CHAPTER 10 PRACTICAL SECURITIES CONSIDERATIONS IN PUBLIC AND PRIVATE OFFERINGS
| Jurisdiction | United States |
(Nov 1982)
PRACTICAL SECURITIES CONSIDERATIONS IN PUBLIC AND PRIVATE OFFERINGS
Kutak Rock & Huie
Denver, Colorado
INDEX
Introduction
Statutory Due Diligence Framework
Case Law Concerning Due Diligence
SEC and NASD Pronouncements Concerning Due Diligence
Due Diligence and Integrated Disclosure
Special Due Diligence Considerations in Private Placements
Broker/Dealer Record Keeping Requirements
Due Diligence Checklist
A. Private Placements and Public Offerings Not Involving Incorporation of Exchange Act Filings
1. The company and its industry
2. Corporate status and actions
3. Issuer's business
4. Financial Statements
5. Capital stock
6. Banking relationships and borrowings
7. Property
8. Management
9. Employee relations
10. Litigation
11. Miscellaneous documents and matters
B. Special Considerations for Tax Shelter Offerings
C. Special Considerations for Offerings Incorporating Exchange Act Reports
Integration of Securities Offerings
Footnotes 10-32
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Introduction
This paper will focus on two significant concerns in public and private offerings of securities under the federal securities laws: due diligence and integration. Although not defined in the federal statutes which regulate securities offerings, due diligence has one basic meaning: a reasonable investigation, depending on the facts and circumstances, in order to provide a reasonable basis for believing and actual belief that the offering document was both complete and accurate.
Integration, on the other hand, in the securities context, has two dissimilar meanings. For many years it was used in securities law to describe the prohibited situation where an issuer would attempt to circumvent the registration requirements of the Securities Act of 1933 ("Securities Act") by engaging in a series of or simultaneous allegedly exempt offerings which were in fact one continuous offering requiring registration. More recently, the term integration has been used by the securities bar to describe the blending of the disclosure requirements under the Securities Act with those existing under the Securities Exchange Act of 1934 ("Exchange Act"). Through a procedure of incorporation by reference, certain publicly-held companies are able to incorporate into a registration statement information previously filed by them with the Securities and Exchange Commission ("Commission") pursuant to the requirements of the Exchange Act. The development of incorporation by reference of Exchange Act, documents into Securities Act registration statements, however, has raised substantial concerns among underwriters and their advisors. How, they ask, can they be duly diligent with respect to documents prepared and filed by the issuer some time prior to the offering and without their participation? As will be seen, the Commission, by promulgating Rule 415, has attempted to alleviate the problems created, but at the same time the Commission has made it virtually impossible for an underwriter to perform adequate due diligence for an instantaneous offering under that Rule.
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Statutory Due Diligence Framework
The federal securities laws contain two types of provisions upon which a claim for liability may be based in connection with public and private offerings. The first is found in both the Securities Act and the Exchange Act, namely, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act, and are commonly referred to as the antifraud provisions. They do not contain an express concept of due diligence. Rather, in order to establish liability for violation of those sections, it is necessary to prove that the person charged acted with "scienter." The cases, including two leading Supreme Court decisions,1 do not define scienter but make it clear that a showing of more than mere negligence or carelessness is required. Gross negligence, wilfull misconduct and wanton disregard are the terms generally associated with scienter. Adequate due diligence in the distribution of securities, including the conduct of a reasonable investigation with respect to the offering document, should help establish that scienter was not present.
The second type of statutory provision is found only in the Securities Act and expressly refers to due diligence. Section 11 of the Securities Act, which applies to registered offerings but not private placements, imposes liability upon various classes of participants in the registration process for any material misrepresentation or omission in a registration statement (including the prospectus). Section 11(a) of that statute provides, in part, that:
In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security...may...sue...(1) every person who signed the registration statement; (2) every...director...or partner of the issuer...; (3) every person who [consented] to become a director...or partner...; (4) every [expert, and] (5) every underwriter with respect to such security.
In order to recover under Section 11, a purchaser of a registered security need only to prove that he purchased the security and that there was a material misstatement or omission in the registration statement or prospectus. He will recover from the issuer so long as the statute of limitations had not
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expired and the issuer cannot prove that the purchaser knew of the untruth or omission at the time of purchase. In other words, the issuer has no due diligence defense.
Section 11(b), however, provides several affirmative defenses for persons other than the issuer, making a distinction between "expert" and "nonexpert" statements in the registration statement. With respect to "expertised" portions of the registration statement, to escape liability a defendant (other than the expert on whose authority the portion was included) need not have made an investigation at all. He must only prove that:
he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue, or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading, or that such part of the registration statement did not fairly represent the statement of the expert or was not a fair copy of or extract from the report or valuation of the expert...2
It is the area of "nonexpertised" portions of the registration statement (and for experts on the portions they expertized) that the due diligence defense arises. Section 11(b) provides a defense with respect to those parts of the registration statement neither made on the authority of an expert, nor purporting to be a statement made by an official person or a copy of a public official document, if the defendant can prove that:
...he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading...(emphasis added).3
A reasonable investigation resulting in reasonable grounds to believe and actual belief is what due diligence is all about. Section 11(c) states that:
In determining...what constitutes reasonable investigation and reasonable ground for belief, the standard of reasonableness shall be that required of a prudent man in the management of his own property.
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The standard of reasonableness under Section 11(c) has been described as a "standard of the street,"4 a standard that depends to some extent on what constitutes commonly accepted commercial practice. It therefore is desirable to keep abreast of what other people are doing in similar transactions. Failure to follow street practice may weigh heavily in establishing liability, while following such practice and missing something may nevertheless permit the defense to be maintained.
As noted above, Section 11(a) liability attaches "when such part [of the registration statement] became effective." It is not sufficient to conduct a due diligence investigation up to the point when a registration statement is initially filed and assume there will be no changes thereafter. Significant events affecting material changes may well occur subsequent to the filing and before effectiveness; due diligence must therefore be brought down to the effective date of the registration statement.
Section 12 of the Securities Act is similar in many respects to Section 11, both covering untrue statements and omissions and both not requiring scienter. Unlike Section 11, however, Section 12 applies to any person who offers or sells a security and not only to certain specified classes. Further, it extends to untrue statements or omissions contained in documents meeting the statutory definition of a prospectus, even if not contained in a registration statement, and to oral communications. Section 12 applies to both registered and unregistered offerings, but there must be a showing of privity; the purchaser of the security can only recover from the seller from whom he purchased.
Section 12(1) imposes liability on a person offering or selling a security in violation of the registration requirements of the Securities Act. Section 12(2) provides that any person who:
offers or sells a security (whether or not exempted by the provisions of Section 3, other than paragraph (2) of subsection (a) thereof), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by...
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