The due diligence process from the underwriter's - Fried Frank

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THE DUE DILIGENCE PROCESS FROM
THE UNDERWRITER’S PERSPECTIVE
Valerie Ford Jacob
Fried, Frank, Harris, Shriver & Jacobson LLP
March 2008
Copyright © 2008 by Fried, Frank, Harris, Shriver
& Jacobson LLP. All rights reserved.
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Table of Contents
1. WHY DO UNDERWRITERS CONDUCT DUE DILIGENCE ...................... 5
2. THE DUE DILIGENCE DEFENESE UNDER U.S. LAW ............................. 5
3. WHEN IS THE DUE DILIGENCE PERFORMED ...................................... 8
4. WHAT ARE THE COMPONENTS OF THE DUE DILIGENCE
PROCESS ................................................................................................. 9
a. Background Due Diligence ........................................................ 10
b. Business Due Diligence ............................................................. 10
c. Financial Due Diligence ............................................................. 11
d. MD&A Due Diligence ................................................................. 13
e. Legal Due Diligence .................................................................. 14
f. Accounting Due Diligence ......................................................... 15
g. Backup ....................................................................................... 17
h. Backup vs. Verification .............................................................. 17
i. Corporate Governance/Sarbanes-Oxley Due Diligence ........... 18
j. Audit Committee Due Diligence ................................................ 19
5. SPECIAL CONSIDERATIONS FOR EUROPEAN DUE
DILIGENCE ...............................................................................................20
6. SEVERAL DUE DILIGENCE CONSIDERATIONS SPECIFICALLY
FOR DEBT OFFERINGS ..........................................................................20
7. WHY DO BANK-DEBT ARRANGERS CONDUCT DUE
DILIGENCE .............................................................................................20
a. Bank Debt Due Diligence Standards Differ From Underwriter
Standards .................................................................................. 21
8. WORLDCOM LITIGATION: CASE STUDY ON UNDERWRITER DUE
DILIGENCE ...............................................................................................22
9. CONCLUSION ...........................................................................................25
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1. WHY DO UNDERWRITERS CONDUCT DUE DILIGENCE
• There are six principal reasons why underwriters perform due
diligence:
• Due diligence will assist in understanding the company and
thereby help in drafting a more accurate prospectus or
offering document.
• During the due diligence process you may uncover negative
information about the company which may cause the deal to
be restructured, delayed or even, on occasion, pulled.
• The due diligence process may indicate that third party
consents or approvals are necessary in order to consummate
the transaction.
• Investors expect the underwriters or initial purchasers to have
conducted full due diligence and protection of the investment
bank’s institutional reputation requires that bankers do
thorough due diligence. Negative surprises after an offering is
completed reflect badly on the investment bank which
underwrote the deal.
• Liability in connection with the public offering of securities
can be imposed upon those accepting responsibility for the
prospectus. The prospectus is required by law to include and
truthfully represent all material information about the
company. In U.S. litigation involving allegations of
inaccurate disclosure in the U.S. prospectus, the underwriters
can assert due diligence as a defense to liability.
• Markets outside the United States may require analogous
procedures. For example, it is the U.K. practice to “verify”
each statement in the prospectus in part to protect against this
type of liability.
2. THE DUE DILIGENCE DEFENSE UNDER U.S. LAW
• Section 11 of the Securities Act of 1933 provides that any person
acquiring a security in an offering can sue specified defendants if
the disclosure in the prospectus is not accurate in a material respect.
• The statute provides that the defendants in any such suit may
include the underwriters, the directors of the company, the
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company’s principal executive officer, principal financial
officer and principal accounting officer, and the company’s
auditors and other experts named in the prospectus.
• However, the statute also provides underwriters with a due
diligence defense. The applicable standard depends on
whether the misstatement is made in reliance on an expert’s
opinion.
