On July 24, 2018, the Securities and Exchange Commission (the “SEC”) proposed rule amendments to Rules 3-10 and 3-16 of Regulation S-X in order to simplify and streamline the financial disclosure requirements for registered offerings of guaranteed and collateralized debt securities. The SEC has stated that the reduced burdens from the revised rules should encourage issuers to register more debt offerings rather than relying on unregistered offerings. In its press release, SEC Chairman Clayton noted, as many corporate finance professionals can attest, that issuers often elect not to pursue SEC registrations of guaranteed debt securities or certain secured debt offerings because of the burdens of the current rules.
The fact sheet and proposed rule release can be found here.
Rule 3-10 of Regulation S-X
Rule 3-10 of Regulation S-X generally requires separate financial statements to be filed for each subsidiary guarantor of registered securities, with several exceptions. In order to take advantage of the exceptions (i) the guarantee by a subsidiary must be full and unconditional and (ii) the subsidiary must be 100% owned. In the event an exception is met, the parent company of the subsidiary guarantors can instead include consolidating financial information in a footnote to its financials, which is required to be provided for as long as the guaranteed securities are outstanding. In situations where the issuer has not previously prepared such consolidating financial information, significant time and cost can be incurred in producing this information.
Under the proposed amendments, separate financial statements of subsidiary guarantors could still be omitted if certain conditions are met and if the parent company provides certain modified, and substantially less burdensome, alternative disclosures. The proposed amendments would also increase the number of corporate structures to which the rule’s exceptions would apply. In particular, the proposed amendments would:
- Replace the requirement that the subsidiary be 100% owned by the parent company with a requirement that the subsidiary be consolidated in the parent company’s financial statements;
- Replace condensed consolidating information with summarized financial information (as defined in Rule 1-02(bb)(1) of Regulation S-X) and other non-financial disclosures regarding the issuers, the guarantors and the terms of the guarantees;
- Expand the required qualitative disclosures concerning the guarantees, the issuer and the guarantors and replace the quantitative thresholds for when additional disclosures are required with a materiality threshold;
- Permit the alternative disclosures to be disclosed outside of the parent company’s financial statements in the initial prospectus for such debt securities and allow such parent company to postpone the inclusion of such disclosure in its financial statements until its subsequent annual and quarterly reports, beginning with the annual report for the fiscal year in which the first bona fide sale of the subject securities is completed;
- Eliminate Rule 3-10’s requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors that are significant relative to the value of the securities being registered and instead only require pre-acquisition financial statements if required under Rule 3-05 of Regulation S-X, which is used with respect to Form 8-K; and
- Replace the obligation to provide the alternative disclosures for as long as such guaranteed securities are outstanding with a requirement that such alternative disclosures must only be provided if the reporting obligations of the Securities Exchange Act of 1934 with respect to such guaranteed securities continue to apply.
Rule 3-16 of Regulation S-X
As currently in effect, Rule 3-16 of Regulation S-X requires a registrant to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral for any class of registered securities, as if the affiliate were a seperate registrant. Such securities will constitute a substantial portion of the collateral if the principal amount, par value, book value or market value, whichever is greater, of such securities is greater than or equal to 20% of the principal amount of the securities being offered, without taking into account the overall materiality of the pledged collateral in the context of the entire collateral package. These requirements often result in issuers negotiating the inclusion of a “collateral cut-back” provision in the indenture or collateral documents governing the debt securities, which automatically excludes from the collateral package any securities that would trigger the requirements of Rule 3-16. In particular, the proposed amendments to Rule 3-16 would:
- Replace the requirement to provide separate financial statements with a requirement to provide substantially less burdensome financial and non-financial disclosures about the affiliate and the collateral arrangements in a supplement to the registrant’s financial statements;
- Permit the proposed financial and non-financial disclosures to appear in the offering documents and subsequent periodic reports in the same manner as the revised Rule 3-10 disclosures; and
- Replace the substantial portion 20% threshold used to determine whether disclosure is required with a requirement to provide disclosure with respect to the pledged securities only to the extent material to the holders of the collateralized securities.
The proposed revisions to the rules could have several implications for issuers of debt securities. These include:
- Potentially Lower Interest Rates. The liquidity provided by the registered nature of such debt securities, together with the credit enhancements stemming from the guarantee or collateral, could result in a lower cost of capital for the issuer.
