INSIGHTS. The Corporate & Securities Law Advisor. Compensatory Equity Offerings. Mid-Year Enforcement Update. Public Offerings of Guaranteed Debt

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1 INSIGHTS The Corporate & Securities Law Advisor VOLUME 32, NUMBER 9, SEPTEMBER 2018 Compensatory Equity Offerings Page 3 Mid-Year Enforcement Update Page 6 ROBERT B. ROBBINS, CINDY V. SCHLAEFER, SUSAN P. SEROTA, and JESSICA LUTRIN of Pillsbury Winthrop Shaw Pittman LLP examine SEC amendments to Rule 701, which exempt offerings of securities under compensation plans by non-reporting issuers, and the SEC s issuance of a concept release on simplifying and modernizing the rule. MARC J. FAGEL of Gibson, Dunn & Crutcher LLP provides an update on significant enforcement actions in the first half of 2018, including those involving financial fraud, insider trading, and investment advisers. Public Offerings of Guaranteed Debt Page 21 MICHAEL FRIEDMAN of Pepper Hamilton LLP discusses proposed amendments to the SEC s financial disclosure requirements for the guarantors and issuers of guaranteed securities that are to be registered for public offering. DEPARTMENTS 27 IN THE COURTS Contractual consent rights 31 STATE CORNER Validation of defective acts in Delaware 36 CLIENT MEMOS Valuable, practical advice

2 2 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER 2018 INSIGHTS The Corporate & Securities Law Advisor Editor-in-Chief AMY L. GOODMAN (phone) EDITORIAL ADVISORY BOARD KENNETH J. BIALKIN Skadden, Arps, Slate, Meagher & Flom, LLP, DENNIS J. BLOCK Greenberg Traurig, FAITH COLISH Carter Ledyard & Milburn LLP, ARTHUR FLEISCHER JR. Fried, Frank, Harris, Shriver & Jacobson, LLP, JAMES C. FREUND Skadden, Arps, Slate, Meagher & Flom, LLP, EDWARD F. GREENE Cleary Gottlieb Steen & Hamilton LLP, KARL A. GROSKAUFMANIS Fried, Frank, Harris, Shriver & Jacobson, LLP, Washington, DC JOHN J. HUBER FTI Consulting, Inc., Washington, DC STANLEY KELLER Locke Lord LLP, Boston, MA DONALD C. LANGEVOORT Professor, Georgetown Law Center, Washington, DC JOHN M. LIFTIN General Counsel The D.E. Shaw Group, GARY G. LYNCH Bank of America Merrill BRUCE ALAN MANN Morrison & Foerster, LLP, San Francisco, CA JOHN F. OLSON Gibson, Dunn & Crutcher LLP, Washington, DC JEAN GLEASON STROMBERG Washington, DC HERBERT WANDER KattenMuchinRosenman LLP, Chicago, IL JOHN MARK ZEBERKIEWICZ Richards, Layton & Finger, P.A., Wilmington, DE EDITORIAL OFFICE 76 Ninth Avenue Wolters Kluwer Richard Rubin, Publisher Kathleen Brady, Managing Editor INSIGHTS (ISSN No ) is published monthly for a subscription rate of $1,199/1 year; $150/Single Issue by Wolters Kluwer, 76 Ninth Avenue, POSTMASTER: Send address changes to INSIGHTS, 7201 McKinney Circle, Frederick, MD To subscribe, call For customer service, call For article reprints and reprint quotes contact Wrights Media at or go to This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other professional assistance is required, the services of a competent professional person should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations.

