After the WorldCom corporate scandal broke, SEC investigators and lawyers found pervasive fraudulent activities by WorldCom executives. The SEC alleged that various underwriters who had participated in WorldCom’s 2000 and 2001 public debt offerings had failed to conduct adequate due diligence of WorldCom and its business practices, forcing the underwriters to settle with investors and the government for a combined $6 billion. The government accused these underwriters and their lawyers of failing to uncover the wrongdoings of top WorldCom executives prior to each of the offerings. The WorldCom settlement offers a profound lesson on the importance of the due diligence investigation process in connection with preparing the registration statement for a client company.
The pressure on lawyers advising companies during the planning process to find possible wrongdoings goes beyond the executive suite. For example, as it prepared for an IPO, Uber’s top lawyer prepared a transparency report to quantify how many people have been sexually assaulted during Uber rides. Preparing such a report is challenging, as many Uber passengers have not reported sexual assaults. But, if Uber faces a class action lawsuit for sexual assault acts by their drivers, the issue of whether this was investigated as part of the due diligence could become important.
An incompetently conducted due diligence in connection with preparing investors’ documentation opens the door to potential legal liability for issuers and underwriters. As demonstrated by WorldCom securities litigation settlements, the liability stakes are potentially sky-high! A properly conducted due diligence investigation of the proposed issuer of securities for public sale must include a well-conducted and thorough investigation of the issuer’s business, corporate history, board of directors and management, financial operations and statements and operations.
The term “due diligence” is not mentioned in the statutory language of the Securities Acts of 1933 and 1934. Rather, the concept or idea of a due diligence investigation is invoked as a potential defense for participants in securities offerings. To create a defense of due diligence, parties must conduct a reasonable investigation or exercise reasonable care.
Thus, the concept and purpose of due diligence generally mean a set of processes and procedures that will:
(A) establish a defense for underwriters and others under the various federal securities laws;
(B) promote accurate and full disclosure of material documents to investors;
(C) identify any provisions in a company’s contractual obligations, regulatory finding or requirement or statutory basis that may impact an offering of securities;
(D) identify any actual or potential risk which might rise from participating in an offering of securities; and
(E) ensure that the issuer is fully compliant with the disclosure requirements of the SEC in connection with the offering of securities.
Preparing the Registration Statement
Preparing a client company for the SEC registration process, or any other major corporate financing, requires attorneys to play a variety of roles in the due diligence process. For example, lawyers and their staffs may:
(A) advise the client on the legal requirements of full and accurate disclosure of material documents in connection with preparing and filing a registration statement with the SEC;
(B) identify corporate documents that may be required for disclosure and inclusion in the registration statement; and
(C) assemble and organize corporate documents and data files. Paralegals and junior attorneys often play significant roles in assembling, copying, scanning and organizing the thousands of corporate documents and files that are required to prepare the registration statement.
Some key points to consider in this process are:
(1) Use secured, encrypted online database to distribute documents.
Many of the firms that need access to the document database may be scattered throughout the US, including the accountants, brokers and underwriters, management consultants, investment bankers and other law firms. Using standard database software can ensure that all participants will know how to manipulate documents and navigate the contents of the database. Also, it is critical to create redundant, back-ups of all documents and files.
(2) Create a parallel “hard copies” document and file room.
Many firms use traditional banker boxes to hold and organize key corporate and accounting document copies held in a centralized “data room.” Though the importance of creating paper versions of each document is lessening as technology evolves, it’s still standard practice.
(3) Create specialized teams for the corporate documents review & organization:
A large, temporary team of junior attorneys and paralegals will likely be required to review and organize a massive number of corporate documents and files.
(4) Consider the underwriter’s counsel’s needs:
The underwriter and investment bankers will craft a working draft of the preliminary prospectus which will be included under Part I of the registration statement. It is vitally important to anticipate the documents that the underwriter’s counsel may be requesting in preparing the preliminary prospectus. The underwriter’s counsel will rely on the corporate general counsel and outside law firm attorneys to identify and organize key documents required for the Prospectus. Any delays in responding to the underwriter counsel’s requests for documents will delay the filing of the registration statement, and perhaps even delay the offering.
Federal securities laws make it unlawful to disclose any untrue statement of material fact or omit a material fact that is necessary to prevent any other statement from being misleading in connection with a securities offering. The general rule on materiality as developed by the Supreme Court is that there must be a substantial likelihood that the misstated or omitted fact would have been considered by the reasonable investor in making his or her investment decision. But there is no exact definition of materiality in the context of securities offering disclosures.
Accordingly, many attorneys take a “scorched-earth” approach to conducting due diligence. This approach seeks to identify all potential documents, transactions, files, social media content, etc., that may be material to prospective investors. Once these documents are red-flagged, they are brought to the attention of the management for closer scrutiny, examination and to assess their relevance. Finally, these red-flagged documents are brought to the attention of counsel for the underwriters to determine their materiality and to decide whether or not to disclose them. Ultimately, the burden falls on underwriters’ counsel as they are the final gatekeepers of information to be disclosed to investors.
In suspending the registration statement and prospectus filed by the Richmond Corporation, the SEC issued an opinion which said:
It is a well-established practice, and a standard of the business, for underwriters to exercise diligence and care in examining into an issuer’s business and accuracy and adequacy of the information contained in the registration statement. By associating himself with a proposed offering, an underwriter impliedly represents that he had made such an investigation in accordance with professional standards. Investors properly rely on this added protection which has a direct bearing on their appraisal of the reliability of the representations in the prospectus.
The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the investing public. Such dereliction, moreover, does not serve the statutory objectives of achieving a prospectus for the sale of securities which, in all material respects, contains the information necessary for an informed evaluation of the securities offered.
