On July 24, 2018, the Securities and Exchange Commission (“SEC”) voted to propose rule amendments (the “Proposed Rules”) to simplify and streamline the current financial disclosure requirements for issuers and guarantors of SEC-registered guaranteed debt securities, as well as for affiliates whose securities collateralize an issuer’s securities. The Proposed Rules would amend Rules 3-10 and 3-16 of Regulation S-X, including by moving portions of Rule 3-10 and all of Rule 3-16 to a new Article 13 of Regulation S-X consisting of new Rules 13-01 and 13-02. The Proposed Rules are open for public comment until late September, after which time the SEC is expected to review and respond to comments and issue final rules.

The SEC stated that the Proposed Rules are intended to reduce compliance burdens, thereby encouraging more issuers to issue guaranteed and/or secured securities in SEC-registered transactions. Because of the often material time and cost burdens that can result from compliance with the current rules (including in connection with obtaining audits), many issuers turn to private offerings, in particular Rule 144A transactions, or seek alternative sources of capital, such as guaranteed and secured credit facilities, rather than issuing guaranteed debt securities in SEC registered transactions. By decreasing these burdens, the Proposed Rules are intended to ultimately lead to more SEC-registered offerings of guaranteed and collateralized securities, providing issuers with increased access to the capital markets and investors with additional protections that are not present in private transactions. The Proposed Rules are also intended to benefit investors by eliminating disclosures that are not useful.

Rule 3-10 of Regulation S-X

Background & Current Rule

Because a guarantee is a separate security from the underlying debt security, each guarantor of a registered debt security is necessarily a separate SEC registrant. As a result, Rule 3-10(a) of Regulation S-X sets forth the general rule that every issuer and guarantor of a registered debt security must file the full financial statements required for an SEC registrant pursuant to Regulation S-X (including full audited annual financial statements and unaudited interim financial statements). Rules 3-10(b)-(f) set forth five exceptions to this general rule that permit a parent company to satisfy the financial statement requirements of Regulation S-X on behalf of its subsidiary issuers and guarantors by including condensed consolidating financial information and/or certain alternate disclosures (collectively, “Alternate Disclosures”) in the footnotes to its financial statements, in each case, subject to the conditions contained therein.[1]

Under current rules, in order to qualify for the Alternate Disclosures, (a) each subsidiary guarantor or subsidiary issuer must be 100% owned by the parent company, (b) each guarantee must be full and unconditional and (c) where there are multiple guarantees, the guarantees must be joint and several. With certain exceptions, the Alternate Disclosures consist of condensed consolidating financial information (including all the major captions on the parent company’s balance sheet, income statement and cash flow statement), with separate columns for (i) the parent company, (ii) the guarantor subsidiaries on a combined basis, (iii) the non-guarantor subsidiaries on a combined basis, (iv) consolidating adjustments and (v) total consolidated amounts. The Alternate Disclosures must be presented in the footnotes to the parent company’s financial statements for the same periods required for the parent company (requiring an audit for the same periods, as applicable) and for as long as the guaranteed debt securities are outstanding.

Proposed Rules

The Proposed Rules would continue to permit parent companies to satisfy the financial statement requirements of Regulation S-X on behalf of their subsidiary issuers and guarantors; however, (a) each subsidiary guarantor or subsidiary issuer would only need to be consolidated on the parent company’s financial statements (rather than 100% owned), and (b) any subsidiary guarantees would no longer be required to be joint and several or full and unconditional.

Under the Proposed Rules, rather than providing the Alternate Disclosures, parent companies would only be required to provide summarized financial information (including select balance sheet and income statement line items) along with any qualitative or quantitative information about the guarantors, the issuers and the guarantees and any additional information that would be material to making an investment decision with respect to the guaranteed debt security (collectively, the “Proposed Alternate Disclosures”). The summarized financial information included in the Proposed Alternate Disclosures would include separate columns for (i) the issuer and guarantors on a combined basis and (ii) the non-guarantors on a combined basis, in each case eliminating intercompany transactions. In addition, a parent company could omit the summarized financial information from the Proposed Alternate Disclosures if it is immaterial, provided the parent company includes a statement to that effect along with the reasons for its conclusion.  Under the Proposed Rules, the materiality analyses are made by the issuer; while providing less certainty than the current rules, the Proposed Rules would allow companies to exercise their judgement to assess what information is important to investors.

