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

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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. 22 110
• 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 23 111
Page 1: 3 THE DUE DILIGENCE PROCESS FROM TH
Page 5 and 6: 1. WHY DO UNDERWRITERS CONDUCT DUE
Page 7 and 8: or other written or oral statement
Page 9 and 10: numbers which become available for
Page 11 and 12: • interviews with senior manageme
Page 13 and 14: • revenue recognition • goodwil
Page 15 and 16: • Correspondence with the SEC or
Page 17 and 18: • In U.K. public equity offerings
Page 19 and 20: j. Audit Committee Due Diligence
Page 21: • During the due diligence proces
Page 25 and 26: • “It argues in particular with

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

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