ABA Section of Business Law
ABA Section of Business Law
Business Law Today
November/December 1999
Legal-ease
Parents, subsidiaries, guaranties
By Howard Darmstadter
Recently, I was involved in writing two "plain English" prospectuses under the shelf-registration rules. The experience got me thinking about how the modern shelf-registration prospectus obtained its awkward shape.
A shelf-registration prospectus consists of two parts, commonly labeled the prospectus and the prospectus supplement. The prospectus gives general background information about the issuer and the securities. It is preceded by the supplement, which describes the particular securities being issued — the amount, interest rate, maturity, underwriters, etc.
Suppose you register $10 billion of bonds. You can then issue $1 billion in January with a 5 percent interest rate and a 10-year maturity, and another $800 million in February with a 15-year maturity and a 6 percent coupon. The prospectuses for the two issuances will be identical, but the supplements will vary to take account of the different terms of the bonds.
Breaking the document in two has produced confusion about the relation of the pieces. To start with, the prospectus/supplement terminology does not square with the Securities Act or the rules. "Prospectus" is a statutory term that refers to the entire document consisting of the prospectus supplement and the so-called "prospectus," which I’ll now call the "core prospectus."
I suspect that the misuse of "prospectus" goes back to the early days of shelf registration. In bygone times, registrants would only file the core prospectus with the registration statement. That made sense, because a form of supplement would be a slender document consisting almost entirely of blanks. Consequently, calling the only thing that was filed the "prospectus" must have seemed unavoidable.
If your registration statement contains only a core prospectus, it makes sense to give the cover page of the core the full treatment the rules require for the cover page of a prospectus. That may explain why today the "cover" of a core prospectus, 44 pages deep in a prospectus, will sport the legends and other rigmarole that regulation S-K prescribes for a cover page.
The SEC no longer lets you file a core prospectus without a prospectus supplement, for good reason. Evolution in the securities markets has produced all sorts of securities whose specific terms can’t be described in less than several dozen pages. There is no way an SEC reviewer can understand these securities without seeing at least a mock-up of the prospectus supplement.
In the prospectuses I worked on, we tried to clarify the relation of the core and the supplement right at the beginning: Immediately before or after the table of contents, we have a "How to read this prospectus" section, which explains that:
• the prospectus consists of a prospectus supplement followed by a core prospectus,
• the core gives general background information while the supplement gives specific information about the securities being offered, and
• the supplement may modify the information in the core.
This last point enabled us to drop most of the "Except as otherwise stated in the prospectus supplement …" language that normally runs wild through the core prospectus.
We also dropped most of the statements in the core that such-and-such "will be explained in the applicable supplement." What is an investor to make of such a statement? For investors, there’s only one supplement — the one they’re holding in their hands — and they don’t have to wait for it.
Most of this language comes from an understandable tendency of prospectus drafters to adopt the perspective of the SEC reviewer rather than the perspective of the investor. (Self-preservation, said Thomas Hobbes, is the first law of nature.) From the reviewer’s perspective, a core prospectus is a document that will (future tense) be attached to many different supplements. But from the investor’s perspective, the core prospectus is presently firmly attached to one and only one prospectus supplement.
An investor, for example, does not have to be told in the core prospectus that the securities will be offered in a firm underwriting or a best efforts underwriting or a private placement. The prospectus supplement describes the particular mode of distribution; the various ways in which the securities are not distributed are of no interest to the investor. For the investor, it’s clutter, but you can understand why an SEC reviewer would want to see it.
A core prospectus isn’t expected to change with every issuance (or "takedown," as I’m learning to say), so there’s a premium on having one-size-fits-all sections. But these sections are likely to contain lots of material that is of no value to an investor in the particular series described in the supplement.
My mortgage-backed securities core prospectus, for example, has a long section describing the legal difficulties in foreclosing on a mortgage loan, enforcing a due-on-sale clause or otherwise attempting to exercise contractual remedies in the seven states where most of our mortgaged properties are located. OK, said I, why don’t we take the discussion of the individual state’s laws out of the core? In any issuance, we can include in the supplement a discussion of only those states where there are a material number of mortgages.
Great idea, kid! said everyone, but ... no one is going to want to play around with the supplement at the last minute. Least of all, I had to admit, me. So our prospectus for securities backed solely by California mortgages still contains pages of information about how you foreclose a mortgage in the Nutmeg State, the Sunshine State, the Empire State, the Garden State, the Chicago State and the Great State of Texas.
We did, however, manage to place seven pages of information on adjustable rate mortgages (ARMs in the biz), buydown loans and agency certificates — stuff that we’re unlikely to securitize — in an appendix. The core states that "if a series does not contain a material amount of ARMs, buydown loans or agency certificates, the appendix may be omitted." And we’ve omitted it ever since. It’ll be there in the unlikely event that we need it, and it’s not there when it’s not needed.
Cost and timing considerations may explain another oddity. The supplement invariably has its own page numbering system, S-1 to S-whatever. It would be more convenient for the reader to have a uniform numbering system for the whole prospectus, but that would require rejiggering the core’s pagination for each takedown of securities.
The core invariably carries its own date, which can be earlier than the supplement’s date. This provides a succinct explanation of why the supplement can conflict with and override an earlier core, but should provide little additional comfort. If the core is correct as of its date but materially incorrect at the date of the prospectus, you’d better make sure the supplement supplies the correction. If there’s been a major development, cautious lawyers will want to revise the core.
Prospectuses contain lots of defined terms. It’s common for the core and the supplement to each contain its own index of defined terms. That’s inconvenient, since the normal expectation is that an index will be at the end. Moreover, it’s hard to find the supplement’s index, which is at the end of the supplement — that is, in the middle of the document. The obvious solution is to have a single index of defined terms at the end of the document, just as you (now) have a single table of contents at the front.
At least you should have a table of contents at the front. Section 502 of regulation S-K says that you must "… on either the inside front or outside back cover page of the prospectus, provide a reasonably detailed table of contents." Nonetheless, I still see shelf-registration prospectuses where the table of contents at the front is only for the supplement; deep in the document, there’s another table of contents for the core. I think this practice also goes back to the days when only the core was filed with the registration statement, but I can’t see how splitting the table of contents in this way complies with today’s rules. On the other hand, plain English is also a rule (421, in case you missed it), and I still see many prospectuses that are a long way from compliance.
Darmstadter is an assistant general counsel at Citigroup in New York City. You can e-mail him at darmstadte@citi.com.
Author’s note: This column is the first of a series — four, maybe — on the SEC’s plain English rule. My next column will deal with the SEC’s war on parentheticals.
