Underwriters’ Due Diligence Obligations in the Wake of In re WorldCom
by Marc Rossell and Andrew Stemmer

The smoke surrounding the WorldCom, Inc. securities litigation has begun to clear and Wall Street is stretching to understand its implications. Many securities industry insiders hoped the case would yield guidance as to what would constitute a “reasonable investigation” for purposes of satisfying an underwriter’s due diligence obligations. However, in the end, the underwriter defendants all decided to settle the claims against them before such guidance could be obtained. Part of their motivation to settle undoubtedly stemmed from the decision by U.S. District Court Judge Denise Cote denying summary judgment to the underwriter defendants.¹

The court determined that there were triable issues of fact that could permit a jury to conclude that the underwriters had not conducted a reasonable investigation. In particular, the court found that the underwriters may have ignored a number of warning signs that should have caused them to question the integrity of WorldCom’s financial reporting, despite the existence of an audit report. In addition, the court held that underwriters cannot rely exclusively on unaudited financial information and comfort letters, because unaudited financial statements and the limited review reports that often accompany them are not “expertised” portions of the registration statement and thus are subject to a higher standard of due diligence.

The WorldCom decision is best understood as part of the recent trend of judicial decisions and regulatory actions against “gatekeepers”— directors, executive officers, auditors, audit committees, lawyers, and underwriters—for failing to fulfill their duties to the investing public. The decision challenges many of the industry’s long held—though possibly illfounded —assumptions regarding underwriters’ due diligence obligations, including underwriters’ ability to rely on comfort letters from auditors, and makes quite clear that underwriters cannot completely rely on audited financial statements in the face of “red flags.”

The court’s holding raises many difficult questions for underwriters, who have traditionally relied on comfort letters and audited financial statements in their due diligence efforts— particularly when facing the time constraints associated with underwritten shelf offerings. In the wake of this decision, underwriters are reassessing due diligence obligations and procedures and are reviewing a host of related issues dealing with the role and liability of the various participants in the offering process.

Material Misstatements and Omissions

Under Section 11(a) of the Securities Act of 1933, underwriters can be held liable for portions of registration statements that 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.”² In determining whether a registration statement contains materially misleading information, the court examines whether the information, when taken in context, would be misleading to a reasonable investor. Material facts may include information regarding a company’s probable future, its earnings, or its distributions, and any information that could affect an investor’s decision to purchase, sell, or retain a company’s securities.³

Materiality is a fact-intensive inquiry and is not subject to a formulaic approach or “brightline” rule; the SEC has never provided an explicit definition of the term. Furthermore, in determining whether misstatements or omissions are material, courts will read a registration statement or prospectus as a whole and base their decisions on the totality of the circumstances.⁴

The Due Diligence Defense

Section 11(b) of the Securities Act provides two affirmative defenses against liability for underwriters and persons other than the issuer in SEC-registered securities offerings. Taken together, these defenses often are referred to as the “due diligence” defense. The standards for establishing the two defenses differ, however, depending on whether the challenged disclosure purports to be made on the authority of an expert (“expertised” portions of the registration statement).

An underwriter relying on “expertised” portions of the registration statement will not be found liable for material misstatements or omissions if:

he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue and that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.⁵

When dealing with “non-expertised” information in the registration statement, an underwriter will not be liable if:

he had, after reasonable investigation, reasonable grounds to believe and did believe, at the time such part of the registration statement became effective, that the statements therein 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.⁶

Accountants qualify as experts, and audited financial statements included or incorporated by reference in a registration statement are considered “expertised.”7 Accordingly, it would appear that underwriters are entitled to rely on audited financial statements in the registration statement. But, as discussed below, such reliance may not be blind, nor is it unfettered in the face of socalled “red flags.”

