Arthur Andersen Audits - Still an Underwriter's Dilemma

You have an underwriting client that wants to conduct an offering. The company's previous auditors were Arthur Andersen. Its new auditors audited the company's 2002 financials, but the company did not get a re-audit of the AA numbers. In addition, if you proceed with the offering, the company's new auditors will not comfort the AA numbers. For your protection (and the company's) you ask to have the AA financials re-audited. The company refuses because a re-audit is too expensive and will slow down the transaction. The client is even threatening to find a different underwriter to lead the transaction if you require the AA financials to be re-audited.

The fact pattern above, although still somewhat rare, is one that you may face this year. In deciding whether to proceed with the transaction, you need to understand the risks the transaction poses to your due diligence defense and what steps you may want to take if you decide to proceed without a re-audit.

An Underwriter's Due Diligence Defense

Section 11 of the Securities Act of 1933 allows plaintiffs who purchase securities under a materially misleading registration statement to bring a civil claim against the issuer. This Section 11 liability extends to underwriters that participate in offerings conducted under materially misleading registration statements. However, if an underwriter can establish a due diligence defense, a plaintiff cannot recover from the underwriter.

The requirements for an underwriter to establish its due diligence defense vary depending on whether portions of a registration statement are "expertised" by others:

• for "expertised" portions of a registration statement, an underwriter (i) has no express duty of investigation and (ii) needs only to have no reason to believe and does not believe the information is false or misleading; and
  
  
• where information is not expertised, the underwriter (i) must conduct a reasonable investigation and (ii) must have no reason to believe and does not believe the information is false or misleading.

Experts, such as auditors, have direct liability to investors for information they consent to include in a registration statement. SEC rules historically have required the experts to provide a consent in order for audited financials to be included in a registration statement. In light of the AA dissolution, the SEC adopted a special rule that automatically dispensed with the consent requirement for former AA clients if the issuer meets certain conditions. This rule allows issuers to use the AA audit without SEC restriction.

The use of the AA financials without a re-audit poses risk to an underwriter, because it is unknown whether the absence of an accountant's consent has the effect of making the AA financials nonexpertised. If the financials are deemed nonexpertised, underwriters must perform a reasonable investigation of these financials in order to establish their due diligence defense. It is even less clear what a reasonable investigation would be in these situations. Although, respected authorities suggest that the lack of a consent for AA financials does not make the financials nonexpertised, there is no legal precedent which assures this result if an underwriter is sued by a harmed investor. In addition, a court may feel sympathetic to a plaintiff in this setting. Moreover, even if an underwriter is not required to conduct a reasonable investigation, the more lenient standard of "no reasonable ground to believe" might impose additional steps on the underwriters in this situation, given the presence in the registration statement of financials certified by a now defunct auditor.

When making the ultimate decision to accept or reject the engagement, an underwriter may wish to consider some of the following:

• the seasoning and reputation of the issuer and its management;
• whether the issuer is offering equity, where accounting irregularities can produce more price variability than fixed income securities;
• how long the underwriter has been working with the issuer and whether the underwriter has previously conducted an offering for the issuer;
• if the former AA accountants are now at the new auditing firm;
• if AA gave comfort in the past to the same underwriters or even to other underwriters;
• whether the underwriter's firm has a research analyst that follows the company;
• the fact that the most recent fiscal year has been audited by a reputable firm; and
• whether the most recent fiscal year is the most important to an understanding of the issuer and whether prior years while required, are not really helpful to understanding the issuer's economic drivers going forward.

A Suggested Approach

As discussed above, if an underwriter decides to proceed with a transaction in this setting without a re-audit of the financials, the underwriter accepts the risk that in the event of litigation (i) the underwriter must demonstrate that it had no reasonable ground to believe that the information in the AA financials was false or misleading and (ii) the underwriter may need to demonstrate that it conducted a reasonable investigation of the AA financials. Although, it is impossible to know what a court would expect of an underwriter if litigation actually did arise, the following are some ideas, short of requiring a re-audit, that may bolster an underwriter's due diligence defense:

• intensify the accounting due diligence effort by having face-to-face accounting due diligence meetings or retain external accounting experts to devise questions and perhaps testing procedures to probe weaknesses in prior period financials;
• interview the AA engagement partner or partners, who may now be with the new accountant (and may even be the audit partner);
• discuss with the new auditors the availability of alternative comfort procedures that might be used on the AA numbers (unfortunately, it is unlikely that the new auditors will even touch or mention the numbers, except to provide mathematical comfort on the percentage change from period to period);
• request certifications from company management that are comparable to the certifications that auditors get, providing representations as to key elements of the financials;
• have the company management tick and tie the AA numbers;
• review all prior audit reports, consents, management letters and comfort letters from AA;
• consider bringing the underwriting firm's research analyst, if one follows the issuer, over the wall to help assess risks;
• in addition to including required disclosure in the registration statement regarding no liability to investors from a nonconsenting auditor, the underwriters may wish to include additional disclosure that a plaintiff cannot recover if the underwriters have a due diligence defense.