Thus, while the underwriter of the public offering bears great responsibility in facilitating the disclosure of all material data and information about the company and its offering materials to investors, equal exposure may fall on the company’s corporate counsel assembling the required due diligence documents.
Obtaining and Submitting Corporate Documents
Production of corporate documents represents a baseline, as production of other documents and files often results from the initial review of these documents. These documents are representative of the types of documents and files that have been requested previously by the SEC from issuers. Additional documents that relate to a specific industry, for example, may also be included in the preliminary document production.
In preparing to advise and represent a corporate client exploring a public offering of securities, legal counsel should prepare and submit a preliminary document request list early in the process. The timing depends on the length of the relationship between the law firm and client company. A new client, for example, will require early determination of any potential conflicts of interest. Working with a long-standing relationship, the law firm will presumably have a deeper knowledge of the business and management team. There are no general rules of thumb here except that where a client is clearly set on going public, the preparation must begin early enough to maximize flexibility in going forward with the IPO.
Preliminary documents include certified copies of the articles of incorporation, by-laws, board of directors’ meeting minutes, written consents, minutes of shareholders’ meetings, board of directors’ committee meeting minutes and materials distributed at all meetings of the shareholders, board of directors or board committee meetings. All items requested should cover a period of the last three years.
Another set of corporate documents that should be requested of the company include any reports or correspondence (hard or electronic) to the company’s board of directors regarding foreign payments or compliance with US currency transaction reporting laws, as well as reporting requirements under the Foreign Corrupt Practices Act, for three years immediately prior to the expected filling date of the registration statement.
Lawyers should obtain copies of all corporate stock books and ledgers and other records of issuance of stock by the company. In addition, a list of current shareholders is required, including addresses, the number of shares owned by each of them, consideration paid and dates the shares were acquired. A key requirement is the identification of all shareholders having any family or business relationship with any officers and directors of the company.
Another important set of documents includes a schedule of holders of any stock options to purchase securities, including warrants or other rights to buy. The names and addresses of these holders of options and warrants, the number of options or warrants held, their exercise prices, the dates of the granting of all options and warrants, any position in the company of the holders and the number of shares owned by the holders.
In addition, corporate counsel should prepare an organizational chart of the company, including key officers, and board members, and an accompanying ownership chart that identifies all entities or investments in which the company directly or indirectly owns interests. It should also produce a list of all jurisdictions where the company does business, owns property or is qualified to do business. Similarly, corporate counsel should help revise or create a document that states the company’s principles of corporate governance or corporate governance guidelines.
The company must also produce all documents and other information related to any material litigation, administrative proceedings, governmental investigation or regulatory review or inquiry that is pending or occurred in the previous three years, if it could affect the company or any of its officers or directors. Note that some of the documents submitted voluntarily or as requested by the SEC may be classified under the attorney-client privilege and thus may require a limited waiver of the privilege to share with the SEC during the registration process.
Other legal matter documents to be shared with the SEC may include:
Memoranda or correspondence with counsel regarding material information about pending or threatened litigation or litigation settled, terminated or dismissed by a court or administrative agency in the last three years;
Any material consent decree, judgment or other orders, settlement agreements involving the company or to which any of its officers or directors have been a party; and
Memoranda or correspondence between the company and the company’s counsel or accountants or to any regulatory authority in the last three years related to material litigation in which the company or any officers or directors may be involved.
§ Financial Documents
Financial information comprises central components of the registration statement. Of course, the financial documentation is extremely important to preparing the prospectus which is included in the registration statement. The following list of financial documents and data represents the tip of the iceberg, as the SEC may require additional financial, tax-related, and financing documents. However, this list represents a sample of the types of financial documents that should be incorporated in the due diligence process conducted by legal counsel for the company:
(i) Audited company financial statements for the last three years. The audit must be conducted by an independent certified public accounting firm that is approved and certified to audit the financial statements of publicly held companies.
(ii) The company’s chief executive officer and chief financial officer certificates filed under the Sarbanes-Oxley Act for all annual and interim reports and internal compliance certificates or sub-certificates;
(iii) Most recent internal financial statements for the company;
(iv) Copies of all private placement memoranda used in the past three years in connection with the sale of securities to private investors;
(v) Copies of all annual reports and interim financial reports distributed to shareholders for the past three years;
(vi) Current company budgets and financial plans and projections;
(vii) Description statement of the company’s current internal controls in response to Section 404 of the Sarbanes-Oxley Act.
Many more documents and files may be required at the request of the SEC, depending on the offering size, company’s history and business, industry and circumstances.
The process of collecting and organizing the required documentation for the registration process requires significant time. Counsel and supporting legal professionals play a variety of roles in the process. An error in judgment in failing to disclose a material document, no matter how insignificant and obscure, may result in delay of the offering, or potential litigation and liability should the securities offering proceed.
In our next module, we’ll look at private securities offerings. While these are not as complex as public offerings, they are also subject to many rules and regulations.
 In re WorldCom, Inc. Sec. Litig., 388 F. Supp. 2d 319 (S.D.N.Y. 2005)
 Reference to the “company” refers to the hypothetical corporate client seeking advice from counsel.
 “As Uber Prepares to Go Public, This Man Is Racing to Clean It Up” March 3, 2019. NY Times
 15 U.S.C. § 77k(b)(3)(A)
 15 U.S.C. § 77k(b)(3)(B)
 See TSC Industries v. Northway, 426 U.S. 438 (1976); also Basic Inc. v. Levinson, 485 U.S. 224 (1988)
 In the Matter of The Richmond Corporation, 41 S.E.C. 398 (1963)
 15 U.S.C.section 7241