Rule 436 under the Securities Act provides that reports on unaudited financial statements are not “expertised,” and thus are subject to the reasonable investigation requirement.8 Indeed, underwriters must conduct both a reasonable investigation and possess a reasonable belief in the truth of the disclosure. Section 11(c) states that “the standard of reasonableness shall be that required of a prudent man in the management of his own property.”⁹

Whether an investigation satisfies an underwriter’s due diligence obligations “is a question of degree, a matter of judgment in each case.”¹⁰ What constitutes a “reasonable ground to believe” will vary with the degree of involvement of the individual underwriter, its expertise, and its access to the pertinent information and data.¹¹ Consequently, the investigation an underwriter must make to satisfy its due diligence obligations will depend on the facts surrounding each issuance.

Due Diligence in the Context of Shelf Offerings

In the 1980s, the Securities and Exchange Commission began allowing seasoned companies to utilize shelf registration and integrated disclosure to offer securities on an expedited basis. Companies offering securities “off the shelf ” file one registration statement and then incorporate future filings made under the Securities Exchange Act of 1934. The SEC also promulgated Rule 415, which permitted a wider array of companies to take advantage of shelf registration. For companies that qualified, the SEC’s actions resulted in a drastic reduction in both the cost and preparation time associated with traditional offerings. Where previously an issuance may have taken months to prepare, it could now be accomplished in a matter of days, if not hours.

While much of the securities industry applauded the SEC’s initiative to streamline the offering process, some were quick to note the negative implications for underwriters. During the comment period for Rule 415, commenters expressed concerns regarding “the adequacy of the amount, content and timing of disclosure, particularly respecting due diligence.”¹² Further, in a dissenting opinion to the adopting release, Commissioner Thomas stated that “Rule 415 does not provide time for underwriters to discharge adequately their due diligence responsibilities . . . . [T]here is little if any time between selection of the underwriters and the sale, [and] no due diligence is practical at any time during the pre-sale process.”¹³

Despite underwriters’ concerns, the SEC clearly stated that “[t]he integrated disclosure system, past and proposed, is . . . not designed to modify the responsibility of underwriters and others to make a reasonable investigation. Information presented in the registration statement, whether or not incorporated by reference, must be true and complete in all material respects and verified where appropriate.”¹⁴ Although the SEC was clear that its efforts to streamline the offering process vis-à-vis Rule 415 and Form S-3 would not alleviate underwriters’ due diligence obligations, it did enact Rule 176¹⁵“to make explicit what circumstances may bear upon the determination of what constitutes a reasonable investigation and reasonable grounds for belief as these terms are used in Section 11(b) of the Securities Act.”¹⁶

The pertinent circumstances considered under Rule 176 include the type of issuer; the type of security; the type of person; 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 underwriter; and the availability of information with respect to the registrant. While Rule 176 provides several vague circumstances that courts should consider in determining whether an underwriter has fulfilled its due diligence obligations, the rule does not, in any way, alter traditional due diligence requirements. Consequently, underwriters have received little to no guidance from the SEC as to what constitutes adequate due diligence under the Securities Act, especially with respect to shelf offerings.

The Circumstances of WorldCom

The WorldCom plaintiffs alleged that, commencing at least as early as 2001, WorldCom was engaged in a scheme to hide and manipulate its declining financial condition. In 2002, in the wake of an internal audit, it became apparent that WorldCom had not made transfers from “line cost” expenses, its largest operating expense, to capital accounts in accordance with generally accepted accounting principles. There were also additional accounting problems, such as the misreporting of capital expenditures, amortization and depreciation, goodwill, and assets. Plaintiffs contended that the financial statements incorporated in WorldCom’s registration statements for its 2000 and 2001 bond offerings contained serious errors and were materially false and misleading, and they brought suit against a number of parties, including the underwriters.

The underwriters moved for summary judgment, arguing that they had conducted extensive due diligence in connection with the registration statements. They also claimed that they were entitled to rely on WorldCom’s auditor’s comfort letters and limited review report on the unaudited financial statements, as well as on the audited financial statements, and had no duty to inquire further as whether such information was reliable.