• The statute specifically provides a complete defense with
respect to any part of the registration statement that does not
rely on the authority of an expert if the underwriter “had,
after reasonable investigation, reasonable ground to believe
and did believe, . . . that the statements [in the registration
statement] were true and that there was no omission to state a
material fact required to be stated therein or necessary to
make the statements therein not misleading.”
• Where entitled to rely upon the opinion of an expert, there
will be no liability if the underwriter “had no reasonable
ground to believe, and did not believe, . . . that the statements
[in the registration statement] 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.”
• Section 12(a)(2) provides that any purchaser of a security can sue
any person who offered or sold the security, by means of a
prospectus or oral communications which contains a material
misstatement or omission, unless the defendant “did not know, and
in the exercise of reasonable care could not have known” of the
misstatement or omission. Section 12(a)(2) does not make any
distinction based upon “expertised” statements.
• The SEC has stated that the standard of care under
Section 12(a)(2) is less demanding than that prescribed by
Section 11 (i.e., Section 11 requires a more diligent investigation
than Section 12(a)(2)). The SEC also has stated that any
practices or factors that would be considered favorably under
Section 11 also would be considered favorably under the reasonable
care standard of Section 12(a)(2).
• In December 2005, the SEC adopted a number of reforms to the
securities offering process. In particular, SEC Rule 159 provides
that, for purposes of determining whether a preliminary prospectus
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or other written or oral statement gives rise to prospectus-level
Section 12(a)(2) liability for the user because it includes a
materially false or misleading statement at the time of sale (i.e.,
pricing), only information conveyed to investors at or prior to the
time of sale may be considered. Accordingly, information conveyed
after pricing (e.g., by a final prospectus) will not be taken into
account in determining whether all material information was
delivered to investors. This new rule has put additional pressure on
the offering process through more emphasis on completing
diligence earlier in the process and the preparation of updates prior
to pricing.
• An SEC rule identifies the following factors as important in
determining how much due diligence is necessary for underwriters
to meet the statutory standard:
• the type of issuer,
• the type of security,
• reasonable reliance on officers, employees and others whose
duties should have given them knowledge of the particular
facts,
• the type of underwriting arrangement, the role of the
particular person as an underwriter and the availability of
information with respect to the registration, and
• whether, with respect to a fact or document incorporated by
reference, the particular person had any responsibility for the
fact or document at the time of the filing from which it was
incorporated.
• U.S. courts may consider these factors in the context of 144A
offerings as well.
• Although the underwriting agreement contains an indemnity by the
company to the underwriter for any losses sustained by the
underwriter, the indemnity should not be deemed a substitute for
effective due diligence, for the following reasons:
• the indemnity may not be enforceable,
• the underwriter may be required to litigate aspects of the
indemnity,
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• the company may not have enough money to back up the
indemnity,
• for foreign issuers, the company’s assets may be located
outside the United States, making them much harder to
access, and
• even if the indemnity is enforceable and the underwriter can
recoup its monetary losses, the harm to the underwriter’s
reputation from bad publicity, and the time and resources
necessary to defend against securities litigation, can be
significant.
3. WHEN IS THE DUE DILIGENCE PERFORMED
• Due diligence is an ongoing process which should be continuously
done from the date of receipt of the initial mandate through the
closing date.
• In a typical U.S. registered underwritten offering, most of the due
diligence is done before the first filing of the registration statement
with the SEC. This includes most of the legal due diligence, the
management interviews and the accounting due diligence. (This is
completed before the distribution of the “red herring” or
preliminary offering memorandum in a Rule 144A/Regulation S
offering, as the SEC does not review and comment on such
offerings.)
• Sometimes site tours are done after the first filing. In a
Rule 144A offering, this is typically done before printing of
the preliminary offering memorandum.
• Although it is a better practice to finalize customer and
supplier interviews before the first filing, sometimes customer
and supplier interviews are done after the first filing because
companies are concerned about prematurely disclosing their
transaction.
• Frequently, the drafting sessions can be extremely useful as due
diligence sessions. Sometimes more due diligence can be accomplished
with management at a drafting session than at the management
interviews themselves.
