SEC Issues Final Rule to Simplify Disclosure Requirements Related to Guarantors and Collateralizations of Securities (March 10, 2020)

SEC Issues Final Rule to Simplify Disclosure Requirements Related to Guarantors and Collateralizations of Securities

by Anish Alemao, Kathleen Malone, and Doug Rand, Deloitte & Touche LLP

Background

On March 2, 2020, the SEC issued a final rule 1 that amends the disclosure requirements related to certain registered securities under SEC Regulation S-X, Rules 3-10,2,3 and 3-16,4 which currently require separate financial statements for:

Subsidiary issuers and guarantors of registered debt securities unless certain exceptions are met.
Affiliates that collateralize registered securities offerings if the affiliates’ securities are a substantial portion of the collateral.

The final rule is generally effective for filings on or after January 4, 2021. However, early application is permitted.

The final rule is based on the premise that the primary source of information that investors in guaranteed debt or collateralized securities rely on is the consolidated financial statements of the parent company. Therefore, alternative financial disclosures or narrative disclosures (collectively, the “Alternative Disclosures”) may be provided in lieu of separate financial statements of the guarantors or affiliates.

With respect to the disclosure requirements related to issuers and guarantors of guaranteed debt securities or issuers of registered securities whose affiliates collateralize those securities, the final rule:

Replaces the previous requirement under Rule 3-10 to provide condensed consolidating financial information in the registrant’s financial statements with a requirement to provide alternative financial disclosures (which include summarized financial information of the parent and any issuers and guarantors, as well as other qualitative disclosure) in either the registrant’s MD&A or its financial statements.
Simplifies the requirements in Rule 3-10 that currently must be met for a parent company to qualify for exceptions allowing it to provide Alternative Disclosures rather than full audited financial statements (e.g., by replacing the requirement that a subsidiary issuer or guarantor be 100 percent owned with a requirement that it be consolidated in the parent company’s financial statements).
Eliminates the current requirement in Rule 3-10(g) to provide preacquisition financial statements for recently acquired subsidiary issuers and guarantors. However, in certain circumstances, an issuer is required to provide preacquisition summarized financial information.
Replaces the current requirement in Rule 3-16 to provide separate financial statements for an affiliate that collateralizes a substantial portion of a security with a requirement to provide summarized financial information and other narrative disclosures.
Reduces the periods for which summarized financial information is required to the most recent (1) annual period and (2) year-to-date interim period.
Relocates the Alternative Disclosures requirements in Rule 3-10 to new Rule 13-015 in SEC Regulation S-X.
Adds to Regulation S-X a new Rule 13-02,6 which is applicable to collateralized securities.7

These highlights are discussed in the sections below.

In drafting the final rule, the SEC took into consideration constituents’ feedback on its July 2018 proposed rule.8 As noted in the final rule, the newly issued amendments to current Rules 3-10 and 3-16 are intended to “make the disclosures easier to understand, and reduce the costs and burdens to registrants.”

Financial Disclosures About Guarantors and Issuers of Guaranteed Securities

The table below compares certain disclosure requirements and definitions under existing Rule 3-10 with those of the final rule.

