On March 2, 2020, the Securities and Exchange Commission (the "SEC") adopted amendments to Rules 3-10 and 3-16 of Regulation S-X, largely contained in new Rules 13-01 and 13-02, respectively, which are intended to improve the quality of disclosure for, and increase the frequency of, registered offerings of guaranteed and collateralized debt securities. The final rules (the fact sheet and rule release can be found here) were adopted largely as originally proposed in July 2018 (see our prior alert available here). In the press release, SEC Chairman Clayton noted that the rules represent an effort by the SEC to modernize its rules and simultaneously increase investor protection, reduce compliance burdens and enhance capital formation. The amendments will be effective on Jan. 4, 2021, but voluntary compliance is permitted in advance of the effective date.
Rule 3-10 of Regulation S-X
Current 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 and where exceptions allowing reduced disclosure for financing subsidiaries pursuant to Rule 3-10(b) are not applicable, significant time and cost can be incurred in producing this information.
Under the amendments, separate financial statements of subsidiary guarantors may still be omitted if certain conditions are met and if the parent company provides certain modified, and substantially less burdensome, alternative disclosures. The amendments also increase the number of corporate structures to which the rule's exceptions apply. In particular, the amendments will:
- 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) (although additional line item information may be required in some circumstances) and other non-financial disclosures regarding the issuers, the guarantors and the terms of the guarantees and reduce the number of periods required to be presented to the most recently ended fiscal year and most recent interim period, if applicable;
- 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 requirement to disclose information about each guarantor that is material for investors to evaluate the sufficiency of the guarantee;
- Permit the alternative disclosures to be disclosed outside of the parent company's financial statements in all SEC filings;
- 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 summarized financial information when the issuer or guarantor is itself an acquired business (in accordance with the guidance in Rule 11-01(d) of Regulation S-X) that is significant (using the 20 percent threshold for significance in Rule 3-05 of Regulation S-X); 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 separate 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 amendments to Rule 3-16 will:
- 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 financial and non-financial disclosures to appear outside of the footnotes to the financial statements in SEC filings; and
- Replace the substantial portion or 20% threshold used to determine whether disclosure is required with a requirement to provide disclosure with respect to the pledged securities in all cases, unless they are immaterial.
The revisions to the rules could have several implications for issuers of debt securities. These include:
- Facilitates Guarantees by Controlled Subsidiaries. Allows guarantor subsidiaries that are between 50% and 99.9% owned to qualify for reduced financial disclosure.
- 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 amendments to Rule 3-10 and Rule 3-16 to provide the required disclosures outside of the parent company's financial statements will alleviate the time and expense of obtaining an audit for such information and allow issuers to more quickly access favorable capital markets, especially in scenarios where this information has not already been required to be disclosed in the issuer's periodic reporting.
- The Trust Indenture Act of 1939 (the "TIA"). While the amendments reduce the burdens of complying with Rule 3-16, issuers of registered debt securities collateralized by the securities of their affiliates 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 securities , 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 any exclusion from the collateral package needed to prevent the application of Rule 3-16 could constitute a release for purposes of Section 314(d) of the TIA.
- Up-C Structures. The amendments 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 the current Rule 3-10's requirement to provide standalone financial statements inapplicable with respect to such subsidiaries. Under the new rules, as long as such operating subsidiaries are consolidated in the Up-C parent entity's financial statements, such entity will be permitted to provide the substantially less burdensome disclosures in connection with a registered offering.
- Guaranteed Debt Offerings Following an Acquisition. The 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 amended rules, issuers and guarantors need only provide pre-acquisition summarized financial information (as opposed to financial statements) and generally only in circumstances where financial statements would already be required by Rule 3-05. This is particularly relevant to MLPs who may 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.
i 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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