The community of securities-offering managers (and their lawyers) stood up and took notice on 15 December 2004. That was the day Judge Denise Cote of the US Federal District Court in New York City issued a decision denying pre-trial judgment in favour of the managers (or underwriters, as they are known in the US) of nearly $17bn (£8.99bn) of bonds issued by WorldCom in 2000 and 2001. That decision would have precipitated a jury trial in the class action litigation commenced by WorldCom bondholders. Its full impact, however (the first lengthy judicial exploration of the legal requirements of due diligence in 37 years), was not fully recognised until 16 March 2005, when, after an intermediate decision by Judge Cote relating to the allocation of liability among the managers and WorldCom’s non-executive directors, the last of the 16 managers settled the class action litigation for an aggregate amount of more than $6bn (£3.17bn).
Why was this decision so noteworthy? And why did it lead 15 investment banks (one of the 16 had settled prior to the decision) to settle for an enormous aggregate sum rather than continue in the litigation?
Some background would be helpful to put this all in context. As part of the litigation surrounding WorldCom’s collapse, bondholders’ representatives sued the managers of the two WorldCom debt offerings, alleging that financial statements (and some non-financial disclosures) that were incorporated into the selling prospectuses for the debt offerings were materially inaccurate and incomplete.
The US federal securities laws establish strict liability for the issuing company for materially false or misleading statements in prospectuses, but permit defences to liability for managers of offerings if, as to expertised information (eg audited financial statements), they relied reasonably on the experts and if, as to all other information, they performed due diligence and reasonably believed the information to be true and complete. The WorldCom managers had moved for summary judgment on the grounds that the due diligence and reliance on audited financial statements shielded them from liability. Without a settlement, a summary judgment motion is the last point in pre-trial proceedings at which a defendant can avoid going before a jury, selected more or less at random, for determination of all facts in dispute.
The managers had underwritten and sold to the public two Securities and Exchange Commission-registered debt offerings by WorldCom, the first in 2000 for around $5bn (£2.64bn) and the second in 2001 for $11.9bn (£6.29bn). Both involved short-form ‘shelf’ registration statements incorporating by reference previously filed financial and textual material. The documentary evidence of the managers’ accelerated (nine-day) due diligence review of WorldCom’s financial statements for the 2000 offering was a single memorandum that described a telephone call between the managers and their counsel on the one side, and WorldCom’s chief financial officer (CFO) on the other. The CFO gave conclusory answers regarding WorldCom’s financial situation. The memorandum does not show that the interviewers asked the CFO any pressing questions. The underwriters instead relied heavily on a ‘cold comfort’ letter from WorldCom’s auditors, Arthur Andersen, regarding the company’s unaudited financial statements for the first quarter of 2000.
By the time of the second offering in 2001, WorldCom’s stock price had dropped dramatically. Rating agency Standard & Poor’s had lowered WorldCom’s credit rating and several of the banks participating in the offering had lowered their own in-house evaluations of WorldCom’s creditworthiness. The due diligence effort lasted a little over a month.
During the subsequent hearings, Judge Cote stated that “underwriters’ reliance on audited financial information may not be blind. Rather, where red flags regarding the reliability of an audited financial statement emerge, mere reliance on an audit will not be sufficient to ward off liability.”
While the judge left unclear what types of information would rise to the level of a ‘red flag’, she did not accept the managers’ argument that “an audited figure can never constitute a red flag and impose a duty of investigation”. Rather, she found that, whether the particular facts raised by bondholders’ representatives constituted red flags sufficient to require further investigation, was an issue of fact for a jury to determine. That finding did not mandate due diligence as a prerequisite to reliance, but it did in effect consider what due diligence had been performed in assessing whether reliance was “reasonable”.
As to whether the managers’ demand for, and receipt of, Arthur Andersen’s comfort letters demonstrated that the managers had conducted a “reasonable investigation” of the unaudited financial material, Judge Cote found that, although receipt of the comfort letters was “important evidence”, the question of whether the managers had performed sufficient due diligence was a factual question that could not be resolved on the summary judgment record before the court, but again was a matter for a jury to determine.
What are the ramifications of the WorldCom decision apart from the facts particular to WorldCom? Judge Cote’s opinion changes substantially the likelihood that managers of securities offerings will win summary judgment motions based on a due diligence defence. Even though the opinion is not a binding precedent on any other US court, the scarcity of authority on the due diligence defence, and the comprehensive nature of the opinion, make it likely that the case will be cited frequently in the future.
In its aftermath, every investment bank involved in underwriting securities to be sold in or into the US is, with its counsel, reviewing its due diligence procedures. There is, however, no single or perfect solution to the issue of how much due diligence is enough or what kind of due diligence is appropriate.
The practice of record keeping assures increased importance in such a situation – record keeping pertaining to the meetings, the site visits, the conference calls, the document reviews and so on; and the record keeping going beyond the mere fact that any of these exercises took place, to include specific detail as to questions asked and responses given and so on.
The use of and reliance on financial information is, of course, foremost on participants’ minds. While Judge Cote disclaimed any requirement that managers retain yet another accounting expert to perform an independent examination of an issuer’s financial statements, it may be that, in certain cases, cautious managers determine to do just that.
Finally, the constraints of completing an offering in today’s securities markets, where information flows at light speed, will continue to be balanced against the protection afforded by extended investigation. It may be that certain investment banks determine not to proceed with underwriting certain offerings where the impact of those constraints is seen to outpace the availability of that protection.
Peter Ruhlin is a capital markets partner in Linklaters‘ New York office