3 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER SECURITIES REGISTRATION Public Offerings of Guaranteed Debt and the SEC s Proposed Rule Changes The SEC treats guarantees of securities as securities separate from the securities guaranteed. It now has proposed amendments to the financial disclosure requirements for the guarantors and issuers of guaranteed securities. By Michael H. Friedman On July 24, 2018, the Securities and Exchange Commission (SEC) proposed amendments to its financial disclosure requirements for guarantors and issuers of guaranteed securities that are to be registered for public offering. 1 The SEC intends for its proposed changes: (1) to promote transparent disclosure of material information regarding the guaranteed securities without unnecessary and distracting complexity, and (2) to reduce costs of compliance with current SEC requirements. Through the proposed amendments, the SEC seeks to encourage companies choosing between (a) a public offering, with the greater liquidity afforded securities issued in such offerings and the lower capital costs associated with the greater liquidity, and (b) a private capital raise to choose the public offering alternative, thereby affording investors the enhanced protections of registration under the Securities Act of 1933 (Securities Act). In short, the proposed amendments seek to enhance disclosures in registered offerings; reduce compliance costs of registered offerings and thereby enable issuers to capture the reduced capital costs from registered offerings; and extend to investors the greater protections of registered offerings. Both the current SEC rules and the proposed amendments proceed from the general requirement Michael H. Friedman is a partner at Pepper Hamilton LLP. that every issuer of a registered security that is guaranteed, and every guarantor of the registered security, must file financial statements specified in Regulation S-X. As a result of this general requirement, each of the issuer and guarantor(s) also would have ongoing reporting obligations under the Securities Exchange Act of 1934 (Exchange Act). The rules, however, contain conditional exceptions to the general requirement, and if one of these exceptions is met, then the financial statements otherwise required may be simplified and the ongoing reporting requirements under the Exchange Act may be eliminated or reduced. What the proposed amendments would do, in essence, is, first, to relax certain of the conditions that must be met for an issuer to qualify for an exception and, second, to simplify the financial information that an issuer relying on an exception must prepare and disclose. Guarantee as Separate Security The SEC treats guarantees of securities as securities separate from the securities guaranteed. This treatment of guarantees as separate securities comports with the economic reality that an investor in a debt or debt-like security is relying, solely or partially, on the creditworthiness of the guarantor. In recognition of such reliance, SEC rules require, in the absence of an exemption, registration under the Securities Act of the offer and sale of both the security guaranteed and the guaranty itself, and, as part of such registration, disclosure of financial information about both the issuer of the guaranteed security and the guarantor. The common sense underlying the separate security analysis can easily be seen in the case where an issuer with marginal net worth and marginal free-standing financial prospects obtains 2018 CCH Incorporated and its affiliates. All rights reserved.

4 22 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER 2018 a guarantee of its securities from another (perhaps affiliated) entity with a mint chip balance sheet. Surely, investors will be pricing their investment in the offered securities on the full or partial strength of the guarantor and will want, and be entitled to, information on the guarantor. After all, in substance, the investment is, in whole or part, in the creditworthiness of the guarantor. Parent Guarantees; Subsidiary Guarantees Guaranteed securities can take many forms and involve multiple guarantors, who may or may not be affiliated with each other. The focus of this article is on those debt and debt-like securities that are guaranteed by one or more members of the same consolidated group. One reason for this focus is that most guaranteed debt securities involve the credit of a parent and one or more of its direct or indirect subsidiaries, each of which generally is part of the same consolidated group for financial statement purposes. 2 A parent holding company or parent operating company may be the issuer of debt securities, with guarantees provided by one or more subsidiaries. Or a subsidiary may itself be the issuer of debt securities, with guarantees provided by the parent and/or by one or more other subsidiaries. The subsidiaries may or may not be wholly-owned. A related reason for this focus is the SEC s view that [T]he consolidated financial statements of the parent company are the principle source of information for investors when evaluating the debt security and guarantee together. This principle is grounded in the idea that the investment is in the consolidated enterprise when: (1) the parent company is fully obligated as either issuer or full and unconditional guarantor of the security; (2) the parent company controls each subsidiary issuer and guarantor, including having the ability to direct all debt-paying activities; and (3) the financial information of each issuer and guarantor is included as part of the consolidated financial statements of the parent company. 3 Before turning to the details of the rules, and proposed amendments, we address general considerations in the design of the preferred debt security. Designing the Securities Package Step one. In the first instance, business considerations will inform the preferred design of the security to be offered. These business considerations will include features that generally do not raise nuanced legal or financial statement issues, such as the preferred maturity date(s); whether to include mandatory and optional redemption, defeasance and sinking fund provisions; convertibility and exchangeability features; and the like. Business considerations also include the benefits and detriments of secured versus unsecured debt, a subject that implicates various rules, including Rule 3-16 of Regulation S-X relating to financial statements of affiliates whose securities collateralize the securities being registered. A key consideration for any company with subsidiaries is which entity within the consolidated group will be the issuer and which entities, if any, will be guarantors. If there are to be guarantees, will the guarantors be permanently committed on their guarantees for the life of the guaranteed debt, or may the guarantors be released if they are sold or spun-off? At this stage, the considerations will be informed by many factors, including views of rating agencies; the parent company s desire to preserve operating and financing flexibility for the consolidated group; and general debtor-creditor issues, such as structural subordination concerns 4 and fraudulent conveyance concerns with upstream guarantees. In short, in the first instance, the preferred design will be the one that entails the lowest interest rate; fits effectively into the issuer s laddering of maturities dates for its debt service obligations; and preserves operating, investing and financing flexibility for the consolidated group. Step two. As the team is developing its working view of the preferred design, the legal and accounting

