Exemplary Stories

Exemplary Stories

Short stories, novellas, fables – they all serve the salutary purpose of illuminating lessons in how we should act. Relatively simple story lines are embellished to make them more interesting, but themes recur. Just as fiction employs commonly recurring literary devices, so it seems that even complex corporate fraud can be reduced to familiar tropes: a wall of inventory piled 20 boxes high (and two boxes deep) is passed off as a full warehouse; legitimate questions by auditors are disdainfully dodged with the kind of theatricality that would make a dive-prone soccer player blush (read the WorldCom case, involving one of the biggest corporate frauds, and easily imagine a formerly feted CEO pounding the table and telling the underwriters and their counsel, “We’re not a gang. We’re a club!”); and financial projections graphed in the shape of a hockey stick are received with the furrowed brow and solemn reverence that is naturally due to a client who is paying handsome underwriting fees that will boost one’s standing in the league tables. A handful of court cases have illuminated how the various parties in the course of an offering of securities should act.

A synopsis of recurring lessons:

  • The risk of liability depends on one’s role – inside director or NXD, underwriter, etc.
  • Directors and underwriters should never rely on the oral word of management regarding the accuracy of the prospectus. (The corollary is that management should not be affronted – nor affect to be. A thorough verification exercise redounds to everyone’s benefit. “Доверяй, но проверяй” – “Trust, but verify” – as the Russian proverb says.)
  • Verify management’s representations by reference to original, written materials readily available such as corporate minutes, books, loan agreements and various other corporate agreements.
  • Comprehensive, Yet Comprehensible: Prepare a prospectus that illuminates investors’ understanding of the business. It should not be unnecessarily repetitive.
  • Maintain a sense of proportion and exercise judgment as to what is material.

[By way of background, Section 11 of the U.S. Securities Act of 1933 (the Securities Act) creates almost absolute liability in the issuer for material misstatements of fact or omissions to state a material fact in a document used to sell securities to the public. Section 11(b)(3) of the Securities Act provides the so-called “due diligence” defense, an affirmative defense to liability that requires that a defendant show that “he had, after reasonable investigation, reasonable ground to believe and did believe” that there were no material misstatements or omissions in the prospectus used in a sale of securities to the public. (Thus, a defendant may fulfill his burden of investigation and still not have reasonable cause to believe in the completeness of the prospectus or he may simply fail in his duty to investigate. Liability will lie in either case.) For ease of use by a broader audience, this synopsis conflates different bases for liability under the Securities Act and focuses on the practical responsibilities of persons involved in securities offerings.]

The words get bandied about, “due diligence,” “verification,” “reasonableness” and “materiality,” and everyone involved in the process wants to know what, exactly, is required to discharge his or her duty of care and avoid liability. Courts have treated different persons in a securities offering as having different burdens to bear in making a due diligence defense. These issues are relevant to both financing transactions as well as M&A transactions in which securities are offered in payment.

The Securities Act defines the measure of “reasonableness” as that of a reasonably prudent person managing his or her own property. Courts have described the word “material” as meaning whatever an average prudent investor ought reasonably to be informed about, i.e., matters which an investor needs to know before he or she can make an intelligent, informed decision whether or not to buy the security. A material fact is one that would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available. The due diligence inquiry must focus not on whether particular statements, taken separately, were literally true, but whether the representations in a prospectus, taken together and in context, would have misled a reasonable investor about the nature of the securities. A prospectus will put a securities issuer (and its directors and underwriters) at risk if the prospectus does not disclose material objective factual matters, or if it buries those matters beneath other information, or treats them cavalierly.

The answer to the question “how much is enough?” when it comes to due diligence and drafting the prospectus is, of course, the lawyer’s favorite answer, “it depends” – in this context, on who is asking the question. For purposes of drafting the prospectus, the usual answer is that the highest level of accuracy is sought by the deal team of lawyers, bankers and company management preparing the prospectus because no one on the deal team wants to take on responsibility for making the judgment call that any particular fact was so immaterial that accuracy was unimportant. However courts are far more pragmatic, and their views expressed in case law are illuminating for the various parties at risk for prospectus liability. The quality of the prospectus (meaning, how well it informs the investor) is far more important in the court’s view than the quantity. In fact, the quantity of disclosure can be counter-productive when it no longer illuminates the reader’s understanding.

Judges provide incisive literary criticism of prospectuses. What makes for a good read in prospectus disclosure? In Feit v. Leasco Data Processing Equipment Corporation, the court gave a critical assessment of the abstruse disclosure in prospectuses: “In at least some instances, what has developed in lieu of the open disclosure envisioned by the Congress is a literary art form calculated to communicate as little of the essential information as possible while exuding an air of total candor. Masters of this medium utilize turgid prose to enshroud the occasional critical revelation in a morass of dull, and—to all but the sophisticates—useless financial and historical data. In the face of such obfuscatory tactics the common or even the moderately well informed investor is almost as much at the mercy of the issuer as was [prior to the Securities Act]. He cannot by reading the prospectus discern the merit of the offering.”