Plaintiffs responded that mere reliance on comfort letters, without more, never constitutes a reasonable investigation, and that reliance on audited financial statements was impermissible in this case because numerous red flags and storm warnings triggered a duty to investigate the accuracy of WorldCom’s financial reporting. The court agreed with plaintiffs that there were genuine issues of triable fact and denied the underwriters’ motion in large part.

Unaudited Financial Statements and Comfort Letters

The underwriters argued that they were entitled to rely on unaudited interim financials, as well as the comfort letters that WorldCom’s auditors issued, without further investigation unless plaintiffs could establish that the underwriters had actual notice of “red flags.” They further argued that, at least in the context of seasoned issuers engaged in a shelf registration, there is no difference between an underwriter’s right to rely on unaudited financial information and the right to rely on audited financial information as long as the underwriter receives a comfort letter from the auditor.

In denying the motion for summary judgment, the court noted that there were issues of fact that could permit a jury to determine that the underwriters had not conducted a reasonable investigation:

• The limited number and cursory nature of conversations between the underwriters and WorldCom and its auditors;
• The underwriters’ failure to inquire beyond the formulaic answers given by management in response to their queries;
• The underwriters’ own internal downgrading of WorldCom’s credit ranking and the steps they took to hedge their own exposure in their role as creditors of WorldCom; and
• The underwriters’ awareness of WorldCom’s declining financial position and that of the telecommunications industry as a whole.

The underwriters’ internal downgrading of WorldCom’s credit ranking and the steps they took to decrease their exposure were, in the court’s view, “red flags” that should have caused them to investigate further and question the integrity of WorldCom’s financial accounting. With respect to the underwriters’ superficial questioning of WorldCom’s executives and auditors, the court noted that it has long been understood that “[t]acit reliance on management assertions is unacceptable [and that] the underwriters must play devil’s advocate.”¹⁹

Audited Financial Information

With respect to WorldCom’s 2000 registration statement, the underwriters claimed they were entitled to rely on the audit reports and the audited financial statements filed as part of WorldCom’s 1999 and 2000 Form 10-K annual reports because they constituted expertised portions of the registration statement. Plaintiffs replied that WorldCom’s reported E/R ratio was significantly lower than that of its two largest competitors, and that this discrepancy constituted a red flag. The court agreed and denied the underwriters’ motion for summary judgment based on its finding that a reasonable jury could conclude that this discrepancy should have triggered a duty to investigate even audited numbers. The court rejected the underwriters’ argument that audited numbers never can constitute such a “red flag,” stating that there “is no category of information which can always be ignored by an underwriter on the ground that it constitutes a business event. What is ordinary in one context may be sufficiently unusual in another to create a duty of investigation by a prudent man.”²⁰

With respect to the 2001 registration statement, plaintiffs argued that three facts triggered the underwriters’ duty to investigate: (1) the discrepancy between WorldCom’s reported E/R ratio and that of its competitors; (2) the ongoing declining value of WorldCom’s long distance business; and (3) WorldCom’s CEO’s financial position, which was directly linked to the value of WorldCom stock, and therefore gave him a motive to manipulate the stock price. The court found that an issue of fact existed from which a reasonable jury could conclude that the first two items raised red flags. However, with respect to WorldCom’s CEO, the court disagreed with plaintiffs and found that, although the underwriters were aware that the CEO had used a great deal of WorldCom stock as collateral for personal loans, that fact alone was insufficient, as a matter of law, to trigger the underwriters’ duty to investigate since there was no showing that the underwriters knew the CEO intended to commit fraud.

Where Do We Go From Here?

