Due Diligence on Issuers

Due diligence is the core supervisory activity of an investment-banking principal in a public offering. It is also the only thing standing between an underwriter and strict liability when something in the registration statement turns out to be wrong.

The Due-Diligence Defense

The registration-statement liability provision lets a purchaser whose securities are traceable to the registration statement sue for a material defect at effectiveness. Fraud and scienter are not required. Reliance generally is not required, but a purchaser acquiring after publication of an earnings statement covering at least twelve months after effectiveness must satisfy the statute's reliance condition. Defendants other than the issuer may have specified defenses.

The due-diligence defense has two prongs:

For non-expertised portions, the underwriter must establish reasonable investigation and reasonable grounds for its belief. A reasonable allocation of work does not eliminate each underwriter's responsibility to support its own defense.

For expertised portions, the underwriter can rely on the expert (e.g., the auditor's clean opinion) as long as nothing in the underwriter's investigation suggested the expert's work was unreliable. The underwriter is not required to re-audit.

Exam Tip: Gotchas

• Good faith is NOT enough. The standard is reasonable investigation, an objective standard. An underwriter who relied on issuer-supplied information without independent verification has not done reasonable investigation regardless of subjective good faith.
• The defense is unavailable to the issuer. A misstatement in the registration statement is strict liability for the issuer. Only directors, signatories, underwriters, and experts get the defense.
• The expert defense for underwriters is narrower than people think. The underwriter relies on the auditor for the audited numbers; the underwriter still has to independently investigate the un-audited narrative (MD&A, business description, risk factors). Audited financials are a small fraction of a registration statement.

Required Due-Diligence Activities

A defensible due-diligence record covers four substantive areas plus a bring-down refresh at the end.

1. Business and Financial Review

• Management interviews with the CEO, chief financial officer (CFO), COO, and (when applicable) division heads
• Site visits to material operating facilities
• Review of audited and interim financial statements
• Accounting policies review (revenue recognition, capitalization choices, reserves)
• Cash-flow forecasts and the assumptions behind them
• Major contracts: customers, suppliers, distribution agreements, licensing

2. Legal Review

• Corporate organization: charter, bylaws, capitalization, subsidiary structure
• Material contracts: change-of-control, exclusivity, indemnification provisions
• Litigation: pending, threatened, settled-with-payment matters
• Regulatory standing: Food and Drug Administration (FDA), EPA, FCC, securities-regulatory licensure as applicable
• Intellectual property: patents, trademarks, license agreements
• Change-of-control provisions in material agreements (do they trigger on the IPO?)

3. Industry / Competitive Review

• Market position: market share, customer concentration, supplier concentration
• Competitive risks: pricing power, technological obsolescence, new entrants
• Regulatory environment: pending changes, recent enforcement actions in the industry

4. Management Background Review

• Prior disciplinary history of officers and directors (FINRA BrokerCheck, SEC enforcement, state actions)
• Regulatory issues: settled or pending matters involving management
• Prior litigation involving management
• Related-party transactions: ownership of vendors, lessors, customers

5. Bring-Down Diligence

A bring-down is a refresh of due-diligence findings just before pricing and again at closing. It includes:

• Final officers' certificates confirming no material adverse change since the last review
• Comfort letters from auditors covering financial information published in the prospectus
• Negative-assurance legal opinions from issuer counsel
• Re-confirmation that representations and warranties in the underwriting agreement remain true

Exam Tip: Gotchas

• Bring-down diligence is REQUIRED, not optional. The investigation completed two weeks before pricing is stale. The bring-down refresh at pricing and closing makes the defense defensible at the moment the deal goes effective.
• Comfort letters are limited in scope. Auditors give comfort on specific financial information that was prepared by them or audited by them. Comfort does not cover MD&A narrative or projections; those remain non-expertised and require independent investigation.
• A material adverse change between filing and pricing requires re-disclosure. A negative bring-down (a finding of MAC) means the registration statement may need to be amended before sales can proceed.

Documentation: The Diligence File

The supervisory principal must ensure due-diligence work is documented in a diligence file maintained for the offering. The file is the record that the underwriter performed reasonable investigation. Without the file, the defense is harder to establish.

The diligence file is subject to FINRA examination and to plaintiffs' discovery in any future registration-statement civil-liability lawsuit. A well-organized file is the underwriter's best evidence; a chaotic file is the plaintiff's best evidence.

Exam Tip: Gotchas

• The principal sign-off must occur BEFORE pricing. A retrospective approval after the deal closes does not create a defensible record. The principal's review and sign-off is itself part of the "reasonable investigation."
• Retain diligence records under their applicable categories and triggers. A file may contain records with different retention periods. Civil limitation and repose periods do not independently set those periods. Check litigation and regulatory preservation holds before destruction; offering closing does not authorize discarding the file.
• A common audit failure is missing primary-source documents. A well-drafted memo summarizing diligence findings is not enough; the file must include the underlying documents (auditor reports, contracts reviewed, background-check pulls). Summaries alone are insufficient.

Issuer Personnel Not Deemed Brokers

A separate but related rule defines a safe harbor for associated persons of an issuer who participate in the issuer's own securities offering. The safe harbor says such persons are NOT deemed brokers requiring registration if specific conditions are met:

• No statutory disqualification
• No commissions or other transaction-based remuneration for participation
• No current broker-dealer association
• Compliance with one of three alternative activity routes in the issuer-associated-person safe harbor

The routes cover specified institutional or exempt transactions; substantial non-sales duties with a twelve-month broker-dealer lookback and limits on offering participation; or limited approved written communications, responses to purchaser-initiated inquiries, and ministerial work. Substantial non-sales duties are not a universal condition of every route. Failure to fit the safe harbor does not by itself establish a registration violation; the underlying broker analysis still matters.

The rule matters because it lets issuer employees participate in selling the issuer's own securities (in a private placement or registered direct) without registering as a broker-dealer. The principal supervising a deal that uses issuer personnel must verify the safe harbor conditions are met.

Exam Tip: Gotchas

• The safe harbor protects ISSUER personnel only. It does not exempt third-party brokers, finders, or any person who is paid commissions on sales. The safe harbor narrows quickly if the person is paid based on success.
• The "no commission" condition is strict. Bonuses tied to capital raised are functionally commissions and disqualify the safe harbor.

What Should You Check on Exam Day?

• Can you distinguish the due-diligence standard for non-expertised portions from the lower standard for expertised portions like audited financials?
• Do you know why bring-down diligence at pricing and closing is required, not optional, for the due-diligence defense?
• Can you state when the principal's sign-off on the diligence file must occur relative to pricing?
• Do you know why comfort letters do not cover the business narrative or projections in the diligence file?