Over the past year, SPACs have been through market shifts, regulatory thrashing, economic issues, novel litigation theories, and SEC enforcement actions. I touched on all of these in my previous post for the SPAC Notebook, but for this month’s edition, I turn to some of the most commonly asked but not necessarily answered questions that are top of mind for many SPAC teams right now.
These two questions keep popping up in my inbox:
How can our SPAC team handle the 1% excise tax?
Are there new avenues to get a SPAC deal done?
How to Handle the 1% Excise Tax
The Inflation Reduction Act, which was signed into law on August 16, 2022, establishes a new 1% excise tax on certain stock buybacks by domestic public companies. Many experts, including most attorneys I’ve spoken to, believe the provisions of this new law could be broad enough to possibly pull SPAC redemptions into their sphere.
Option 1: Liquidate Before Year-End
As a result of the new excise tax, most SPAC teams that do not currently have a deal in the works are rushing to liquidate before January 1, when the tax becomes effective. According to SPAC Research, as of December 2, 64 SPACs have liquidated this year, with the frequency of liquidations increasing significantly in the last two quarters. There were 18 liquidations in October.
Source: SPAC Research
Although we have not seen many post-liquidation lawsuits so far, some litigators expect that the increased number of liquidations will prompt the plaintiff’s bar to test some of those liquidation decisions and proceedings in court. Therefore, a careful look at whether an extension of D&O insurance coverage (also known as a tail) for the SPAC’s directors and officers post-liquidation is warranted.
Option 2: Extend and Cover the Tax Bill
Other SPAC teams that believe they will get a deal done before their deadline or have one on the table but are waiting to close in early 2023 may be willing to risk becoming subject to the excise tax. These teams usually are looking to extend their investment period for another three to six months.
But, of course, with such an extension landing the SPAC and any of its redemptions square into 2023, the question is who will pay for the excise tax? Will it be the SPAC sponsor or the shareholders? Will this tax come out of the trust funds, or will the sponsors need to come up with additional sponsor capital to cover what could end up being a multimillion-dollar tax bill?
Some SPACs, like the Data Knights Acquisition team, realizing that this could become a sticking point for shareholders who need to approve their extension, are coming out with promises that they will not touch the trust but will cover the tax out of sponsor capital. Other SPAC teams will likely follow this strategy as well.
Option 3: Extend but Leave the Tax Bill to Shareholders
Other SPAC teams may have a different view. Depending on how the SPAC’s documentation is written, some SPACs may take the position that the excise tax, like franchise and other taxes, will need to come out of the trust funds. This will, of course, endanger the $10-per-share shareholder investment, especially if these same SPACs decide to keep their trust funds in cash to avoid tripping the SEC’s Investment Company Act safe harbor. Will the shareholders of these SPACs go along with this idea, or will they object via a lawsuit? We have yet to find out.
New Avenues for SPAC Dealmaking
Necessity is the mother of invention, and that proverb is proving to be true in SPAC land. Aside from the creative ways SPAC teams are enticing their shareholders to approve extensions, many teams are looking for alternative avenues for getting a deal done.
Having realized that they may not have what it takes to land or close a deal but not wishing to liquidate, some SPAC teams now are considering two options: a team swap or a public company merger.
Team Swap
In a team swap, the old team enters a sharing or hand-over arrangement with a new team, in which they share some of the economics of the deal, but essentially the new team takes the reins on finding a suitable target and/or closing the transaction. The new team invariably brings deal know-how and connections to the table. As for the old team, walking away with a fraction of interest in a potential deal versus 100% of interest in no deal is often a better alternative.
As you can imagine, these swaps are difficult to accomplish. They are also challenging when it comes to insurance coverage. The old team wants to be covered in case they’re pulled into a lawsuit or an enforcement action after the swap. And the new team, of course, wants to be protected as well.
For insurance underwriters who based their terms and premium pricing on the track record of the old team, a new team with a different track record may not be palatable. If the underwriter is not willing to extend the original policy to the new team, the new team may need to go looking for new coverage, which may be unavailable or a lot more expensive than what the old team was able to obtain 18+ months ago.
The costs of this coverage will need to be folded into the swapping arrangement the two teams ultimately agree on. Having this conversation with your SPAC insurance broker before entering into any agreements is key.
Complicating the situation is coverage for the outgoing team after the swap. If the new team obtains a new policy, it is unlikely to cover the old team’s directors and officers, and the old policy is unlikely to continue after the swap. The outgoing team then will need to consider whether it needs to buy tail coverage for its original policy, another cost that it may not have anticipated. The new team may be willing to cover this cost, but again, this discussion needs to happen before completing the swap. That way, the insurance broker will be able to advise the two teams on the best course of action.
Public Company Merger
On the theory that some public companies may be more willing and able than private companies to enter into a merger with a SPAC, some SPAC teams are considering a merger with an already existing public company. An example of such a transaction is the October 31, 2022, closed merger of Coeptis Therapeutics Inc. with the SPAC Bull Horn Holdings Corp. The SPAC sponsor reportedly liked the idea because of greater transparency stemming from the publicly available performance record of the target.
For the public company, a merger with a SPAC provides a cash infusion from the SPAC’s trust account and access to the SPAC team’s expertise. For the SPAC, aside from the undeniable benefit of getting the deal done, the risk is presumably reduced for several reasons. First, there are fewer issues with public company readiness, a problem that has plagued many newly de-SPACed companies. And second, there is the greater transparency of an already publicly filed business. I’ll leave it to the bankers to opine on whether the economics of these kinds of deals will benefit the investors in the SPAC and the target company.
From the insurance perspective, interesting questions come up as far as coverage of the original SPAC and its team prior to the merger. As with other unusual SPAC-related situations, the insurance coverage and costs need to be looked into thoroughly ahead of making any major budgeting decisions.
Mergers with already public companies arguably miss the point of the SPAC vehicle, which was designed as an alternative to a traditional IPO. However, in the current hostile market, I would not be surprised to see other similar transactions in the near future.
Looking Ahead
It is heartening to see the recent uptick in deal activity in the SPAC world. According to November’s Nasdaq SPAC Monitor, although SPAC IPO activity is understandably down this year, October was the hottest month for SPAC merger announcements since December 2021.
Despite the recent wave of liquidations that make it feel like every SPAC is liquidating right now, SPAC Insider reports that only 12.9% of the 2020 SPAC class and 2% of the 2021 SPAC class have liquidated so far. This is a much smaller ratio than for the 2010 through 2016 SPAC vintages. We’ve also seen 26 announced mergers in October 2022. Although the enterprise values of those deals are unsurprisingly down versus last year (average $800 million in 2022 versus $2.3 billion in 2021), the increased pace of deals is a welcome change. Perhaps we’ll see even more deals with novel structures and approaches as the SPAC market continues to evolve and adapt.
An earlier version of this article appeared in the Woodruff Sawyer SPAC Notebook.
This article describes two recent Delaware decisions relevant to the Model Business Corporation Act (the “MBCA”). One of those decisions relates to a board’s determination of the availability of surplus to support distributions to stockholders, and the other upholds, at the motion to dismiss stage, a claim that the directors breached their fiduciary duty by not taking action in response to a stockholder’s demand. In addition, this article describes recent decisions in MBCA states addressing the meaning of “fair value” and the application of director liability shields to exculpate directors from monetary liability.
Determining Surplus to Support Distributions
Corporations often make distributions to stockholders by way of dividends and stock buybacks. For private equity–backed companies, it is not unusual to see leveraged recaps in which the corporation borrows funds to make distributions to the private equity investors. These distributions raise the question for a board of directors of whether the corporation has sufficient funds that are legally available to permit a lawful distribution under the corporate statute. The failure to satisfy the statutory requirement for distributions can result in personal liability for the directors. Determining the funds legally available for distributions can be challenging.
Delaware and MBCA Distribution Laws
Sections 160 and 173 of the Delaware General Corporation Law (the “DGCL”) set the limits on a Delaware corporation’s power to repurchase stock and issue dividends. Section 160 provides that no corporation may purchase or redeem its shares when the capital of the corporation is impaired or would be impaired as a result of such purchase or redemption. A repurchase impairs capital if the funds used for the repurchase exceed the amount of the surplus.[1] Sections 170 through 173 impose similar requirements for the payment of dividends. Section 170 provides that a board of directors may declare and pay dividends on shares of the corporation’s capital stock either (i) out of its surplus (within the meaning of section 154) or (ii) if there is no surplus, out of the corporation’s net profits for the fiscal year in which the dividend is declared or the preceding fiscal year—so-called “nimble dividends.” The term “surplus” generally means the excess of the corporation’s total assets over the sum of the total liabilities and capital of the corporation (usually the aggregate par value of its outstanding shares). If the test for a lawful distribution or dividend is not met, the directors face personal liability under section 174, which is not subject to exculpation by a charter provision permitted by section 102(b)(7). However, a director is “fully protected” under section 172 from personal liability if he or she relied in good faith upon the corporation’s records or upon its officers, employees, board committees, or experts in determining that the corporation had adequate surplus to support the distribution or dividend.
The MBCA follows a similar approach to the DGCL, although with more statutory precision and some notable differences. Under section 6.40(c), distributions, which include dividends in the MBCA’s terminology, may not be made if the corporation would not be able to pay its debts as they become due in the usual course of business (the “equity insolvency test”) or its total assets would be less than the sum of its total liabilities and the amount that would be required to satisfy the preferential rights that the holders of senior classes or series of shares would have upon dissolution (the “balance sheet test”). MBCA section 6.40(d) provides that the board of directors may base its determination either on the corporation’s financial statements prepared using accounting principles reasonable in the circumstances, which would include those prepared in accordance with generally accepted accounting principles (GAAP), or on a fair valuation or other method reasonable in the circumstances. Under section 7.32, a director approving the improper distribution is personally liable to the corporation for the excess amount if it is established that the director did not meet the standards of conduct in section 8.30, which require that a director act in good faith and in a manner that the director reasonably believes to be in the best interests of the corporation (the so-called duties of care and loyalty). Section 8.30(e) offers protection for directors by providing that a director is entitled to rely on information, opinions, reports, or statements, including financial statements, prepared or presented by officers or employees, lawyers, accountants, or other advisers, or a board committee, so long as the director does not know that reliance is unwarranted.
Challenges to Distributions
When a distribution is challenged, it is usually because the board of directors used the present value[2] of the corporation’s assets to determine surplus rather than the amounts reflected on the corporation’s financial statements, which are usually lower. For example, a board might use the current appraised value of real estate even though that real estate is carried on the financial statements at its historic cost less accumulated depreciation. The Delaware Supreme Court has held that a board can use present value in determining surplus as long as it does so in good faith and on a consistent basis.[3] However, what if the board instead relies on the amounts shown on the corporation’s GAAP financial statements?
The Chemours Decision
The Delaware Court of Chancery addressed this question and provided important guidance in the case of In re The Chemours Company Derivative Litigation.[4] The Chemours Company (“Chemours”) was spun-off by the E.I. DuPont de Nemours Company (“DuPont”) in 2015. In the spin-off Chemours assumed certain environmental liabilities of DuPont, which Chemours subsequently claimed to be vastly in excess of the amount that DuPont had stated. This dispute was settled by DuPont’s agreeing to share the environmental liabilities. After the spin-off, Chemours made a series of stock repurchases and dividend payments based upon the board’s determination that Chemours had adequate surplus based upon the amount of the contingent environmental liabilities reflected on its audited financial statements. The plaintiffs, claiming that demand on the board was excused because it would be futile, brought a derivative action challenging these distributions and dividends as exceeding the available surplus, specifically alleging that the board should have used the amount of the contingent environmental liabilities actually expected rather than relying on the amount shown on the audited balance sheet. To support this allegation, the plaintiffs cited Chemours’ own allegations in its dispute with DuPont. Under GAAP, specifically FASB ASC 450–20 (formerly FAS No. 5), only contingent liabilities that are probable and reasonably estimable are accrued and reflected as liabilities on the financial statements.[5] If a material contingent liability is not probable but is reasonably possible, footnote disclosure is required. Footnote disclosure is also required even if a contingent liability is reasonably possible or probable but is not presently estimable.
The Court addressed whether the plaintiffs had met the burden of proving that demand was futile because a majority of the Chemours directors faced a substantial likelihood of liability. In so doing, the Court addressed the substance of the claims and found that the plaintiffs had failed to plead specific facts implying that the directors faced a substantial likelihood of liability because of the distributions, and therefore the plaintiffs were not entitled to bring the derivative action without first making a demand on the board.
The Court began its analysis of the likelihood of liability by observing that boards of directors have broad authority to determine the amount of a corporation’s surplus and, in that connection, the method of determining surplus. Therefore, the Court said that it would defer to the board’s calculation of surplus “so long as [the directors] evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud”— i.e., that the values “reasonably reflect present values.” The Court ruled that the board was not required to depart from GAAP in determining the corporation’s reserves for contingent liabilities in the calculation of the corporation’s surplus. Accordingly, the Court found that the directors were not “willful or negligent” as required to subject them to liability under section 174. The Court also found that the directors were “fully protected” under section 172 in relying on the corporation’s financial statements, consulting with management and financial advisors, and receiving presentations on the environmental liabilities. Finally, the Court found that the plaintiffs’ general claim of breach of fiduciary duty, apart from liability for improper distributions, did not result in a substantial likelihood of liability because any such liability was subject to exculpation as permitted by section 102(b)(7), absent bad faith, which the plaintiffs did not plead with particularity.
Applicability to MBCA
The Court’s approach to distributions and dividends in the Chemours opinion is consistent with the approach of the MBCA, as explained in the Official Comment to section 6.40. The Chemours opinion gives directors considerable flexibility, and therefore protection from liability, in making determinations of the corporation’s surplus to support decisions on dividends and other distributions to stockholders. This allows directors to determine present values, such as the current fair market value of the corporation’s assets, and in some cases to use reserves for contingent liabilities reflected in a corporation’s GAAP financial statements. The Official Comment to section 6.40 states that “[t]he determination of a corporation’s assets and liabilities for purposes of the balance sheet test of section 6.40(c)(2) and the choice of the permissible basis on which to do so are left to the judgment of its board of directors.” Similar to Delaware law, the Official Comment to section 6.40 indicates that “[o]rdinarily a corporation should not selectively revalue assets,” but “should consider the value of all its material assets,” and similarly, “all of a corporation’s material obligations should be considered and revalued to the extent appropriate and possible.” Section 6.40 authorizes the use of financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances and, consistent with the Chemours decision, also authorizes any other “method of determining the aggregate amount of assets and liabilities that is reasonable in the circumstances.” This means that “a wide variety of methods may be considered reasonable in a particular case even if any such method might not be a ‘fair valuation’ or ‘current value’ method.”
These determinations under both the DGCL and the MBCA need to be made in good faith, and to demonstrate good faith boards of directors should follow a careful and considered process. That process should be recorded as part of the minutes.
Although reliance on financial statements can protect directors from personal liability for improper distributions, directors dealing with contingent liabilities, whether operating under the DGCL or the MBCA, will want to go beyond the amounts shown in the financial statements. In order to comply with their fiduciary duties, they also should consider the broader information included in any footnote disclosures required under the applicable accounting standards, even if liability for a breach of those duties may be covered by an exculpation provision in the charter.
Determining Fair Value in Appraisal Proceedings
The primary issue in an appraisal proceeding is the determination of the fair value of the shares held by shareholders exercising their appraisal rights. Section 13.01 of the MBCA defines “fair value” for purposes of appraisal proceedings based on “[t]he value of the corporation’s shares … using customary and current valuation concepts and techniques generally employed for similar businesses in the context of a transaction requiring appraisal … and without discounting for lack of marketability or minority status….” This definition gives a court considerable discretion to consider various methodologies including, as applicable, the deal price, unaffected share price analysis, comparable precedent transactions, a comparative company analysis, asset valuations, and a discounted cash flow (DCF) analysis. The method or methods that may be used can vary based upon the circumstances of the particular transaction, and the favored methods have changed over time.