The WorldCom decision in many ways highlights the discrepancy between the standards of liability for underwriters in registered securities offerings, which have not evolved since the enactment of the Securities Act, and the timing demands of the modern marketplace. Although there have been several attempts by the private bar, as well as the SEC itself, to remedy these discrepancies, the law in this area has never changed, and underwriters have not obtained any relief from their diligence obligations, despite the continuing evolution of the offering process. Because the WorldCom decision fails to provide guidelines as to what acts would constitute a sufficient due diligence investigation, the industry may wish to consider imploring Congress to “modernize” underwriters’ due diligence requirements in the context of shelf offerings.²¹

The WorldCom decision makes clear that, despite the timing constraints investment banks face when underwriting an offering of securities off a shelf registration statement, they may not ignore warning signs that cast doubt on the integrity of audited financial statements. Nor is mere superficial questioning of a company’s executives sufficient to constitute a reasonable investigation.

The court in WorldCom appears to have concluded that where red flags place in doubt the reliability of expertised portions of a registration statement, the due diligence obligations of underwriters with respect to those portions somehow become indistinguishable from the obligations applicable to portions that are nonexpertised (i.e. a duty to undertake a reasonable investigation). How to recognize a “red flag” and conduct an investigation in a manner designed to uncover “red flags” will be among the tough questions that underwriters will have to grapple with in the wake of this decision.

Judge Cote’s holding constitutes a check on the ability of underwriters to rely exclusively on the work of auditors. The statute still permits underwriters to rely on expertised portions of the registration statement. However, such reliance is not without limitation; audited financial statements are not “get out of jail free cards.” Judge Cote stated that “[i]f red flags arise from a reasonable investigation, underwriters will have to make sufficient inquiry to satisfy themselves as to the accuracy of the financial statements, and if unsatisfied, they must demand disclosure, withdraw from the underwriting process, or bear the risk of liability.”²² While the court did not provide a checklist of red flags, it did say that anything that would cause an underwriter to lose confidence in portions of the registration statement premised upon audited financials would, in fact, constitute a red flag. Furthermore, even if a reasonable investigation would not have exposed inaccurate financial reporting or fraud (as may have been the case with WorldCom, which essentially used two sets of books to mask accounting fraud) underwriters still must conduct a reasonable investigation if they hope to successfully assert their due diligence defense. Consequently, process becomes an integral element of the defense, even if ultimately nothing is uncovered.

The fraudulent conduct and facts underlying the WorldCom case are somewhat unusual. On the other hand, the decision reflects the climate of increased scrutiny placed upon underwriters and other “gatekeepers” in the context of securities offerings. Accordingly, underwriters may be well served by conducting due diligence with an eye toward the specter of litigation that may be looming on the horizon and the evidentiary hurdles they will meet in presenting a due diligence defense to a judge or jury.

At the very least, underwriters should follow a delineated due diligence method and process. How much detail and follow-up is needed will depend on the results of the initial investigation in light of the circumstances of each case. Boilerplate questions and simply “going through the motions” are not recommended, and an active role in seeking and verifying information should be encouraged. Underwriters also should consider to what extent the due diligence process should be documented to reflect the work done and, consequently, document-retention policies should be reviewed and re-examined. By anticipating how, in hindsight, a judge or jury may view their actions (or lack thereof), underwriters may increase the possibility of successfully asserting the due diligence defense, and improve their chances of disposing of a lawsuit in the early stages of litigation.

Some underwriters have expressed concern that Judge Cote’s ruling requires that they essentially re-audit a company’s financial statements. However, the decision makes clear that the term “reasonable inquiry” encompasses many modes of analysis between obtaining a comfort letter and doing little more, and performing a total re-audit of a company’s financial information. As the court noted, in the face of significant red flags, a prudent underwriter may choose to retain an accounting expert to review the financial statements to confirm that a particular accounting treatment is appropriate or that no further inquiry or disclosure is required. If the expert concludes that the financial statements do not conform to GAAP, a new audit may be required and the offering would most likely fail to proceed as planned.

The court’s decision is not likely to have a significant impact on the manner in which underwriters perform due diligence in the context of initial public offerings or in other situations where substantial time can be allocated to the diligence and drafting process. However, these issues are of real significance in repeat, shelf-registered offerings where time pressures often severely limit the amount of due diligence an underwriter can conduct and where an underwriter’s prior experience with a particular issuer may be limited.

