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.

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 AND to private offering memoranda (sometimes called offering circulars or PPMs, private placement memoranda)
• 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 conduct in private placements

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.
• The standard applies to private offering memoranda too, not just public registration statements. The "untrue statement / material omission" wording is the controlling frame either way.

Review of the Issuer's Business (DD Scope)

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.

The Reasonable Investigation Standard

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 SEC's guidance lists the circumstances that will be considered in assessing whether the investigation was reasonable.

• The standard is situation-specific: no checklist guarantees compliance
• Factors include:
  • Type of issuer, type of security, and type of underwriting arrangement (seasoned issuer vs first-time initial public offering, IPO; investment-grade debt vs speculative equity; firm-commitment vs best-efforts underwriting)
  • Whether the investigator has any relationship with the issuer other than as underwriter (e.g., prior banking relationship that may have produced independent knowledge)
  • Reasonable reliance on the issuer's officers, employees, experts, and other persons whose duties place them in a position to know the facts
  • Availability of information about the issuer (well-followed public reporter vs first-time filer)
  • Responsibility for incorporated documents: Whether the person had a role in producing or filing any document incorporated by reference into the registration statement

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. Whether an investigation was "reasonable" depends on the issuer profile, security type, underwriter role, time available, 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.