• The underwriters should have a separate due diligence discussion
with the company with respect to new quarterly or year-end
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numbers which become available for inclusion in the offering
document.
• In particular, it is important to update the due diligence between the
time of filing the initial registration statement and the time of
printing red herrings, and between the time of printing red herrings
and the pricing date.
• When markets are uncertain and offerings are delayed for
long periods of time, it is particularly important to update the
due diligence when printing red herrings or pricing the deal
because changes in the business may be more numerous over
the longer time period.
• Results for the business since the end of the most recent
publicly reported quarter need to be carefully scrutinized
because they are typically not disclosed in the offering
memorandum or prospectus.
• Underwriters should conduct “pre-pricing” and “pre-closing” due
diligence bring-down telephone calls with the company.
4. WHAT ARE THE COMPONENTS OF THE DUE DILIGENCE
PROCESS
• The amount of due diligence performed will of necessity vary from
deal to deal. It is therefore difficult to establish a uniform set of
procedures for all deals.
• In an offering of debt securities, the company’s existing and future
liquidity and cash flows may be more significant than in an equity
deal. In equity deals, the growth prospects of the company may be
more important than the company’s short term cash flows. This will
impact the type of due diligence performed.
• The various components of the due diligence process include:
• background due diligence,
• business due diligence,
• financial due diligence,
• MD&A due diligence,
• legal due diligence,
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• accounting due diligence,
• backup review,
• corporate governance/Sarbanes-Oxley due diligence, if
appropriate, and
• audit committee due diligence, if appropriate or deemed
necessary.
a. Background Due Diligence
• Underwriters can review public sources of information
about a company and its industry:
• Lexis/Nexis searches of newspaper and magazine articles
about the company, its directors and officers and its industry,
as well as Google searches (should be done as early as
possible in the deal)
• Analyst or rating agency reports on the company or industry
sector
• Industry-specific magazines (such as Automotive Rental
News or Chemical Report)
• The company’s web site (which may include archived press
releases and investor presentations)
• The company’s SEC, statutory or stock exchange filings
• Prospectuses or SEC filings of companies in the same
industry
• Press releases or articles regarding the company or the
industry
• Third party chat rooms devoted to the company
• Public information about the country in which the company
conducts most of its business
b. Business Due Diligence
• The underwriters will also engage in a formal business due
diligence procedure which may include some or all of the
following elements:
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• interviews with senior management (CEO, CFO, SVPs) of
the company
• It is often a good idea to ask the same question to
different people at different levels of management in a
company. Sometimes you will get conflicting answers.
• background check of management
• interviews with the company’s middle management, such as
the officers in charge of marketing, sales, human resources,
production, manufacturing or other core areas
• site tours of the company’s principal facilities or retail
locations
• interviews with the company’s principal customers, suppliers
or other business partners
• These interviews should be conducted without the
company’s presence.
• In some transactions the underwriters may retain specialized consultants.
For example, the underwriters may retain retail consultants
to tour and evaluate a new distribution center or information
systems consultants to evaluate the company’s systems.
• The underwriters should follow up with the company or other
appropriate persons on issues raised by the consultants.
• In general, the underwriters and underwriters’ counsel should
regularly communicate with each other about issues they each
uncover during the due diligence process.
c. Financial Due Diligence
• Bankers review in detail the company’s projections and business
model with the company’s CFO and financial management.
Underwriters’ counsel should be involved in the process.
• Bankers should analyze the reasonableness of the assumptions
underlying the projections. Bankers should evaluate
whether the business model is realistic.
• Bankers may review a base case model, a best case model
and a worst case model.
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• Bankers should perform a sensitivity analysis to determine
the key drivers and risk factors for the business.
• Bankers should review the company’s capital expenditure
plans (for maintenance and for growth) and need to consider
when large cash outlays by the company are required.
• Bankers should compare the company’s key financial
statistics with the statistics of competitors.
• Review of projections will frequently result in modifications or
enhancements to the description of the company’s business
strategy and MD&A in the prospectus.
