Reasonable Investigation in a Post-Sarbanes World: What's New in Due Diligence for Underwriters?

What's New in Due Diligence For Underwriters?

By David Miller and Douglas Wright

Section 11 of the Securities Act makes underwriters of a new issue liable to purchasers for material misstatements or omissions in a registration statement unless, having undertaken a reasonable investigation, the underwriter has no reason to believe the registration statement contains any such misstatement or omission. Underwriters fulfill this statutory responsibility in a number of different ways, including:

• review of legal and other material issuer documents
• interviews with key management
• participation in drafting sessions
• representations, warranties and covenants in underwriting agreements
• opinions of issuer's and underwriters' counsel
• physical inspections of material properties
• review of historical and projected financial performance
• interview with outside accountants

The limited new issue market has provided a welcome opportunity to reflect on how underwriters' due diligence may need to change to meet the new and heightened expectations of regulators and an investing public whose faith in the capital formation process has been severely challenged. What are some of the changes in underwriters' due diligence we have seen or may see?

Accounting, Accountants and Audit Committees. Historically, and absent special circumstances, underwriter interaction with accountants has been limited to the accountant's participation in the organizational meeting and drafting sessions (which is frequently limited), a relatively brief interview outside the presence of financial management, and review and discussion of the accountants' comfort letter.

New or on the horizon:

• more extensive analysis of corporate accounting and related disclosures, including off balance sheet arrangements, revenue recognition, non-GAAP data, critical accounting policies, issuer's use of GAAP and its strengths and weaknesses in the context of the issuer (i.e., check the box approaches v. principles-based approaches that enhance financial transparency), and evidence of earnings management
• insistence on accountant involvement in MD&A disclosure. We may even see some requests for SSAE #8 accountant's opinions, which cover the entire MD&A disclosure, not just numbers
• review of accountant independence for compliance with new rules
• review of internal controls and accountant's report in periodic reports pursuant to Sarbanes-Oxley Act (SOX) § 404
• more extensive face-to-face meetings with accountants to address these accounting matters
• review of audit committee charter, composition, responsibilities and compliance with new rules; meeting with audit committee chair to discuss these matters and, if different, meeting with any designated "audit committee financial expert" under SOX § 407

Disclosure Controls. Underwriters and their counsel need to review carefully the issuer's disclosure controls as adopted under SEC rules. This review could include:

• review and evaluation of written description of controls
• meetings with representatives of the disclosure committee or, if none exists, the persons principally responsible for formulating and implementing disclosure controls
• review and evaluation of any report concerning effectiveness of disclosure controls and changes made as a result of identified defects

Certifications. The underwriters should make specific inquiry of the issuer's CEO and CFO concerning the manner of certification of periodic reports under SOX § 302 and their views concerning the effectiveness of the certification process and the resulting accuracy of periodic reports. These officers should also explain their company's philosophy concerning disclosure and the integrity of the disclosure process.

Similarly, underwriters should question management concerning management's assessment of internal controls and the effectiveness of the internal control structure and financial reporting procedures.

MD&A. The Fortune 500 review, the rulemaking on off-balance sheet, pro forma non-GAAP financial information and critical accounting policies and SEC public statements all point toward a renewed and energetic focus on the quality, transparency and completeness of an issuer's MD&A. Underwriters and their counsel must give special attention and care to this content area of disclosure, not only for strict compliance with SEC rules, but also to assure a highly qualitative, forward-looking and understandable narrative of the key economic drivers of the issuer's results and financial condition that goes beyond GAAP.

Compliance with SOX. While underwriters need to weigh cost and benefit, and while historically exhaustive legal compliance checks are not considered part of a reasonable Section 11 investigation, consideration should be given in the current climate to a more thorough review of key and newly implemented SOX law and rules, including:

• extensions of credit to directors and executive officers
• whistleblowing procedures
• Form 4 reporting, Reg BTR and other insider trading practices
• design and implementation of a code of ethics for the senior financial management

Corporate Governance. Integral to the success of future offerings will be a high degree of investor confidence in the corporate governance practices of issuers. SOX law and rules will drive some of these practices. NYSE and NASD rules will dictate other best practices. Underwriters and counsel should carefully scrutinize these practices, not just for compliance with applicable law and regulations, but also for consistency with developing practices, especially in areas not expressly addressed by law and regulations. A review of the composition and processes of the board and the board committees, including a review of committee charters, seems appropriate. Underwriters may find the market demanding early compliance with new rules and regulations. In other words, there may be a premium payable for good governance.

