SEC Adopts Amendments to Rules 3-10 and 3-16 of Regulation S-X in Certain Registered Debt Offerings

Skadden, Arps, Slate, Meagher & Flom LLP

On March 2, 2020, the Securities and Exchange Commission (SEC) adopted amendments that reduce and simplify the financial disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well for affiliates whose securities collateralize a registrant’s securities. The amendments revise Rules 3-10 and 3-16 of Regulation S-X, and relocate part of Rule 3-10 and all of Rule 3-16 to the new Article 13 in Regulation S-X, which is comprised of new Rules 13-01 and 13-02.

The changes are part of the SEC’s ongoing efforts to ease disclosure and capital formation burdens for public companies while continuing to ensure that investors have access to material information. The amendments will be effective January 4, 2021, but voluntary compliance is permitted in advance of the effective date.

Below is a brief summary of existing Rule 3-10 and Rule 3-16, followed by the most prominent amendments to such rules. Also included herein is a table, excerpted from the SEC release, that includes side-by-side comparisons of the main features of the existing and final rules.

MAIN Existing Rules 3-10 and 3-16 of Regulation S-X

Rule 3-10

Rule 3-10, which is in effect as currently worded until January 4, 2021, requires each issuer and guarantor of registered debt securities (which effectively includes securities issued in Rule 144A private placements with registration rights) to file its own audited annual and unaudited interim financial statements. However, Rule 3-10 contains five exceptions that conditionally allow a parent company to provide abbreviated disclosures in its own financial statements to cover a subsidiary issuer or guarantor. All five exceptions require that (1) each subsidiary issuer and guarantor be “100% owned” by the parent company; (2) each guarantee be “full and unconditional”; and (3) the parent company provide certain disclosures in its consolidated financial statements (the Alternative Disclosures).

The form and content of the Alternative Disclosures are determined based on the facts and circumstances of the issuer and guarantor structure and could range from brief narrative disclosures to, more commonly, highly detailed condensed consolidating financial information (Consolidating Information). Preparation of the Consolidating Information, while less costly than full financial statements, is often challenging and time-consuming, and can be costly, as many registrants do not typically design their accounting systems to capture the required information for each individual issuer or guarantor. In consequence, many companies have avoided registered offerings in favor of unregistered "private-for-life" bond offerings, which are not subject to these rules.

Subsidiary issuers and guarantors that are permitted to omit their separate financial statements under Rule 3-10 are automatically exempt from the public-company reporting provisions under the Exchange Act via Rule 12h-5. The parent company, however, is required to continue to provide the Alternative Disclosures in its annual and quarterly reports for as long as the guaranteed securities are outstanding, even if the subsidiary issuer or guarantor otherwise could suspend its reporting obligation by operation of Exchange Act Section 15(d)(1) or compliance with Rule 12h-3.

Recently acquired subsidiary issuers and guarantors are addressed separately, and less favorably, under Rule 3-10. A parent company registration statement covering the issuance of guaranteed debt securities must include one year of audited, and, if applicable, unaudited interim pre-acquisition financial statements for recently acquired subsidiary issuers and guarantors that are significant and have not been reflected in the parent company’s audited results for at least nine months of the most recent fiscal year.1

Rule 3-16

Rule 3-16 requires separate audited and interim financial statements for an issuer’s affiliate if the securities of that affiliate are pledged as collateral for a registered offering and those securities constitute a “substantial portion” of the collateral for the securities being registered. 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 the greatest, equals 20% or more of the principal amount of the securities that are being secured. If this test is met, the issuer is required to file full financial statements of each qualifying affiliate. Subsequent to the registered offering, the issuer has to continue to provide full audited financial statements of each such affiliate in its annual reports, but is not required to provide any interim financial statements in its quarterly reports.

