On Monday, without an open meeting, the SEC voted, with a dissent from Commissioner Allison Lee, to adopt final amendments to Rules 3-10 and 3-16 of Reg S-X. Part of the SEC’s Disclosure Effectiveness Initiative, the amendments are designed to streamline and modernize the financial disclosure requirements applicable to registered debt offerings that involve guaranteed or collateralized securities, such as subsidiary guarantees. According to the press release, 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. 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.” According to the SEC, by improving disclosure and reducing the compliance burden, the final amendments may encourage issuers “to offer guaranteed or collateralized securities on a registered basis, thereby affording investors protection they may not be provided in offerings conducted on an unregistered basis.” The rules will apply to several categories of issuers, including foreign private issuers, smaller reporting companies and issuers offering securities pursuant to Reg A. The changes were originally proposed in July 2018. (See this PubCo post.) The amendments will become effective on January, 4, 2021, but voluntary compliance will be permitted in advance of the effective date.
Commissioner Lee expressed her concern that the rulemakings undertaken as part of the Initiative, including these final amendments, reveal “certain unexamined, unproven, and, in some instances, downright implausible assumptions undergirding these efforts.” First, she observes that the amendments do not address an identified problem, especially given that the data shows an increase in registered debt offerings. Yet, in her view, the amendments will allow registrants to avoid providing audited financial statements for affiliates that guarantee or collateralize debt securities, reduce the amount of alternative disclosure required (and give management more flexibility to determine its content) and allow the disclosures to be provided outside of the financial statements where they are not required to be audited.
Moreover, the amendments rely on “regulatory intuition” in assuming, “without evidence or data, that less disclosure and greater reliance on materiality judgments by management will yield better disclosure for investors. In fact, there is evidence of risk associated with relying too heavily on management’s materiality judgments, but we do not weigh, nor even adequately recognize, that risk.” Nor, in her view, have investors asked for or supported the changes. Rather, at the proposing stage, investors expressed concern about allowing alternative unaudited disclosure, not mention that now, under the final rules, audited disclosure is not even required in subsequent periodic reports, as was initially proposed. The amendments also assume that reduction of required disclosures and available protections will increase the number of registered debt offerings, but, she argues, there is no data to support that intuition. Finally, she takes issue with the assertion in the release that reduced disclosure will actually result in increased transparency by leading to more registered offerings. That, she said, is a “tough case to make, and we have not done so in the release.” On the whole, she believes, the amendments do not fairly balance the interests of registrants and investors.
Currently, 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, as if the affiliate were a separate registrant, if the affiliate’s securities are used to collateralize the registrant’s debt securities. The proposal would amend and relocate part of Rule 3-10 and all of Rule 3-16 in new Rules 13-01 and 13-02 in Article 13 of Reg S-X.
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 an “overarching principle”:
“the consolidated financial statements of the parent company are the principal source of information for investors when evaluating the debt security and its guarantee together. This principle is grounded in the idea that the investment is in the consolidated enterprise when: (1) the parent company is fully obligated as either issuer or full and unconditional guarantor of the security; (2) the parent company controls each subsidiary issuer and guarantor, including having the ability to direct all debt-paying activities; and (3) the financial information of each subsidiary issuer and guarantor is included as part of the consolidated financial statements of the parent company.”
In these circumstances, the SEC noted, full financial disclosures for each subsidiary issuer and guarantor are “generally not material”; rather, “consolidated disclosures about the parent company, as supplemented with details about the issuers and guarantors, is sufficient.” Commenters on the proposal observed that “the principal value of subsidiary guarantees to investors is that the guarantees improve the investor’s claim on the assets of the subsidiaries in the event of a default and therefore supplemental financial information for subsidiary guarantees should focus on factors impacting structural subordination, not the financial ability of any individual subsidiary guarantor to make payment under the guarantee.”
The amendments will simplify the exercise by providing just 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 Rule 13-01. Under the final amendments, the conditions for eligibility are as follows:
- “The consolidated financial statements of the parent company have been filed;
- The subsidiary issuer or guarantor is a consolidated subsidiary of the parent company;
- The guaranteed security is debt or debt-like [as defined in the rule]; and
- One of the following eligible issuer and guarantor structures is applicable:
- The parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or
- 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.”
