At a glance
On March 2, the SEC made significant changes to its disclosure requirements
relating to certain debt securities. The new rules impact disclosures related to registered securities that are guaranteed and those that are collateralized by the securities of an affiliate. The rules become effective January 4, 2021, with voluntary compliance permitted immediately.
The changes include:
- expanding the population of subsidiary issuers and guarantors that can use the SEC’s guarantee-related disclosure framework;
- simplifying and focusing the disclosure models; and
- permitting the disclosures to be made outside of the financial statements.
The changes are intended to make the disclosures easier to understand, allow the disclosures to be tailored based on materiality and specific facts and circumstances, and reduce the costs and burdens of compliance. The SEC indicated that the new rules may result in more registered offerings of guaranteed or collateralized securities, which could lower the cost of capital and increase investor protections.
Key changes relating to guaranteed securities
Under US securities laws, a guarantee of a debt security is also a security, and the offer and sale of the guarantee generally must be registered under the Securities Act unless exempt from registration. If the offer and sale is registered, each issuer and each guarantor must generally file the financial statements required of a registrant in accordance with Regulation S-X. Additionally, absent an exemption, the offer and sale of the securities under the Securities Act causes each issuer and guarantor to become subject to the reporting requirements of Section 15(d) of the Exchange Act, which, among other things, would require each issuer and guarantor to file periodic reports (e.g., Forms 10-K and 10-Q) with the SEC (for at least the fiscal year in which the Securities Act registration statement became effective).
The SEC has historically recognized that full Securities Act and Exchange Act disclosure by every subsidiary issuer and guarantor may not be necessary because in many cases an investor’s evaluation of the debt and guarantee together focuses on the consolidated financial statements of the parent company. Accordingly, the SEC provides an alternative disclosure framework and permits subsidiary issuers and guarantors to omit full financial statements when specified conditions are satisfied.
The SEC also exempts subsidiary issuers and guarantors from requirements to file separate reports under the Exchange Act (e.g., Forms 10-K and 10-Q) if they are permitted to omit financial statements. The eligibility requirements for omitting the financial statements are set forth in Rule 3-10 of Regulation S-X. One requirement that must be satisfied in order to omit financial statements is that the parent company provides specified disclosures (which have been updated and relocated to new Rule 13-01 of Regulation S-X).
Broader eligibility for subsidiary issuers and guarantors
The new rules expand the population of subsidiary issuers and guarantors that are permitted to omit their financial statements in connection with registration statements and that are exempt from the requirements to file subsequent periodic reports (e.g, Forms 10-K and 10-Q) with the SEC. For instance, in a significant change from the prior rules, a subsidiary issuer or guarantor may now qualify to use the SEC’s guarantee-related disclosure framework if it is a consolidated subsidiary of the parent company. Previously, the subsidiary issuer or guarantor had to be 100% owned by the parent company to use the framework provided by Rule 3-10. Additionally, prior requirements that subsidiary guarantees be full and unconditional and joint and several have been eliminated and replaced with additional disclosure requirements included in Rule 13-01. Consistent with the prior rules, if the parent is the guarantor, its guarantee must be full and unconditional.
Significant changes to the disclosure requirements
The new rules introduced significant changes to the form and content of the disclosures that must be provided by a parent company in order to qualify for the relief provided in Rule 3-10. These changes (which are reflected in Rule 13-01) include:
- expanding required non-financial disclosures to include (a) information about (i) the issuers and guarantors, (ii) the terms and conditions of the guarantees, and (iii) how the structure of the guarantees and other factors may affect payment, and (b) a list of each subsidiary issuer or guarantor in an exhibit to the applicable filing;
- requiring the parent company to present summarized financial information for each issuer and guarantor (collectively referred to as the obligated group) instead of condensed consolidating balance sheets and statements of comprehensive income and cash flows;
- permitting the summarized financial information to be presented on a combined basis for the obligated group with appropriate eliminations;
- requiring summarized financial information only as of and for the most recently completed fiscal year and subsequent year-to-date interim period (if applicable) instead of as of and for all periods presented in the parent’s financial statements (as was required for the condensed consolidating financial statements by the prior rules);
- permitting the parent company to provide the disclosures outside of its financial statements rather than requiring them to be presented as a footnote to its consolidated financial statements;
- requiring disclosures only to the extent material (four example fact patterns in which summarized financial information may be omitted are provided); and
- requiring disclosure of additional information (which could include additional line items of summarized financial information) if that disclosure would be material for investors to evaluate the sufficiency of the guarantee or to ensure that the disclosures are not misleading.