Recently, the Supreme Court of North Carolina in Reynolds American Inc. v. Third Motion Equities Master Fund Ltd.[6] had the opportunity for the first time to interpret the provisions of the North Carolina version of the MBCA to determine if the North Carolina Business Court properly determined the fair value of the shares in an appraisal proceeding of the tobacco company, Reynolds American, which was acquired by British American Tobacco. The Business Court determined that the fair value of the shares did not exceed the deal price of $59.64 plus interest that had been paid to the dissenting shareholders and therefore no further payments were required.
In upholding the Business Court decision, the North Carolina Supreme Court, in an extensive and detailed analysis, cites freely to the well-developed body of Delaware decisional appraisal law and significantly defers to the exercise of discretion by the Business Court in determining fair value based on the evidence before it. In particular, the Court held that the Business Court’s primary reliance on the deal price was justified, even though the acquisition of Reynolds American by a large, but non-controlling shareholder was not actively marketed. The Business Court used other factors, including indicia of a robust deal process and various other “customary and current valuation concepts and techniques” to confirm that the deal price was indicative of the fair value.
By extensively citing to the well-developed body of Delaware law on determining fair value in an appraisal proceeding, the North Carolina Supreme Court provides support for using the Delaware decisions as relevant precedent for determining fair value under the MBCA, notwithstanding the differences in the appraisal provisions between the two corporate statutes.
A final issue addressed by the Court was the dissenting shareholders’ claim that they were entitled to additional interest under the North Carolina counterpart of MBCA section 13.30(e). Although acknowledging that the provision is “ambiguous,” the Court held that it would be nonsensical and contrary to the legislative intent to award an interest windfall and encourage “appraisal arbitrage” when no additional payment on the shares was due.
Determining Fair Value for Purchase in Lieu of Dissolution
Section 14.34 of the MBCA permits a corporation in a proceeding for judicial dissolution under section 14.30(a)(2) to elect to purchase the petitioning shareholder’s shares at their “fair value.” If the parties cannot agree on the price and terms of the purchase, the court is required to determine the fair value of the shares and the terms and conditions of the purchase, including whether payments may be made in installments and whether to award any expenses. However, the MBCA does not define “fair value” for purposes of section 14.34 or refer in section 14.34 or in the Official Comment to the definition of “fair value” for appraisal purposes in section 13.01.
In Bohack v. Benes Service Co.[7] the Nebraska Supreme Court addressed the meaning of fair value under the provision of the Nebraska Model Business Corporation Act (“NMBCA”) comparable to section 14.34. The Court began by deciding to look to the appraisal provisions of the NMBCA for guidance as to the meaning of fair value in section 14.34. Section 13.01 requires that the fair value of a corporation’s shares be determined using “customary and current valuation concepts” and “without discounting for lack of marketability or minority status.” Although the Official Comment to section 13.01 states that the “specialized” definitions in section 13.01 apply only to chapter 13, the Court stated that it was not foreclosed from looking to the definition in section 13.01. It noted that the Official Comment was not adopted as part of the NMBCA but went on to observe that in the earlier version of the Official Comment, there was a statement that a court applying section 14.34 might find it useful to consider valuation methods applicable to an appraisal proceeding. That statement is no longer in the Official Comment to section 14.34 in the 2016 Revision of the MBCA. Although the Court noted on this issue and on the discounts issue discussed below that the Nebraska legislature did not adopt the Official Comment, it recognized that the Official Comment is a relevant resource in interpreting the statutory provisions. This reflects the general approach of courts in other states where the Official Comment has not been formally adopted as part of the state’s corporation statute. Some states make it a practice to mention in their legislative history that the Official Comment to the MBCA should be considered in interpreting the statute.
The Court next determined that discounts for lack of marketability and minority status should not apply because they are excluded, with certain exceptions not applicable in this case, from the definition of fair value for appraisal purposes. It noted the distinction between “fair value” and “fair market value” in other Nebraska statutes. The Court declined to consider a statement in the Official Comment to an earlier version of the MBCA that a minority discount may be appropriate under section 14.34, a statement that is also no longer in the Official Comment to the 2016 Revision of the MBCA. The Court noted again that the Official Comment was not adopted as part of the NMBCA but went on to state that the Official Comment to the definition of fair value in Section 13.01 states that discounts for lack of marketability or minority status are inappropriate in most appraisal actions because they give the majority an opportunity to take advantage of the minority that is being forced to accept the transaction triggering the appraisal. The Court analogized an appraisal transaction to a forced buyout under section 14.34. However, the Court did not reference other parts of the extensive discussion in the earlier Official Comment identifying the differences between a proceeding under section 14.34 and an appraisal proceeding under chapter 13 that could affect the Court’s approach to determining fair value. Those differences include the relevance of liquidation value under section 14.34 when there is deadlock, the need for adjustments when the value of the corporation has been diminished by wrongful conduct of controlling shareholders, and the appropriateness in some circumstances of a minority discount. The earlier Official Comment made it clear that the approach to a valuation is very much dependent on the particular facts and circumstances, that a court in a proceeding under section 14.34 has considerable flexibility, and that using valuation methods relevant to judicial appraisal is permissible. The reasons for the Court’s unwillingness to consider portions of the earlier Official Comment that were not included in the Official Comment to the 2016 Revision are not entirely clear. The elimination or revision of a statement in an earlier Official Comment as part of the editorial process of the Corporate Laws Committee does not necessarily mean that the earlier statement was deemed incorrect or no longer relevant by the Committee. The reasons for editorial changes vary based upon the particular comment omitted or revised. In general, the editing of the Official Comment in the 2016 Revision was designed to streamline it and serve solely as a guide to the interpretation of the applicable statutory provisions and not necessarily because they were no longer considered relevant or correct.
The Court determined that a going concern value was appropriate in the circumstances because the corporation would be continuing in business. It then went into the details of the appropriate valuation methodology, which had unique aspects and which do not need to be recounted here.
Director Liability Shield
In Meade v. Christie,[8] which involved a shareholder’s challenge to a going private merger, the Supreme Court of Iowa addressed the relationship of the Iowa counterparts of sections 8.30 and 8.31 of the MBCA and the application of the exculpation provisions authorized by section 2.02(b)(4) of the MBCA (referred to by the Court as the “director shield statute”), and the procedural requirements of those provisions. In its opinion reversing and remanding the trial court’s denial of a motion to dismiss by the director defendants, the Court referenced the Official Comment to the 2016 Revision of the MBCA and analyzed the differences between the exculpation provisions of the Iowa Business Corporation Act (the “IBCA”), which are based on those in the MBCA, and DGCL section 102(b)(7).[9]
The case involved a class action brought by a former shareholder of an Iowa insurance holding company who alleged that the directors breached their “fiduciary duties of care, loyalty, good faith, and candor” by approving the merger in “a flawed process that resulted in too low a price being paid to the minority shareholders.” The issue considered by the Court on appeal was whether the shareholder’s pleadings were sufficient to show that the IBCA’s counterpart of MBCA section 8.31 did not protect the directors from liability. The appeal also involved the issue of whether the claim was a direct or derivative claim but, because of its determination that the directors’ motion to dismiss should be granted, the Court did not have to reach the issue of whether the trial court was correct in finding that the claim was properly brought as a direct claim.
The Court began its analysis by discussing the standards of conduct for directors under section 8.30, describing them generally as a duty of care and a duty of loyalty. It then noted that, although section 8.30 provides the standards of conduct, section 8.31 sets forth the conditions for holding a director liable for money damages. Under section 8.31, a director is not liable unless the complainant establishes that an exculpatory provision in the corporation’s articles of incorporation authorized by section 2.02(b)(4) does not apply. Since the holding company had adopted an exculpatory provision that tracked the statutory authorization, the Court then analyzed whether the shareholder pled facts sufficient to show that one of the exclusions to exculpation, specifically “intentional infliction of harm on the corporation or the shareholders,” applied.
In reaching its conclusion that the shareholder’s allegations were insufficient to establish the “intentional infliction of harm” exclusion, the Court looked at the background of exculpation statutes, referring to the MBCA’s Official Comment, and compared the MBCA and Delaware exculpation provisions.
Citing the explanation of the Corporate Laws Committee for the addition of a director exculpation provision,[10] the Court noted that policymakers in the mid-1980s, concerned about qualified individuals declining to serve on boards of directors, began advocating for enhanced protections for corporate directors. These concerns arose out of court rulings that expanded directors’ personal liability for money damages, notably the Delaware decision in Smith v. Van Gorkom.[11] After Delaware and other states, including Iowa, amended their corporate statutes to permit director exculpation provisions, the MBCA was amended to further increase the protections for directors. Iowa amended its statute in 2003 to adopt the MBCA exculpation provision. The Court observed that the Delaware exculpation provision in section 102(b)(7), which excludes from exculpation “acts or omissions not in good faith or which involve intentional misconduct,” picks up a broader range of fiduciary misconduct than the narrower exclusion of “intentional infliction of harm” standard in the MBCA and the IBCA. Citing the Official Comment to section 2.02(b)(4) stating that the use of “intentional” refers to a specific intent to perform or fail to perform the acts with actual knowledge that it will cause harm, the Court stated that the MBCA standard would not exclude from exculpation claims of reckless conduct, conscious disregard of a duty, or intentional dereliction of a duty, all of which are excluded from exculpation in Delaware. Based on the MBCA’s higher bar for an exclusion from liability and the resulting heightened pleading requirement, the Court held that the shareholder’s allegations were insufficient to establish an “intentional infliction of harm on the corporation or the shareholders” by the directors. The Court observed that this result was consistent with the purpose of exculpation, to provide not only protection from liability but also to avoid the costs and stress of litigation. It also noted that shareholders who believe a merger buyout price is inadequate have the alternative remedy of appraisal rights under section 13.02.
Director Duties in Assessing Demand
Unlike Delaware, which has a demand required/demand excused approach to derivative actions, the MBCA follows a universal demand approach.[12] The fundamental premise for the universal demand requirement in the MBCA is that the board of directors should have an opportunity to assess demands and to act in the best interest of the corporation, subject to judicial oversight of its action. Underlying this premise is the requirement that directors fulfill their fiduciary duties in dealing with a demand.
In Garfield v. Allen,[13] the Delaware Court of Chancery considered a challenge by a stockholder of The ODP Corporation to an equity compensation award to the chief executive officer on the ground that it exceeded the limits of the equity compensation plan approved by the stockholders. The Court held that the complaint stated a claim for relief based on a breach of fiduciary duties by the directors in not correcting the violation after the stockholder sent a demand letter to the board calling attention to the issue.
In upholding the claim, the Court noted that it was based on a “novel theory” that the Court accepted with “admitted trepidation” because it could permit plaintiffs in the future to create claims by sending demands to boards if those demands are not acted upon. Nevertheless, although historically a board’s rejection of a litigation demand has only affected parties who control the derivative claim and has not been held to be grounds for a separate breach of fiduciary duty claim, the Court found the logic of the claim in this case sound because it indicated a possible conscious failure of the directors to act that could equate to a knowing, wrongful action. The Court, however, urged caution in dealing with this as a basis for such claims going forward.[14]
This article originally appeared in the Winter 2022 issue of The Model Business Corporation Act Newsletter, the newsletter of the ABA Business Law Section’s Corporate Laws Committee. Read the full issue and previous issues on theCorporate Laws Committee webpage. Another article by the same author discussing several other recent Delaware decisions relevant to the MBCA appears in the Summer 2021 issue of The Model Business Corporation Act Newsletter. One of those decisions has been reversed by the Delaware Supreme Court, as discussed in an update also appearing in the Winter 2022 issue.
The views expressed in this article are solely those of the author and not Locke Lord LLP or its clients. No legal advice is being given in this article.
See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 153 (Del. 1997). ↑
The Delaware courts use the phrase “present value” in this context to mean the current fair market value of the corporation’s assets, not the “present value” of the corporation’s future cash flows, as used in financial analyses. ↑
See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 155 (Del. 1997); see also Morris v. Standard Gas & Electric, 63 A.2d 577, 582 (Del. Ch. 1949). ↑
The claim in Garfield involved the alleged liability of the directors for a breach of their fiduciary duties under Delaware law. As noted in the discussion of the Meade v. Christie decision under “Director Liability Shield” above, the standards of conduct for directors under MBCA section 8.30 and the conditions for holding directors liable for monetary damages under MBCA section 8.31 are different. ↑
The market for digital assets has exploded in recent years. Digital and virtual currency activities provide great opportunities financially and technologically. However, such currencies can be utilized for illicit activity through exchanges, peer-to-peer exchanges, mixers (a service that mixes different streams of potentially identifiable cryptocurrency), and darknet markets, which increase the risk of money laundering and terrorist financing. Financial institutions and other industry players have both struggled with and embraced digital currencies to varying degrees. With innovation and increased popularity comes risk.
The U.S. government is keen to identify ways to mitigate the risks that digital assets present, while recognizing that opportunities and potential benefits may exist. On March 9, 2022, President Biden issued the Executive Order on Ensuring Responsible Development of Digital Assets (EO). The EO was the first whole-of-government strategy to address not only the risks of digital assets, but also the benefits of their underlying technology. The EO outlined six priorities that factor into addressing a national policy for digital assets and called for interagency coordination to implement the EO.[1]
Most recently, on September 16, 2022, the White House published a fact sheet that combines data from the nine reports submitted to date in response to deadlines included in the EO. The fact sheet articulates the first comprehensive framework that supports the six priorities for responsibly developing digital assets, which includes regulatory considerations and makes clear that misuse will give rise to enforcement.
The United States has already pursued enforcement in the cryptocurrency space, particularly against mixers. Mixers provide anonymity and aid in hiding the origin and movement of funds. Recently, the U.S. Department of the Treasury’s Office of Foreign Assets Controls (OFAC) imposed sanctions on Tornado Cash, a virtual currency mixer, which was utilized to launder more than $7 billion worth of virtual currency since 2019. The figure included more than $455 million stolen by the previously sanctioned Lazarus Group of the Democratic People’s Republic of Korea (DPRK) back in 2019. Additionally, the Treasury’s Financial Crimes Enforcement Network (FinCEN) assessed a $60 million civil money penalty against the owner and operator of a virtual currency mixer for violations of the Bank Secrecy Act (BSA) and its implementing regulations. Enforcement further signals the necessity for financial institutions and those in the virtual currency industry to mitigate the risks presented by virtual currencies.
As part of a company’s Bank Secrecy Act / Anti-Money Laundering (BSA/AML) and sanctions programs, it is critical to prevent sanctioned persons and other illicit actors from exploiting digital currency for illicit and criminal purposes. Even if not formally subject to such regulations, each company in the industry should take a risk-based approach to assess the various risks associated with different virtual currency services, develop and implement measures to mitigate such risks, and address the challenges anonymizing features can present to compliance with BSA/AML and sanctions obligations. Given recent enforcement actions, mixers should generally be considered high risk, and companies should proceed with caution when considering whether to process transactions involving mixers, unless appropriate processes and controls are in place to prevent money laundering or identify illicit or designated actors.
Since we can expect the U.S. government to exercise its authority against malicious cyber actors to expose, disrupt, and hold accountable perpetrators that enable criminals to profit from cybercrime and other illicit activity, it is crucial that financial institutions and businesses engaged in the financial services sector consider these priorities and actions in their efforts to combat illicit use of digital currencies.
A risk-based approach coupled with a comprehensive risk assessment are critical, foundational aspects of both compliance and combatting financial crime. Revisiting risk assessments periodically is also critical—especially considering the current rate of regulatory change and published guidance in the digital currency space.
