Disclosure Standard and Reasonable Investigation

Due diligence (DD) is the structured investigation a banker runs to identify information that must be disclosed (or that must not be misstated) in offering documents and M&A agreements. The legal anchor is the Securities Act civil-liability standard for registration statements, and the bridge between "we investigated" and "our investigation was reasonable" is the SEC's situational-factor framework for assessing the underwriter's diligence defense.

What Is the Disclosure Standard?

Securities Act civil liability attaches to material defects in registration statements. The standard has two prongs, both of which trigger liability:

• Offering documents shall NOT:
  • Contain an untrue statement of material fact, OR
  • Omit a material fact necessary to make the statements made (in light of the circumstances under which they were made) not misleading
• The standard applies to public offering registration statements. Private offering memoranda (offering circulars, private placement memoranda, PPMs) are not subject to this registration-statement liability standard merely because they are offering documents; they instead require accurate, nonmisleading disclosure under applicable antifraud and other liability provisions
• A registration statement can be technically accurate sentence-by-sentence and still trigger liability if it leaves out a material fact a reasonable investor would want to know
• Antifraud liability under the Exchange Act independently reaches the same untrue-statement-or-omission conduct in private placements, through a different legal provision than the registration-statement standard

Exam Tip: Gotchas

• The standard hits BOTH affirmative untrue statements AND material omissions. A registration statement that is technically accurate but leaves out a known material risk can still trigger liability. The exam loves the "or" in this standard.
• Private offering memoranda are not subject to the registration-statement liability standard just because they are offering documents. Antifraud and other provisions separately require accurate, nonmisleading disclosure there. Don't collapse the two into one standard.

What Does a Banker's DD Review Cover?

The substantive work behind a Securities Act diligence defense is the actual investigation of the issuer. The Series 79 outline lists six categories the banker is expected to cover:

• Financial information review: Historical financial statements, projections, working capital, debt schedule, contingencies
• Business plan review: Strategy, market position, capital plan, growth assumptions, competitive landscape
• Management interviews: Speak with the company's senior leadership (chief executive officer, chief financial officer, division heads, general counsel)
• Third-party interviews: Speak with vendors, suppliers, and customers to corroborate the business condition and confirm dependencies
• Site visits: Physical inspection of operations (plants, warehouses, retail locations, headquarters)
• Bring-down due diligence: A pre-closing refresh confirming that the DD record remains accurate up to the closing date (not just at the signing or pricing date)

Think of it this way: The financials tell you what the company says about itself, the management interviews let you ask the people who run it, the vendor and customer calls let you check what they say against what the world sees, and the site visit lets you confirm the operation physically exists at the scale the financials imply. Each layer corroborates the others.

Exam Tip: Gotchas

• Third-party interviews mean vendors, suppliers, and customers (not just employees of the issuer). Independent corroboration is the point.
• Bring-down DD is not a one-time event at signing. It is a refreshed confirmation pulled close to the closing date so that the DD record remains current. A long gap between signing the underwriting agreement and the closing date widens the bring-down workload.

What Makes an Investigation Reasonable?

Once a DD program is done, defendants who are not the issuer (underwriters, outside directors, experts) can assert a due-diligence defense by showing they conducted a reasonable investigation and had reasonable grounds for belief that the registration statement was accurate. The reasonable-investigation standard lists the circumstances that will be considered in assessing whether the investigation was reasonable.

• The standard is situation-specific: no checklist guarantees compliance
• The relevant circumstances:
  • Type of issuer, type of security, and type of person (the defendant's own role or category)
  • Office held, when the person is an officer
  • Presence or absence of another relationship to the issuer, when the person is a director or proposed director (limited to directors and proposed directors, not every investigator)
  • Reasonable reliance on officers, employees, and others whose duties should have given them knowledge of the particular facts, given that person's own functions and responsibilities
  • When the person is an underwriter: the type of underwriting arrangement, that person's role as underwriter, and the availability of information about the registrant
  • Responsibility for incorporated documents: Whether the person had any responsibility for a fact or document incorporated by reference, at the time of the filing from which it was incorporated

Think of it this way: The framework is a sliding scale. An underwriter on an IPO for a first-time issuer with no analyst coverage is expected to dig deeper than the same underwriter on a follow-on offering for a seasoned public reporter that just filed a clean 10-K. Same legal standard, different practical depth.

Exam Tip: Gotchas

• The framework deliberately does NOT give a fixed checklist. The circumstances considered turn on the issuer profile, security type, the defendant's own type and role (office held, or director status), reliance on knowledgeable personnel, and, for underwriters specifically, the underwriting arrangement and information availability.
• An IPO of a first-time issuer demands a deeper investigation than a follow-on for a seasoned, well-covered public reporter. Issuer profile drives expected depth.
• Reasonable reliance on the issuer's officers, employees, and experts is an explicit factor, but reliance has limits: a banker who knows or should know that a relied-upon statement is suspect cannot hide behind reliance.
• The "other relationship" factor applies only to directors and proposed directors, not to every investigator. Don't generalize it to underwriters or experts who have no director role.

What Should You Check on Exam Day?

• Confirm which prong a fact pattern tests: an affirmative untrue statement or an omission that makes other statements misleading. Both trigger liability.
• Check whether the offering document is a public registration statement or a private offering memorandum; only the registration statement is directly subject to the registration-statement liability standard, while private memoranda are governed by antifraud and other provisions.
• Match the DD scope question to one of the six review categories (financials, business plan, management interviews, third-party interviews, site visits, bring-down DD) rather than assuming "financials" covers everything.
• Confirm a bring-down DD question is about the pre-closing refresh, not the initial signing-date investigation.
• Apply the reasonable-investigation factors as a sliding scale tied to issuer type, security type, and underwriting arrangement, not a fixed checklist.