This week in our playbook, we are talking about guarantor and affiliate financial statements.
First, the bad news: As a general rule, all guarantors must present the same audited and unaudited financial statements as the issuer of the guaranteed securities.
A guarantee of a security (such as a guarantee of a debt or preferred equity security) is itself a security that must be registered under the Securities Act, absent an applicable exemption. As a result, under S-X Rule 3-10(a), the general rule is that guarantors are required to present the same audited and unaudited financial statements as the issuer of the guaranteed securities.
However, you have a shot at a silver lining, because there are exceptions to this onerous requirement.
Fortunately, S-X Rules 3-10(b)-(f) contain a number of important exceptions that permit issuers to disclose financial information about guarantors in a condensed format using a footnote to their own financial statements. Although the footnote approach can involve a fair amount of effort, it is far less burdensome than providing separate audited financial statements for every guarantor, which would be prohibitively expensive in most cases. S-X Rules 3-10(c), (e) and (f) go even further, dispensing with all additional information requirements for guarantors where the parent company issuer (or guarantor) does not have independent assets or operations of its own and all of the parent’s direct and indirect non-guarantor subsidiaries are “minor” (generally, aggregating less than three percent of the consolidated parent) and each guarantee is full and unconditional.
Here is a table describing these important exemptions and when they may apply. REMEMBER: for any of these exemptions to apply, the parent’s audited annual and unaudited interim financial statements must be filed for the periods required.
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Guarantee Scenario
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Financial Statement Requirements
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Parent company issuer of securities guaranteed by some or all of issuer's subsidiaries, where:
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the subsidiary guarantors are 100 percent owned1 by the parent company issuer;
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each guarantee is full – the amount of the guarantee may not be less than the underlying obligation;
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each guarantee is unconditional – holders must be able to take immediate action against the guarantor after a default on the underlying obligation; and
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the guarantees are joint and several (if there are multiple guarantors).
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No separate financial statements for subsidiaries are required under S-X Rules 3-10(e) and (f) if the parent's annual audited and interim unaudited financial statements are filed for the periods required and those financial statements include a footnote (audited for the periods for which audited financial statements are required) with condensed, consolidating financial information for each such period, with separate columns for:
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the parent company;
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the subsidiary guarantor (or subsidiary guarantors on a combined basis);
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any non-guarantor subsidiaries on a combined basis;
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consolidating adjustments; and
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total consolidated amounts.
Note 2 to S-X Rule 3-10(e) and Note 1 to S-X Rule 3-10(f) allow a conditional exemption from providing this footnote if the parent company has no independent assets or operations, the non-guarantor subsidiaries are "minor" (generally, less than three percent of the consolidated parent) and there is a footnote to that effect in the parent financial statements that also notes that the guarantees are full and unconditional and joint and several. Under S-X Rule 3-10(h)(5), "a parent company has no independent assets or operations if each of its total assets, revenues, income from continuing operations before income taxes, and cash flows from operating activities (excluding amounts related to its investment in its consolidated subsidiaries) is less than three percent of the corresponding consolidated amount."
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Operating subsidiary2 issuer of securities guaranteed by parent company, where:
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the operating subsidiary issuer is 100 percent owned by the parent company guarantor;
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the guarantee is full and unconditional; and
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no other subsidiary of the parent is a guarantor.
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No separate financial statements for the operating subsidiary are required under S-X Rule 3-10(c) if the parent's audited annual and unaudited interim financial statements are filed for the periods required and they include a footnote (audited for the periods for which audited financial statements are required) with condensed, consolidating financial information for each such period, with separate columns for:
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the parent company;
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the operating subsidiary issuer;
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any non-guarantor subsidiaries on a combined basis;
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consolidating adjustments; and
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total consolidated amounts.
Note 3 to S-X Rule 3-10(c) provides that this exception is also available if an operating subsidiary issuer meets these requirements except that the parent is a co-issuer with the subsidiary, rather than a guarantor.
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Finance subsidiary issuer of securities guaranteed by parent company, where:
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the finance subsidiary issuer is 100 percent owned by the parent company guarantor;
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the guarantee is full and unconditional; and
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no other subsidiary of the parent is a guarantor.
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No separate financial statements for the finance subsidiary are required under S-X Rule 3-10(b) if the parent's audited annual and unaudited interim financial statements are filed for the periods required and they include a footnote (audited for the periods for which audited financial statements are required) with:
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a statement that the finance subsidiary issuer is a 100 percent-owned finance subsidiary of the parent; and
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the parent has fully and unconditionally guaranteed the securities.