• Bankers and lawyers should verify whether the company’s credit
facilities need to be amended in order to allow the company to
achieve its business plan. For example, the capital expenditures
covenant may limit the company’s expansion plans.
• Bankers can calculate whether the debt or equity offering will
cause the company to violate financial covenants in the
company’s financing documents.
• Bankers should focus on off-balance sheet or under-recorded
liabilities and contingencies, including in particular potential
employee benefit plan liabilities (unfunded pension plans) and
worker’s compensation liabilities.
• Review of financial statement footnotes will describe
potential contingencies.
• Bankers should also focus on large items on the income statement
which affect the quality of the company’s earnings, such as
• unusual or nonrecurring items,
• related party transactions,
• acquisitions and divestitures,
• potential compensation charges as a result of cheap stock
issues and
• reversal of accrued liabilities.
• When dealing with non-U.S. issuers, bankers should also focus
on differences between U.S. and non-U.S. GAAP. Significant
differences may involve:
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• revenue recognition
• goodwill
• pension accounting
• accounting for stock options
d. MD&A Due Diligence
• MD&A is an increasingly important focus of company
disclosure. SEC rules require disclosures about off-balance sheet
liabilities and contractual obligations in the MD&A, and other
SEC guidance calls for disclosure in MD&A of liquidity and
capital resources and related party transactions.
• Segment, divisional, operating unit and product line data should
be carefully reviewed to determine trends that may not be
disclosed in the draft MD&A.
• Underwriters should due diligence the company’s financial
performance since the most recent period included in the MD&A.
Underwriters should obtain as much information in as much
detail as possible for the most recent period. Companies are often
reluctant to do more than say that their numbers seem generally
on target.
• Even though the latest month or interim period would not be
described in the MD&A, any trend which appears in the
financial performance for this most recent period should be
described in the overview section of the MD&A if material.
The new period may show that an uncertain blip in the most
recent quarter is actually becoming a trend.
• It is important to review cost items as a percentage of sales rather
than on a total basis in order to determine the trends in costs.
• Discussions should be held with the appropriate personnel
regarding future, anticipated or possible cost increases, such
as labor costs due to a tight labor market or supply costs due
to a new supply contract.
• Underwriters should focus on changes in margins.
• For example, comparing profit margins (operating income
divided by net sales) of the company over the years can show
the company’s growth in profitability or decline. It is also
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useful to compare the company’s profit margins with those of
the other companies in the industry.
• Increases in profits and sales can mask margin difficulties.
Acquisitions may also mask margin difficulties. Sometimes
margin issues can be detected by focusing on product mix.
• Year to year comparisons are of less value in acquisitive companies
or companies in the process of increasing their number of
stores or outlets. Underwriters need to review the base business
or same store sales to determine what is really happening.
• Additionally, underwriters should diligence the definition of
same store sales or base business sales to make sure the
periods are comparable. For example, some companies may
include a renovated store as a same store which could skew
results or include a new plant in the base business which
could skew the results.
e. Legal Due Diligence
• Attorneys submit a due diligence request list and review some or
all of the following:
• board of director minutes of the company and principal
subsidiaries
• board of director packages
• lawyer letters to accountants
• reports to management from accountants
• charters and bylaws
• stockholders agreements, registration rights agreements,
warrants, preferred stock and other documents relating to the
company’s outstanding securities
• indentures, loan agreements and credit facilities
• other material business contracts
• employment agreements, stock option plans and stock
purchase plans
• D&O questionnaires
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• Correspondence with the SEC or other regulators (including
comment letters and responses)
• Attorneys typically review the company’s outstanding litigation
and, where necessary, interview outside counsel handling
principal litigation.
• Other areas where attorneys may provide particular expertise in
due diligence includes:
• tax diligence, particularly involving IRS investigations,
• intellectual property and a review of the company’s licensing
agreements,
• employee benefit plans and stock option plans,
• special regulatory issues, involving telecommunications or
other areas, and
• government, antitrust, SEC or other investigations of the
company’s business.