The priorities are: consumer and investor protection; promoting financial stability; countering illicit finance; U.S. leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation. ↑
According to the Stanford Law School Securities Clearinghouse Class Action website, plaintiffs filed 110 new securities class action cases in the first half of 2022, a slight increase from the prior year period, with both alleged maximum dollar loss and alleged disclosure dollar loss substantially exceeding prior benchmarks. [1] Underwriters are most commonly included among the defendants in cases premised on alleged violations of the Securities Act of 1933 (“Securities Act”)[2] where, among other things, the underwriter’s exercise of professional judgment in making decisions about the scope and character of due diligence, offering document disclosures, red flags, and materiality is often in controversy.[3]
In resolving such cases, courts face the difficult task of balancing investor protection with well-established concepts of fundamental fairness in the application of the law. Often overlooked or underappreciated, however, is the wide range and complexity of operational, financial, legal, and other matters that underwriters and their counsel encounter throughout the due diligence and disclosure process, and the ongoing, organic, and contextually specific professional judgments they must make. These decisions are both profoundly “judgmental in nature” and specific to a particular set of circumstances (context).[4] Moreover, they must be made in “real time” without the benefit of hindsight.
In assessing the reasonableness of an underwriter’s in situ exercise of professional judgment, it is important to understand that the ultimate issue for the court is not the outcome of the judgments, such as whether more or different due diligence could have been conducted or whether more or different disclosures could have been made. Indeed, judgments can and do differ among professionals, even when presented with the same information in the same context, and one can always imagine more or different kinds of due diligence and disclosure. Rather, the fundamental issue for the court is whether the underwriter reasonably believed that the offering documents did not contain material misstatements or omissions and whether that belief was based on reasonable investigation and reliance.[5] Therefore in assessing reasonableness, a court must consider the basis for the professional judgments that were exercised as a part of the broader process.
Essential aspects of this dimension of the reasonableness inquiry are the so-called “standard processes” and “frameworks”[6] (referred to herein as the “Professional Judgment Framework”) the underwriters followed in making their due diligence, disclosure, and materiality decisions.[7] At least one Securities and Exchange Commission (“SEC”) Advisory Committee has stressed the central relevance of Professional Judgment Frameworks in assessing the reasonableness of professional judgments, observing that professional judgment “should be the outcome of a process in which a person or persons with the appropriate level of knowledge, experience, and objectivity forms an opinion based on the relevant facts and circumstances within the context provided…”[8] Moreover, the Committee’s Draft Decision Memo stated that:
Identifying standard processes for making professional judgments and criteria for evaluating those judgments, after the fact, may provide an environment that promotes the use of judgment and encourages consistent evaluation practices among regulators. [9]
This article explores the broad range and inevitable role of professional judgments by underwriters in registered securities offerings and the relevance to judicial determinations of reasonableness of the guidance-based Professional Judgment Framework underwriters customarily follow in arriving at these judgments. The article begins with an overview of the role of underwriters in securities offerings, the reasonableness standard under which they operate, and common sources of underwriter liability and affirmative “reasonableness” defenses. It next explains the concept of “professional judgment” and its exercise by underwriters in registered securities offerings. Finally, it summarizes the guidance-based Professional Judgment Framework commonly employed in the underwriting industry, including both core principles and customary practices.
I. The Role of Underwriters in Registered Securities Offerings
A. Overview
Public offerings must be registered with the SEC in accordance with the provisions of Section 5 of the Securities Act.[10] The registration process involves, among other things, the preparation of written offering documents (a registration statement and prospectus or prospectus supplement, which in some contexts incorporates other information by reference) that contain mandated information regarding the offering, the issuer, and the issuer’s business.[11] Once the registration statement is declared effective by the SEC, the securities may be offered and sold.
When a company decides to raise capital through a registered securities offering, it typically retains one or more underwriters[12] to manage various aspects of the process through which the company’s securities are offered, sold, and distributed to the public. In the most common form of underwriting, a firm commitment,[13] underwriters purchase the securities from the issuer and sell them to investors. Thus, they serve as an intermediary between the issuer and the investing public.[14]
Among other things, underwriters assist in this process by purchasing the securities for resale to the public and, for a period thereafter, maintaining a stable, liquid aftermarket for trading. Supported by counsel, underwriters also conduct due diligence (which involves both investigation and reliance) into a range of operational, financial, legal, and other matters and make ongoing, organic, and contextually specific professional judgments regarding matters such as the scope of that due diligence, the proper range and extent of disclosure, the presence of red flags and how to respond to them, and materiality.
B. Underwriting Syndicates
Most public offerings involve a group of underwriters, commonly referred to collectively as a “syndicate.” Syndicates typically involve one or a small number of lead (or managing) underwriters that assume primary responsibility for the offering and a larger number of participating underwriters that primarily assist with distribution of the securities.[15] The responsibilities of the underwriting syndicate are typically discharged through the lead underwriter(s) and underwriters’ counsel. These responsibilities include advising the issuer regarding the offering, conducting due diligence, reviewing the offering documents in an effort to ensure that they do not contain material misstatements or omissions, assessing the value of securities to be sold, determining the structure and terms of the offering, and creating and managing the distribution of the securities (sometimes referred to as “bookrunning”).[16] As explained below, all of these matters involve the exercise of professional judgment and, as a result, introduce the risk of ex post challenge to the reasonableness of the judgments made.
C. Underwriters as Informational Intermediaries
Securities underwriters are sometimes described as “informational intermediaries” that undertake to reduce “information asymmetries[17] between issuers and investors.”[18] In this capacity, underwriters “help investors [and] share the cost of acquiring, evaluating, and verifying information….”[19] This intermediary status derives from the fact that underwriters conduct due diligence, review offering document disclosures, and perform other activities in connection with the offering which are deemed, at least in part, to be undertaken on behalf of potential investors.
Among other things, underwriters, unlike investors,[20] typically are given access to both public and non-public information throughout the offering process. Thus, the various roles they play and the risks they assume may be seen as fundamental components of a regulatory and industry approach to ameliorating the risk of informational asymmetry.
Some commentators have asserted that underwriters also are “gatekeepers.”[21] Gatekeepers have been defined as “‘intermediaries who provide verification and certification services to investors’ by pledging their professional reputation….”[22] Proponents of the gatekeeper theory typically assert that, not just underwriters but a range of transactional professionals (including attorneys and accountants)[23] should be subject to liability for the wrongdoing of their clients on the implicit assumption that they possess a degree of power over the conduct of their clients. Whether this is in fact true has been the subject of much debate. Indeed, the theory of gatekeeper liability has been described as one of the “many legal strategies for controlling corporate wrongdoing, [and] perhaps the most complex and difficult to justify.”[24]
II. Underwriter Liability and Affirmative Defenses
A. Overview
Underwriters may incur liability under various federal and state securities laws.[25] Among these are the Securities Act, which creates a risk of civil liability if the offering documents for a registered offering contain material misstatements or omissions, and the Securities Exchange Act of 1934 (“Exchange Act”),[26] which creates a risk of civil or criminal liability for fraudulent conduct. Following is a summary of the common bases of liability for underwriters under each of these Acts and the affirmative “reasonableness” defenses available to them.
B. Section 11 of the Securities Act
Under Section 11 of the Securities Act,[27] any person who purchases a security issued pursuant to public offering documents that contain a material misstatement or omission has a private cause of action. Potential defendants include the issuer, signatories of the registration statement, directors or partners of the issuer, each person named as (or about to become) a director or officer,[28] accountants, engineers, appraisers, or other experts, and underwriters.[29]
Section 11 plaintiffs are not required to prove knowing wrongdoing (scienter),[30] but merely the presence of a material misstatement or omission. Thus, this statute, like Section 12(a)(2) discussed below, focuses only on the presence or absence of material misstatements or omissions in the offering documents.
As explained in more detail below, Section 11 contains two affirmative due diligence defenses[31] that are available to the enumerated defendants including underwriters. The first is a “reasonable investigation” defense for non-expertised material.[32] The second is a “reasonable reliance” defense for expertised material.[33] To meet the burden of proof for the reasonable investigation defense under Section 11, a defendant must establish that it conducted a reasonable investigation and that after such investigation it had reasonable grounds to believe and did believe in the accuracy of the offering documents.[34] To meet the burden of proof for the reasonable reliance defense, a defendant must establish that it had no reasonable ground to believe and did not believe that the expertised portions of the registration statement (such as audited financials) contained material misstatements or omissions.[35]
C. Section 12(a)(2) of the Securities Act
Section 12(a)(2)[36] applies to all sellers[37] of publicly registered securities and prohibits materially false or misleading statements in a prospectus or oral communication related to the sale. Any person who purchases a security issued pursuant to public offering communications that contain such a material misstatement or omission has a private cause of action for rescission or damages.
Like Section 11, a Section 12(a)(2) plaintiff is not required to prove scienter. It only must establish “some causal connection between the alleged communication and the sale, even if not decisive.”[38] Moreover, there is no requirement that the purchaser have relied on the misstatement.[39] Thus, the essential elements of a Section 12(a)(2) violation[40] are: “(1) a direct offer or sale of a security to the plaintiff; (2) in interstate commerce; (3) by means of a prospectus or oral communication; (4) that includes a material misstatement or omission; and (5) an allegation of some loss, where the face of the complaint and judicially noticeable facts do not conclusively negate loss or loss causation.”[41]
For many years, the general understanding was that this statute applied to both public offerings and private placements. However, in 1995, the Supreme Court in Gustafson v. Alloyd Co.[42] held that the statute applies only to public offerings. The basis for excluding private placements appears to derive from two judicial conclusions. The first is that private placements typically involve offerees and purchasers who can fend for themselves and do not need the protections offered by the Securities Act.[43] The second is that private placement plaintiffs have several alternative recourses, including state securities[44] and deceptive practices laws,[45] as well as Section 10(b) of the Exchange Act[46] and Rule 10b-5 promulgated thereunder[47] (the latter two offer remedies for intentional misconduct, which requires a showing of scienter).[48]
Similarly to Section 11, Section 12(a)(2) offers an affirmative “reasonable care” defense. However, unlike Section 11, it contains no reasonable reliance defense, as it does not distinguish expertised and non-expertised material.[49] As discussed below, the SEC[50] and some courts[51] have interpreted “reasonable care” as imposing a different standard than “reasonable investigation.” However, other courts have interpreted the standards as being substantially the same.[52]
D. Section 10(b) and Rule 10b-5 of the Exchange Act
The Exchange Act[53] prohibits fraudulent conduct in the offer and sale of securities. This prohibition applies both to public offerings and private placements, and courts have interpreted it to give plaintiffs a private cause of action.
The principal anti-fraud provisions of the Exchange Act are Section 10(b) and Rule 10b-5 promulgated thereunder.[54] Section 10(b) prohibits the use of any manipulative or deceptive practice in connection with securities offerings.[55] Rule 10b-5 makes it unlawful “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading”[56] in connection with the purchase or sale of securities. These prohibitions apply to oral and written communications as well as manipulative or deceptive practices.
Potential defendants under Section 10(b) and Rule 10b-5 include every participant in the offering, including the issuer, its officers and directors, participating broker-dealers, underwriters, and accountants.[57]
To prove a violation of Section 10(b) and/or Rule 10b-5, a plaintiff must establish each of the following: (i) the plaintiff was either a purchaser or seller of securities,[58] (ii) the defendant misstated a material fact or failed to state a material fact necessary to make statements that were made, in light of the circumstances under which they were made, not misleading,[59] (iii) the defendant had a duty to disclose the information in question,[60] (iv) the plaintiff relied on the allegedly false or misleading statement in making the investment decision,[61] (v) the violations in question caused the plaintiff to undertake the transaction,[62] and (vi) the damages the plaintiff suffered resulted from the misstatement or omission.[63] Courts also have required the plaintiff to prove that the defendant acted with scienter.[64] For example, in Software Toolworks, the Federal District Court for the Northern District of California stated:
Section 10(b) liability requires a showing of scienter — a mental state embracing intent to deceive, manipulate, or defraud. Scienter may be satisfied either by proof of actual knowledge or by proof of recklessness. The reckless conduct necessary to satisfy the scienter requirement is conduct “involving not merely simple, or inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” [citations omitted].[65]
E. Affirmative Defenses
1. Reasonable Investigation Defense
The reasonable investigation defense of Section 11 applies only to those portions of the offering documents “not purporting to be made on the authority of an expert” (non-expertised statements)[66] and is only available to signatories of the registration statement, directors, officers, partners of the issuer,[67] experts, and underwriters.[68] Thus, initial steps in a Section 11 analysis include determining whether the material misstatement or omission is contained in expertised or non-expertised material and whether the defendant is an enumerated party.
To meet the burden of proof for the reasonable investigation defense, a defendant must establish that it conducted a reasonable investigation and that after such investigation had:
reasonable grounds to believe and did believe … 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.[69]
Thus, the focus of the inquiry with respect to non-expertised material is the reasonableness of the party’s investigation (which also may include elements of reasonable reliance as explained in, among other sources, SEC Rule 176(f)[70]).
2. Reasonable Reliance Defense
The reasonable reliance defense of Section 11 applies only to the portions of the offering documents “purporting to be made on the authority of an expert” (expertised statements)[71] and, like the reasonable investigation defense, is only available to enumerated parties.
Not every statement of an expert constitutes expertised material. Section 11 defines an expert as:
every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement, with respect to the statement in such registration statement, report, or valuation, which purports to have been prepared or certified by him.[72]
As Judge Cote explained in WorldCom: “not every opinion qualifies as an expert’s opinion for purposes of the Section 11 reliance defense….”[73] For example, for an accountant’s opinion to qualify as an expert opinion, “it must be reported in the registration statement…, be an audit opinion …, [and] the accountant must consent to inclusion of the audit opinion in the registration statement.”[74]
An expert can assert a due diligence defense with respect to its own expertised material. To do so, the expert must establish either that: (i) it “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” or (ii) the statement in question did not fairly represent the expert’s actual statement.[75]
Non-issuer, non-experts (such as underwriters) can establish a reasonable reliance defense as to expertised material by demonstrating that either: (i) they had “no reasonable ground to believe and did not believe … that the statements [contained in the expertised portion] were untrue or that [they omitted] a material fact” or (ii) the statement in question did not fairly represent the expert’s actual statement.[76] Thus, the reasonable reliance defense does not require a defendant to conduct a “reasonable investigation” of the expertised material.[77]
3. Reasonable Care Defense
As with Section 11, Section 12(a)(2) offers an affirmative due diligence defense, although it requires “reasonable care” as opposed to a “reasonable investigation” or “reasonable reliance.” Section 12(a)(2) makes no distinction between expertised and non-expertised statements for purposes of the reasonable care defense. Thus, both kinds of material are treated the same, and there is no reasonable reliance defense under this statute (though SEC Rule 176(f) makes clear that reasonable reliance is a part of a reasonable investigation, and presumably reasonable care).[78] Section 12(a)(2) is like Section 11 in that it does not require scienter and the burden of proving the defense rests with the defendant.