5 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER members will be vetting design details for feasibility from various vantage points, including in light of applicable financial statement and ongoing reporting requirements. 5 If these requirements would be unduly costly or burdensome, then modifications to the preferred design will need to be made until the selected design accommodates the financial statement and reporting requirements. Step three. At this stage, the team, having determined the design of the guaranteed debt, including the identity of the issuer of the debt and of each of the guarantors of the debt, should have clarity on the following: The form for the registration under the Securities Act of the offer and sale of the guaranteed security and of the guarantee(s). The financial statement, and other disclosure requirements, for each of the issuers of the separate securities to be covered by the registration statement. The ongoing reporting obligations of each of the issuers of the separate securities under the Exchange Act as the result of the registration of the separate securities under the Securities Act. An Overview of Rule 3-10 Rule 3-10(a)(1) of Regulation S-X states the general rule that every issuer of a registered security that is guaranteed, and every guarantor of the registered security, must file specified financial statements. This general rule is subject to five exceptions. If the conditions to an exception is met, then not only will the separate financial statements specified by Rule 3-10 not be required, but, under Rule 12h-5 promulgated under the Exchange Act, the issuer of the guaranteed security or the guarantor that is permitted by an exception to omit financial statements will be exempt from the reporting requirements under Section 13(a) or 15(d) of the Exchange Act. Accordingly, the benefits of qualifying for an exception to the financial statement requirements in Rule 3-10 include both the cost and time savings from not needing to prepare the financial statements that are permitted to be omitted by Rule 3-10 and the relief under Rule 12h-5 from the post-offering reporting requirements under the Exchange Act. 6 The relief afforded by the exceptions in Rule 3-10 should apply only if the creditor-group within the consolidated group is tightly bound together on the guaranteed debt. Currently, the three primary requirements to fit within any of the five exceptions are that (1) the parent company has filed consolidated financial statements; (2) each of the subsidiary issuer and subsidiary guarantor(s) are 100 percent owned (directly or indirectly) by the parent company; and (3) each guarantee is full and unconditional and, if there are multiple guarantees, the guarantees are joint and several. These key terms 100 percent owned and full and unconditional are defined in Rule 3-10(h) and the stringency in the definitions comports with the notion that the relief afforded by the exceptions in Rule 3-10 should apply only if the creditor-group within the consolidated group is tightly bound together on the guaranteed debt. For example, if a guarantor has non-controlling (minority) interests, then these third party interest may be an obstacle to advances under the guaranty and, in any event, under the current rules, these interests will preclude availability of a Rule 3-10 exception for a guaranty by the non-wholly-owned subsidiary. 7 Similarly, if the obligations of a guarantor under its guarantee are triggered only after a creditor has exhausted its collection efforts against the issuer, then the guarantee is not full and unconditional and a Rule 3-10 exception will be unavailable. The key is for the payment obligations of the issuer and each guarantor to be essentially identical and for the risks associated with an investment in the issuer and each guarantor to be essentially identical. The five exceptions in Rule 3-10 are for the following structures: 2018 CCH Incorporated and its affiliates. All rights reserved.