• The underwriters’ counsel typically provides a 10b-5 opinion to
the underwriter which states that the underwriters’ counsel is not
aware of any material misstatement or material omission in the
time of sale information package (i.e., the preliminary prospectus
together with a final term sheet or oral conveyance of final terms)
as well as the final prospectus. The underwriters will receive a
similar opinion from the issuer’s counsel. Courts have cited
receipt of this opinion as a factor in evaluating the underwriters’
diligence.
• Sometimes negotiation of the representations and warranties in
the underwriting agreement can raise due diligence issues if the
company is unable to make standard representations.
• Company counsel may prepare a formal legal due diligence
report in a European context.
f. Accounting Due Diligence
• The bankers and lawyers should interview the company’s principal
accountants and, where material, accountants of acquired entities.
Principal topics of discussion may include:
• the company’s accounting policies generally,
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• the company’s revenue recognition and capital expenditures
policies,
• potential disagreements with the company,
• consistency of the company’s accounting policies with
industry norms,
• issues discussed or raised in the accountants’ “management
letters,”
• off-balance sheet liabilities, if any,
• the company’s liquidity position,
• significant write-offs, if any, and
• proposed changes in the accounting rules or accounting
literature which could impact the company’s financial
statements.
• The company’s accountants should verify whether the company’s
financials will be impacted by cheap stock, beneficial conversion
feature or share based payment issues.
• The company’s accountants should attend drafting sessions or
participate in drafting conference calls. The accountants often
know the company extremely well and can be very helpful in
crafting accurate disclosure.
• Accountants will also provide a comfort letter to the underwriters.
Courts have cited receipt of a comfort letter as a significant
part of the underwriter’s due diligence defense.
• One significant of the comfort letter is the bringdown of the
company’s income statement and balance sheet since the
most recent balance sheet date included in the registration
statement. This can be an important mechanism for verifying
how the company is doing in the most recent months. Alternative
due diligence procedures (certificates, discussions with
management) can also be used in lieu of or in addition to the
comfort letter bringdown.
• It is important for the bankers and the underwriters’ counsel
to consult prior to the pricing on any negative information
which emerges in the accountants’ bringdown of the financial
statements in the comfort letter.
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• In U.K. public equity offerings a long form accountants report is
part of the due diligence process. It will include a statement of
working capital and historical information regarding the issuer.
g. Backup
• Another important part of the due diligence process is making
sure that the underwriters and underwriters’ counsel have
received adequate backup for industry statistics, market share and
similar data included in the prospectus.
• Frequently the sources of major statements, such as the
company’s market share or leading position, will be discussed or,
in some cases, distributed, during initial drafting sessions.
• The underwriters’ counsel should distribute a “backup request” to
the issuer and issuer’s counsel asking for backup for particular
numbers and qualitative phrases.
• In addition to achieving more accurate disclosure, another benefit
of obtaining all of the necessary backup before the first SEC
filing is that in the first round of SEC comments on the
prospectus the SEC frequently asks for backup support for
statements in the prospectus. It will be easier to respond to the
SEC if the company has already gathered all of the backup.
h. Backup vs. Verification
• The U.S. style of due diligence reports is less formal than the
U.K. style. Whereas in the U.S. the underwriters’ counsel will
record the documents reviewed and the persons with whom
counsel discussed various issues, U.K. solicitors often produce
verification notes.
• Verification notes comprise a number of questions based on
every sentence in the prospectus to which answers must be
provided by the responsible parties. Each answer must contain an
appropriate reference to the evidence for, and the source of, the
information underlying the particular answer. Eventually the
solicitor produces the final version of the verification notes with
all supporting documentation for the board of director’s review
and approval.
