On March 2, 2020, the Securities and Exchange Commission (the “SEC”) released its final rule amending the financial disclosure requirements applicable to registered debt offerings that include credit enhancements, including subsidiary debt issuances with parent guarantees. The requirements for these offerings are currently contained in Rules 3-10 (guarantees) and 3-16 (collateralizations) of Regulation S-X. The rule amendments—which were originally proposed in July 2018 and garnered significant support, including from the National Association of Real Estate Investment Trusts (Nareit)—are aimed at improving disclosure, reducing SEC registration-related compliance burdens for issuers and providing investors with protections that would not be present in an unregistered offering according to the SEC.
Subject to designated exceptions, issuers and guarantors of publicly offered debt securities must each file their own audited and unaudited financial statements under the current disclosure requirements. In order to be eligible to omit its separate financial statements, each subsidiary issuer must be wholly-owned by the parent company and each guarantee must be “full and unconditional.” A parent company may then satisfy the financial statement requirements of Regulation S-X on behalf of its subsidiary issuers by including condensed consolidating financial information and/or certain alternate disclosures in the footnotes to its financial statements for as long as the guaranteed securities are outstanding, subject to certain conditions. Subsidiary issuers that are permitted to omit their separate financial statements under Rule 3-10 are also automatically exempt from the reporting requirement of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
Under the new rule, separate financial statements are not required if the subsidiary issuer is consolidated with the parent company (as opposed to wholly-owned), so long as the security is fully and unconditionally guaranteed by the parent company. The parent company must include certain designated disclosures required by the final rule (primarily in the nature of summarized financial information under Rule 1-02(bb) of Regulation S-X), which may be provided outside of the footnotes to the parent company’s consolidated financial statements. The amended non-financial disclosures, among other matters, also expand the qualitative disclosures about the subsidiary issuer. Consistent with the existing rule, additional information that would be material for investors to evaluate the sufficiency of a guarantee is also required. Disclosure will be required of any factors that may impact payments to the holder of the guaranteed security, such as the rights of a non-controlling interest holder.
The new rule will provide significant relief for many REITs, particularly REITs that use the umbrella partnership REIT (UPREIT) structure and rely on non-wholly-owned operating partnership subsidiaries to issue SEC-registered debt securities (see below for a typical UPREIT structure chart). In an UPREIT structure, the parent company REIT is a holding company whose sole asset is generally its interest in the operating partnership. Under Rule 3-10 as it stands today, REITs raising capital through operating partnership subsidiaries that are not wholly-owned frequently incur substantial costs to establish these operating partnerships as separate SEC-registered issuers subject to Exchange Act reporting obligations. The new amendments would permit a parent REIT to omit full financial statements of its operating partnership when the conditions described above are fulfilled, and are expected to alleviate the burden of separately establishing a REIT’s operating partnership subsidiary as an SEC registrant. Some UPREITs with non-wholly-owned operating partnerships have historically issued debt securities at the operating partnership level without a parent guarantee. We believe that under the new rule, these REITs could voluntarily add a parent guarantee to existing operating partnership subsidiary debt to eliminate the separate operating partnership reporting requirements. REITs exploring this alternative should confer with counsel and the lenders under their credit facilities. It is likely that most lenders would require a similar guarantee to be added to outstanding credit facilities to avoid any structural subordination issues. The new rule also eliminates the requirements that issuers furnish pre-acquisition financial statements of recently-acquired subsidiary issuers and guarantors, which is expected to further reduce the costs and burdens associated with issuing guaranteed securities. These measures will permit UPREITs to more efficiently and cost effectively access the capital markets.
The final rule will be effective on January 4, 2021, but issuers can take advantage of the benefits through voluntary compliance in advance of that date. After voluntary compliance, all subsequent Exchange Act reports must comply with the final rules.
Note: the new rule will have no practical impact for UPREITs where the operating partnership is directly or indirectly wholly-owned by the publicly-traded REIT.