Existing Rule 3-10	Final Rule
Guarantor Structures Eligible for Alternative Financial Disclosures (“Qualifying Structures”)
Condensed consolidating financial information and qualitative disclosures, rather than separate financial statements, may be provided for the following qualifying structures:9 An operating subsidiary10 issues securities guaranteed by its parent company, and no other subsidiary of the parent company guarantees the securities (Rule 3-10(c)). A finance or operating subsidiary issues securities guaranteed by its parent company, and the securities are guaranteed by one or more other subsidiaries of the parent (Rule 3-10(d)). A single finance or operating subsidiary guarantees securities issued by its parent company (Rule 3-10(e)). Multiple finance or operating subsidiaries guarantee securities issued by their parent company (Rule 3-10(f)).	Summarized financial information and qualitative disclosures, rather than separate financial statements, may be provided if the guarantor structure meets either of the following requirements: 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. A consolidated subsidiary issues or co-issues (with one or more other consolidated subsidiaries of the parent company) the securities, and the securities are fully and unconditionally guaranteed by the parent company.
Connecting the Dots The final rule simplifies the determination of whether alternative financial disclosures may be provided in lieu of separate financial statements by replacing the various qualifying guarantor structures with two alternative criteria. The SEC expects guarantor structures that qualify under the criteria in existing Rule 3-10 to continue to qualify under either of the two criteria in the final rule.
Additional Eligibility Requirements for Alternative Financial Disclosures
Condensed consolidating financial information and qualitative disclosures are available for qualifying structures only when all of the following conditions are met: Each subsidiary issuer/guarantor is 100 percent owned.11 Each guarantee, regardless of whether it is made by the parent or by a subsidiary, is full, unconditional,12 and joint and several with all other guarantees.	Alternative financial disclosures are available for qualifying structures only when all of the following conditions are met: Each subsidiary issuer/guarantor is consolidated. The parent company either issues or guarantees, on a full and unconditional basis, the guaranteed securities.
Eligibility for Narrative Disclosures
Narrative disclosures about the guarantee(s), rather than condensed consolidating financial information or separate financial statements, may be provided if the guarantor structure meets either of the following requirements: A finance subsidiary13 issues securities guaranteed by its parent company, and no other subsidiary of the parent company guarantees the securities (Rule 3-10(b)). The guarantor structure qualifies for the use of condensed consolidating financial information, and all of the following conditions are met: The guarantee is full and unconditional. The parent company has no independent assets or operations.14 Nonguarantor subsidiaries are minor.15	The final rule provides that a registrant that qualifies for alternative financial disclosures may omit summarized financial information when not material. In addition, Rule 13-01 specifies four circumstances in which a registrant may omit the summarized financial information and instead describe the structure narratively (i.e., provide narrative disclosures): The summarized financial information would not be materially different from the consolidated financial statements of the registrant (i.e., nonguarantors are insignificant). The amounts presented in the summarized financial information (which excludes investments in nonguarantors) would not be material (i.e., the issuers and guarantors do not have material independent assets and operations). A finance subsidiary16 issues a security fully and unconditionally guaranteed by the parent, and no other subsidiaries guarantee the security. A finance subsidiary co-issues a security with the parent, and no other subsidiaries guarantee the security. The last two scenarios are generally consistent with the exception in existing Rule 3-10(b).
Connecting the Dots The circumstances specified in the final rule eliminate certain bright-line thresholds in existing Rule 3-10 associated with the determination that a parent company has no independent assets or operations, or that nonguarantor subsidiaries are more than minor. However, they otherwise largely align with the current circumstances in which narrative disclosure is permitted. The guiding principle is to determine whether the summarized financial information would provide investors in the guaranteed securities with any material, incremental information not already provided in the parent company’s financial statements.
Required Qualitative Disclosures
The SEC registrant using condensed consolidating financial information is required to disclose the following: If true, that each subsidiary issuer or subsidiary guarantor is 100 percent owned by the parent company. If true, that all guarantees are full and unconditional. If there is more than one guarantee, and if true, that all guarantees are joint and several. Any restricted net assets of subsidiary issuers or guarantors. Any significant restrictions on the ability of the parent company or guarantors to obtain funds from the parent company’s subsidiaries.	To the extent material, the SEC registrant using Alternative Disclosures would be required to disclose: A description of the issuers and guarantors. The terms and conditions of the guarantees, including whether a subsidiary guarantee is not full and unconditional or joint and several. Factors that may affect payments to holders of the guaranteed securities, including, but not limited to: The relationship and structure between issuers, guarantors, and nonguarantors. Restrictions on dividends. Limitations on enforceability of the guarantees. The rights of noncontrolling interests. Further, the registrant must file a new exhibit which, for each guaranteed security registered or to be registered, lists the subsidiaries that issue, co-issue, or guarantee the security.
Required Alternative Financial Disclosures