- Quicker Access to Capital Markets. The optionality afforded to issuers by the proposed amendments to Rule 3-10 and Rule 3-16 to provide the required disclosures outside of the parent company’s financial statements in the initial offering document for such debt securities will alleviate the time and expense of obtaining an audit for such information and allow issuers to more quickly access favorable capital markets. Notably, SEC Commissioner Stein, while voting in favor of issuing the proposal, issued a public statement expressing serious concerns, particularly with regards to providing issuers this optionality, and highlighted this as an area that commentators to the proposed rules should focus their attention on. To date, the only relevant comment, from the Principal Accounting Officer of Willis Towers Watson plc, was in favor of providing issuers this optionality.i
- The Trust Indenture Act of 1939 (the “TIA”). While the proposed amendments reduce the burdens of complying with Rule 3-16, issuers of registered debt securities collateralized by the securities of their subsidiaries should still be mindful of the requirements of the TIA, regardless of whether a collateral cut-back provision is included in the indenture or collateral documents. Registered debt securities must be issued under an indenture that is qualified under the TIA. Section 314(d) of the TIA requires, subject to an SEC staff exception set forth in a no action letter to Pregis Corporation that may be applicable to certain debt securitiesii, that if collateral is to be released from a lien securing any debt securities under a TIA qualified indenture, a certificate or opinion must be delivered to the trustee stating the fair value of the collateral being released and that the proposed release will not impair the security under such indenture in contravention of the indenture. Consequently, issuers of registered secured debt securities should be aware that Section 314(d) of the TIA may potentially impose compliance costs independent of Rule 3-16. Importantly, outside of the SEC no-action relief in Pregis, issuers cannot evade compliance with Section 314(d) of the TIA through a collateral cut-back provision, as the SEC has taken the position that any exclusion from the collateral package needed to prevent the application of Rule 3-16 would constitute a release for purposes of Section 314(d) of the TIA.
- Up-C Structures. The proposed rules provide flexibility to “Up-C” structured entities in structuring guaranteed debt offerings. In recent years, the Up-C structure has become increasingly popular in the energy industry both for companies pursuing an initial public offering and, recently, for master limited partnerships (“MLPs”) seeking to restructure in light of current market and industry dynamics. The ability of Up-Cs to pursue a registered offering of guaranteed debt securities is currently severely limited, as many of the operating subsidiaries in such structure have non-voting economic rights that are not 100% held by the sponsor entity, thus rendering the exception to Rule 3-10’s requirement to provide standalone financial statements inapplicable with respect to such subsidiaries. Under the proposed rules, as long as such operating subsidiaries are consolidated in the Up-C parent entity’s financial statements, such entity would be permitted provide the substantially less burdensome proposed disclosures in connection with a registered offering.
- Guaranteed Debt Offerings Following an Acquisition. The proposed amendments ease the ability of companies to quickly undertake a registered debt offering guaranteed by a recently acquired entity. Under current Rule 3-10, issuers of registered debt securities guaranteed by a recently acquired subsidiary are required to provide pre-acquisition audited financial statements if such subsidiary is significant relative to the amount of the securities being registered, which often results in the application of a lower significance level than would be required under Rule 3-05 of Regulation S-X. Under the proposed rules, pre-acquisition financial statements would only need to be filed if required by Rule 3-05. This is particularly relevant to MLPs who consistently acquire entities from their sponsor in drop-down transactions that may be significant relative to the amount of a contemplated debt offering, but immaterial relative to the MLP itself.
The SEC’s proposal will be subject to a 60-day public comment period.
i To see the current comments submitted to the SEC with regards to the proposed amendments please visit the SEC’s website at: https://www.sec.gov/comments/s7-19-18/s71918.htm.
ii The SEC has granted relief from the requirements of Section 314(d) of the TIA to the extent that the following four criteria set forth in the 2007 SEC no-action letter to Pregis Corporation are met: (1) the notes are secured by agreements that are external to the indenture; (2) decisions relating to the collateral maintenance and release are made by a party other than the indenture trustee; (3) neither the trustee nor the noteholders have any control over these decisions; and (4) the collateral securing the indenture securities also secures other debt.
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