• It is becoming more common on dual listed offerings to use a
more “U.S.” style of due diligence procedure with more limited
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verification notes. The proper balance should be discussed early
in a transaction and will depend on the circumstances.
i. Corporate Governance/Sarbanes-Oxley Due Diligence
• In light of the passage of the Sarbanes-Oxley Act and the SEC
rules promulgated thereunder, underwriters may also consider
engaging in a due diligence review of the corporate governance
policies of the company.
• Underwriters could focus on, among other things, the following
topics in discussions with the company:
• filing of CEO/CFO certifications under Section 302 and
Section 906 of the Sarbanes-Oxley Act,
• the company’s disclosure controls and procedures and
internal controls,
• the company’s code of ethics and any exemptions to the
code,
• the company’s whistleblowing procedures,
• any loans from the company to management,
• the composition of the audit committee and whether there is a
“financial expert” on the audit committee,
• the composition of a nominating committee, if applicable,
• the company’s internal audit function,
• the company’s document retention policy,
• any non-audit services provided by the company’s
independent auditors,
• any restatements of the company’s financial statements,
• any unresolved comments from the SEC in connection with
any filing,
• any off-balance sheet transactions, and
• any non-GAAP financial information in its 1934 Act reports
or press releases.
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j. Audit Committee Due Diligence
• Underwriters may also consider having a discussion with the
chairman or a member of the audit committee. This is not
currently a standard practice in the due diligence process, but on
occasion could be helpful as part of an overall diligence review.
Any such discussion could include the following topics:
• the structure of the audit committee,
• the audit committee’s meeting process, review of financial
data and line of communication with the company,
• any significant issues encountered by the audit committee,
• the audit committee’s review process for periodic reports and
monthly statements,
• the audit committee’s review of internal controls,
• the audit committee’s review of any off-balance sheet
liabilities and contingencies,
• the mechanism used by the audit committee to select the
auditors,
• any process for meeting with auditors without management,
• the company’s critical accounting policies;
• any related party transactions,
• the impact of any new accounting or SEC pronouncements
on the company’s financials,
• any goodwill amortization,
• the level of communication between management and the
audit team,
• any significant accounting issues that have arisen in
connection with the most recent periodic reports,
• any material issues discussed at the most recent meetings,
• the audit committee’s review of taxes and tax reserves and
• any significant disagreements between the audit committee
and the auditors or between the audit committee and management.
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5. SPECIAL CONSIDERATIONS FOR EUROPEAN DUE
DILIGENCE
• The legal structures which govern the sale of securities differ in
European countries compared to the U.S. and also differ across
European countries.
• Underwriting liability standards vary by jurisdiction and range from
absolute liability to limited liability for managers and underwriters.
Due diligence defenses may or may not be available. The law is
also not very well developed in this area.
• Issuers in Europe are often less accustomed to U.S. style due
diligence procedures and tend to be more resistant to procedures
considered standard in the U.S.
6. SEVERAL DUE DILIGENCE CONSIDERATIONS SPECIFICALLY
FOR DEBT OFFERINGS
• In debt offerings it is important to focus during the due diligence
process on the following items:
• the effects of transactions on the company’s debt rating,
• the effects of transactions on the company’s cash flow,
• the company’s debt repayment schedule,
• the company’s worst case/downside scenario,
• the use of the proceeds of the debt offering, and
• the necessity of raising additional cash in order to allow the
company to complete its business plan.
7. WHY DO BANK-DEBT ARRANGERS CONDUCT DUE
DILIGENCE
• There are six principal reasons why bank debt arrangers perform
due diligence. With one exception, these are similar to the reasons
underwriters perform due diligence.
• Diligence helps the lender assess the borrower’s credit risk.
• Due diligence will assist in understanding the company and
thereby helping in drafting a more accurate bank book.
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• During the due diligence process you may uncover negative
information about the company which may cause the deal to
be restructured, delayed or even, on occasion, pulled.
• The due diligence process may indicate that third party
consents or approvals are necessary in order to consummate
the transaction.
• Syndicate members expect the arranger to have conducted full
due diligence and the arranger’s institutional reputation
requires that bankers do thorough due diligence.
