Financing Subsidiaries and SEC Registration

As readers of this publication know, in order to address the expected new U.S. regulatory capital requirements, a number of U.S. bank holding companies have been creating new finance company subsidiaries. This article discusses a variety of SEC rules and regulations that simplify the registration process for using these entities, as well as certain limitations.

Using the Parent Company's Registration Statement. Under General Instruction I.C of SEC Form S-3, a wholly owned subsidiary of an S-3 eligible company can utilize the parent company's short form shelf registration statement for primary offerings of investment grade securities. This provision enables these subsidiaries to take advantage of the parent company's reporting status for purposes of effecting a shelf registration. This will be the case whether or not the parent corporation is a "WKSI" or a "non-WKSI" (including a WKSI that has become an "ineligible issuer").

Separate Financial Statements? Regulation S-X governs the financial statement requirements for registration statements and for periodic reports. Under Rule 3-10 of Regulation S-X, separate financial statements for a subsidiary with a parent guarantee are not required to be set forth in a registration statement if (a) that subsidiary is 100% owned (whether directly or indirectly) by the parent corporation, and if (b) the securities issued by the subsidiary are "fully and unconditionally" guaranteed by the parent corporation. Rule 3-10, as amended in 2000, builds upon some of the SEC's prior no-action guidance.

The SEC reached this position due to its reasoning:

"...if a finance subsidiary issues debt securities guaranteed by its parent company, full disclosure of the finance subsidiary's financial information would be of little value. Instead, investors would look to the financial status of the parent company that guaranteed the debt to evaluate the likelihood of payment."

What Is a Finance Subsidiary? A subsidiary will be 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." If this condition is satisfied, then no financial information about it will be required in the parent company's financial statements. The parent company's financial statements must include a footnote stating that this entity is a 100%-owned finance subsidiary of the parent company and that the parent company has fully and unconditionally guaranteed the securities.

New Form 10-K and Form 10-Q Requirements? When creating a new SEC registrant, the "sponsor" will of course ask whether or not it is creating a burdensome and potentially expensive ongoing disclosure obligation under the Exchange Act. However, this need not be the case—under Rule 12h-5 under the Exchange Act, these financing subsidiaries are not required to file separate periodic reports.

What Is a Full and Unconditional Guarantee? Under Rule 3-10, for a guarantee to be deemed "unconditional," when an issuer of a guaranteed security fails 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.

However, under the rules, a guarantee will not be "full and unconditional" if it is not operative until some time after default. For example, a subsidiary guarantee would not satisfy this condition if the debt holder must first proceed against the parent issuer, and then only proceed against the subsidiary if a certain amount of time has passed without payment.

Cover Page Disclosures for Structured Notes

Overview

We conducted an informal analysis about cover page disclosures for structured notes. We looked at the pricing supplements for offerings from two different issuers that each had a fairly common structure:

  • index-linked.
  • 3x upside to a cap.
  • 1-1 downside.
  • No interest payments.

One pricing supplement expressed this structure with 1,133 words on the cover page. The other, did so with only 424 words.

Industry participants would read these cover pages and quickly realize how similar these two products are. But if a retail investor had each pricing supplement in hand, that investor might not realize so quickly how similar these offerings are. At least at a superficial level, these two offerings might seem somewhat different.

Of course, this quick study simply reveals what readers of this publication already know: disclosure documents and styles can vary significantly from issuer to issuer, and underwriter to underwriter. But what are the actual requirements of a structured note cover page? This article attempts to discuss that question.

Regulation S-K

Of course, in the context of a registered public offering, we look first to Regulation S-K under the Securities Act of 1933 to tell us the black letter law of cover page disclosures. These requirements are set forth in Item 501(b). The cover page must:

  • set forth the issuer's name;
  • set forth the title of the securities,1 and the amount being offered;
  • provide a brief description of the terms of the securities;
  • set forth the public offering price2 and the underwriting discount;
  • indicate whether the securities will be listed on a stock exchange, providing the trading symbol (if applicable);
  • set forth a cross-reference to the risk factors section;
  • set forth a legend that the SEC has not approved of the securities or the offering;
  • identify the underwriters,3 and, if the offering is not a "firm commitment underwriting", describe the nature of the plan of distribution; and
  • set forth the date of the prospectus.

Item 501(b) requires the cover page to be limited to just that—the cover page. Of course, this can be a bit of a challenge in the case of complex products or complex underliers.

The SEC Weighs In

As you know, the SEC has taken an active interest in cover page disclosures. As a result of the SEC's 2012 sweep letter and its aftermath, pricing supplement cover pages for structured notes now include:

  • estimated value disclosures.
  • a reminder that payments on the notes are subject to issuer credit risk.

In addition, where the issuer is a bank holding company (and not a bank), the SEC has historically encouraged issuers to remind investors that these debt securities are not bank deposits, and are not insured by the FDIC.

FINRA Corporate Financing Rule

One additional small requirement emanates from the FINRA rules. Where the underwriter is affiliated with the issuer, in order to obtain the exemption from FINRA filing for investment grade securities, the cover page of the offering documents for a non-registered offering must indicate that the conflict exists, and cross-reference the "Conflicts of Interest" subsection of the "Plan of Distribution" section. (FINRA Rule 5121(a).) Many registered offerings follow this approach as well (in addition to the separate, but related, "table of contents" requirement that does apply under the FINRA rules to registered offerings).

Additional Disclosures

In addition to the required disclosures, some market participants have added a variety of additional provisions to their cover pages:

  • suitability considerations;
  • key risk factors, particularly the potential loss of principal (for "non-principal protected" notes);
  • "structuring costs" and similar amounts; and
  • explanations of the compensation that "selected dealers" will receive from underwriters.

Regulatory capital changes in Europe (and expected ones in the U.S.) will potentially cause some types of structured notes to convert into equity securities in the event of a failure. This feature also has been added to cover pages.

Additional Marketing Materials?

Needless to say, different market participants have different views as to the best way to present all of the above information, and which of the "optional" information is best suited for a cover page. (The answer may depend upon the nature and sophistication of the investors.) That being said, the combination of regulatory requirements, and occasional

complexity of structured notes, often leads to cover pages that not everyone will agree are the optimal solution. Accordingly, many market participants also rely on additional marketing materials, such as term sheets and offering summaries, to help present information in the manner that they believe is most helpful.

To view the full report please click here.

Footnotes

1 Under the SEC's guidance, the name cannot be misleading. For example, "debt securities" should not be described as "shares." And as readers of this publication know, the term "principal protected" in a title is somewhat problematic. 

2 Which is usually par for structured notes, unless there is a "bulk discount" or a lower price for advised accounts.

3 "Selling group members" are not required to be specifically identified. They would often not wish to be identified, as doing so may increase the likelihood that they will be viewed as "statutory underwriters" for liability purposes 

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.

© Morrison & Foerster LLP. All rights reserved