6 24 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER 2018 A finance subsidiary issues securities guaranteed by its parent; An operating subsidiary issues securities guaranteed by its parent; A subsidiary issues securities guaranteed by its parent and one or more other 100 percent owned subsidiaries of the parent; A parent issues securities guaranteed by a single 100 percent owned subsidiary; A parent issues securities guaranteed, jointly and severally, by multiple 100 percent owned subsidiaries. Eligibility to omit financial statements of a subsidiary issuer or guarantor under one of the five structures is conditioned on the provision of specified information, referred to as Alternative Disclosures. Although the form and content of Alternative Disclosures depends on the selected structure and circumstances, commonly the Alternative Disclosures include provision for condensed consolidating financial information for the applicable subsidiaries. Consolidating information consists of detailed financial information of all major captions in the financial statements and is presented in columnar form for each category of parent and subsidiaries as issuer, co-issuers, guarantors and non-guarantors. The objective is to clearly present to investors those assets, liabilities and cash flows that are obligated on the debt securities and those that are not. Given the complexity of many corporate structures, the preparation of condensed consolidating financial information has often proved to be unduly burdensome, and has been a notable reason why many issuers have opted to issue guaranteed debt securities under Rule 144A or through another plan of distribution exempt from registration under the Securities Act. 8 Proposed Amendments to Rule 3-10 The proposed amendments to Rule 3-10 continue to adhere to the core view that investors in guaranteed debt securities rely primarily on the consolidated financial statements of the parent company. However, in notable respects, the proposed rules would relax conditions to omission of financial statements. The proposed amendments would, among other matters: replace the condition that a subsidiary issuer or guarantor be 100 percent owned, directly or indirectly, by the parent company with a condition that subsidiary be consolidated in the parent company s consolidated financial statements; retain the requirement that the parent either be the issuer or provide a full and unconditional guaranty but permit a subsidiary guaranty not to be full and unconditional or joint and several subject to required disclosure of the terms and conditions of such limitations; expand the qualitative disclosures about the guarantees, the issuers and guarantors, such as by describing factors that may affect payment to holders of the guaranteed security (e.g., contractual or statutory restrictions on dividends; limitations on guarantee enforceability; or the rights of a non-controlling interest holder to limit payments on a guaranty); 9 replace detailed condensed consolidating financial information with summarized financial information presented on a combined basis; shorten the period for which such information is required; and eliminate the requirement for separate disclosure of financial information of subsidiaries that are not guarantors; permit the required disclosures to be provided in the MD&A rather than in the notes to the consolidated financial statements in the registration statement covering the offer and sale of the subject securities and thereafter in notes to the financial statements included in Forms 10-K and 10-Q; 10 require that the proposed required disclosures be included in the footnotes to the parent company s consolidated financial statements for annual and quarterly reports beginning with the annual report for the fiscal year during which the first bona fide sale of the subject securities is completed; eliminate the requirement to provide preacquisition financial statements of recently-

7 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER acquired subsidiary issuers and guarantors subject to provision of information about recentlyacquired subsidiary issuers and guarantors if material; and require the proposed required disclosures for as long as the issuers and guarantors have an Exchange Act reporting obligation with respect to the guaranteed securities rather than for so long as the guaranteed securities are outstanding. The SEC has prepared a useful side-by-side comparison of the existing and proposed rules in a chart that appears at the end of the Proposed Rule. Form S-3 Eligibility Generally, companies accessing the public debt markets will want to use a shelf registration statement on Form S-3 because of the speed for takes downs off an effective shelf registration and because of the evergreen-aspect to maintaining the currency of a Form S-3 by virtue of forward-incorporation by reference permitted by a Form S-3. This raises the question as to which issuers, including guarantors, are eligible to use Form S-3. A subsidiary itself may be eligible to use a Form S-3. For example, the subsidiary may have voluntarily filed a Form 10 to register a class of equity under the Exchange Act and may have issued at least $1 billion in non-convertible debt securities during the past three years on a Form S-1. Or the subsidiary may be a majority-owned operating partnership of a REIT that qualifies as a well-known seasoned issuer. Even if a single subsidiary is eligible to use a Form S-3, it would be the rare case indeed for multiple subsidiary guarantors to each meet the eligibility requirements. However, the rules permit majority-owned subsidiaries to join in a parent company s Form S-3 (for example, through registration of guarantees) if the subject securities are non-convertible securities, other than into common equity, and the transaction takes one of several specified forms. One of the specified forms is for subsidiary guarantees either of parent debt or of another subsidiary s debt where the parent provides a full and unconditional guaranty. 11 Trust Indenture Act of 1939 A guarantor is an obligor under the Trust Indenture Act pursuant to Section 303(12). Generally, the key issue that arises under the Trust Indenture Act with respect to guarantees relate to mechanisms under the indenture for adding and removing guarantors. In interpretive guidance, the SEC has stated that: A supplemental indenture providing for the substitution of a new obligor need not be qualified under the Trust Indenture Act if the substitution takes place pursuant to a provision of the old indenture and is not subject to the approval or consent of security holders. If approval by debt holders must be solicited, the sale of a new security is deemed to occur and therefore, a Securities Act registration statement should be filed and the indenture under which the new security is to be issued must be qualified. 12 Accordingly, it is important to address expressly in the indenture the mechanism for adding and removing guarantors. Conclusion With the potential relaxation in SEC rules governing financial information of guarantors of debt securities, we can expect that many public companies that have stayed away from the public market for their debt securities will revisit the benefits of public debt offerings if the proposed rules take effect substantially as proposed. Notes 1. Release No Financial Disclosures About Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant s Securities. Hereafter, the Proposed Rule. 2. A notable exception is in the area of municipal finance, where bonds of state and local governments or public 2018 CCH Incorporated and its affiliates. All rights reserved.