The requirement to provide summarized financial information for each member of the obligated group instead of condensed consolidating financial information is one of the most significant changes from the prior rules. Under the new rules, the summarized financial information for the members the obligated group will consist of:
- the selected balance sheet and income statement line items specified in Rule 1-02(bb)(1) of Regulation S-X;
- separate line items for amounts due from, amounts due to, and transactions with related parties and subsidiaries that are not part of the obligated group; and
- a note describing the basis of presentation.
The summarized financial information must exclude all subsidiaries that are not issuers or guarantors, even if an issuer or guarantor would otherwise consolidate the non-issuer or non-guarantor subsidiary under the applicable accounting framework. Accordingly, an issuer’s or guarantor’s investment balances in non-issuer or non-guarantor subsidiaries would be excluded from the summarized financial information.
When information provided under Rule 13-01 is relevant to some, but not all members of the obligated group, the parent company should assess whether disaggregation of the summarized financial information is required.
Ability to cease reporting
In a significant change from the prior rules, the parent company will be permitted to cease providing the disclosures required by Rule 13-01 if the related subsidiary issuers’ or guarantors’ reporting obligations have been suspended. Under the prior rules, the parent company was required to provide the condensed consolidating financial information for as long as the guaranteed securities were outstanding regardless of whether the subsidiary issuers or guarantors could have suspended their Exchange Act reporting obligations.
This change harmonizes Rule 3-10 with the requirements for suspension of reporting obligations and eliminates the anomalous outcome when a parent was required to continue to provide the disclosure required by Rule 3-10 even when the subsidiary issuer or guarantor could have suspended its own reporting obligations.
Recently acquired subsidiary issuers and guarantors
In another significant change, the new rules require a parent company to provide summarized pre-acquisition financial information in a Securities Act registration statement relating to guaranteed securities when the parent company has acquired a significant business after the date of the parent’s most recent balance sheet date if the acquired business and/or one or more of its subsidiaries are issuers or guarantors. Significance under the new rules will be evaluated at a 20% threshold based on the tests of significance used currently for evaluating business acquisitions (e.g., Rule 3-05 of Regulation S-X). Under the prior rules, the parent company was required to provide audited and sometimes unaudited pre-acquisition financial statements for certain recently acquired subsidiary issuers or guarantors based on their significance to the amount of securities being registered.
Key changes relating to certain collateralized securities
A collateral pledge is a common type of credit enhancement that issuers use to reduce their cost of capital. A pledge is a residual equity interest that could potentially give the secured party a direct claim to the pledged asset in the event of a default.
The SEC’s reporting requirements relating to registered securities that are collateralized by the pledge of an affiliate’s securities are based on the overarching belief that investors make their investment decisions relating to these types of securities primarily based on the registrant’s consolidated financial statements with supplemental details about the affiliate whose securities are pledged as collateral.
The SEC’s reporting requirements relating to securities collateralized by a pledge of an affiliate’s securities have been historically set forth in Rule 3-16 of Regulation S-X. Because registrants often structured debt agreements to specifically avoid the existing requirements of Rule 3-16 by releasing affiliate securities pledged as collateral if the disclosure requirements would be triggered, Rule 3-16 will continue to govern the reporting requirements applicable to securities issued and outstanding before January 4, 2021 if the parent had not previously provided financial statements under the requirements of that rule.
The provisions of new Rule 13-02 of Regulation S-X apply to securities issued on or after January 4, 2021 and to securities issued and outstanding before January 4, 2021 if the parent had previously provided financial statements under the requirements of Rule 3-16.