4. Implied Affirmative Defense Under the Exchange Act
Unlike Sections 11 and 12(a)(2) of the Securities Act, neither Section 10(b) nor Rule 10b-5 contains an express due diligence defense. Nonetheless, the reasonableness of a defendant’s conduct may influence a court’s views regarding whether scienter exists (a mandatory element of plaintiff’s burden of proof).[79]
Courts have held that establishing an affirmative defense under Sections 11 or 12(a)(2) of the Securities Act negates the existence of scienter under Section 10(b) of the Exchange Act with respect to materially false or misleading statements.[80] For example, the court in Software Toolworks held that “[b]ecause we conclude that the Underwriters acted with due diligence…, we also hold that the Underwriters did not act with scienter regarding those claims.”[81] The judicial reasoning in this regard appears to be that if a defendant reasonably believed the statements made in the offering documents based on its reasonable investigation or reasonable reliance, then that defendant cannot be said to have acted either with scienter or recklessness “with respect to the same assertions under [the Exchange Act].”[82]
III. The Concept of Reasonableness
A. Overview
The standard by which courts assess underwriter due diligence, including the exercise of professional judgment as relates to it, is “reasonableness.” The Securities Act defines reasonableness as what a prudent person (in a similar context) would have done in the management of his or her own property.[83]
While the prudent person has been described as an objective standard,[84] based on a review of case law and relevant literature, the term appears more appropriately understood as a legal fiction reflecting something between the average and ideal persons as determined on a case-by-case basis by the court.[85] As one author put it:
reasonableness is not an empirical or statistical measure of how average members of the public think, feel, or behave…. Rather, reasonableness is a normative measure of ways in which it is right for persons to think, feel, or behave …[86]
Perhaps the best, albeit still opaque, articulation of this concept was offered more than a century ago by Justice Oliver Wendell Holmes, who stated that legal standards of care should be judged against the conduct of “the ideal average prudent man.”[87]
B. Authoritative and Informative Guidance
As the SEC,[88] the Financial Industry Regulatory Authority (“FINRA”) and its predecessor the National Association of Securities Dealers (“NASD”),[89] courts, and other authoritative and informative sources have concluded, reasonableness must rest on its own facts and context.[90] While legislators, regulators, courts, and other authoritative and informative sources have offered guidance regarding the reasonableness of underwriter conduct in certain contexts, no authoritative source has successfully developed a one-size-fits-all checklist of reasonableness appropriate to all contexts (indeed, those undertaking such an effort have consistently determined that such an effort is futile). [91]
Courts assess reasonableness flexibly,[92] applying a “sliding scale”[93] that varies with transactional context,[94] positional context,[95] situational context,[96] and temporal context.[97] Moreover, courts have stressed that the standard is “reasonableness” not “perfection,”[98] with one court even going so far as to note that it would be “truly surprising, given the advantage of hindsight” if one could not find at least some shortcomings in an underwriter’s conduct, but that one’s ability to “poke holes” in that conduct is not dispositive.[99]
Thus, what is reasonable conduct is context specific. The American Bar Association’s Committee on Federal Regulation of Securities Task Force in its “Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws,” (“ABA Due Diligence Task Force” and “ABA Due Diligence Task Force Report”) for example, stated that: “as a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”[100] Similarly, the NASD has stated that the “type of due diligence investigation that is appropriate will vary….”[101] And, the formal report of the SEC’s Advisory Committee on Corporate Disclosure[102] stressed:
The important point is that each subject person should evaluate the surrounding facts, including the extent of his prior relationship with the registrant, and utilize techniques of investigation appropriate to the circumstances of the offering….
Judicial interpretations of Section 11 have confirmed the principle that what constitutes reasonable investigation and reasonable ground for belief depends upon the circumstances of each registration. The prospect of continued flexible application of that standard by the courts should provide assurance to subject persons that they will not incur unreasonable investigative burdens.[103]
Thus, in assessing reasonableness, including in the exercise of professional judgment, a court must consider the totality of the context.
A further relevant consideration in the reasonableness assessment is industry custom and practice. As Judge Cote stated in Federal Housing Finance Agency v. Nomura: “Industry standards are relevant to the reasonableness inquiry,”[104] especially where the offering involves traditional securities; where the market is competitive; and where the custom and practice are well-established and addressed in pronouncements of government regulators, self-regulatory organizations, and/or practitioner and academic literature.[105] While following the practices common in the industry is not, as Judge Cote explained, dispositive of statutory reasonableness, conduct that conforms to such customary practice may enhance the likelihood that the conduct will be considered reasonable by the court.
In Special Report: Due Diligence Seminars, the NASD described these industry customs and practice as the “standards of the street”:
The standard of reasonableness under Section 11 is, in a sense, a “standard of the street.” In considering whether an underwriter has conducted a reasonable investigation, therefore, one must realize that the standard of reasonableness is not an absolute standard that never changes. Rather, “due diligence” may be construed as a standard that depends to some extent on what constitutes commonly accepted commercial practice. If you can establish that the steps taken meet the standard of the trade as it presently exists, a court should not, in applying the Section 11(c) standard, hold you liable for not being duly diligent despite the fact that you missed something and there was a material omission in the registration statement. What other underwriters are doing and the due diligence standards that are followed on the street are highly relevant in establishing one’s defense. Since the prudent man standard may be construed as a “standard of the street,” one is very reluctant to do anything that varies from street practice because that may weigh heavily in establishing liability. If every other underwriter uses a particular procedure, anyone who varies from that procedure is inviting trouble. It is important, then, to be aware of what other people are doing in similar transactions. This does not mean that that is as far as one should go, but if one does not go as far as the standard of the street, he may be exposing himself to potential liability.[106]
The notion that industry standards are relevant considerations in assessing reasonableness mirrors other areas of the law such as torts where:
[i]n determining whether conduct is negligent, the customs of the community, or of others under like circumstances, are factors to be taken into account, but are not controlling….[107]
Finally, the ABA Due Diligence Task Force summarized the relevance of industry standards in the assessment of reasonableness as follows:
[Reasonableness] requires “exercising [at least]…such attention, perception of the circumstances, memory, knowledge of other pertinent matters, intelligence, and judgment as a reasonable man would have.” In this connection, one should be entitled to cite “the usual and customary conduct of others under similar circumstances…, as an indication of what the community regards as proper” and as “a composite judgment as to the risks of the situation and the precautions required to meet them.”[108]
C. Dangers of Perceptual Biases
In making decisions about complex matters, such as the reasonableness of an underwriter’s professional judgments regarding due diligence, disclosures, red flags, and materiality, humans often use shorthand techniques, referred to as heuristics, to facilitate those decisions. Heuristics are the genesis of perceptual bias, which refers to mental errors caused by these simplified information processing strategies.[109]Such biases include “hindsight bias” (judging a matter, such as an underwriter’s exercise of professional judgment, based on information learned after the fact) and “outcome bias” (judging a matter based on the outcome of the matter to which it related).[110] These biases typically are unconscious and therefore may inadvertently affect judicial or regulatory determinations of reasonableness.[111]
While the temptation to assess an underwriter’s exercise of professional judgment using heuristics including after-acquired information is understandable, succumbing to hindsight, outcome, or other forms of perceptual bias is analytically unsound and intellectually undisciplined. Moreover, it can lead to errant reasoning and faulty conclusions. Indeed, as the Federal District Court for the Northern District of California stated in Software Toolworks:
The Court cannot evaluate an underwriter’s due diligence defense with the benefit of hindsight. The overall investigation performed here was reasonable under the circumstances at the time of the investigation.[112]
Thus, one must avoid judging reasonableness based on perceptual biases given that the inquiry into an underwriter’s conduct, including its due diligence and related exercises of professional judgment, is based on process, not results.[113]
IV. The Concept of Professional Judgment
A. Overview
The term “professional judgment” is not defined in federal securities laws, and the processes and practices associated with the appropriate exercise of an underwriter’s professional judgment in securities offerings is rarely addressed in authoritative and informative literature. Therefore, to understand the concept, one must consider a range of commentary and guidance.
B. Authoritative and Informative Guidance
Professional judgment has been described as “the capacity to logically assess situations or circumstances and to draw sound, objective conclusions that are not influenced by cognitive traps and biases or by emotion.”[114] Some sources have analogized the concept to Aristotle’s definition of wisdom,[115] which as described in The Nicomachean Ethics is “the ability to deliberate well about which courses of action would be good and expedient….”[116] Elaborating on this analogy, these sources note that professional judgment is “neither a matter of simply applying general rules to particular cases nor a matter of mere intuition”[117] but rather “a process of bringing coherence to conflicting values within the framework of general rules and with sensitivity to highly contextualized facts and circumstances.”[118]
The SEC Advisory Committee on Improvements to Financial Reporting (“SEC Financial Reporting Advisory Committee”) addresses professional judgment at some length in its 2008 Draft Decision Memo (“Advisory Committee Draft Memo” or “Draft Memo”).[119] While the Draft Memo focuses primarily on accounting and auditing issues, it also purports to address a broader universe consisting of “gatekeepers, including auditors and underwriters,” and a number of the concepts set forth therein are enlightening.[120]
In the Draft Memo, the Advisory Committee refers to professional judgment as involving “good faith”[121] and “well-reasoned, documented professional judgments,”[122] noting that “those making a judgment should be expected to exercise due care in gathering all of the relevant facts prior to making the judgment.”[123] Moreover, the Advisory Committee explained:
Professional judgment…should be the outcome of a process in which a person or persons with the appropriate level of knowledge, experience, and objectivity forms an opinion based on the relevant facts and circumstances within the context provided….[124]
The Advisory Committee stressed that professional judgments are not statements of fact and that different professionals may make different judgments based on the same information:
Professional judgments could differ between knowledgeable, experienced, and objective persons. Such differences between reasonable professional judgments do not, in themselves, suggest that one judgment is wrong and the other is correct. Therefore, those who evaluate judgments should evaluate the reasonableness of the judgment, and should not base their evaluation on whether the judgment is different from the opinion that would have been reached by the evaluator.[125]
As explained above, underwriters, of necessity, make many ongoing professional judgments regarding, among others, the scope and character of the due diligence to be conducted, the implications of that due diligence for the disclosures in the offering documents, red flags, and materiality. All of these professional judgments may be, and often are, challenged, through the lens of hindsight, in post-closing litigation and enforcement actions. However, as explained above and as the Advisory Committee noted, “the use of hindsight to evaluate judgment…is not appropriate.”[126]
C. Relevance of a Professional Judgment Framework
According to the Advisory Committee Draft Memo, professional judgments should be executed pursuant to “standard processes” involving a “framework [that] may provide investors with greater comfort that there is an acceptable rigor that companies follow in exercising reasonable professional judgment.”[127] The SEC Financial Reporting Advisory Committee explained its rationale for this conclusion as follows:
Identifying standard processes for making professional judgments and criteria for evaluating those judgments, after the fact, may provide an environment that promotes the use of judgment and encourages consistent evaluation practices among regulators.[128]
In the case of underwriters, a guidance-based “framework” incorporating “standard processes” for the exercise of professional judgment has been commonly employed in the industry for many years. That framework and those standard processes are based on more than six decades of guidance from the SEC[129] and its Corporate Disclosure Advisory Committee,[130] FINRA (and its predecessor the NASD),[131] the ABA Due Diligence Task Force,[132] the Securities Industry and Financial Markets Association (“SIFMA”),[133] and practitioner and scholarly literature.[134] The core principles and customary practices associated with this Professional Judgment Framework are addressed in the next sections of this article.
V. The Inevitability of Professional Judgments by Underwriters
A. Overview
As explained earlier, underwriters (and, indeed, other transactional professionals) inevitably are required to make many judgments throughout the securities offering process. As the SEC Corporate Disclosure Advisory Committee explained:
…[the] value of judgment should not be overlooked. Facts are not pristine, clearly defined, unequivocal, or susceptible of a single interpretation. As the complexities of industrial enterprise have grown the opportunities for diverse judgments concerning the importance of individual facts or complex configurations of facts have multiplied….[135]
The factors to be considered in making such judgments can be extensive and, as explained above, are unique to the context presented. Moreover, the exercise of professional judgment often involves significant and varying levels of uncertainty. Thus there is no precise formula or “preflight checklist” regarding how to make an informed professional judgment. Each individual or team must decide, on a case-by-case basis, what factors to consider, how those factors should be analyzed and assessed, and then, applying their knowledge and expertise, reach their own conclusions. In the context of a registered offering of securities, these judgments typically involve, among others, the scope and character of due diligence, the nature and extent of disclosures, red flags, and materiality.
B. Materiality
Nearly every aspect of an underwriter’s work for a public offering of securities involves making professional judgments about what information is material. Judicial pronouncements regarding materiality have arisen primarily in the context of offering document disclosures; however, much of the judicial analysis and discussion is relevant to a range of materiality judgments.
Among the concepts applicable to professional judgments regarding materiality are:
Materiality should be evaluated with reference to a “reasonable investor” standard involving a multi-faceted, fact-specific inquiry incorporating both qualitative and quantitative factors.[137]
A matter is material “if there is a substantial likelihood that a reasonable shareholder would consider it important” and, as relates to disclosure, if the matter would have “significantly altered the ‘total mix’ of information available.”[138]
Regarding offering document disclosures, courts have held that the central issue is “whether representations, viewed as a whole, would have misled a reasonable investor.”[139] However, courts also have cautioned that:
Some “misrepresentations in an offering are immaterial as a matter of law, because it cannot be said that any reasonable investor could consider them important in light of adequate cautionary language set out in the same offering.”[140]
“Some information is of such dubious significance that insistence on its disclosure may accomplish more harm than good.”[141]
Materiality judgments by underwriters are unavoidable in the context of a securities offering. They include, among others, defining what information is material for purposes of tailoring the scope and character of due diligence, assessing the proper nature and extent of disclosures in the offering documents, and deciding when something is a red flag and, if so, how to respond to it. Each of these matters is addressed separately below.
C. Due Diligence
Understandably, each issuer and offering presents an extensive array of complex operational, financial, regulatory, and other matters. As a result, each securities offering is unique and presents different transactional, situational, positional, and temporal contexts.[142]
As a result, no underwriter due diligence undertaking, no matter how carefully structured and performed, can ever probe the depths of every conceivable matter, nor can it be assured of revealing every piece of information that may later be cast as material. Indeed, such a standard would be profoundly unfair and constitute a burden no underwriter, no matter how dedicated or competent, could bear. Rather, the underwriter must exercise professional judgment in defining the scope and character of its due diligence. Therefore, at the beginning of the securities offering process (and potentially at various points along the journey), underwriters and their counsel endeavor to determine what issues are likely to be material to a prudent person and focus their due diligence on those matters. This process, which of necessity involves professional judgment, is referred to as “tailoring.”
D. Disclosures
Just as an underwriter must make professional judgments regarding the tailoring decisions undertaken regarding the scope and character of due diligence, so too it must make professional judgments regarding the appropriate nature and extent of the disclosures to be contained in the offering documents. As with all exercise of professional judgment, this can be a challenging endeavor especially since underwriters are not expected to possess the intimate knowledge of corporate affairs of insiders and typically have more limited access to information.[143] As the SEC Corporate Disclosure Advisory Committee explained:
…[N]o organization, even an “information disseminator,” can or expects to collect all the information desired or even required for investment decision-making. Even the most broadly based “information disseminator” necessarily makes decisions as to which specific items of information will be collected, processed and communicated to users. This is not an objective process; it is judgmental and evaluative.[144] …
Ranking or selection is required essentially because all disseminators obtain or receive far more information than they can communicate to users. Since even highly specialized disseminators operate within a limited space, judgments as to what information shall be communicated are necessary.[145]
Moreover, the Committee explained that the materiality of a given disclosure is “judgmental in nature”:
Although the Committee believes that ideally it would be desirable to have absolute certainty in the application of the materiality concept, it is its view that such a goal is illusory and unrealistic. The materiality concept is judgmental in nature and it is not possible to translate this into a numerical formula. The Committee’s advice to the Commission is to avoid this quest for certainty and to continue consideration of materiality on a case-by-case basis as disclosure problems are identified.[146]
As a result of these and other considerations, an underwriter’s professional judgments regarding disclosures “will necessarily encompass the selection of facts to be disclosed or withheld, the timing of disclosures, [and] the wording of releases and documents…”[147]
E. Red Flags
A common allegation in securities offering lawsuits against underwriters is that they encountered so-called red flags and failed to make appropriate professional judgments related to them. Under authoritative and informative guidance, red flags require further action in accordance with the contextually applied prudent person standard.[148]
As an initial matter, it is important to understand that there is no one-size-fits-all definition of a “red flag” that is appropriate in all contexts. Indeed, as Judge Cote stated in her seminal WorldCom ruling, what constitutes a red flag “depends on the facts and context of a particular case.”[149] For example, Judge Cote defined a red flag in the context of a securities offering as “any information that would cause a ‘prudent man in the management of his own property’ to question the accuracy of the registration statement.”[150] Moreover, she cautioned that one must take care to distinguish a red flag from an “ordinary business event,”[151] recognizing that what might be unusual in one context may be a customary attribute of an issuer’s business or industry in another context.