The Proposed Alternate Disclosures would only be required to be presented as of and for the most recently ended fiscal year and any interim period included in the parent company’s consolidated financial statements and for as long as the issuer and guarantors have a reporting obligation with the respect to the securities under the Securities Exchange Act of 1934 (the “Exchange Act”). In addition, the Proposed Alternate Disclosures may be presented outside of the footnotes to the parent company’s consolidated financial statements (for example, in MD&A) until the beginning of the first fiscal year after the first bona fide sale of the guaranteed debt securities is complete (delaying the requirement for an audit).

The following chart summarizes the material terms of the proposed amendments to current Rule 3-10 under the Proposed Rules:

Rule 3-16 of Regulation S-X

Background & Current Rule

Because collateralizing a security is not issuing a security, entities are not considered separate SEC registrants solely by virtue of pledging collateral. However, when an affiliate’s securities constitute a “substantial portion”[2] of the collateral for a class of an issuer’s SEC registered securities, Rule 3-16 of Regulation S-X requires the issuer to include in its own financial statements the full financial statements of such affiliate that would have been required if such affiliate was an SEC registrant.

Proposed Rules

In lieu of full financial statements, the Proposed Rules would only require issuers to include summarized financial information (including select balance sheet and income statement line items) and, to the extent material, certain non-financial disclosures regarding the affiliate, the securities pledged as collateral, the terms of the pledge and any additional qualitative or quantitative information that would be material to making an investment decision with respect to the collateralized security (collectively, the “Proposed Alternate Rule 3-16 Disclosures”). In addition, the obligation to provide the Proposed Alternate Rule 3-16 Disclosures would only arise when such disclosures are material to the holders of the collateralized security, rather than when the value of the affiliate’s pledged securities exceeds a numerical threshold. Further, subject to certain materiality exceptions, the Proposed Alternative Rule 3-16 Disclosure could be presented for multiple affiliates on a combined basis.

The following chart summarizes the material terms of the proposed amendments to current Rule 3-16 under the Proposed Rules:

Potential Benefits to UPREITs

We believe the Proposed Rules may be beneficial to many publicly traded real estate investment trusts (“REITs”) that utilize the traditional umbrella partnership REIT (“UPREIT”) structure and currently rely on their non-100% owned operating partnership subsidiaries to issue SEC-registered debt securities.

In the traditional UPREIT structure, the REIT serves as (or controls) the general partner of an operating partnership subsidiary that, in turn, owns all of the REIT’s real estate assets and conducts substantially all of the REIT’s business. The operating partnership typically issues units of limited partnership interest in the operating partnership to sellers in private unregistered transactions as consideration for contributions of real estate assets, and, as a result, the operating partnership typically is not 100% owned by the REIT although it is consolidated in the REIT’s financial statements. Because the parent company REIT is a holding company with no assets other than its interest in the operating partnership, it is often not viewed as a creditworthy debt issuer absent subsidiary guarantees. 

Because current Rule 3-10 does not permit a parent company to provide the Alternate Disclosures when its subsidiary guarantors or subsidiary issuers are not 100% owned, many REITs incur the time and expense to establish their operating partnerships as separate SEC registrants with their own financial reporting obligations[3] so they may raise capital by either (a) issuing SEC-registered debt securities at the operating partnership level that are guaranteed by the REIT or (b) issuing SEC-registered debt securities at the REIT level that are guaranteed by the operating partnership.[4]  By allowing a parent company to provide the Proposed Alternate Disclosures when its subsidiary guarantors or issuers are consolidated in the parent company’s financial statements, rather than 100% owned, the Proposed Amendments would alleviate the burden of separately establishing a REIT’s operating partnership subsidiary as an SEC registrant with its own financial reporting obligations, thereby permitting UPREITs to more efficiently and cost effectively access the capital markets.

[1] The five exceptions in current Rules 3-10(b)-(f) apply to the following five scenarios: (b) finance subsidiary issuer of securities guaranteed by its parent company; (c) operating subsidiary issuer of securities guaranteed by its parent company; (d) subsidiary issuer of securities guaranteed by its parent company and one or more other subsidiaries of that parent company; (e) single subsidiary guarantor of securities issued by the parent company of that subsidiary; and (f) multiple subsidiary guarantors of securities issued by the parent company of those subsidiaries.

[2] For purposes of Rule 3-16, securities are deemed to constitute a “substantial portion” of collateral if the aggregate principal amount, par value or book value of the securities as carried by the registrant, or the market value of such securities, whichever is the greatest, equals 20% or more of the principal amount of the secured class of securities.

[3] Such registrants may be permitted to file combined reports in certain circumstances.

[4] We note that option (b) is rarely used in practice.