Key changes applicable to securities subject to Rule 13-02
Rule 13-02 contains several significant differences as compared to Rule 3-16 including:
- requiring the registrant to present non-financial disclosure such as (a) information about (i) the securities pledged as collateral, (ii) the affiliates whose securities are pledged, (iii) the terms and conditions of the collateral arrangement, and (iv) whether a trading market exists for the pledged securities, and (b) a list of each affiliate whose securities are pledged as collateral (including the identity of the pledge securities) as an exhibit to the applicable filing;
- requiring the registrant to present summarized financial information for each affiliate whose securities are pledged as collateral instead of Rule 3-16’s requirement for full financial statements for each affiliate as if the affiliate were a registrant;
- permitting the summarized financial information to be presented on a combined basis, with appropriate eliminations;
- requiring summarized financial information only as of and for the most recently completed fiscal year and subsequent year-to-date interim period (if applicable) instead of Rule 3-16’s requirement for financial statements as of and for all periods required for a registrant;
- permitting the registrant to present the disclosures either as a footnote to its financial statements or outside of its financial statements;
- requiring disclosure in the registrant’s Form 10-Qs (as applicable);
- requiring disclosures only to the extent material (two examples of situations in which summarized financial information may be omitted are provided) instead of using Rule 3-16’s 20% significance threshold based on the principal amount of the secured class of securities; and
- requiring disclosure of additional information (which could include additional line items of summarized financial information) if that disclosure would be material for investors to evaluate the collateral pledge or to ensure that the disclosures are not misleading.
The format of the summarized financial information of affiliates under Rule 13-02 is similar (although not identical) to the format of the summarized financial information relating to guaranteed securities under Rule 13-01 described above. However, the summarized financial information required by Rule 13-02 includes the financial information of all subsidiaries that would be consolidated by an affiliate whose securities have been pledged as collateral, even if the securities of the affiliate’s consolidated subsidiaries were not pledged. This difference recognizes a fundamental distinction between a pledge of securities (a residual equity interest) and a guarantee (which is focused on a legal obligation to pay).
Recently acquired affiliates
Rule 13-02 requires summarized pre-acquisition financial information for recently acquired affiliates whose securities are pledged as collateral only when the registrant has acquired a significant business after the date of the registrant’s most recent balance sheet date. As with Rule 13-01, significance under Rule 13-02 will be evaluated at a 20% threshold based on the tests of significance used currently for evaluating business acquisitions (e.g., Rule 3-05 of Regulation S-X). Rule 3-16 does not specifically reference the requirements relating to recently acquired affiliates whose securities are pledged as collateral for debt that is being registered. However, the SEC has indicated that full audited annual and, if applicable, unaudited interim financial statements of a recently acquired affiliate would be required if the affiliate meets Rule 3-16’s existing 20% significance threshold based on the principal amount of the secured class of securities.
FPIs, smaller reporting companies, and Regulation A issuers
The corresponding requirements applicable to foreign private issuers (FPIs), smaller reporting companies, and Regulation A issuers have also been updated to reflect the new rules. Those entities should refer to the SEC’s adopting release and related rule amendments for specific details.
The new rules become effective January 4, 2021. Any registration statement first filed on or after January 4, 2021 must comply with the new rules. Additionally, any post-effective amendment to a Securities Act registration statement to include either the registrant’s latest audited financial statements in the registration statement or to update the prospectus under Securities Act Section 10(a)(3) filed on or after January 4, 2021 must comply with the final amendments.
If a reporting company was required to comply with the new rules in a registration statement, all Exchange Act periodic reports for periods ending after that registration statement became effective would have to comply with the new rules as well.
For all other reporting companies, the annual report on Form 10-K (or Form 20-F) for fiscal years ending after January 4, 2021, and quarterly reports on Form 10-Q (if applicable) for quarterly periods ending after January 4, 2021, must comply with the new rules.
Voluntary compliance with the new rules is permitted immediately.