Amended Rules 3-10 and 3-16

Rule 3-10

The amendments to Rule 3-10 make it easier to omit separate financial statements and reduce the required alternative supplemental financial and nonfinancial disclosure about the subsidiary issuers and/or guarantors and the guarantees. The amendments to Rule 3-10:

  • Replace the condition that a subsidiary issuer or guarantor be 100% owned by the parent company with a condition that it be consolidated in the parent company’s consolidated financial statements.
    • Removing the “100% owned” condition will permit certain joint venture entities to provide credit support in the form of a guarantee(s). It also will provide additional financing flexibility for public companies that use the so-called “UP-C” structure. While the “100% owned” test only considers shares with voting rights for corporate subsidiaries, it considers all membership interests (voting and nonvoting) for noncorporate subsidiaries. In an Up-C structure, although the publicly traded parent company typically owns 100% of the voting interests in the private operating partnership or operating limited liability company, because it does not own 100% of all of the membership interests in the noncorporate private operating entity, such entity is not currently considered “100% owned” under Rule 3-10. Accordingly, the private operating entity and the publicly traded parent company cannot sell or guarantee registered debt without preparing separate audited financial statements for each entity and making the private operating entity a separate reporting company under the Exchange Act.
  • Replace the specific issuer and guarantor structures permitted under the five exceptions in Rules 3-10(b) through (f) with a broader two-category framework where the parent company’s role as issuer, co-issuer, or full and unconditional guarantor with respect to the guaranteed security will determine whether the issuer and guarantor structure is eligible for the benefits of the rule. An issuer and guarantor structure satisfies this framework if (1) the parent company issues or co-issues (on a joint and several basis with one or more of its consolidated subsidiaries) securities that are guaranteed by one or more consolidated subsidiaries; or (2) a consolidated subsidiary issues or co-issues (with one or more other consolidated subsidiaries of the parent company) the securities, and the securities are guaranteed fully and unconditionally by the parent company.
    • Because the role of the parent company determines whether an issuer or guarantor structure is eligible, the role of the subsidiary guarantors is irrelevant for determining overall eligibility. As a result, the existing conditions that subsidiary guarantees be full and unconditional as well as — where there are multiple guarantees —joint and several no longer will be imposed on subsidiary guarantors.
    • The SEC expects issuer and guarantor structures that currently qualify under Rule 3-10 to continue to qualify under either of the two alternative categories in the revised framework.
  • Replace the Consolidating Information specified in existing Rule 3-10 with more abbreviated financial and nonfinancial disclosures:
    • The amended financial disclosures require, for each issuer and guarantor, summarized financial information, as specified by Rule 1-02(bb)(1) of Regulation S-X3.2 Additional line item disclosure is required only to the extent the parent company determines that providing it would be material for investors to evaluate the sufficiency of the guarantee. The change in requirements provides significant relief as compared to current rules because (1) only select captions from the balance sheet and income statement have to be presented and (2) summarized financial information will not require disclosure of any information related to the statements of cash flows.
      • The summarized financial information of each issuer and guarantor may be presented on a combined basis; information related to subsidiaries that are not issuers or guarantors (and any consolidating adjustments) will no longer be required. This compares favorably against the current requirement of condensed consolidating financial information that included separate columnar information about the parent company, subsidiary issuers and guarantors, and any other subsidiaries of the parent company on a consolidated basis, consolidating adjustments and the total consolidated amounts.
      • The summarized financial information is required only for the most recently completed fiscal year and the most recent interim period included in the parent company’s consolidated financial statements (as compared to the current requirement, which covers all periods included in the parent company’s most recent consolidated financial statements).
    • The nonfinancial disclosures should include, to the extent material, certain qualitative disclosures about the guarantees and the issuers and guarantors, as well as any additional information that may affect payments to holders of the guaranteed security.
      • For example, if a subsidiary guarantee is not full and unconditional or joint and several, and such terms are material, (1) the terms should be disclosed and (2) separate summarized financial information should be provided for any subsidiary guarantor that has not provided a full, unconditional, and joint and several guarantee.
  • Permit the proposed disclosures to be provided outside the footnotes to the parent company’s audited annual and unaudited interim consolidated financial statements in the registration statement covering the offer and sale of the subject securities and any related prospectus, and in any subsequent filings.
    • Permitting the disclosures to be located in the MD&A or other prominent location, as opposed to within the company's financial statements, is intended to reduce the costs and delays associated with auditing the disclosures. Additionally, by relocating the disclosures from the financial statements, the disclosures would become eligible for the liability protections of the safe harbor under the Private Securities Litigation Reform Act of 1995.