• Although no law specifies the content of a bank information
memorandum, in litigation, due diligence may establish
necessary defenses to liability on the part of the arranger.
a. Bank Debt Due Diligence Standards Differ From
Underwriter Standards
• Reduced arranger liability concerns for disclosure errors or
omissions result in greater flexibility in terms of what to include
in the information memorandum and how it is included.
• Less labored disclosure is required.
• Projections (the business model) are normally central to the
information memorandum.
• Although the diligence topics covered and matters reviewed are
similar, the diligence focuses on identifying potential credit
“black holes,” confirming matters stated in the information
memorandum and confirming that known liabilities (actual or
contingent) are appropriately reflected in the business model.
• There can be greater flexibility in formulating an appropriate due
diligence review. For example, in an acquisition financing, the
arranger may choose to rely on appropriate diligence reports
addressed to it from legal advisors to the borrower since (1) the
legal documentation and issues that normally would be reviewed
by the arranger’s own counsel would be the same, and (2) the
borrower and lenders’ interests in a “good” acquisition are
aligned.
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8. WORLDCOM LITIGATION: CASE STUDY ON UNDERWRITER
DUE DILIGENCE
• In December 2004 an important decision issued in the Southern
District of New York evaluated an underwriter’s due diligence in
the context of two bond offerings by WorldCom.
• The case arose in connection with Worldcom’s bankruptcy
and related restatement of its 2000 and 2001 financial
statements, which included approximately $76 billion of
adjustments and reduced Worldcom’s net equity from
$50 million to negative $20 billion.
• Bondholders brought class action suits which alleged material
misstatements and omissions in the registration statements for
two Worldcom bond offerings in May 2000 and May 2001.
The cases were brought under Sections 11 and 12(a)(2) of the
Securities Act of 1933. Defendants included Worldcom, its
directors and senior officers, Arthur Anderson (its primary
auditor) and the lead underwriters for the offerings.
• The defendant underwriters sought judicial declarations of
summary judgment, stating that they had satisfied their due
diligence defense under both Sections 11 and 12(a)(2). The
underwriters said that all of the alleged misstatements were
issues of accounting, based primarily on errors in the financial
statements, and thus the underwriters were entitled to rely on
the audits and comfort letters they had received.
• The written record of due diligence for the May 2000 offering was
a memorandum prepared by underwriters’ counsel. The memo described
a May 17, 2000 conversation in which WorldCom’s CFO
was asked questions about a pending merger with Sprint, whether
WorldCom had experienced problems integrating prior acquisitions,
and whether there were any other material issues. The
memorandum also outlined WorldCom’s board minutes, listed its
public filings, referred to its press releases, and discussed Sprint
documents. The underwriters also received a comfort letter. The
due diligence for the 2001 offering was similar.
• With respect to alleged misstatements in the audited financial
statements, the court refused to grant summary judgment in favor
of the underwriters, who argued that they were entitled to rely on
the clean audit opinions included in the registration statement.
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• Even though the financial statements were audited, the
plaintiffs claimed that the underwriters had a reasonable
ground to question the reliability of the data. Plaintiffs
showed that WorldCom’s critical ratio of line costs to revenue
was 43%, significantly lower than the equivalent ratio of its
two closest competitors, Sprint (53.2%) and AT&T (46.8%).
The plaintiffs claimed that this discrepancy triggered a duty to
investigate such a crucial measurement of the company’s
health. Ultimately a significant reason for WorldCom’s
financial statement restatement was due to significant
understatement of line costs.
• The underwriters argued that an audited figure can never
constitute a red flag and impose a duty of investigation,
because they are “expertised” by the accountants. However,
the court said that “the existence of red flags can create a duty
to investigate even audited financial statements.” In this case,
the court concluded, a reasonable person would have inquired
further about the discrepancy between the audited figures and
the comparable information from competitors.
