit more abbreviated financial and nonfinancial disclosures (“Revised Alternative Disclosures”) than the Alternative Disclosures previously required. The following are the most significant changes to Rule 3-10:
- The five exceptions in current Rule 3-10 will be replaced with a broader two-category framework focused on the parent company’s role as the issuer, the co-issuer, or the full and unconditional guarantor.
- Subsidiary issuers and guarantors will no longer need to be “100% owned” by the parent company, as long as they are consolidated in the parent company’s consolidated financial statements.
- Issuers will be permitted to provide the Revised Alternative Disclosures outside the notes to the parent company’s financial statements in all filings in the MD&A or other prominent location.
Rule 3-16 of Regulation S-X
Current Rule 3-16 requires separate annual and interim financial statements for each affiliate whose securities constitute a “substantial portion” of the collateral for any class of securities registered or being registered. Securities of the affiliate are deemed to constitute a “substantial portion” of the collateral if either the aggregate principal amount, par value or book value of the pledged securities (as carried by the issuer), or the market value of the pledged securities, whichever is the greatest, equals 20 percent or more of the principal amount of the securities that are being secured. Subsequent to the registered offering, the issuer must continue to provide full audited financial statements of each such affiliate in its annual reports but need not provide any interim financial statements in its quarterly reports. As a practical matter, most issuers of collateralized debt securities have chosen to avoid Rule 3-16 by pursuing private placements.
The new rule replaces the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with certain abbreviated financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the registrant that issues the collateralized security. The amendments replace the 20 percent threshold with a requirement to provide the abbreviated financial and non-financial disclosures in all cases if the information would be material for investors to evaluate the pledge of the affiliate’s securities as collateral. The registrant will be permitted to provide the abbreviated financial and non-financial disclosures outside of the notes to the parent company’s financial statements. The abbreviated financial and non-financial disclosures will be required in the issuer’s periodic reports.
The amendments also add a new Exhibit 22 to Item 601 of Regulation S-K, on which the parent company must list (1) each subsidiary that is a guarantor, issuer, or co-issuer of guaranteed securities registered or being registered, and (2) each affiliate whose securities are pledged as collateral, identifying the securities that are pledged.
Companies currently complying with Rule 3-10 or Rule 3-16 may be able to take advantage of these new, less burdensome disclosure requirements, if applicable, as soon as their first-quarter 2020 Form 10-Qs.