It is important to understand that the mere presence of a red flag has no bearing on the reasonableness of an underwriter’s conduct including its exercise of professional judgment. That matter is determined based on the underwriter’s awareness of the red flag, its response to it, and whether the red flag negated the underwriter’s belief that the offering documents did not contain material misstatements or omissions. Thus, even if a red flag is found to exist, an underwriter may still have acted reasonably provided the matter was adequately addressed such as through further investigation, disclosure in the offering documents, or other means the court deems reasonable.
VI. Underwriting Industry’s Guidance-Based Professional Judgment Framework
A. Overview
Because all professional judgments involve a degree of subjectivity, a properly constructed and employed Professional Judgment Framework (which commonly includes both core principles and customary practices) can assist courts, regulators, and others assessing the reasonableness of the exercise of professional judgments.
As the SEC Financial Reporting Advisory Committee has explained, establishing and following a Professional Judgment Framework is important to sound decision-making.[152] Moreover, other organizations, such those providing guidance to financial reporting decision makers, concur:
The professional judgment framework identifies core principles and provides a structured process to guide decision makers through how to make, assess and document significant judgements….[153]
For many years, underwriters, like others including accounting professionals, have commonly employed a Professional Judgment Framework involving both core principles and customary practices. The following portions of this article explain both.
B. Core Principles
1. The Professional Judgment Process Relies on Issuers to Provide Relevant and Accurate Information
In conducting due diligence, assessing disclosures and red flags, and making materiality judgments about both, underwriters rely on issuers to provide relevant and accurate information. Judicial decisions and regulatory guidance acknowledge this, noting among other things that if information was deliberately concealed from the underwriters, their exercise of professional judgment is likely to be impaired.[154] Thus, a core principle of the underwriting industry’s Professional Judgment Framework is that issuers, and indeed others involved in the offering process, will fulfill their own obligations to disclose relevant and accurate information to the underwriters and will understand that such information will be used by the underwriters and their counsel to make professional judgments regarding a range of matters throughout the process including as relates to due diligence and disclosures.
2. The Professional Judgment Process Is Disclosure Focused
The securities offering regulation regime under which underwriters in the United States operate is disclosure focused, not merit-focused.[155] Therefore, a significant focus of the underwriter’s activities in a public offering involve efforts designed to help ensure that the offering documents do not contain material misstatements or omissions.
It is important to understand, however, that whether offering documents contain material misstatements or omissions is a separate and distinct question from whether an underwriter’s conduct, including its professional judgments regarding due diligence, disclosures, red flags, and materiality, is reasonable.[156]
For example, in its Conference Report related to the Securities Act, the Committee on Interstate and Foreign Commerce stated that liability is different for underwriters than for issuers:
[T]o require them [persons other than the issuer] to guarantee the absolute accuracy of every statement that they are called upon to make would be to gain nothing in the way of an effective remedy and to fall afoul of the President’s injunction that the protection of the public should be achieved with the least possible interference to honest business.[157]
Moreover, the SEC has acknowledged and confirmed its agreement with this Congressional intent:
Congress’ goal was not to have underwriters act as insurers of an issuer’s securities. Accordingly, Congress provided underwriters and others with a ‘due diligence’ defense. An underwriter is not liable under Section 11 [of the Securities Act] for the non-expertised portions of the registration statement if, after reasonable investigation, it had reasonable grounds to believe (and did believe) that the statements in the registration statement “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….”[158]
Thus, both authoritative and informative sources make clear that underwriters are not guarantors of statements made in offering documents, and that Congress never intended to impose guarantor status on them. Instead, their obligation is to form a reasonable belief, based on reasonable investigation and reliance, that the offering documents did not contain material misstatements or omissions.[159]
3. The Professional Judgment Process Includes Both Investigation and Reliance
An underwriter’s professional judgments in a securities offering derive from and are based on both its independent investigation (both current and cumulative, as explained below) and its reliance on persons whose duties place them in a position to know about the matter in question. Reliance may either be on experts regarding expertised material (such as an issuer’s audited financial statements) or on non-experts regarding non-expertised material (such as legal opinions,[160] comfort letters and responses to circle-up requests,[161] issuer representations and warranties, and management certifications[162]). Underwriters generally may rely on expertised material without the necessity of an independent investigation[163]and on the non-expertised material as part of a reasonable investigation.
Under subsection (f) of SEC Rule 176 entitled “Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act,” underwriters may appropriately rely on persons whose duties place them in a position to know about the matter in question:
In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief meeting the standard set forth in section 11(c), relevant circumstances include, with respect to a person other than the issuer…(f) Reasonable reliance on officers, employees, and others whose duties should have given them knowledge of the particular facts (in the light of the functions and responsibilities of the particular person with respect to the issuer and the filing).[164]
Thus, the SEC has made clear that reliance is not limited to expertised material but is also a relevant part of a reasonable investigation (and by extension the exercise of reasonable care) related to non-expertised material. Similarly, courts have expressed the view that an underwriter can discharge its due diligence obligation with respect to non-expertised material by relying (as part of its reasonable investigation or exercise of reasonable care) on such persons.
In sum, reasonable reliance on the statements of and information provided by persons “whose duties place them in a position to know,” whether experts or otherwise, is an element of reasonable investigation and reasonable care.[165] Indeed, reasonable reliance on others—including the issuer’s management team, attorneys, and independent accounting professionals—has been a component of guidance-based industry custom and practice for decades that facilitates the orderly and efficient progress of securities offerings. Moreover, it recognizes the reality that no underwriter, however capable or dedicated, can independently investigate every aspect of an issuer, its business operations and financials, or the offering.
4. The Professional Judgment Process Strikes a Balance Between Reliance and Verification
While a number of judicial decisions have addressed the concept of verification of information relied upon, Rule 176(f) contains no express requirement that the information relied on thereunder be verified by an underwriter. Nonetheless, an underwriter’s alleged failure to verify such information is often in controversy in securities offering litigation. Therefore, core principles of the underwriting industry’s Professional Judgment Framework include a recognition that verification may be appropriate in some (but not necessarily all) contexts. As Judge McLean explained in one of the earliest underwriter defendant cases, Escott v. BarChris:
It is impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case.[166]
In considering the relationship between reliance and verification, Professor Leahy, a former capital markets practitioner at a global law firm and now a tenured professor, has observed that a prudent person (the benchmark for underwriter conduct) does not always consider it necessary to verify all information it receives:
[m]ost likely, a prudent investor would not bother to perform her own investigation of the issuer’s statements if (1) there were good, objective reasons for the investor to trust the issuer’s statements in question; or (2) the issuer had effectively warranted the statements. Under such circumstances, a prudent investor probably would either simply (1) make sure that the issuer was objectively trustworthy or (2) independently verify whether the issuer could likely make good on its express warranty.[167]
In addressing the passages of BarChris and Feit commonly cited as support for the proposition that an underwriter’s trust in management is irrelevant in assessing the reasonableness of its reliance, Professor Leahy asked: “does a prudent person never trust?” After examining the rulings in BarChris and Feit, he concluded that prudent persons do indeed trust, noting that:
On its face, BarChris explicitly rejects trust. Underwriters performing due diligence must not trust the issuer’s statements, the decision commands, because ‘a prudent [person] … would not’ do so…. In fact, Judge McLean’s inflexible edict does not hold up to scrutiny for several reasons. First, the BarChris court cited no authority for the proposition that a prudent person never trusts. And there is no legal precedent for this proposition, either in securities laws or the analogous context of the law of trusts. Nor is the author aware of any empirical data to support the assertion that trust in management is an anathema to the prudent investor. [Indeed] Judge McLean’s commandment to [defendants] is not to ‘never trust management’—which defies logic—but rather, to ‘never trust management unless there is good, objective reason to do so.’[168]
Finally, it is important to note that when an underwriter deems verification judgmentally appropriate, it can be accomplished in a variety of ways and on the basis of a range of sources from both inside and outside the issuer. Several courts, for example, have found “internal” verification activities to be compelling. For example, in Weinberger v. Jackson and Software Toolworks, the respective courts noted favorably several verification activities undertaken by the underwriters that did not involve sources of information outside the issuer (thus, the verification was “internal”). These included meetings with management and a review of company provided documents.[169] Courts also have found favorable indications of reasonableness in verification activities that were “outside” the issuer and its management, such as interviews with customers, lenders, manufacturers, and distributors.[170]
In sum, the industry’s Professional Judgment Framework recognizes that verification is not required in all contexts. Whether or precisely when it may be required (and the exact nature of the kinds of verification activities that may be appropriate) is ultimately a matter of professional judgment.
5. The Professional Judgment Process Involves Both Current and Cumulative Due Diligence
An underwriter’s exercise of professional judgment in a securities offering is typically based in significant part on it experience and the results of its due diligence. In this regard, it is important to understand that underwriter due diligence (which as explained above involves both independent investigation and reliance) typically has two temporal parts—current due diligence and cumulative due diligence. Current due diligence is conducted at or around the time of the offering. Cumulative due diligence is conducted over a more extended timeframe (often in less formal or regimented ways) prior to the time of the offering. Cumulative due diligence is especially relevant in the context of an expedited offering such as a shelf takedown, but it is also often present in other contexts such as initial public offerings.
Cumulative due diligence can derive from a variety of sources, including prior transactions and business dealings between the issuer and one or more of the underwriters or their affiliates (such as lending transactions or advisory work) and ongoing engagement in the issuer’s industry (for example, through analyst coverage and/or bringing an analyst over the wall[171] to assist the underwriting team in its due diligence). This is why the SEC has stated that an assessment of an underwriter’s due diligence should consider preexisting familiarity with the issuer and the industry, which the SEC has described as a “reservoir of knowledge.”[172] This reservoir means that an underwriter’s due diligence for a given offering, and the professional judgments it makes in part on the basis thereof, does not start from a blank slate but rather builds on the reservoir of knowledge associated with these kinds of activities.
C. Customary Practices
1. Overview
In addition to the core principles discussed above, the underwriting industry’s customary Professional Judgment Framework includes several specific practices that, like the core principles, are based on many decades of authoritative and informative guidance. These practices are summarized in the following schematic:
2. Underwriters Build on “Reservoirs of Knowledge”
As explained above, underwriter due diligence (which informs the exercise of professional judgment) may be both current and cumulative in nature, with current due diligence building on “reservoirs of knowledge” derived from cumulative due diligence conducted over time. Consistent with SEC guidance,[173] where such a reservoir of knowledge is present, underwriters build on that foundation in defining the scope and character of their current due diligence. The practice of building on reservoirs of knowledge (including any such reservoir possessed by counsel) facilitates the making of informed professional judgments.
3. Underwriters Assemble a Team Appropriate to the Context
Professional judgments may be made independently by an individual or collectively by a group of individuals on the underwriter’s team. Accordingly, a customary practice incorporated into the industry’s Professional Judgment Framework is staffing the underwriting team with persons whose experience and expertise make them suited to the context.[174] Such staffing typically involves both more experienced senior personnel and more junior or less experienced personnel working under their supervision. This team is supported by legal counsel that typically conducts legal, regulatory, and documentary due diligence and assists with the process of drafting and/or reviewing the disclosures contained in the offering documents.[175] The practice of assembling an appropriate team for the offering facilitates the making of informed professional judgments.
4. Underwriters Conduct Review and Approval Processes
Serving as an underwriter involves many financial, legal, and reputational risks. Therefore, a customary practice under the industry’s Professional Judgment Framework typically includes an internal review and approval process. This process commonly requires a broader cross-section of the investment bank (typically including one or more persons who are less engaged in the “shovel-and-spade” work of the transaction-specific work) to reach a decision regarding an underwriter’s participation in an offering.[176]
Such review and approval processes commonly involve preparation of memoranda or other documentation regarding the issuer, offering, due diligence conducted to a specified point in time, and other matters. Such memoranda or documentation typically are presented to one or more internal committees whose approval is required to proceed with the transaction.[177] The practice of conducting internal review and approval processes provides an additional level of checks and balances regarding the exercise of professional judgments.
5. Underwriters Conduct an Independent Investigation
Another customary practice under the industry’s Professional Judgment Framework (and regulatory mandate) is the performance of due diligence by the underwriting team and underwriters’ counsel. While the precise scope and nature of the due diligence conducted is context specific, it typically involves a range of formal activities such as meetings; conference calls; due diligence sessions with, among others, attorneys, accountants, members of the issuer’s management and/or staff (internal sources), and, depending on the context, third parties (external sources); offering document reviews; and bringdown sessions. It also typically involves less formal activities such as email communications, telephone calls, texts, and informal discussions. Both formal and informal due diligence processes may occur in person or virtually.
Moreover, as explained above, an underwriters’ due diligence process may begin with a consideration of information learned through prior cumulative due diligence related to the issuer and/or the industry. With the goal of reasonableness in mind, the proper scope and character of due diligence is determined with reference to the context and in the exercise of the underwriter’s professional judgment.
6. Underwriters and Counsel Review Offering Documents
As explained earlier, the securities regulatory regime in the United States is focused on disclosure. Therefore, among the customary practices included in the underwriting industry’s Professional Judgment Framework is a focus on the disclosures contained in the offering documents.
Typically, underwriters, in collaboration with underwriters’ counsel, review offering document disclosures to make professional judgments regarding their consistency with the results of due diligence and to support a belief that the offering documents do not contain material misstatements or omissions (the issuer’s independent auditor and both issuer’s and underwriters’ counsel also review them for a similar purpose and make representations to the underwriters in support of their due diligence).
Because the offering document drafting and review process tends to focus on the offering documents in a line-by-line, word-by-word fashion, these sessions are part of the information disclosure and verification process and, therefore, a part of the due diligence process that supports the exercise of professional judgment.[178] In addition, drafting sessions allow the participants to make collective judgments regarding disclosures based on information learned in the course of due diligence, thereby enhancing the quality of the professional judgments made regarding the sufficiency of the disclosures.
7. Underwriters Conduct Bringdown Due Diligence
Another customary practice under the industry’s Professional Judgment Framework is the conduct of bringdown due diligence which occurs at various latter stages of the offering process such as pre-pricing and pre-closing.[179]
This bringdown process is designed to give underwriters and underwriters’ counsel a final formal opportunity to question the issuer and others directly about various matters, including whether there have been any significant changes that need to be reflected in the offering documents and, if not, to confirm the continuing material accuracy and completeness of the statements made therein. They also give issuers and others an opportunity to apprise the underwriters of any recent material developments. Due to the late-in-process timing of the bringdown process, it is not intended to repeat steps already taken by the underwriters in prior stages, such as earlier due diligence calls or meetings, but is intended as a final check on a range of matters relevant to the exercise of professional judgment. The practice of conducting bringdown due diligence sessions facilitates the making of informed professional judgments.
8. Underwriters Support Their Professional Judgments with, Among Other Things, Opinions and Representations of Counsel, Issuer Representations and Warranties, Management Certifications, and Auditor Comfort Letters
A final customary practice under the industry’s Professional Judgment Framework is for underwriters to support their professional judgments with certifications and assurances from others whose duties place them in a position to know about the matters in question (as contemplated by SEC Rule 176(f) discussed above). These commonly include legal opinions, representation letters, representations and certifications of the issuer and senior management, and comfort letters and circle-ups from the issuer’s independent auditor.
The legal opinions typically address a range of legal and regulatory matters, such as due organization and compliance with legal or regulatory requirements. The representation letters typically address the adequacy of the offering documents disclosures[180] and take the form of so-called negative assurances by counsel that nothing has come to its attention that caused it to believe that the offering documents contain any untrue statements of material fact or omit to state a material fact necessary to make the statements therein not misleading in light of all the circumstances. To give these opinions and representation letters, law firms typically conduct their own independent investigation, including a review of the offering documents and the completion of an internal review and approval process.[181]
Similarly, underwriters support their professional judgments with representations and certifications from the issuer and its management who, like the attorneys noted above and the auditors below, are persons “whose duties should have given them knowledge of the particular facts.”[182] Among these are confirmations that the offering documents do not contain material misstatements or omissions. Because underwriters are not operators of the issuer’s business and do not take part in its management, these assurances provide additional support for the underwriters’ belief that the offering documents do not contain material misstatements or omissions. By requiring the issuer (typically in representations and warranties in the underwriting agreement) and individual officers (typically in certificates issued pursuant to the closing conditions of the underwriting agreement) to certify matters including the lack of material misstatements or omissions in the offering documents, the industry’s Professional Judgment Framework imposes an enhanced level of formality and weight on the issuers and officers that further enhances the basis for their professional judgments.
