In June 2005, the Securities and Exchange Commission adopted a series of new rules, commonly known as the securities offering reform, that significantly altered the securities registration and offering process. As a result of that reform, some offerings that once required months to complete can be consummated in just a few days—or even hours. That is particularly true of so-called "overnight" deals, which involve the sale of shares through an underwritten offering with no road show, and "bought" deals, in which underwriters purchase securities from the issuer prior to marketing securities to the public.
In this time-compressed deal-making environment, overnight and bought deals compel underwriters to move quickly through due diligence—putting them at increased risk for legal liability under Section 11(a) of the Securities Act of 1933.
Since the law does not consider timing constraints to be a legitimate defense, underwriters with a brief due diligence period must take appropriate steps to limit their liability. There are actions that underwriters can and should take—before and after the deal—to help establish the "due diligence" defense to Section 11(a) liability that is provided under Section 11(b).
Section 11 Liability and Defenses
Under Section 11(a), an underwriter is liable at law or in equity if any part of the registration statement "contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading…" In determining materiality, a court will not inquire into the underwriter's timing constraints, but will instead assess whether the statements, taken together and in context, would have misled a reasonable investor about the nature of the investment.
Section 11(b) provides two affirmative defenses to Section 11(a) liability: the expert defense and the non-expert defense, which are collectively known as the due diligence defense.
The expert defense provides that an underwriter who relies on any part of the registration statement that was purportedly produced on the authority of an expert is shielded from liability if the underwriter "had no reasonable ground to believe and did not believe…that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading…"
As a result of the existence of the expert defense, an unwary underwriter in the midst of a rapidly moving overnight or bought deal may believe the law allows for unlimited reliance on those portions of the registration statement that were drafted by an expert, such as the audited financial statements. The expert defense, however, is often as much a trap as it is an affirmative defense. Recent judicial decisions, including those in the WorldCom securities litigation, emphasize that underwriters may not blindly rely on audited financial statements or other expertized information in the face of red flags. In fact, in the WorldCom litigation, the court refused to grant the underwriters' motion to dismiss, which was brought on the basis that the underwriters properly relied on the audited financial statements.
The non-expert defense provides that an underwriter who relies on any part of the registration statement that was purportedly not made by an expert is shielded from liability if the underwriter "had, after reasonable investigation, reasonable ground to believe and did believe…that the statements therein were true and that there was no omission to state a material fact…" The reasonableness of an investigation is not captured by any bright-line rule; instead, Section 11(c) of the Securities Act notes that in determining what constitutes reasonable investigation and reasonable grounds to believe a statement is true, the standard of reasonableness to be used is "that required of a prudent man in the management of his own property."
Therefore, the amount of required investigation varies depending on the type of issuer and the type of security offered. For example, an underwriter should perform extensive diligence when reviewing an early-stage company undergoing an initial public offering, since the company has not yet been subjected to extensive Wall Street scrutiny. Likewise, if the securities to be offered are short-term notes or structured securities, the underwriter must carefully investigate the issuer's current economic results and short-term projections.
Limiting Your Exposure
As noted earlier, timing constraints experienced in overnight and bought deals—or in any follow-on offering with a compressed marketing time frame—are not a defense and do not lower the bar for establishing the due diligence defense. Therefore, when confronted with a brief period for diligence, it is important for an underwriter to act quickly and decisively to limit potential exposure and take advantage of the due diligence defense in the event something goes wrong. The following steps can help establish the defense in this context.
1. Continuously monitor your industry. As an underwriter, you should know the companies in your industry so you can react quickly when brought into a deal. Regularly review SEC filings, press releases and analyst reports of companies in your industry. Keep up with industry trends through trade journals. Attend investor relations meetings and industry conferences.
2. Identify red flags. Look into aggressive or unusual accounting practices that involve significant financial issues. Ask about recent changes in accounting policies or significant financial discrepancies between the issuer and its competitors. Pay attention to industry-wide downturns and heavy pressure to meet financial expectations.
3. Complete as much of the due diligence checklist as possible. Do not abandon a standard due diligence checklist in an overnight deal. Instead, focus on what can be accomplished quickly and what provides the greatest likelihood of turning up concerns. Review public filings, including exhibits and recent press releases, as well as minutes of all recent board and committee meetings. Verify key market data where cited in the prospectus. If there is a mission-critical contract—such as a key supply, distribution, licensing or credit agreement—make sure you understand the terms and verify that its importance is being accurately conveyed to investors.
4. Ask questions and make calls. Challenging questions provide some of the best evidence for the due diligence defense. Cursory inquiries and tacit reliance on management assertions are not sufficient. Verify the issuer's representations by interviewing major customers, distributors, suppliers and, in some cases, liquidity sources. Arrange and attend an auditor due diligence call, as well as a call with the audit committee chair.
5. Follow up promptly. If the investigation uncovers any irregular information, immediately follow up with the issuer, independent auditors or another appropriate party. For example, if other investment banks abandoned a past offering attempted by the issuer, investigate why the prior deal fell through.
6. Discuss the interim financials with management. Since interim financial statements are not expertized, they should be discussed extensively with management. Compare the issuer's financial outlook to that of its competitors and discuss industry-wide trends. Thoroughly review the "management's discussion and analysis" in the issuer's most recent quarterly filing and make sure the reasons for the issuer's financial performance and outlook are clearly understood by you—and are accurately conveyed in the offering disclosure.
7. Obtain comfort letters from the independent auditors. Keep in mind that comfort letters accompanying unaudited financial statements will not unilaterally relieve an underwriter from the duty to conduct a reasonable investigation. However, they are one factor in the reasonable investigation analysis. Always push for the maximum comfort possible under applicable accounting pronouncements, including permitted assurance with respect to completed monthly periods if the offering is mid-quarter.
8. Retain counsel quickly. Underwriters' counsel can perform a significant amount of due diligence while the deal is being put together. Due to high transaction volume, experienced underwriters' counsel may already have a deep understanding of industry trends and expectations. You should also request that underwriters' counsel document the diligence process during and following the offering so that you have a written record to produce should litigation arise.
9. Don't rely on the lead underwriter. Each underwriter has to establish its own due diligence defense. Since the lead underwriters typically have a different risk-reward ratio than other underwriters due to better economics, piggybacking may be unwise. An independent review, even if limited in scope, can provide significant protection to co-managers.
The key to limiting or avoiding liability in an overnight or bought deal is to act quickly and decisively. The clock is ticking, so it is important to make good use of all the available time—taking an approach that limits your liability and enables a due diligence defense in a worst-case scenario.