Underwriters that are invited to participate in a syndicated offering later in the process should consider what additional steps, if any, they should take to assure themselves that adequate diligence has been performed by the lead underwriters and counsel. The WorldCom decision raises questions regarding whether an underwriter can be held liable for more than the amount of securities it underwrote in the offering.

The decision, combined with the effect of recent regulatory actions, will undoubtedly raise the bar on accounting diligence. Paradoxically, auditors, already besieged by extensive litigation, may be expected to resist this trend. Requiring banks to undertake a more intense accounting investigation may further exacerbate the sensitivity of auditing firms, which already have become progressively more self-protective in the diligence process, to any effort by banks to get them more involved in underwriters’ due diligence procedures.

For seasoned issuers, underwriters may want to consider developing an internal process to monitor companies continuously—verifying interim financial statements, and comparing these companies’ financial data with those of other companies in the same industry, long before an issuance is planned.²³ Although investment banks routinely follow and analyze comparable company financials in particular industries, they typically have focused on this analysis for valuation purposes, not as an integral element of the due diligence investigation. The WorldCom decision implies that such analyses should be undertaken as a matter of course in any offering.

Underwriters and seasoned issuers also should consider making more efficient use of designated underwriters’ counsel, and perhaps should establish procedures together to monitor corporate developments, analyze interim financial data, and conduct diligence on an ongoing basis. (Granted, some issuers may resist this approach).²⁴ Other steps might include using more accounting-trained bankers as part of the diligence teams and conducting more intensive training for bankers in due diligence investigations, particularly in the auditing and accounting area. More extensive diligence with a company’s audit committee and deeper inquiries into a company’s internal controls and its process for financial reporting often will be appropriate. While such measures certainly involve additional costs, the expense may be worthwhile in order to avoid the costs of defending a lawsuit, with the attendant risk of an adverse judgment and resulting negative publicity.

Industry groups have been closely analyzing the WorldCom decision in an attempt to better understand its practical implications and perhaps formulate a regulatory approach to the issues raised. The development of best practices and standard due diligence checklists also may help to regiment the diligence process and protect the underwriters that adhere to them. It is too soon to tell whether any regulatory relief or further guidance will be forthcoming. What is clear is that Judge Cote’s decision has caused the potential beneficiaries of the due diligence defense to keep their eyes more closely on the accounting ball and not rely blindly on the external auditors.

Notes

1. In re WorldCom, Inc. Sec. Litig., 346 F. Supp.2d 628 (S.D.N.Y. 2004).

2. 15 U.S.C.A. § 77k(a) (2005).

3. In re Worldcom, 346 F. Supp.2d at 658 (citing Kronfeld v. Trans World Airlines, Inc., 832 F.2d 726, 732 (2d Cir. 1987)).

4. Id.; see also Circumstances Affecting Reasonable Investigation and Reasonable Belief, SEC Release No. 33-6335, 1981 WL 31062 at 13 (Aug. 6, 1981).

5. Securities Act § 11(b)(3)(C) (emphasis added); 15 U.S.C.A. § 77k(b)(3)(C) (2005).

6. Securities Act § 11(b)(3)(A) (emphasis added); 15 U.S.C.A. § 77k(b)(3)(A) (2005).

7. In re Worldcom, 346 F. Supp.2d at 664 (citing Securities Act § 11(a)(4); 15 U.S.C.A. § 77k(a)(4) (2005)).

8. See 17 C.F.R. § 230.436(c) (2005).

9. 15 U.S.C.A. § 77k(c) (2005). Appearing as amici curiae on behalf of the underwriter defendants, the Securities Industry Association and the Bond Market Association attempted to persuade the court that the “prudent man standard must be interpreted from the point of view of a prudent man who has determined to buy securities in a shelf offering recognizing the timing and manner of such offering and the qualifications that the issuer must meet even to be eligible to use the shelf registration process.” Brief of the Securities Industry Association and the Bond Market Association, Amici Curiae, in Support the Motion [sic] of Underwriter-Related Defendants for Summary Judgment, available at <www.bondmarkets.com/assets/files/Due%20Diligence%20Brief.pdf>, at 7. If the court had adopted this standard it would have represented a marked departure from what can only be described as a rigid application of Section 11(c).