Underwriting Agreements. While there is great temptation to single out each new law and regulation for special attention in the underwriting agreement through a host of new representations and warranties, the evolving practice focuses more on one or two key areas that have the potential for significant impact on the quality of the registration statement. These include:

• disclosure controls rep
• general compliance with SOX rep
• issuer covenant to take steps to comply in the future with SOX requirements as they become effective

Comfort Letters. Perhaps never have these letters been more important. Yet underwriters are experiencing a tide of rising conservatism among auditors (can we blame them?), which makes them even more reluctant than ever to deal with numbers or words that can't be traced directly or indirectly to accounting records of the issuer or its consolidated subs. Areas where this can be problematic are off balance sheet arrangements, which may hold contingent liability for an issuer, but which are controlled by an unaffiliated third party.

Research Analysts. At the time of this publication, the final terms of the global settlement with Wall Street firms are not yet public. Nor have proposed NASD and NYSE rules relating to certain IPO practices been adopted. Nevertheless, certain practices relating to the involvement of research analysts in the offering due diligence process have emerged or can be expected to emerge:

• Research analysts should not engage in any communication with an issuer in furtherance of obtaining investment banking business from a company prior to the investment bank being engaged. Any contact an analyst has with the issuer prior to that time must be limited to matters of financial and business analysis associated with the investment bank's due diligence investigation of the company.
• To reinforce this, some investment banks prohibit research and investment banking from conducting due diligence together. Further, any communication concerning due diligence findings to investment banking must be made in the presence of underwriters' or other outside counsel or internal compliance or legal staff.
• Research should not review in the diligence process material, non-public information, including management projections of public companies absent an agreement concerning confidentiality pending public disclosure by the issuer. Any such disclosure to analysts could be problematic because public disclosure may never come and the analyst's ability to write research on the issuer may be compromised as a result.

Lawyers' Professional Responsibility. New SEC rules applicable to lawyers working for the issuer in an offering are sure to make issuer's counsel more cautious than ever and may help underwriters in the due diligence process. These rules, which become effective in August 2002, apply to any attorney appearing and practicing before the SEC in the representation of an issuer.

By their terms, and as confirmed by the SEC, these rules do not apply to underwriters' counsel.

The core of the new rules requires attorneys subject to its prescriptions when they become aware of "evidence of material violation" to report that evidence to the issuer.

A "material violation" means credible evidence that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur of an applicable U.S. federal or state securities law or of a fiduciary duty arising under U.S. federal or state law.

While issuer's counsel, much like underwriters' counsel, tends to serve the role of watchdog over the offering, the added risk of direct SEC sanctions may tend to enhance the rigor with which such counsel participates in the disclosure process.

Accelerated Reporting by Issuers. Underwriters and their counsel have always been challenged by an integrated disclosure system in which Exchange Act reports they did not help prepare are incorporated by reference into a prospectus. For larger, more seasoned issuers, which come to market regularly, this problem is sometimes addressed through quarterly due diligence updates. But even here, underwriters are not invited to comment upon or participate in the drafting of periodic reports. The new SEC rules to be phased in will shorten the filing time for 10-Ks and 10-Qs and will no doubt further reduce the opportunities for underwriters and their counsel to have any meaningful impact on periodic reports that may be incorporated by reference.

Unfortunately, this may lead to an increase in the number of "fixes" that underwriters must employ when confronted with unacceptable Exchange Act disclosure. Depending on the circumstances, these may include:

• enhanced risk factor disclosure
• amendment of the periodic report
• restatement of the relevant disclosure in the registration statement
• current developments disclosure

Due Diligence Checklist. Investment bankers are reminded to look over their form due diligence lists to make sure they address, as appropriate, some of the issues raised here.

Underwriters and their counsel should bear in mind that reasonable investigation is not a static concept. Rather, it must be shaped to meet the changing demands of the investment community. SOX and related SEC rules will require increased vigilance from underwriters and their counsel if they are to establish the reasonableness of the underwriters' investigation. The perceived needs of the underwriters will be tested by issuers and their counsel who may resist material changes to previously accepted norms, especially where they occasion intrusions on management time and other intangible, as well as financial, costs.