The Feit v. Leasco case was decided in 1971, when “cut and paste” was a literal scissors and glue job, and not a word processing metaphor. The typical prospectus in those days was hefty if it ran to 100 pages. These days, word processing on computers enables a draftsman, paralyzed by the insecurity of underdeveloped judgment, to replicate disclosure throughout the prospectus in the vain hope that repetition will heighten the talismanic power of disclosure.

The Dramatis Personæ

The leading case on due diligence in U.S. courts is Escott v. BarChris Construction Corporation, commonly referred to as the BarChris case, which arose from the collapse of the fad for bowling (and polyester knit team shirts) in the U.S. in the 1950s. It is small consolation to most deal team members that the issuing corporation itself has “almost absolute” liability for material misstatements in, or material omissions from, a prospectus. What most individuals in a conference room working on a prospectus (or asked to sign off on it as a director) want to know is, “what is my potential liability?” BarChris, and another case called Weinberger v. Jackson, describe the liability of various participants in a public offering of securities and provide practical guidance to the principal actors in an offering.

In simplest metaphorical terms, the closer one is to the hot core of a nuclear reactor, the more precautions one should take. What constitutes “reasonable investigation” and a “reasonable ground to believe” will vary with the degree of involvement of the individual (e.g., director, underwriter) in the issuer’s affairs, his or her expertise, and his or her access to the pertinent information and data. What is reasonable for one director may not be reasonable for another by virtue of their differing positions in relation to the company.

Outside Directors

For the diligence that is due by an outside director, the court in Weinberger v. Jackson provided useful guidance: an outside director named in the case was not obliged to conduct his own independent investigation into the accuracy of all the statements contained in the prospectus. The court stated that the outside director could rely upon the reasonable representations of management, if his own conduct and level of inquiry were reasonable under the circumstances.

By way of illustrative example, the court noted that the outside director was reasonably familiar with the company’s business and operations and he regularly attended board meetings at which the board discussed every aspect of the company’s business. The outside director had reviewed the company’s financial statements and was familiar with the company’s development of its new product lines. He had also reviewed six drafts of the prospectus and saw nothing suspicious or inconsistent with the knowledge that he had acquired as a director, and he discussed certain aspects of the prospectus with management. Each of these supporting factors was indicative of the requisite standard of care, i.e., the prudent management of his own property.

It is not imperative that each factor is present, but rather that the course of conduct is consistent with this degree of prudence. In the court’s view, it was not necessary for an outside director to make specific inquiries of the company’s management with respect to representations made in the prospectus, so long as the statements in the prospectus were consistent with the knowledge of the company that he had reasonably acquired in his position as a director.

Newly appointed directors often ask what their risk of liability is. They will have had little opportunity to become familiar with the company’s affairs. The question is whether, under such circumstances, the newly appointed director did enough to establish his or her due diligence defense with respect to the prospectus. The reasoning in an early English case under the Companies Act is instructive. In Adams v. Thrift, it was held that a director who knew nothing about the prospectus and did not even read it, but who relied on the statement of the company’s managing director that it was “all right,” was liable for its untrue statements. The BarChris court reached the same conclusion as to a newly appointed director caught up in the drama.

Executive Directors …and their Stunt Doubles (NXDs, but on the Inside)

Inside directors with intimate knowledge of corporate affairs and of the company’s particular transactions will be expected to make a more complete investigation and have more extensive knowledge of facts supporting or contradicting inclusion of information in the prospectus than outside directors will. The BarChris case imposed on inside directors such stringent requirements of knowledge of the issuer’s affairs that one might conclude that liability will lie in practically all cases of misrepresentation. Their liability approaches that of the issuer as guarantor of the accuracy of the prospectus.

However it is important for directors to understand that a court’s analysis does not elevate form over substance – it is not a mechanistic sorting of directors into artificial categories of those having “inside” knowledge and “outside” status. The analysis depends on how much the director ought to know. In two cases, BarChris and Feit v. Leasco, the courts elaborated on a distinction between executive directors and outside lawyers who were also directors.

The BarChris court treated the director-lawyer, Grant, as an “outside” director despite the fact that he had been a director for eight months prior to the public offering in question and had prepared the prospectus; Grant therefore had sufficient knowledge of his and the issuer’s obligations under securities law and the issuer’s business that he could not pose as a shy, doe-eyed, crimson-cheeked ingénue when the issuer’s business went pear-shaped. The court then held Grant to a very high standard of independent investigation of the registration statement because of his peculiar expertise and access to information, and held him liable for failure to meet that standard.

In contrast, the Leasco court treated the director-lawyer, Hodes, as an insider for liability purposes because he had been a director for three years at the time the prospectus was filed with the regulator and he had been so intimately involved in the prospectus drafting that to treat him as anything but an insider “would involve a gross distortion of the realities of [the issuer’s] management”. (The controversy in the Leasco case turned on an accounting issue of an acquisition target, and although Hodes was not an executive officer of the issuer, he had been deeply involved in negotiations over the matter and the structuring of the acquisition.)