A final example of reliance-based support for the underwriter’s professional judgments is the receipt of comfort letters from the issuer’s independent auditor.[183] These letters usually incorporate responses to circle-up requests. Circle-ups refer to the underwriters’ or their counsel’s line-by-line review of the offering materials and the “circling” of financial figures and similar statements made in them regarding which the underwriters seek confirmation and/or support from the issuer’s independent auditor and a description of the basis therefore.[184] Like legal opinions, negative assurance letters, issuer representations and warranties, and management certifications, such comfort letters and circle-ups impose an enhanced level of formality and weight on the auditor and further enhance the basis for the underwriters’ professional judgments.
VII. Conclusion
Throughout the securities offering process, underwriters are required to make many ongoing, organic, and contextually specific professional judgments. Most notable among these are judgments regarding the scope and character of due diligence, the nature and extent of disclosures, red flags, and materiality. These decisions are both profoundly judgmental in nature and specific to a particular set of circumstances. Moreover, they must be made in real time without the benefit of hindsight.
The reasonableness of these professional judgments is commonly at issue in securities litigation involving underwriter defendants. In resolving such cases, courts face the difficult task of assessing reasonableness in a way that balances investor protection with fundamental fairness in the application of the law. As explained in this article, essential aspects of the reasonableness inquiry regarding the exercise of professional judgment by underwriters are the “standard processes” and “framework” pursuant to which such judgments are made. Developing a better understanding of and appreciation for the underwriting industry’s guidance-based processes and framework pursuant to which such judgments are made will assist courts in striking an appropriate balance between these two legitimate, indeed foundational, considerations.
Mr. Lawrence is an adjunct professor of advanced due diligence studies at the Dedman School of Law, Southern Methodist University, and a prominent transactional scholar and practitioner. His published work has been cited authoritatively by the Federal District Court for the Southern District of New York, in filings before the Supreme Court of the United States, and in academic and practitioner publications, and he has advised the U.S. Securities and Exchange Commission. Among others, he is the author of the two-volume treatise Due Diligence in Business Transactions, a leading work in the field for more than twenty-five years, and the graduate texts Due Diligence: Investigation, Reliance & Verification—Cases, Guidance & Contexts; Due Diligence: Law, Standards and Practice; Due Diligence, a Scholarly Study; and Due Diligence in Negotiated Transactions: Applied Skills & Exercises. He holds a J.D. degree from Vanderbilt Law School and has been admitted to the bars of New York, the District of Columbia, and Texas. Portions of this article, adapted to the topic addressed, draw in part from selected material included in Mr. Lawrence’s extensive prior publications including the texts noted above and In Search of Reasonableness: Director and Underwriter Due Diligence in Securities Offerings, 47 Sec. Reg. L.J. 189 (Fall 2019).
See, e.g., Roger J. Dennis, Materiality, and the Efficient Capital Market Model: A Recipe for the Total Mix, 25 WM & MARY L. REV. 373 (1983). ↑
1 HOUSE COMM. ON INTERSTATE AND FOREIGN COMMERCE REPORT OF THE ADVISORY COMMITTEE ON CORPORATE DISCLOSURE TO THE SECURITIES AND EXCHANGE COMMISSION (November 3, 1977) (“SEC Corporate Disclosure Advisory Committee Report”) at 327 (“Although the Committee believes that ideally it would be desirable to have absolute certainty in the application of the materiality concept, it is its view that such a goal is illusory and unrealistic. The materiality concept is judgmental in nature and it is not possible to translate this into a numerical formula. The Committee’s advice to the Commission is to avoid this quest for certainty and to continue consideration of materiality on a case-by-case basis as disclosure problems are identified.”). ↑
DRAFT DECISION MEMO OF THE SECURITIES AND EXCHANGE COMMISSION ADVISORY COMMITTEE ON IMPROVEMENTS TO FINANCIAL REPORTING, American Law Institute – American Bar Association Continuing Legal Education ALI-ABA Course of Study, February 21–22, 2008, Corporate Governance: The Changing Environment (ALI 2008) (“SEC Financial Reporting Advisory Committee Draft Memo”). ↑
Id. at *72. The Committee’s focus was the exercise of professional judgment in the context of financial reporting, and therefore a number of its observations and recommendations were made with reference to that context. However, the general principles articulated by the Committee, especially as they relate to the importance of “standard processes” and “frameworks” in the exercise of professional judgment, are relevant in other contexts, as the Draft Memo noted. See, e.g., id. at *53. ↑
See, e.g., Milton Cohen, “Truth in Securities” Revisited, 79 HARV. L. REV. 1340, 1344–45 (1966). ↑
The Securities Act defines an underwriter as: “…any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking….” 15 U.S.C. § 77b(a)(11). ↑
In a firm commitment underwriting, the underwriters are obligated to purchase the securities from the issuer and thereby assume the risk of selling those securities to investors. See Edward F. Greene, Determining the Responsibilities of Underwriters Distributing Securities Within an Integrated Disclosure System, 56 NOTRE DAME L. REV. 755, 763 (1981). ↑
In re WorldCom, Inc. Sec. Litig., 346 F. Supp. 2d 628, 662 (S.D.N.Y. 2004). ↑
See generally William K. Sjostrom, Jr., The Due Diligence Defense Under Section 11 of the Securities Act of 1933, 44 BRANDEIS L.J. 549, 584–85 (Spring 2006); Shane Corwin and Paul Schutz, The Role of IPO Underwriting Syndicates: Pricing, Information Production and Underwriter Competition, 60 J. FIN. 443, 445–450 (2005). ↑
See generally Noam Sher, Negligence Versus Strict Liability: The Case of Underwriter Liability in IPO’s, 4 DEPAUL BUS. & COMM. L.J. 451 (2006). ↑
Information asymmetry refers to the notion that one party to a transaction may have more or superior information compared to another. See generally Nathalie Dierkens, Information Asymmetry and Equity Issues, J. FINANCIAL QUANT. ANAL., vol. 26, no. 2 (1991). The securities offering due diligence process, along with the risks of liability, reputational tarnish, or other forms of injury offering participants may incur, is an informational asymmetry mitigant. ↑
Anita Indira Anand, The Efficiency of Direct Public Offerings, 7 J. SMALL & EMERGING BUS. L. 433, 435 (2003). ↑
Institutional (or “sophisticated”) investors typically conduct independent due diligence before acquiring securities in a registered offering. Moreover, FINRA regulations state that the scope of an underwriter’s due diligence “will necessarily depend upon [factors such as] whether the offerees are retail investors or more sophisticated institutional investors.” FINRA, Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings (2010). The ABA Due Diligence Task Force Report echoes this sentiment when it identifies the following factors a relevant to underwriter due diligence: (i) “the degree to which participants in the market—particularly professional investors, rating agencies, and securities analysts—obtain and disseminate information about issuers,” (ii) “the degree to which relevant investors rely on a rating assigned to the underwritten securities by an independent rating agency,” and (iii) “the degree to which relevant investors have independent access to information and credit judgments about the issuer.” Comm. on Fed. Reg. of Sec., Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 BUS. LAW 1185, 1240 (“ABA Due Diligence Task Force Report”). Thus, institutional investors are more likely to possess a range of information about the offering as well as internal expertise to efficiently complete a valuation of the securities being offered. Anita Indira Anand, The Efficiency of Direct Public Offerings, 7 J. SMALL & EMERGING BUS. L. 433, 445-446 (2003). Commonly, such investors conduct their own research and monitor factors such as historical performance and prior offering results. Id. at 446. As a result, “the underwriter’s information function becomes less important for institutional shareholders because of their level of sophistication and the active manner in which they pursue their investments. Indeed, institutional investors’ relative sophistication means that they are less in need of the underwriter’s services….” Id. ↑
See, e.g., Arthur B. Laby, Differentiating Gatekeepers, 1 BROOK. J. CORP., FIN. & COMM. L. Vol. I (2006) 119; Peter B. Oh, Gatekeeping, 29 J. CORP. L. 735, (Summer 2004); Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, II.1 J.L. & ECON. 54 (1986). ↑
Lawrence Cunningham, Beyond Liability: Rewarding Effective Gatekeepers, 92 MINN. L. REV. 323, 328 (2007). ↑
John Coffee, The Attorney as Gatekeeper: An Agenda for the SEC, 103 COLUM. L. REV. 1293, 1296 (June 2003). ↑
Andrew F. Tuch, The Limits of Gatekeeper Liability, 73 WASH. & LEE L. REV. ONLINE 619 (2017). ↑
Liability may also arise in other ways including under common law. ↑
Section 15 of the Securities Act provides that any person who controls a person liable under Section 11 or Section 12 of the Securities Act is liable jointly and severally with and to the same extent as the controlled person. The term “controls” is broadly defined for purposes of this section, and the concept of control can include directors, officers, and principal stockholders, depending on the specific facts and circumstances. 15 U.S.C. § 77o. ↑
The term “scienter” refers to a state of mind required to hold a defendant legally accountable for his acts. ↑
An issuer does not have an affirmative due diligence defense under Section 11 of the Securities Act. The situation under Section 12(a)(2) is more nuanced, but the result is effectively the same. The term “seller” is not expressly defined in the Securities Act, and historically its meaning has been subject to judicial determination (see, e.g., Pinter v. Dahl, 486 U.S. 622, 623–24 (1988) (explaining that the term “seller” must be defined by the court); Davis v. Avco Fin. Serv. Inc., 739 F. 2d 1057, 1064 (6th Cir.), cert. denied, 470 U.S. 1005 (1984) (considering the meaning of the term “seller” in Section 12 of Securities Act); Cady v. Murphy, 113 F. 2d 988 (1st Cir.), cert. denied, 311 U.S. 705 (1940) (addressing the meaning of term “seller”)). However, in 2005, the SEC clarified that issuers are “sellers” for purposes of section 12(a)(2) in firm commitment underwritings (“Securities Offering Reform,” Securities Act Release No. 33-8591, 85 S.E.C. Docket 2871, 2005 WL 1692642 (Aug. 3, 2005)) and subsequently adopted Rule 159A to that effect. 17 C.F.R. § 230.159A (for purposes of section 12(a)(2), “seller shall include the issuer of the securities sold … and the issuer shall be considered to offer or sell the securities”). However, any arguable defense under Section 12(a)(2) may be illusory. See SEC Corporate Disclosure Advisory Committee Report at 451 (“The company [issuer] itself has no defenses under the 1933 Act.”); Jack C. Auspitz and Susan E. Quinn, Litigator’s View of Due Diligence, CONDUCTING DUE DILIGENCE 2003 (Practising Law Institute, 2003) at 146 (citing Robert Alan Spanner, A Litigation Perspective on Prospectus Preparation Process for an IPO, 116 SEC. REG. L.J. 115, 127 (1988)) (“There is no statutory due diligence defense for issuers under Section 11 or Section 12(a)(2). Issuers are held to the highest standards of liability, because for them ‘omniscience is virtually presumed and omnicompetence is required.’”). See also Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983) (“[l]iability against the issuer of a security is virtually absolute….”). ↑
Non-expertised material is any information contained in the offering documents not purporting to be made on the authority of an expert. See 15 U.S.C. § 77k (a)(4). ↑
An expertised statement is any information contained in the offering documents purporting to be made on the authority of an expert. Id. ↑
Thus, such a defendant will be liable if it either did not meet the standard of reasonableness in its investigation or, even meeting that, if it did not have a reasonable ground to believe in the accuracy and completeness of the offering documents. Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 576 (E.D.N.Y, 1971). ↑
Courts have ruled that in appropriate circumstances, the reasonableness of a defendant’s Section 11 due diligence may be resolved on summary judgment. See, e.g., In re Software Toolworks, Inc., 789 F. Supp. 1489 (N.D. Cal. 1992), aff’d in part, rev’d inpart, 38 F. 3d 1078 (9th Cir. 1994), amended, 50 F. 3d 615 (9th Cir. 1995), cert. denied, 516 U.S. 907 (1995) at 50 F. 3d. 621; Weinberger v. Jackson, No. C-89-2301-CAL, 1990 WL 260676 (N.D. Cal. Oct. 11, 1990); Phillips v. Kidder Peabody & Co., 993 F. Supp. 303 (S.D.N.Y. 1996); Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co., 1998 U.S. Dist. LEXIS 11783 (W.D. Mich. June 15, 1998); Lilley v. Charren (Kenetech Sec. Litig.), No. C-98-20416 JF (N.D. Cal., Aug. 9, 1999). See also Federal Housing Finance Agency v. Nomura Holding America, Inc., 68 F. Supp. 3d 439, 468 (S.D.N.Y. 2014), aff’d 873 F. 3d 85 (2d Cir. 2017) (finding no due diligence defenses as a matter of law and granting summary judgment to the plaintiff). ↑
See, e.g., Vannest, et al. v. Sage, Rutty & Co., 960 F. Supp. 651, 655 (W.D.N.Y. 1997); In re JWP Inc. Sec. Litig., 928 F. Supp. 1239, 1261 (S.D.N.Y. 1996). ↑
See, e.g., Anheuser-Busch Cos. v. Summit Coffee Co., 934 S.W. 2d 705, 706 (Tex. App. 1996) and Argyropoulos, et al. v. Mednet, et al., 1997 U.S. Dist. LEXIS 10497 (C. D. Cal. 1997) (applying Gustafson in dismissing Section 12 claims but sustaining claims based on state securities laws). ↑
See, e.g., Lennon v. Christoph, 1996 U.S. Dist. LEXIS 9943 (N.D. Ill. 1996) (dismissing the Section 12(a)(2) claims but sustaining claims for violation of state securities, negligent misrepresentation, deceptive practices, and common law fraud). ↑
Reckless disregard (as opposed to negligence) may also constitute intentional conduct. See Elliott J. Weiss, Securities Act Section 12(a)(2) After Gustafson v. Alloyd Co.: What Questions Remain?, 50 BUS. LAW. 1209, 1222 (1995). ↑
See “Securities Offering Reform,” Securities Act Release No. 33-8591, 85 S.E.C. Docket 2871, 2005 WL 1692642 (Aug. 3, 2005) at *79 and n. 430 (“Additionally, commenters asked us to reaffirm the statement from the 1998 proposals that ‘Section 11 requires a more diligent investigation than Section 12(a)(2),’ so as to avoid any implication that our view of the matter has changed. We have determined not to propose modifications to Rule 176 at this time. We believe, however, as we have stated previously, that the standard of care under Section 12(a)(2) is less demanding than that prescribed by Section 11 or, put another way, that Section 11 requires a more diligent investigation than Section 12(a)(2). Moreover, we believe that any practices or factors that would be considered favorably under Section 11, including pursuant to Rule 176, also would be considered as favorable under the reasonable care standard of Section 12(a)(2).”). ↑
See, e.g., Software Toolworks, 50 F.3d 615, 621 (“[b]oth standards are similar, if not identical”); Weinberger, 1990 WL 260676, at *2 (“[t]he standards under sections 11 and 12 are essentially the same….”). See also John Nuveen & Co. v. Sanders, 450 U.S. 1005, 1010 n.4, 101 S. Ct. 1719, (the analysis of each on summary judgment is the same) (1981) (Dissent, Justice Powell). ↑
In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) the Supreme Court held that private plaintiffs have no “aiding and abetting” causes of action under Rule 10b-5. Previously, both courts and the SEC had held that parties such as accountants, attorneys, and trustees, among others, could be held liable as “aiders and abettors.” The Court reaffirmed its Central Bank of Denver ruling in Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc. 552 U.S. 148 (2008) (plaintiffs have no private right of action against secondary parties alleged to have aided securities fraud—such claims may only be brought by the SEC in an enforcement proceeding). ↑
See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). ↑
17 C.F.R. § 240.10b-5. See also TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important” in making the relevant investment decision.). ↑
Defendants are not liable for a failure to disclose information allegedly withheld from the market unless the defendant had a duty to disclose the information at the time. Chiarella v. United States, 445 U.S. 222, 230 (1980) (Rule 10b-5 allegations involving silence are “premised upon a duty to disclose arising from a relationship of trust and confidence between the parties to a transaction”); Dirks v. S.E.C., 463 U.S. 646, 654 (1983) (Rule 10b-5 requires a duty of disclosure arising from the relationship between the parties); Gallagher v. Abbott Labs., 269 F. 3d 806, 808 (7th Cir. 2001) (“[w]e do not have a system of continuous disclosure. Thus, issuers and underwriters are entitled to remain silent (about good news as well as bad news) unless positive law creates a duty to disclose”). ↑