10. Escott v. Barchris, 283 F. Supp. 643, 697 (E.D.N.Y. 1968).

11. Feit v. Leasco Data Proc. Equip. Corp., 332 F. Supp. 544, 577 (E.D. N.Y. 1971).

12. See Delayed or Continuous Offering and Sale of Securities, SEC Release No. 33-6423, 1982 WL 35934, at 5 (Sept. 2, 1982); see also SEC Release No. 33-6335, supra note 4, at 5 (“Underwriters and others have expressed concern regarding their ability to discharge fully their responsibilities under Section 11 with respect to registration statements incorporating substantial information from periodic reports.”)

13. SEC Release No. 33-6423, supra note 12, at 6. Commissioner Thomas went even further in identifying the difficulties underwriters would face in the context of shelf offerings by stating that most underwriters “will not have participated in the preparation of the issuer’s Exchange Act reports that are incorporated by reference . . . and, therefore, they will need more, rather than less, time to perform a due diligence investigation . . . . Furthermore, the underwriter’s weakened relationship with the issuer and the perceived need for haste will make it extremely difficult for the underwriter or its counsel to suggest, let alone require . . . any changes. Id. at 15; see also Brief of the Securities Industry Association and the Bond Market Association, supra note 9, at 7.

14. SEC Release No. 33-6335, supra note 4, at 10. The SEC also “emphasized that due diligence requires a reasonable investigation of all the information presented therein and any information incorporated by reference.” Id.

15. See 17 C.F.R. § 230.176 (2005).

16. SEC Release No. 33-6335, supra note 4, at 1. The SEC rejected the Securities Industry Association’s alternative proposal of a safe harbor rule shielding underwriters from Section 11 and Section 12(2) liability under certain delineated circumstances. Id. at 7.

17. See 17 C.F.R. § 230.436(c) (2005).

18. In re Worldcom, 346 F. Supp.2d at 678.

19. Id. at 675 (citing Feit, 332 F. Supp. at 582); see also SEC Release No. 33-6335, supra note 4, at 10 (“The Commission specifically rejects the suggestion that the underwriter needs only to read the incorporated materials and discuss them with representatives of the registrant and named experts.”)

20. In re Worldcom, 346 F. Supp.2d at 680 (emphasis added).

21. See Michael Bobelian, “Post-Worldcom Liability—Underwriters Look for Guidance From the Courts, SEC,” N.Y.L.J., March 17, 2005, at 5.

22. In re Worldcom, 346 F. Supp.2d at 684.

23. The SEC has encouraged continuous due diligence measures for underwriters who must cope with severe time constraints and has stated that it “believes that the development of anticipatory and continuous due diligence techniques [i]s consistent with the integrated disclosure system and will permit underwriters to perform due diligence in an orderly, efficient manner.” Shelf Registration, SEC Release No. 33-6499, 1983 WL 408321 at 6; see also SEC Release No. 33-6335, supra note 4, at 10, 11 (Underwriters should “develop in advance a reservoir of knowledge about the companies that may select the underwriter to distribute their securities registered on short form registration statements.”).

24. See SEC Release No. 33-6499, supra note 23, at 5.

About the Author

Marc Rossell (mrossell@tpw.com) is a partner in the Corporate and Securities practice group of Thacher Proffitt & Wood LLP. Andrew Stemmer (astemmer@tpw.com) is an associate in the firm’s Litigation & Dispute Resolution practice group.