The condensed consolidating financial information should be presented in a columnar format and may be condensed in both annual and interim periods, in accordance with the general guidance on interim financial statements in SEC Regulation S-X, Rule 10-01.17,18 Condensed consolidating financial information should be presented for the balance sheet and statements of income and comprehensive income, as well as for statements of cash flows as applicable, and should include any of the following columns if applicable: Parent. Subsidiary issuer(s) of the security. Subsidiary guarantor(s). Nonguarantor subsidiaries. Consolidating adjustments.	Disclosure of the following line items, together with a brief description of the basis of presentation, would be required when summarized financial information18 of the issuers and guarantors is presented: Current and noncurrent assets. Current and noncurrent liabilities. Redeemable preferred stock. Noncontrolling interests. Revenues. Gross profit. Income (loss) from continuing operations. Net income (loss). Net income (loss) attributable to the entity. Additional line items may be necessary if such disclosure would be material to an investor’s evaluation of the sufficiency of the guarantee(s). Transactions between issuers and guarantors presented on a combined basis should be eliminated. Information for nonguarantors or nonissuers should be excluded. Separate presentation is required for transactions with, and amounts due from or due to, (1) nonguarantor subsidiaries (i.e., those amounts that do not arise from the issuers’ or guarantors’ investment in the nonguarantors) and (2) other related parties. The information may be presented on a combined basis; however, to the extent that the information provided is applicable to one or more, but not all, issuers and guarantors, separate disclosure of summary financial information may be required for the relevant guarantors and issuers to the extent material. For example, if a subsidiary’s guarantee was not full and unconditional, that fact would be disclosed and separate financial information would be provided for the subsidiary unless such information can be provided narratively.
Connecting the Dots The change in requirements provides significant relief since (1) only certain captions from the balance sheet and income statement would have to be presented and (2) summarized financial information does not require disclosure of any information related to the statements of cash flows. In addition, the final rule permits presentation on a combined basis for both issuers and guarantors, rather than requiring separate presentation of the parent, issuer, and guarantors. Further, the final rule does not require disclosure of any information related to nonguarantor subsidiaries or consolidating adjustments. While existing Rule 3-10 requires an issuer’s or guarantor’s investment in a nonissuer or nonguarantor to be reflected under the equity method in the condensed consolidating financial information, the final rule specifies that the summarized financial information should not reflect investments of the parent, issuer(s), or guarantor(s) in nonguarantor subsidiaries.
Periods Presented
In registration statements related to the offering of the guaranteed securities and in periodic reports of the registrant on Form 10-K, Form 10-Q, or Form 20-F, a registrant is required to present:
Condensed consolidating financial information for the same periods as required for the registrant.	Summarized financial information for only the most recent annual period and the most recent year-to-date interim period, as applicable.
Connecting the Dots The final rule reduces the number of periods for which summarized financial information must be presented, providing relief from current requirements since certain events require retrospective application in the financial statements, including, but not limited to, changes in (1) the guarantor structure and (2) accounting policies. By limiting the periods presented to only the most recent annual period and the most recent year-to-date interim period, the final rule will substantially reduce the burden of retrospectively revising this disclosure, which is often cumbersome for registrants that present multiple years of condensed consolidating financial information under existing Rule 3-10.
Location of Alternative Disclosures
Condensed consolidating financial information and qualitative disclosures must be included in the audited annual financial statements and unaudited interim financial statements for both registered and to be registered securities.	For periodic reporting on Form 10-K, Form 10-Q, or Form 20-F, a registrant would be required to provide the disclosures in its MD&A or financial statements. For to be registered securities, a registrant would be permitted to provide the required disclosures in its MD&A, in its financial statements, or immediately following “Risk Factors” in the registration statement for the offer and sale of the guaranteed securities. If a registrant elects to include the disclosures in its financial statements, such disclosures would be subject to audit (in the case of Forms 10-K and 20-F) or review (in the case of Form 10-Q) by its auditors.
Connecting the Dots Although the proposed rule would have allowed presentation outside of the financial statements in a registration statement for the guaranteed securities, it would have required presentation in the financial statements for all periods beginning with the annual report following the offering. In contrast, the final rule allows registrants to present the Alternative Disclosures outside of the financial statements in any filing in which they are required.
Suspension of Reporting Requirement
Condensed consolidating financial information and qualitative disclosures must be provided for as long as the guaranteed securities are outstanding, even if the subsidiary issuer or guarantor would otherwise be eligible for suspension of its reporting obligation.20	A registrant is permitted to cease providing Alternative Disclosures if the subsidiary issuer’s or guarantor’s reporting obligation has been suspended.
Requirements for Any Recently Acquired Subsidiary Issuer or Subsidiary Guarantor (“Recently Acquired Subsidiary Guarantor”)
Registration statements for debt securities must include the preacquisition financial statements of any recently acquired subsidiary guarantor if (1) 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 (2) the net book value or purchase price, whichever is greater, of the subsidiary is 20 percent or more of the principal amount of the securities being registered. The financial statements should include audited21 financial statements of the subsidiary for its most recent fiscal year preceding the acquisition and unaudited financial statements for any applicable interim periods.	Registration statements for debt securities must include the preacquisition summarized financial information of any recently acquired subsidiary guarantor if (1) the subsidiary has not been included in the registrant’s most recent balance sheet and (2) the recently acquired subsidiary guarantor is considered a significant business22 in accordance with the criteria in Rule 1-02(w) when 20 percent is substituted for 10 percent.
Connecting the Dots The significance tests for determining whether acquiree financial statements are required for a recent acquisition in accordance with SEC Regulation S-X, Rule 3-05,23 are different from those currently in Rule 3-10(g). Acquiree financial statements may be required under existing Rule 3-10(g) but not under Rule 3-05, or vice versa. This disparity has often created confusion for registrants. The final rule eliminates the requirement currently in Rule 3-10(g) to provide financial information about recently acquired subsidiary guarantors unless financial statements are required under Rule 3-05.