Reliance may be established by showing a “fraud on the market” meaning they relied on the integrity of the market price which allegedly reflected the false or misleading information rather than relying directly on the allegedly false or misleading statements at issue. See, e.g., Basic, Inc. v. Levinson, 485 U.S. 224 (1988). ↑
To establish loss causation, the misstatement or omission must induce a purchase or sale and produce a loss. See, e.g., Bennett v. United States Trust Co., 770 F. 2d 308 (2d Cir. 1985), cert. denied, 474 U.S. 1058 (1986). The plaintiff must show that it bought or sold in reliance on a misstatement, a loss then ensued, and the loss was caused by the misstatement. Thus, the plaintiff must show that the misrepresentation is related to the resulting loss. See, e.g., Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F. 3d 154, 172 (3d Cir. 2001) and Suez Equity Investors, L.P. v. Toronto Dominion Bank, 250 F. 3d 87, 95–96 (2d Cir. 2001). ↑
See, e.g., Schlick v. Penn-Dixie Cement Corp., 507 F. 2d 374, 380–81 (2d Cir. 1974). ↑
In Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), the Supreme Court ruled that Congress’s use of the words “manipulative or deceptive” in conjunction with “device or contrivance” suggested that Congress intended Section 10(b) to apply only to knowing or intentional misconduct. Justice Powell wrote that the “use of the words ‘manipulative,’ ‘device,’ and ‘contrivance’ … make unmistakable a Congressional intent to proscribe a type of conduct quite different from negligence.” Id. at 199. In particular, the Court noted that “[a]lthough the extensive legislative history of the 1934 Act is bereft of any explicit explanation of Congress’s intent, we think the relevant portions of that history support our conclusion that Section 10(b) was addressed to practices that involve some element of scienter and cannot be read to impose liability for negligent conduct alone.” Id. at 201. In another case, the Supreme Court stated that that scienter may be inferred if the evidence is “cogent and compelling.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 309–310 (2007). However, the Court declined to resolve whether recklessness is sufficient to meet the standard. Id. at 319 n.3 (“The question whether and when recklessness satisfies the scienter requirement is not presented in this case.”). Other courts have developed their own approaches to the issue. For example: Second Circuit: motive and opportunity sufficient to establish scienter. See, e.g., Novak v. Kasaks, 216 F. 3d 300, 310 (2d Cir. 2000); Ganino v. Citizens Utils. Co., 228 F. 3d 154, 168–69 (2d Cir. 2000); Acito v. IMCERA Grp., Inc., 47 F. 3d 47, 52 (2d Cir. 1995); Ninth Circuit: see, e.g., In re Silicon Graphics, Inc. Sec. Litig., 183 F. 3d 970, 974 (9th Cir. 1999) ([R]eckless conduct can also meet this standard ‘to the extent that it reflects some degree of intentional or conscious misconduct,’ or what we have called ‘deliberate recklessness.’” S. Ferry LP, No. 2 v. Killinger, 542 F. 3d 776, 782–83 (9th Cir. 2008) (citing Silicon Graphics, 183 F. 3d at 983 (9th Cir. 1999); Glazer Capital Mgmt., LP v. Magistri, 549 F. 3d 736, 743 (9th Cir. 2008) (quoting In re Silicon Graphics, 183 F. 3d at 974); Eleventh Circuit: see, e.g., Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., 594 F. 3d 783, 790 (11th Cir. 2010) (recklessness is “limited to those highly unreasonable omissions or misrepresentations that involve … an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.”); Mizzaro v. Home Depot, Inc., 544 F. 3d 1230, 1238 (11th Cir. 2008); and Third Circuit: see, e.g., In re Advanta Corp. Sec. Litig., 180 F. 3d 525, 534 (3d Cir. 1999) (“Congress’s use of the Second Circuit’s language compels the conclusion that the Reform Act establishes a pleading standard approximately equal in stringency to that of the Second Circuit.”). ↑
Section 15 of the Securities Act provides that any person who “controls” a person liable under Section 11 or Section 12 of the Securities Act is liable jointly and severally with and to the same extent as the controlled person. The term “controls” is broadly defined for purposes of this section, and, depending on the specific facts and circumstance, the concept of control can include directors, officers, and principal stockholders. ↑
Id. (the reliance defense applies to “any part of the registration statement purporting to be made upon his authority as an expert or purporting to be a copy of or extract from a report or valuation of himself as an expert, (i) 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.”). ↑
See, e.g., 17 C.F.R. § 230.176 and “The Regulation of Securities Offerings,” Securities Act Release 33-7606A, 1998 WL 792508 (Nov. 17, 1998) (“SEC Release No. 33-7606A”). ↑
See, e.g., NASD, Notice to Members 73-17, Proposed New Article III, Section 35 of the Rules of Fair Practice Concerning Underwriter Inquiry Standards Respecting Distributions of Issues of Securities to the Public (March 14, 1973). ↑
Escott v. BarChris Construction Corp., 283 F. Supp. 643, 692 (S.D.N.Y. 1968). ↑
As one court noted: “[t]here is little judicial authority regarding what is required to establish [reasonableness under] either of the two defenses, but those courts that have addressed the questions have provided some guidance.” See, e.g., In re Enron Corp. Sec. Deriv. & ERISA Litig., No. MDL-1446, 2005 WL 3704688 (S.D. Tex. Dec. 5, 2005) at *17. ↑
See, e.g., William K. Sjostrom, The Due Diligence Defense Under Section 11 of the Securities Act of 1933, 44 BRANDEIS L. J, 549, 550 (2006) (“…the standard [of due diligence] varies by defendant type based on a sliding scale which takes into account the defendant’s involvement with the particular company and the defendant’s involvement with the particular offering”); “Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act,” Securities Act Release No. 33-6335, 1981 WL 31062 (Aug. 6, 1981) (“SEC Release No. 33-6335”) at *14 (“Congress intended that there would be variation in the [thoroughness] of the investigation performed by the different persons subject to Section 11 liability…’”) (internal citations omitted). ↑
Transactional context refers to the nature of the securities offering such as whether it involved equity or debt securities, an initial public offering, or a shelf takedown. ↑
Positional context refers to the role of the person in question, such as whether it was a lead underwriter or participating underwriter. ↑
Situational context refers to matters such as the size and complexity of the issuer and its business, the experience and skills of the persons involved, and the reservoir of knowledge already possessed by those engaged in the due diligence. ↑
Temporal context refers to the timeframe within which the due diligence occurred and the custom and practice that existed at such time. ↑
Int’l Rectifier, 1997 WL 529600 at *7. See alsoIn re Worlds of Wonder Sec. Litig., 814 F. Supp. 850 (N.D. Cal. 1993), aff’d in part, rev’d in part, 35 F. 3d 1407, 1427 (9th Cir. 1994). ↑
Committee on Federal Regulation of Securities, Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws, BUS. LAW., Vol. 48 (May 1993) (“ABA Due Diligence Task Force Report”) at 1232. ↑
NASD, Notice to Members: 03-71 Non-Conventional Investments: NASD Reminds Members of Obligations When Selling Non-Conventional Investments (Nov. 2003). ↑
NACD, SPECIAL REPORT DUE DILIGENCE SEMINARS, (1981) at 6. ↑
RESTATEMENT (SECOND) OF TORTS §295A (1965). The comments to the Restatement further stress the relevance of custom: “If the actor does what others do under like circumstances, there is at least a possible inference that he is conforming to the community standard of reasonable conduct; and if he does not do what others do, there is a possible inference that he is not so conforming…. [W]here there is nothing in the situation or in common experience to lead to the contrary conclusion, this inference may be so strong as to call for a directed verdict….” Id. at § 295A comment b. Seealso Fed. R. Evid. 406 (customs and routine practices are admissible as evidence to prove action in conformity therewith). ↑
ABA Due Diligence Task Force Report at 1232–33, citing RESTATEMENT (SECOND) OF TORTS § 289(a) (1965) and W. Page Keeton et al., PROSSER AND KEETON ON THE LAW OF TORTS § 33 (5th ed. 1984) at 193. ↑
See generally John S. Hammond, Ralph L. Keeney, and Howard Raiffa, The Hidden Traps in Decision Making, HARV. BUS. REV. (2006) 84 (no. 1); Ron Howard, Decision Analysis, Strategic Decision and Risk Management Certificate Program Class Materials (Stanford 2006). ↑
R. MacCoun, Hindsight Bias, INT’L ENCYC. SOC. & BEHAVIORAL SCI. (2001); Jonathan Baron and John C. Hershey, Outcome Bias in Decision Evaluation, 54 J. PERS. AND SOC. PSYCH. 569 (1988). ↑
See John S. Hammond, Ralph L. Keeney, and Howard Raiffa, The Hidden Traps in Decision Making, HARV. BUS. REV. (2006) 84 (no. 1). ↑
Software Toolworks, 789 F. Supp. 1489, 1496-98. (Emphasisadded.) ↑
See generally Jonathan Baron and John C. Hershey, Outcome Bias in Decision Evaluation, 54 J. PERS. AND SOC. PSYCH. no. 4 (1988). ↑
See, e.g., 17 C.F.R. § 230.176; see also, SEC Release No. 33-7606A at *92–99. ↑
See SEC Corporate Disclosure Advisory Committee Report. While the Committee rejected the notion of rigid definitions and checklists, it concluded that it would be advisable for the SEC to adopt a rule setting out several non-exclusive, contextually oriented factors courts should consider in assessing the issue of reasonableness as it relates to the affirmative “reasonableness” defenses. SEC Release No. 33-6335 and Rule 176 were part of the response to this recommendation. ↑
As previously noted, FINRA (and its predecessor the NASD) have consistently stated that there is no one-size-fits-all approach to underwriter due diligence, and that what is reasonable can only be determined considering the context presented. ↑
See generally ABA Due Diligence Task Force Report at 1232–33; see also, id. at 1204 (quoting a November 6, 1981, letter from the Securities Industry Association Corporate Finance and Federal Regulation Committees to the SEC Committee: “We believe that what constitutes a reasonable investigation depends on all the surrounding circumstances, including, but not limited to, those described in proposed Rule 176. We believe these include the quality of the issuer (its size, the type and stability of business or businesses in which it is engaged, whether it is regulated, its financial condition, its earnings history and its prospects); the type of the security (including the terms of the security, the size of the issue and, if debt, its maturity and credit rating, if any); the quality of its management, auditors and outside counsel, if any, involved; the time available for an investigation and the degree of cooperation extended by management…”); id. at 1232 (“As a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”). ↑
In re Refco Inc. Securities Litigation, No. 05 Civ. 8626 (GEL), Memorandum of Law of Amicus Curiae the Securities Industry and Financial Markets Association in Opposition to Lead Plaintiffs’ Motion for Partial Summary Judgment, (S.D.N.Y May 6, 2009) at 12, available at https://www.sifma.org/wp-content/uploads/2017/05/refco-inc-securities-litigation.pdf (last visited Oct. 27, 2022) (SIFMA Refco Brief) (“Like any flexible standard of prudent conduct, the Section 11 due diligence defense has no content in the abstract. It only has meaning in a specific factual context, i.e., the conduct of underwriters of a particular registered public offering of securities. Congress did not enact a detailed code of specific obligations for underwriters, as it did with the extensive disclosure requirements imposed on issuers by a web of SEC rules and forms. Instead, it commanded judges and juries to determine what was ‘reasonable’ or ‘prudent,’ using those commonly accepted common law terms as their only guide.”). ↑
See generally Due Diligence: Investigation, Reliance & Verification, at 19–23; see also, Robert J. Haft, Arthur F. Haft, and Michelle Haft Hudson, DUE DILIGENCE—PERIODIC REPORTS AND SECURITIES OFFERINGS, § 7:3 (West, 2021–2022 ed.) (Haft, Haft & Hudson). ↑
SEC Corporate Disclosure Advisory Committee Report at XVIII. ↑
Basic Inc. v. Levinson, 485 U.S. 224, 234 (1988). ↑
See, e.g., Matrixx Initiatives, Inc., et al. v. Siracusano, 563 U.S. 27 (2011); Litwin v. Blackstone Grp., L.P., 634 F. 3d 706, 717 (2d Cir. 2011). ↑
TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). ↑
Rombach v. Chang, 355 F. 3d 164, 178 (2d Cir. 2004). ↑
Halperin v. eBanker USA.com, Inc., 295 F. 3d 352, 357 (2d Cir. 2002). This is commonly referred to as the “bespeaks caution” doctrine. ↑
Ernest L. Folk, III, Civil Liabilities Under the Federal Securities Acts: The BarChris Case Part II-The Broader Implications, 55 VA. L. REV. 199, 242 (1969). ↑
See generally WorldCom, 346 F. Supp. 2d at 679–680. ↑
Nomura, 68 F. Supp. 3d at 473. In the context of an unregistered private placement, FINRA referred to a red flag as information “that would alert a prudent person to conduct further inquiry.” FINRA Regulatory Notice: Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings, Notice 10-22 (Apr. 2010) at 6. ↑
See generally SEC Financial Reporting Advisory Committee Draft Memo. ↑
Technical Policy Board of ICAS, A PROFESSIONAL JUDGEMENT FRAMEWORK FOR FINANCIAL REPORTING DECISION MAKING (ICAS, 2016 ed. 2) at 1. ↑
See, e.g., Feit, 332 F. Supp. at 582 (underwriters’ actions should be considered in light of their limited access to company information); Competitive Assocs., Fed. Sec. L. Rep. at 97,337 (diligent inquiry cannot always discover covert conspiracy); 17 C.F.R. § 230.176(g) (a circumstance affecting the determination of reasonableness is the “availability of information with respect to the registrant”). ↑
According to the SEC, the objective of the disclosure-not-merit governance regime is to: “prohibit deceit, misrepresentations, and other fraud in the sale of securities” so that investors, not the government, can make informed judgments about whether to purchase an issuer’s securities. https://www.sec.gov/answers/about-lawsshtml.html (last visited, Oct. 25, 2022). ↑
Indeed, as is clear from the affirmative due diligence defenses Congress has made available to underwriters, an underwriter’s conduct can be reasonable even if the offering documents are found to have contained material misstatements or omissions. ↑
H.R. REP. No. 85, 73rd Congress, 1st Session. 9, 1933 WL 983, 1993 at 5. The comment of President Franklin Roosevelt referred to in this passage appears on page 2 of the Conference Report (“The purpose of the legislation I suggest is to protect the public with the least possible interference to honest business.”). ↑
Julia K. Cowles, Due Diligence for Securities Offerings: A Roadmap for Effective Document Review, 1746 PLI/CORP 193, 196 (June 2009) (“Often counsel is asked to provide a ‘disclosure letter’ or ‘negative assurance letter’ or (less correctly) a ‘10b-5 letter’ expressing its belief that the offering document does not contain any misstatements or omissions of material facts. The so-called ‘disclosure letter’ or ‘negative assurance letter’ is an important component of the due diligence defense.”). ↑
See generally Valerie F. Jacob and Stephanie J. Goldstein, CONDUCTING DUE DILIGENCE IN A SECURITIES OFFERING, § 7.1 (Practising Law Institute 2009) (“Jacob & Goldstein”) (comfort letters are “a long-standing and standard part of the due diligence process and important component of the underwriters’ efforts to establish a due diligence defense…. In addition to helping establish a due diligence defense, comfort letters function as an important tool in the due diligence process….”). In a public offering of securities, auditors typically issue comfort letters with respect to unaudited financial information contained in the offering documents. These letters typically contain, among other things: (i) “negative assurances” by the auditor that nothing of concern came to its attention in reviewing that information, (ii) a description of the accounting and other procedures it followed during its review, and (iii) confirmation that the auditor is independent from management. In a securities offering, at least two comfort letters are common, one immediately prior to the effective date of the registration statement and/or pricing of the offering and a second bring-down letter issued prior to the closing. Courts and the SEC consider comfort letters and the unaudited financial information they address to be non-expertised material for purposes of the Section 11 and Section 12(a)(2) affirmative defenses. See also Phillips v. Kidder Peabody Co., 933 Supp. 303, 323 (S.D.N.Y 1996) aff’d 108 F. 3d 1370 (2d Cir 1997) (“underwriters’ extensive due diligence into the issuers business and reliance on cold comfort letters from the company’s auditors supported underwriters’ reasonable belief in the accuracy of the information in the prospectus underwriters therefore met the standards of due diligence required by Sections 11 and 12(2).”). Moreover, in John Nuveen & Co. v. Sanders, 450 U.S. 1005, 1010 n.4, Justice Powell (dissenting) spoke to financial information and what he viewed as the appropriate level of reliance by non-accounting professionals on statements made by the independent auditors. Among other things, he stated that reliance on certified financial statements (it is unclear whether Justice Powell was referring here to audited information or more generally to any financial information “certified” [as distinct from “audited”] by an auditor) “is essential to the proper functioning of securities marketing, to the trading in securities, to the lending of money by banks and financial institutions, and to the reliance by stockholders on the reports of their corporations.” He also stated that “almost by definition, it is reasonable to rely on financial statements certified by public accountants,” and added that “where breaches by accountants occur [presumably in either audited or unaudited information], it is the accountants themselves—not those who rely in good faith on their professional expertise—who are at fault and who should be held responsible.” 450 U.S. 1005 at 1010, n. 4. And even the WorldCom court acknowledged that “In assessing the reasonableness of the investigation, their receipt of the comfort letters will be important evidence, but it is insufficient by itself to establish the defense.” WorldCom, 346 F. Supp. 2d at 682. ↑