Because the subsidiary is not required to be 100% owned, subsidiary issuers or guarantors that have issued securities convertible into their own voting shares would be eligible; however, the amendments require the parent to provide disclosures that address the material risks associated with non-controlling interests in the subsidiary, including a description of any factors that may affect payments to holders of the guaranteed security, such as the rights of a non-controlling interest holder, and to provide summarized financial information attributable to those subsidiaries.
In addition to the eligibility requirements above, the amendments will:
- Replace “consolidating information” with “summarized financial information” (as defined in Rule 1-02(bb)(1) of Reg S-X) of the issuers and guarantors (although additional line item information may be required in some circumstances), which may be presented on a combined basis (with some exceptions), excluding the financial information of non-issuer and non-guarantor subsidiaries, and reduce the number of periods required to be presented to the most recently ended fiscal year and most recent year-to-date interim period, if applicable.
- Note here that the SEC believes “a parent company should consider materiality and exercise [judgment] in determining the appropriate level of aggregation of issuers and guarantors based on the nature of the disclosure. In this regard, it may be useful to consider quantitative factors, such as the financial significance of the affected issuers and guarantors, and qualitative factors, such as the nature of the facts and circumstances applicable to the issuers and guarantors.”
- Expand the qualitative disclosures about the terms and conditions of the guarantees and about the issuers and guarantors, how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities.
- Eliminate quantitative thresholds for disclosure and require disclosure of additional information to the extent material, including additional financial and narrative information about each guarantor that would be material for investors to evaluate the sufficiency of the guarantee. To help assess materiality, the final rule identifies four non-exclusive scenarios in which the required information could be omitted on the basis that it is not material, provided the applicable scenario is disclosed to investors:
“1) The assets, liabilities and results of operations of the combined issuers and guarantors of the guaranteed security are not materially different than corresponding amounts presented in the consolidated financial statements of the parent company;
2) The combined issuers and guarantors, excluding investments in subsidiaries that are not issuers or guarantors, have no material assets, liabilities or results of operations;
3) The issuer is a finance subsidiary of the parent company, the parent company has fully and unconditionally guaranteed the security, and no other subsidiary of the parent company guarantees the security; and
4) The issuer is a finance subsidiary that co-issued the security, jointly and severally, with the parent company, and no other subsidiary of the parent company guarantees the security.”
- Permit the supplemental financial and non-financial disclosure about the subsidiary issuers and/or guarantors and the guarantees (the “alternative disclosures”) to be provided either in the footnotes to the parent’s financial statements (requiring an audit) or in MD&A in all its filings; if not in the notes or MD&A, then the parent must include the disclosures in its prospectus immediately following “Risk Factors,” if any, or otherwise, immediately following pricing information described in Item 105 of Reg S-K.
- Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, but require pre-acquisition summarized financial information about significant recently acquired subsidiary issuers and guarantors when the parent determines it has acquired a significant “business” after the date of its most recent balance sheet included in its consolidated financial statements, and that acquired business and/or one or more of its subsidiaries are obligated as issuers and/or guarantors.
- Require the alternative disclosures only for so long as the issuers and guarantors have an Exchange Act reporting obligation with respect to the guaranteed securities (i.e., cessation is permitted when the Section 15(d) obligation is suspended automatically by operation of Section 15(d)(1) or through compliance with Rule 12h-3) rather than for so long as the guaranteed securities are outstanding.
There are also a number of proposed detailed changes discussed in the release.
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, as if the affiliate were a separate registrant. The SEC observes that, in “practice, affiliates whose securities collateralize a registered security are almost always consolidated subsidiaries of that registrant.” “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. The final amendments reflect the SEC’s belief that “investors in securities that are collateralized by securities of a registrant’s affiliate(s) rely primarily on the consolidated financial statements of the registrant and supplemental details about the affiliate(s) whose securities are pledged when making investment decisions. 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.” Although information about the affiliates would be material to consider in the event of foreclosure, the SEC believes that, in most cases, separate affiliate financial statements would not be material.