Affiliates Whose Securities Collateralize Securities

Under existing Rule 3-16, SEC registrants are required to include separate financial statements of affiliates whose securities constitute a “substantial portion of the collateral”24 for any class of securities registered or being registered. These disclosures are intended to help investors evaluate an affiliate’s ability to satisfy its commitment in the event of default. Currently, Rule 3-16 does not contain any accommodations to the requirement for separate financial statements. In practice, however, Rule 3-16 is infrequently applied because the provisions in collateral agreements often limit the amount of collateral provided to such an extent that it does not represent a “substantial portion.” See Effective Date and Transition for a discussion of the final rule’s transition guidance on applying amended Rule 3-16 and new Rule 13-02.

Rule 13-02 replaces the requirement to provide separate financial statements when the bright-line “substantial portion of the collateral” test is met with the requirement to provide certain financial and nonfinancial disclosures about the affiliate(s) and collateral arrangement, if material.25 Disclosures under the final rule include the following:

Summarized financial information as specified in Rule 1-02(bb)(1) for each affiliate whose securities are pledged (the information may be presented on a combined basis).
A description of the security pledged, each affiliate whose security is pledged, and the terms and conditions of the collateral arrangement (including events that may require delivery of collateral).
A description of the trading market for the affiliates’ security pledged as collateral (or, if no such market exists, a statement to that effect).
Any other quantitative or qualitative information that would be material to investors’ evaluation of the pledge of the securities as collateral.
An exhibit, for each collateralized security, that lists each of the affiliates whose securities are pledged as collateral and the specific securities pledged.
For a Securities Act of 1933 (the “Securities Act”) registration statement in connection with the offering of collateralized securities, preacquisition summarized financial information if both of the following conditions are met:
- The registrant acquired a significant business (i.e., a business that meets the criteria in Rule 1-02(w) when 20 percent is substituted for 10 percent) after the date of the most recent balance sheet included in the filing.
- The acquired business collateralizes the registrant’s security.

For registrants with affiliates whose securities collateralize an issue registered or being registered, the final rule provides guidance similar to that for guarantors on periods presented, the content of summarized financial information,26 and location of disclosures.27 For more information about the SEC’s amendments to its disclosure requirements for guarantors, refer to the table above.

Effective Date and Transition

The effective date of the final rule is as follows:

Periodic reports — The final rule applies to annual reports on Form 10-K or Form 20-F for fiscal years ending after January 4, 2021, and quarterly reports on Form 10-Q for quarterly periods ending after January 4, 2021. For example, a calendar-year-end registrant would be required to first comply with the final rule in its quarterly report on Form 10-Q for the quarter ending March 31, 2021. If a registrant applies the final rule in a registration statement (as discussed below), all periodic reports for periods ending after the registration statement becomes effective must comply with the final rule.
Registration statements — The final rule applies to:
- Securities Act registration statements first filed on or after January 4, 2021.
- Any post-effective amendment to a Securities Act registration statement filed on or after January 4, 2021, that either includes a registrant’s latest audited financial statement in the registration statement or updates the prospectus under Section 10(a)(3) of the Securities Act.
- Any Exchange Act registration statement that is first filed on or after January 4, 2021.

Registrants may voluntarily comply with the final rule before January 4, 2021. Once a registrant voluntarily complies, all future periodic reports must comply with the final rule.

Grandfathering for Collateralized Securities

Historically, many registered offerings with collateral features were structured to avoid the requirement to furnish separate financial statements by including provisions that limited the amount of collateral to less than a “substantial portion” (“collateral cutback provisions”). Since many agreements may have explicitly referred to Rule 3-16, eliminating Rule 3-16 may have had unintended consequences on existing collateral cutback provisions. Therefore, the final rule retains existing Rule 3-16 in its entirety and adds a scope paragraph to clarify that Rule 3-16 will continue to apply to registered collateralized securities outstanding before January 4, 2021, for which no separate financial statements have previously been provided. The new scope paragraph is intended to allow existing collateral cutback provisions to remain operable while allowing registrants that previously provided separate financial statements in accordance with Rule 3-16 to benefit from the amendments in the final rule.