• Similarly, plaintiffs said that the underwriters should have
questioned the accuracy of WorldCom’s reported assets, given the
public knowledge of the deterioration in MCI’s long-distance
telephone business. Since $29 billion of WorldCom’s $47 billion
purchase price for MCI was attributed to goodwill, an intangible
asset, the underwriters should have known that an asset impairment
charge was necessary. The court concluded that “there are issues of
fact regarding WorldCom’s statement of its assets that a jury may
find raised a red flag and imposed upon the Underwriter
Defendants the obligation to inquire.”
• With respect to alleged misstatements in unaudited financial
statements, the court also refused to grant summary judgment in
favor of the underwriters, who argued that they were entitled to rely
on the accountant’s comfort letter and the absence of any
knowledge of accounting red flags on their part.
• The court found that, with respect to unaudited financial
statements, in order to succeed with a due diligence defense,
the underwriters must show that they conducted a reasonable
investigation of the non-expertised portions of the registration
statement and had reasonable ground to believe that the
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interim financial statements were true. Receipt of a comfort
letter is important evidence but by itself is insufficient to
establish a due diligence defense.
• The underwriters argued that no amount of diligence could
have uncovered WorldCom’s massive accounting fraud, since
even the auditors had not detected it. However, the court
found that even if it appears that an investigation would have
proven futile in uncovering a fraud, the underwriter must still
conduct a reasonable investigation in order to prevail on the
due diligence defense.
• The underwriters argued that if they could not rely on a comfort
letter for their due diligence of the unaudited financial statements,
underwriters will always have to hire their own accounting firms in
order to check the work done by the company’s auditors. However,
the court responded that it was not imposing any obligation on
underwriters to hire auditors in every offering.
• “The term ‘reasonable investigation’ encompasses many
modes of inquiry between obtaining comfort letters from an
auditor and doing little more, on one hand, and having to reaudit
a company’s books on the other. Nonetheless, if aggressive
or unusual accounting strategies regarding significant issues
come to light in the course of a reasonable investigation,
a prudent underwriter may choose to consult with accounting
experts to confirm that the accounting treatment is appropriate
and that additional disclosure is unnecessary.”
• The court questioned whether the underwriter’s due diligence effort
was satisfactory.
• “The Lead Plaintiff has shown that there are questions of fact,
however, as to whether the Underwriter Defendants conducted
a reasonable investigation in either 2000 or 2001. It points to
what it contends is evidence of the limited number of
conversations with the issuer or its auditor, the cursory nature
of the inquiries, the failure to go behind any of the almost
formulaic answers given to questions, and the failure to
inquire into issues of particular prominence in the Underwriter
Defendants’ own internal evaluations of the financial
condition of the issuer or in the financial press.”
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• “It argues in particular with respect to 2001, that having
internally downgraded WorldCom’s credit rating and having
taken steps to limit their exposure as WorldCom creditors, the
Underwriter Defendants were well aware that WorldCom was
in a deteriorating financial position in a troubled industry, and
that a reasonable investigation would have entailed a more
searching inquiry than that undertaken by the Underwriter
Defendants. Given the enormity of these two bond offerings,
and the general deterioration in WorldCom’s financial
situation, at least as of the time of the 2001 Offering, they
argue that a particularly probing inquiry by a prudent
underwriter was warranted. These issues of fact require a jury
trial.”
• The underwriters ending up settling the case for $6.0 billion. The
underwriting fees earned on the offerings totaled only $84.0 million.
9. CONCLUSION
• Underwriters should participate in the offering process with a
healthy amount of “skepticism” about the claims of management.
• People do not always tell the truth, sometimes unintentionally, and
people may neglect to tell you important facts.
• In evaluating underwriter due diligence, courts look favorably on
underwriters that follow up on red flags when they are detected.
• Courts also advise underwriters not to simply rely on the statements
of management but to verify management’s statements.
• The underwriters should explain to the company in advance of the
offering that the due diligence effort is aimed at creating a more accurate
disclosure document (which benefits the company) and also
helps the underwriters satisfy their own regulatory requirements.
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NOTES