This exception is also available if a finance subsidiary issuer meets these requirements except that the parent is a co-issuer with the subsidiary, rather than a guarantor.
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Operating or finance subsidiary issuer of securities guaranteed by parent company and one or more other subsidiaries of parent company, where:
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the issuer and all subsidiary guarantors are 100 percent owned by the parent company guarantor;
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the guarantees are full and unconditional; and
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the guarantees are joint and several.3
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No separate financial statements for subsidiaries are required under S-X Rule 3-10(d) if the parent's audited annual and unaudited interim financial statements are filed for the periods required and they include a footnote (audited for the periods for which audited financial statements are required) with condensed, consolidating financial information for each such period, with separate columns for:
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the parent company;
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the subsidiary issuer;
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the guarantor subsidiaries on a combined basis;
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any non-guarantor subsidiaries on a combined basis;4
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consolidating adjustments; and
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total consolidated amounts.
This exception is also available if a subsidiary issuer meets these requirements except that the subsidiary is not a joint and several guarantor. In that case, the condensed consolidating financial information should include a separate column for the subsidiary.
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Recently acquired subsidiary issuer or subsidiary guarantor, where:
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the subsidiary has not been included in the audited consolidated results of the parent company for at least nine months of the most recent fiscal year; and
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the purchase price or net book value (as of the most recent fiscal year end prior to the acquisition), whichever is greater, of the subsidiary (or group of subsidiaries that were related prior to the acquisition) is 20 percent or more of the principal amount of the securities being registered.
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Separate financial statements are required under S-X Rule 3-10(g) for each such subsidiary, including:
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audited financial statements for the subsidiary's most recent fiscal year prior to the acquisition; and
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unaudited financial statements for any required interim periods.
These requirements apply even if (i) the recently acquired subsidiary would otherwise be eligible for the use of condensed consolidating footnote presentation or (ii) S-X Rule 3-05 would not require financial statements. In addition, note that the auditors of the recently acquired subsidiary must be PCAOB registered and the audit report must refer to PCAOB standards, even in the case of a newly acquired entity that is not an SEC reporting company (i.e., where S-X Rule 3-05 would otherwise permit use of a non-PCAOB registered auditor).
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We can’t always be standup guys. Let’s talk about stock pledges.
Separate audited and interim financial statements are generally required for an issuer’s affiliate if the securities of that affiliate are pledged as collateral for the offering and those securities constitute a “substantial portion” of the collateral for the securities being registered. See S-X Rule 3-16 and Financial Reporting Manual Topic 2600.1. Securities of the affiliate are deemed to constitute a “substantial portion” of the collateral if 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 greater, equals 20 percent or more of the principal amount of the securities that are being secured. See S-X Rule 3-16. If that is the case, an affiliate must file (or incorporate by reference) the same financial statements that it would be required to file if it were the issuer. For this reason, it is often uneconomical to secure bonds with stock pledges in publicly registered offerings or private placements with registration rights. One way around this is to provide that individual stock pledges will fall away automatically if ever the existence of the pledge would trigger a separate financial statement requirement. Another way is to issue the bonds privately in a Rule 144A-for-life offering without registration rights. Be sure to discuss the pros and cons of these approaches with your client.
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1 Under S-X Rule 3-10(h)(1), a subsidiary is 100 percent owned if all of its outstanding voting shares are owned, directly or indirectly, by its parent company. The term “voting shares” includes all rights, other than as affected by events of default, to vote for election of directors, and the sum of all interests in an unincorporated person. See S-X Rule 1-02(z). Convertible securities and options to buy voting shares would typically be considered voting shares. Note that this standard is different from the definition of “wholly-owned subsidiary” under S‑X Rule 1-02(aa), which is “a subsidiary substantially all of whose outstanding voting shares are owned by its parent and/or the parent’s other wholly owned subsidiaries.”
2 A subsidiary is an operating subsidiary if it is not a “finance subsidiary.” See S-X Rule 3-10(h)(8). In turn, a subsidiary is a finance subsidiary “if it has no assets, operations, revenues or cash flows other than those related to the issuance, administration and repayment of the security being registered and any other securities guaranteed by its parent company.” S-X Rule 3-10(h)(7).
3 Pursuant to Note 4 to S-X Rule 3-10(d), if any of the subsidiary guarantees is not joint and several with the guarantees of the parent company or the guarantees of the parent company and the other subsidiaries, each subsidiary guarantor whose guarantee is not joint and several need not include separate financial statements, but the condensed consolidating financial information must include a separate column for each subsidiary guarantor whose guarantee is not joint and several.
4 The column for non-guarantor subsidiaries may be omitted if the non-guarantor subsidiaries are minor.