Looking Ahead

The final rule represents a substantial simplification and highlights the SEC’s continued focus on improving disclosure effectiveness and encouraging capital formation. The SEC is currently working on other significant rulemaking related to financial reporting, including its proposed amendments 28 to financial disclosures about acquired and disposed businesses, which are discussed in Deloitte’s May 9, 2019, Heads Up. Stay tuned for further developments.

Footnotes

SEC Final Rule Release No. 33-10762, Financial Disclosures About Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant’s Securities.

SEC Regulation S-X, Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.”

Rule 3-10 applies not only to registered guaranteed debt securities but also to guaranteed preferred securities whose payment terms are substantially similar to debt (e.g., trust preferred securities).

SEC Regulation S-X, Rule 3-16, “Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered.”

SEC Regulation S-X, Rule 13-01, "Guarantors and Issuers of Guaranteed Securities Registered or Being Registered."

SEC Regulation S-X, Rule 13-02, "Affiliates Whose Securities Collateralize Securities Registered or Being Registered."

Rule 3-16 is retained for certain grandfathered securities. For more information, see Effective Date and Transition.

SEC Proposed Rule Release No. 33-10526, Financial Disclosures About Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant’s Securities.

Exceptions also apply to subsidiaries that co-issue, rather than guarantee, securities issued by their parent company.

Existing Rule 3-10 defines an operating subsidiary as a subsidiary that is not a finance subsidiary, and it defines a finance subsidiary as a subsidiary that “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.” The final rule largely aligns the definition of a finance subsidiary with that in existing Rule 3-10 and removes the definition of an operating subsidiary.

Rule 3-10 (h)(1) states that a “subsidiary is ‘100% owned’ if all of its outstanding voting shares are owned, either directly or indirectly, by its parent company. A subsidiary not in corporate form is 100% owned if the sum of all interests are owned, either directly or indirectly, by its parent company other than:

(i) Securities that are guaranteed by its parent and, if applicable, other 100%-owned subsidiaries of its parent; and

(ii) Securities that guarantee securities issued by its parent and, if applicable, other 100%-owned subsidiaries of its parent.”

Rule 3-10(h)(2) states that a “guarantee is ‘full and unconditional,’ if, when an issuer of a guaranteed security has failed to make a scheduled payment, the guarantor is obligated to make the scheduled payment immediately and, if it doesn’t, any holder of the guaranteed security may immediately bring suit directly against the guarantor for payment of all amounts due and payable.”

See footnote 10.

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 3 percent of the corresponding consolidated amount.

Nonguarantor subsidiaries are minor when their total assets, stockholders’ equity, revenues, income from continuing operations, and cash flows from operating activities, individually and in the aggregate, are less than 3 percent of the parent company’s consolidated totals.

See footnote 10.

SEC Regulation S-X, Rule 10-01, “Interim Financial Statements.”

The basis of accounting used to present the financial information is the same as the SEC registrant’s, except that investments in subsidiaries are accounted for under the equity method rather than consolidated.

See SEC Regulation S-X, Rule 1-02(bb), “Definitions of Terms Used in Regulation S-X (17 CFR Part 210): Summarized Financial Information.”

Reporting obligations may be suspended under Section 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) or Exchange Act Rule 12h-3. For example, an entity may be eligible for suspension of its reporting obligation if, after the fiscal year of initial issuance, the securities of each class to which the registration is related are held of record by fewer than 300 persons at the beginning of the year.

The financial statements are required to be audited by a registered public accounting firm in accordance with the standards of the PCAOB.

The determination of whether a business has been acquired would be made in accordance with the definition of a business in SEC Regulation S-X, Rule 11-01(d).

SEC Regulation S-X, Rule 3-05, “Financial Statements of Businesses Acquired or to Be Acquired.”

Rule 3-16(b) states that “securities of a person shall be 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 percent or more of the principal amount of the secured class of securities” (emphasis added).

Registrants may omit the summarized financial information and related disclosures if (1) the “assets, liabilities and results of operations of the combined affiliates whose securities are pledged as collateral are not materially different than the corresponding amounts presented in the consolidated financial statements of the registrant” or (2) the “combined affiliates whose securities are pledged as collateral have no material assets, liabilities or results of operations.”

Unlike that which is presented for Rule 13-01, summarized financial information presented for Rule 13-02 would include an affiliate’s investment in another subsidiary even if that subsidiary does not collateralize the offering.

Historically, separate financial statements for affiliates that collateralize securities have not been required for Form 10-Q. However, the final rule requires the summarized financial information and nonfinancial disclosure in interim filings on Form 10-Q.

SEC Proposed Rule Release No. 33-10635, Amendments to Financial Disclosures About Acquired and Disposed Businesses.

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