The audit firm in the BarChris case was also scrutinized for its failure to meet its burden of proof for its due diligence defense, i.e., that it had conducted a reasonable investigation of the issuer, with respect to that portion of the prospectus as to which the auditors acted as “experts” (i.e., the financial statements upon which they issued an audit report that was included with the prospectus). Essentially the court took the view that the investigation that was performed was negligent. Various accounting entries should have alerted the audit team member to the facts that existed, and he should have made further inquiry on the subject. It was apparent to the court that the auditor did not understand the transactions that he reviewed. The auditor did not examine any “important financial records” other than the trial balance. As to minutes, he read only what minutes a company officer gave him, which consisted only of the board of directors’ minutes of the issuer. The auditor did not read any of the minutes of the executive committee of the board of directors. Worse still, he did not even know that there was an executive committee, and hence he did not discover that there were notes of executive committee minutes that had not been written up (which in turn should have alerted him to further inquiries). He did not read the minutes of any subsidiary. He asked questions, to which he got answers that he considered satisfactory, and he did nothing to verify them. Since the auditor did not read the minutes of subsidiaries, he did not learn that particular transactions were intercompany sales.

As far as results were concerned, the BarChris court found the auditor’s review of the prospectus was “useless.” Judges can be crisp, and few admonishments are crispier than “don’t be useless.”

The court acknowledged that accountants should not be held to a standard higher than that recognized in their profession, but the review of this prospectus did not come up to that standard. The individual auditor did not take some of the steps that his firm’s written program prescribed. He did not spend an adequate amount of time on a task of this magnitude. Most important of all, he was too easily satisfied with glib answers to his inquiries. This is not to say that he should have made a complete audit. But there were enough danger signals in the materials that he did examine to require some further investigation on his part. Generally accepted accounting standards required such further investigation under these circumstances. It is not always sufficient merely to ask questions.


The courts are particularly scrupulous in examining the conduct of underwriters since the underwriters are supposed to assume an opposing posture with respect to management. Tacit reliance on management assertions is unacceptable; a prudent person in the management of his or her own property would not rely on them. The underwriters must play devil’s advocate. In order to make the underwriters’ participation in the offering of any value to the investors, the underwriters must make some reasonable attempt to verify the data submitted to them. It is impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case.

It is important for underwriters to understand that delegating their investigation to others who are, or ought to be, responsible professionals does not absolve the underwriters of liability. The BarChris court found that the underwriters’ counsel did not make a reasonable investigation of the truth of the prospectus, having made only a cursory examination of incomplete minutes (among other sins of omission). The lead underwriter was bound by its counsel’s failure because the due diligence investigation is not a matter of relying upon counsel solely for legal advice. The lead underwriter delegated to its counsel, as its agent, the task of examining the corporate minutes and contracts, so the court viewed the attorneys as dealing with matters of fact. The BarChris court held that the underwriters must bear the consequences of their failure to make an adequate examination. The other underwriters, who did nothing and relied solely on the lead underwriter and on the lawyers, were also bound by it. It follows that although the underwriters believed that those portions of the prospectus were true, they had no reasonable ground for that belief, within the meaning of the statute. Hence, they also had not established their due diligence defense.

In a sunnier outcome, the court in Feit v. Leasco found there was sufficient evidence that the underwriters and their counsel made a thorough review of all available financial data: (1) they independently examined the issuer’s audit and the report of an actuary on the target (an insurance company), with respect to the particular accounting and valuation matter that was at controversy in that case; (2) the underwriters and their counsel made searching inquiries of the issuer’s major bank; (3) counsel to the underwriters undertook a study of the issuer’s corporate minutes, records and major agreements; and (4) regarding the accounting and valuation controversy at the heart of the case, the underwriters had been particularly careful in their inquiries of the issuer, which was bolstered by considerable prior experience with the accounting issue particular to that industry.

Finally, in respect to the WorldCom case alluded to above, the court stripped away a fiction long indulged by everyone, except perhaps the auditors. Many people had wanted to believe that, because auditors were experts in accounting matters, the portion of the prospectus containing the auditors’ expert opinion required no further investigation by anyone else – it was reasonable to rely on the experts to whom the responsibility fell.

The matter was acutely presented in the WorldCom case precisely because the evidence was that, outside the context of the prospectus, there was plenty of evidence that underwriters and analysts had questions about WorldCom’s accounting treatment of a type of costs peculiar to its industry. It was this “willing suspension of disbelief” that got underwriters into trouble. In the court’s view, the very fact that concerns were expressed outside the context of the offering about possible discrepancies in accounting treatment (for example, in analysts’ reports) precluded the ability to believe that auditors alone assumed responsibility for matters within their expertise.

The broader principle is that it is unwise to abdicate responsibility (in this context, for a reasonable investigation) if one ought to know better, and that is something we have been taught by the poets and playwrights from earliest days.



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