8 26 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER 2018 instrumentalities are backed by bank letters of credit or bond insurance. The separate securities analysis applies to such credit support. However, Section 3(a)(2) of the Securities Act exempts from registration such governmental bonds and a similar exemption under Section 3(a)(2) is available for bank letters of credit and bond insurance. See also Rule 131 under the Securities Act for treatment of separate securities in conduit financings through governmental instrumentalities. 3. Proposed Rule. 4. Structural subordination refers to the fact that claims of creditors of a parent to assets of subsidiaries of the parent are subordinated to claims of direct creditors of the subsidiaries because the creditors of the parent must claim through the parent and the parent, as a mere equity holder of the subsidiaries, is junior in bankruptcy proceedings to claims of direct creditors of the subsidiaries. A common technique to avoid structural subordination is for the subsidiaries to guarantee the parent debt and thereby make the claims of creditors of the parent pari passu with (rather than subordinate to) claims of unsecured creditors of the subsidiaries. Another technique is for the indenture or agreement under which the parent company debt is issued to restrict the right of subsidiaries whose assets will be included in the credit pool from incurring debt, at least absent concurrent guarantees by any such subsidiaries of the parent debt. 5. As discussed below, the team will also want to assess the relevance of the Trust Indenture Act of 1939, particularly insofar as this statute bears on the mechanism by which guarantors can be released or added to the debt securities while such securities remain outstanding. 6. A subsidiary issuer or guarantor that initially meets the requirements in Rule 3-10 for omission of financial statements but subsequently ceases to meet such requirements must commence to file separate reports that contain financial statements under the Exchange Act. 7. A subsidiary in corporate form may qualify as 100 percent owned if all of its voting shares are owned, directly or indirectly, by the parent. See Rule 3-10(h)(1). 8. The Proposed Rule expressly notes that the existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups and may impose undue compliance burdens.... More broadly, the volume of Consolidating Information and level of detail required can undermine [transparent and clear disclosure of material information free of distracting detail. 9. For example, if a non-wholly-owned subsidiary were to guaranty parent company debt, then the operating agreement or partnership agreement of the subsidiary might restrict distributions on the subsidiary s equity without the consent of the holders of the outside interests. Similarly, an upstream subsidiary guaranty of a parent s debt may be vulnerable to a fraudulent conveyance attack if the subsidiary did not receive adequate consideration from the parent for its guaranty. 10. Alternatively, the issuer could include the required disclosures in the prospectus immediately following the Risk Factors section or, in the absence of a Risk Factors section, immediately following pricing information. The Proposed Rule addresses trade-offs associated with the location of the required disclosure. 11. See General Instructions I.B and I.C of Form S Question of Compliance and Disclosure Interpretations under the Trust Indenture Act of 1939.

9 40 INSIGHTS VOLUME 32, NUMBER 9, SEPTEMBER 2018 To subscribe, call or order online at Ordering Additional Copies of INSIGHTS Get multiple copies at a terrific discount and have the most up-to-date information available at your fingertips. Discount Schedule = 20% = 30% = 40% = 47% September / Wolters Kluwer Law & Business US connects legal and business communities with timely, specialized expertise and information-enabled solutions to support productivity, accuracy and mobility. Serving customers worldwide, our products include those under the Aspen, CCH, ftwilliam, Kluwer Law International, MediRegs, and TAGData names.