Among other things, the final amendments will:
- Replace the existing requirement to provide separate financial statements for each affiliate the securities of which are pledged as collateral with a requirement to provide specific financial and non-financial disclosures, including summarized financial information (on a combined basis, but with separate information provided where the combined information is not applicable to all the affiliates), about the affiliate and the collateral arrangement as a supplement to the consolidated financial statements of the registrant that issues the collateralized security.
- Again, the SEC believes that “a registrant should consider materiality and exercise judgment in determining the appropriate level of aggregation of affiliates based on the nature of the disclosure. In this regard, it may be useful to consider quantitative factors, such as the financial significance of the affected affiliates, and qualitative factors, such as the nature of the facts and circumstances applicable to the affiliates.”
- When separate financial information applicable to the affected affiliates can be easily explained and understood, the rule permits narrative disclosure instead of the separate summarized financial information of the affected affiliates.
- Require the financial disclosures to be provided as of and for the most recently ended fiscal year and most recent year-to-date interim period included in the registrant’s consolidated financial statements.
- Require certain non-financial disclosures about the securities pledged as collateral, each affiliate whose securities are pledged, the terms and conditions of the collateral arrangement, and whether a trading market exists for the pledged securities, along with disclosure about additional facts and circumstances specific to particular affiliates that would be material to holders of the collateralized security.
- Permit the proposed financial and non-financial disclosures to be located in any of the registrant’s filings in the same manner as described above related to guarantors and guaranteed securities, that is, if the disclosures are not located in the footnotes to the financial statements or in MD&A, they must be included in the prospectus immediately following “Risk Factors,” if any, or otherwise, immediately following pricing information described in Item 105 of Reg S-K.
- 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 financial and non-financial disclosures to the extent material. Disclosure would also be required of any financial and narrative information about each affiliate if the information would be material for investors to evaluate the pledge of the affiliate’s securities as collateral. To help assess materiality, the rule identifies two non-exclusive scenarios that the SEC believes are the most common circumstances where the financial information would not be material:
“1) The assets, liabilities and results of operations of the combined affiliates whose securities are pledged as collateral are not materially different than the corresponding amounts presented in the consolidated financial statements of the registrant; and
2) The combined affiliates whose securities are pledged as collateral have no material assets, liabilities or results of operations.”
- With regard to pre-acquisition affiliates, require disclosure similar to that required for recently acquired subsidiary issuers and guarantors above.
The final amendments apply to any Securities Act registration statement:
- That is first filed on or after January 4, 2021 and
- Any post-effective amendment filed on or after January 4, 2021, to include either the registrant’s latest audited financial statements in the registration statement or to update the prospectus under Section 10(a)(3).
The final amendments apply to any Exchange Act registration statement that is first filed on or after January 4, 2021.
The final amendments apply to Exchange Act periodic reports as follows:
- If the reporting company was required to comply with the final amendments in a registration statement, all Exchange Act periodic reports for periods ending after that registration statement became effective; and
- For all other Exchange Act reporting companies, the annual report on Form 10-K or Form 20-F, as applicable, for fiscal years ending after January 4, 2021, and quarterly reports on Form 10-Q for quarterly periods ending after January 4, 2021.
Voluntary compliance with the final amendments is permitted in advance of the effective date.
Notably, the final rules do not apply to debt agreements that contain provisions to release affiliate securities pledged as collateral if the disclosure requirements of Rule 3-16 would be triggered. To that end, Rule 3-16 will include “a scope paragraph stating that the requirements of Rule 3-16 apply to each registered security issued and outstanding before January 4, 2021 for which the registrant has not previously been required to provide Rule 3-16 Financial Statements,” and final Rule 13-02 will include “a scope paragraph stating that the requirements of new Rule 13-02 apply to each registered security issued and outstanding before January 4, 2021, for which the registrant has previously been required to provide Rule 3-16 Financial Statements.” However, “any collateralized debt securities issued on or after the compliance date of the final amendments must comply with new Rule 13-02, which is clearly stated in the scope paragraph to final Rule 13-02.”