      Because this information is no longer required to be audited, it is likely that underwriters will push for some level of auditor comfort or company certification on any summarized financial information that is not included in the parent company’s audited financial statements.

  • Eliminate the current requirement to provide pre-acquisition financial statements of recently acquired significant subsidiary issuers and guarantors. However, when a parent company has acquired a significant business after the date of the most recent balance sheet included in its consolidated financial statements, and the acquired business or one or more of its subsidiaries are obligated as issuers or guarantors, certain pre-acquisition summarized financial information will need to be provided in Securities Act registration statements filed in connection with the offer and sale of the subject guaranteed security.
  • Require the proposed financial and nonfinancial disclosures for as long as the issuers and guarantors have an Exchange Act reporting obligation with respect to the guaranteed securities, rather than for as long as the guaranteed securities are outstanding.
    • In many cases when a debt security is offered and sold on a registered basis, there will be fewer than 300 holders of record. Accordingly, in such cases the reporting obligation of subsidiary issuers/guarantors under Section 15(d) would suspend automatically within approximately one year following completion of the registered offering.

Proposed Rule 3-16

The amendments to Rule 3-16 reflect the view of the SEC that separate financial statements of affiliates whose securities are pledged as collateral “are not material in most situations.” The amendments will:

  • Replace the existing requirement to provide separate financial statements for an affiliate whose pledged securities constitute a substantial portion of the collateral for any class of securities offered in a registered offering with a requirement to provide certain abbreviated financial and nonfinancial disclosures about the affiliate and the collateral arrangement if material to investors/holders of the collateralized securities. Required disclosures include the following:
    • a description of the security pledged as collateral and each affiliate whose security is pledged as collateral;
    • a description of the terms and conditions of the collateral arrangement, including the events or circumstances that would require delivery of the collateral;
    • a description of the trading market for the affiliate’s security pledged as collateral or a statement that there is no market;
    • summarized financial information, as specified in Rule 1-02(bb)(1) of Regulation S-X, for each affiliate whose securities are pledged as collateral. The summarized financial information of each such affiliate may be presented on a combined basis and should cover the most recently ended fiscal year and interim period included in the registrant’s consolidated financial statements; and
    • any other quantitative or qualitative information that would be material to making an investment decision with respect to the collateralized security.
  • Permit the proposed financial and nonfinancial disclosures to be located in filings in the same manner as described above for the disclosures related to guarantors and guaranteed securities.

Conclusion

The amendments represent a welcome development in reducing the costs and challenges of complying with the existing rules applicable to guaranteed and collateralized securities. We believe the amendments may cause many debt issuers, especially those with issuer and guarantor or collateral support structures that currently do not comply with existing rules, to revisit whether to access the markets via a registered offering, instead of, for example, a Rule 144A private offering, where the existing rules do not apply. Additionally, we expect many parent companies will welcome the long overdue change that will permit them to cease providing the required financial disclosures for subsidiary issuers or guarantors if the obligation of the subsidiary issuer/guarantors to file periodic reports under Section 15(d) otherwise would have been suspended.

Additional information is available in the adopting release and the SEC’s press release.

Appendix

Set forth below is a table summarizing the main features of existing Rules 3-10 and 3-16, and the final rule changes. The table has been excerpted from the SEC adopting release and is not a substitute for the rules and regulations. It is only a summary of certain requirements contained in the current SEC rules and regulations, as well as a summary of the final amendments. Defined terms used below have the same meaning as in the SEC adopting release.

Chart1

chart2

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1 The requirements to provide separate pre-acquisition financial statements of recently acquired guarantors apply only to Securities Act registration statements and can require more extensive disclosure than Exchange Act periodic reports and acquired business financial statements under Rule 3-05 of Regulation S-X. Furthermore, the significance test for recently acquired guarantors, which compares the net book value or purchase price of the subsidiary to the principal amount of the securities registered, is different from, and stricter than, the usual significance test for acquiree financial statements.

2 Summarized financial information as understood by Rule 1-02(bb) includes current and noncurrent assets, current and noncurrent liabilities, preferred stock, noncontrolling interests, net sales or gross revenues, gross profit, income/loss from continuing operations, net income/loss and net income/loss attributable to the entity.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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