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

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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.” 24 112
• “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. 25 113
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 and 22: • During the due diligence proces
Page 23: • Even though the financial state

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

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