William F. Alderman, Due Diligence in the Post-Enron Era: A Litigator’s Practical Tips on Mitigating Underwriter Risk, CONDUCTING DUE DILIGENCE IN M&A AND SECURITIES OFFERINGS 2009 (Practising Law Institute, 2009) at 99 (“Several courts have noted the significance of the underwriters’ receipt of signed representations and warranties from the issuer, insiders, company counsel and underwriters’ counsel as to the accuracy of the prospectus….These can be included in the underwriting agreement, officer certificates, and/or officer and director questionnaires.”). ↑
But note that in WorldCom, Judge Cote stated “[t]acit reliance on management assertions is unacceptable; the underwriters must play devil’s advocate.” WorldCom, 346 F. Supp. 2d at 675. And the District Court for the Northern District of California held that an “objective even adverse posture” may be in order with respect to some information, such as that provided by management. In re Gap Stores Sec. Litig., 79 F.R.D. 283, 297–300 [quoting Folk UVA at 56] (N.D. Cal. 1978). Moreover, in BarChris, 283 F. Supp. at 696, the court stated that it is not “sufficient to ask questions, to obtain answers, which, if true, would be thought satisfactory, and to let it go at that, without trying to ascertain from the records whether the answers in fact are true and complete,” while in Software Toolworks, the court found that the defendants had “properly followed up any ‘negative or questionable’ information that developed as a result of their investigation.” Software Toolworks, 789 F. Supp. at 1497 ↑
See, e.g., Software Toolworks, 789 F. Supp. at 1497 (interviews with “over a dozen Toolworks…officials”). See also, Weinberger, 1990 WL 260676 at *3 (meetings with “various management personnel”; “reviewed company documents”); Int’l Rectifier, 1997 WL 529600 at *4 (review of internal business plans and “key” contracts); Perrigo, 1998 U.S. Dist. LEXIS 11783 at *52–53 (review of internal growth plans); and Feit, 332 F. Supp. at 561–562 (“rel[ied] upon the issuer and its counsel to produce relevant material from its files”). ↑
See, e.g., Int’l Rectifier, No. 1997 WL 529600 at *4 (speaking with customers, consultants, attorneys, and auditors); Software Toolworks, 289 F. Supp. at 1497 (contacting major customers, distributors, software developers, etc.); Weinberger, 1990 WL 260676 at *3 (contacting suppliers, customers, distributors, etc.). ↑
Bringing a research analyst “over the wall” refers to the practice of allowing an analyst, who typically is prohibited from involvement in investment banking engagements, to assist (under the supervision of a chaperone) the investment banking group in connection with its due diligence for an offering. The “wall” refers to the regulator-mandated separation of analysts and underwriters designed to prevent the deliberate or accidental sharing of inside information that could lead to illegal insider trading. See generallyhttps://www.sec.gov/about/offices/ocie/informationbarriers.pdf (last visited, Oct. 24, 2022). ↑
See SEC Release No. 33-6335 at *11. See also, Haft, Haft & Hudson at § 2:4 (“The nature of the due diligence investigation will vary considerably from one issuer to another because of [among other things] … the underwriter’s involvement over time…. [T]he most effective due diligence is a continuing investment banking relationship.”). ↑
See SEC Release No. 33-6335 at *11; Haft, Haft & Hudson at § 2:4. ↑
See Due Diligence in Business Transactions § 3.01. ↑
See, e.g., Haft, Haft & Hudson, § 2:4 (“Many underwriters utilize a committee of senior officers who make the final decision as to whether the firm will underwrite a proposed transaction.”). ↑
See, e.g., Id. at § 3:3.3 (“[B]ring-down sessions are held in both public and private securities offerings and are intended to update the diligence performed up to that point in time and ensure no material events have occurred that may necessitate disclosure to the market. Bring-down due diligence sessions…are designed to give the company a chance to disclose any recent developments that may be material to the transaction….”). ↑
See, e.g., Scott FitzGibbon and Donald W. Glazer, FITZGIBBON AND GLAZER ON LEGAL OPINIONS: WHAT OPINIONS IN FINANCIAL TRANSACTIONS SAY AND WHAT THEY MEAN (Little, Brown & Company, 1992) at § 2.2.1. ↑
See generallyid. at n. 3. As noted in the narrative above, the formal statement of these opinions and representations by a law firm (as well as the various certifications and comfort from others) requires it to conduct its own separate due diligence and to secure its own internal approvals. This separate level of due diligence enhances the underwriters’ overall due diligence and supports their reliance on the opinions. ↑
On Wednesday, September 7, 2022, acting Comptroller of the Currency Michael J. Hsu gave remarks in New York City at the Clearing House + Bank Policy Institute Annual Conference. Hsu’s remarks, “Safeguarding Trust in Banking: An Update,” were focused on measures the Office of the Comptroller of Currency (OCC) is taking to build stronger trust among consumers in the banking system. [1] These remarks are a follow-up to those he gave last year, reflecting that the OCC will increase scrutiny on bank and financial technology (FinTech) partnerships to ensure consumer confidence in banking services delivered through those programs.[2] In general, the OCC’s view reflects the maturation of the FinTech industry and the focus of banking regulators on ensuring the industry’s continued survival through better regulation, rather than any intention to halt FinTech innovation. Underlying this approach is a concern for the stability of the traditional banking system given the increase in partnerships between traditional banks and FinTech companies.
When discussing the growing number of partnerships between banks and FinTech companies, Hsu encouraged maintaining a “careful and cautious” approach. This is the same approach the OCC has adopted under his direction towards cryptocurrency.[3] He attributes this stance to the federally regulated banking system being largely unaffected by the Terra stablecoin collapse in May, which resulted in several other crypto platforms failing. For bank-FinTech partnerships, however, the “careful and cautious” approach will consist of more thorough supervision and examination of banks partnering with FinTech companies. Hsu pointed out that the drop in FinTech valuation has disproven previous predictions that FinTech disruption to banking would cause traditional banks to go extinct. Instead, FinTechs and banks are partnering, resulting in a mutually beneficial relationship: FinTechs benefit from banks’ trustworthy reputations, longstanding customer bases, and access to cheaper capital and funding sources. Banks, in turn, “gain speed to market and access technological innovation at lower cost.” According to Hsu, bank digitalization requires “expertise and economies of scale” that most banks do not have. So, FinTechs step in. This transition has resulted in an “increasingly de-integrated stack of banking services.”
Bank-FinTech partnerships also focus on providing customers a more seamless experience than those traditionally offered by depository institutions. However, this makes it more difficult for customers, regulators, and the industry to distinguish between where the bank stops and where the tech firm starts. Hsu fears that the de-integration of banking that is taking place, if left unregulated, “is likely to accelerate and expand until there is a severe problem or even a crisis.” He compared this perceived potential crisis of bank-FinTech partnerships to the 2008 financial crisis, where an increasingly complex system initially provides benefits but eventually collapses as a result of improper regulation and attention to detail. Hsu highlighted that the OCC has adapted to changing times in its bank information technology (BIT) examinations to address developments relating to ransomware, artificial intelligence, cloud computing, and distributed ledger technology. However, Hsu fears that the advent of bank-FinTech partnerships is creating new, unseen risks that threaten the growth of these partnerships, threatening consumers and the trust that banks have been rebuilding since 2008. As Hsu stated, “trust is sensitive to surprise.”
To mitigate these risks, the OCC is working on a process to “subdivide bank-FinTech arrangements into cohorts with similar safety and soundness risk profiles and attributes.” To help better focus the efforts, Hsu listed several questions that he says need to be posed and answered to make real progress. These include questions of dividing responsibility between banks and FinTechs, the resiliency of banks when FinTechs face difficulty, reconciling the differences between FinTechs and banks, and what happens when FinTechs fail. Another important question Hsu posed is, “How do banks and their third parties view and treat customers in bank-FinTech arrangements—when do customers go from being the client to becoming the product and how are consumer protections maintained?”
Hsu also referenced the OCC’s recently released five-year Strategic Plan,[4] which explicitly acknowledges current digitalization forces and the need to be “agile and credible” in addressing them. He emphasized the continued efforts of the OCC to work with FinTech companies and map out potential risks to ensure that banking “remains trusted and safe, sound, and fair as the system evolves.”
Since the dawn of the digital age, companies have collected and stored electronic information, from emails and text messages to sales figures and customer analytics. With the ever-increasing volume of data, companies have discovered potent insights and improved operations.
But those benefits have not come risk free. As stewards of growing amounts of sensitive data, companies have exposed themselves to cybersecurity threats, legal liabilities, privacy breaches, and a burgeoning list of regulatory requirements.
As those threats have grown, they have underlined the importance of a company knowing how much data it maintains, where it’s stored, and how it’s secured. Those threats also have highlighted why a data retention and disposition protocol is crucial.
Amidst the frenetic pace of business today, these issues can seem easy to ignore or put off for another day. However, it’s not hard to imagine how data can snowball into a major liability.
After all, at many companies, data management didn’t always pose such a threat. With responsibility for “information governance,” IT departments often took on the assignment. But as companies grew, IT departments became overwhelmed with competing priorities. And soon, what was once five terabytes of data grew into one hundred terabytes spread across the globe without oversight or controls. Add in legacy data, such as backup tapes and proprietary systems, and it becomes even more overwhelming.
Companies can no longer afford a leave-it-to-IT approach to data management. More than ever, they need to develop a cross-functional team from legal, privacy, records management, cybersecurity, and IT that can establish, monitor, and, most importantly, carry out policies.
The importance of data mapping
Every company’s data risk profile is different. A company in a regulated industry like financial services or healthcare will have certain considerations that may differ from companies that operate across borders where data privacy is more complex.
Knowing where data lives is essential for any company, however. Creating a data map is step one in that process.
A data map indexes a company’s data. It can be created with customized software or a text document or spreadsheet. The key is going through the process of systematically identifying all the data inside a company and its location. Ideally, the map should also include best practices around how to save data and when you can legally delete data.
The benefits of going through this process are enormous. For one, it allows for better usage of a company’s data. Employees can better understand what value they can extract by visualizing the kind of data the company has and where it sits. Using these metrics can provide a wealth of information within the company and across its clients.
Creating a map also forces companies to organize their data. Different buckets of data will likely have different retention requirements, and some might have special access permission requirements. Those buckets could include personal employee information, commercial operations, and financial metrics. There might also be buckets with IP, trade secrets, and customer lists.
Avoiding costly data searches
Importantly, a data map provides crucial help in a crisis like a cybersecurity breach. Knowing where to look for evidence of a breach can save time. If your company is involved in litigation, a map can also make discovery more efficient.
Or suppose your company gets a data subject access request (DSAR), a demand consumers may make for data collected about them under privacy regulations such as Europe’s General Data Protection Regulation or the California Consumer Privacy Act. Fulfilling a DSAR, which often must be done quickly, is cheaper and easier with a good data map.
Not all data is created equal. When creating a data retention and deletion policy, every company should determine whether holding onto data serves a business purpose. Obviously, companies must keep business records required by regulatory entities or potentially relevant in ongoing litigation.
Enforcing data deletion policy
However, there is a whole universe of data that falls outside of regulated business records. Whether data is considered beneficial may be in the eye of the user. So, creating a rules-based approach that can be monitored and automated will help to ensure consistent application across the company.
Just as important as this rules-based retention approach is a policy about how to dispose of data. Neglecting this step can have significant economic consequences. While the cost of data storage is less, there is still a cost associated. Additionally, if your company is sued, relevant data that has not been discarded becomes discoverable, even if it should have been deleted under the company’s policy. A lapse like that underscores the need for routine training and vigilant enforcement of the data retention policies.
The challenges around data will only expand. As companies grow, enter new markets and merge, they add more data and more risk. Managing these risks can be painstaking and costly in the short term, but they will save companies time and money in the long term.
On May 25, 2022, the US Securities and Exchange Commission (the SEC or the Commission) proposed rules that would require registered and exempt investment advisers (Advisers) as well as registered investment companies (Registered Funds) to provide standardized environmental, social, and governance (ESG) disclosures to their investors and the Commission (referred to herein as the ESG disclosures proposal). The SEC also proposed amendments to Rule 35d-1, which governs naming conventions for Registered Funds.[1]
These proposed rules aim to enhance ESG disclosure by requiring additional specific disclosure requirements regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures. They also propose to implement a layered, tabular disclosure approach for ESG funds to enable investors to compare ESG funds at a glance, as well as to require certain environmentally focused funds to disclose the greenhouse gas emissions associated with their portfolio investments.[2] The objective of the proposed ESG strategy disclosure framework is to help investors determine whether a fund’s or adviser’s ESG marketing statements are translated into concrete and specific measures to address ESG goals and portfolio allocation. Additionally, the proposed disclosure rules will enable investors to make more informed decisions as they compare various ESG investments. The information required under the proposed rules on ESG investment strategies and disclosures should also be readily available to investment funds and advisers who consider ESG factors in their investment process, and thus is not expected to impose a heavy compliance burden. If adopted, the proposed ESG disclosure rules will mitigate the current risks related to voluntary disclosures—including greenwashing and lack of consistent, comparable, and reliable ESG data—which will boast investors’ confidence in ESG investing.
Over the years, there has been a tremendous growth in ESG investing. This is largely attributed to increasing public concern about and awareness of climate change, social inequities, and corporate accountability.[3] According to Morningstar’s 2022 “U.S. Sustainable Funds Landscape Report,” there were 534 sustainable funds available to US investors in 2021, an increase of 36% from 2020.[4] The money newly allocated to exchange-traded ESG investment funds also increased in 2021 according to Bloomberg, to $120 billion, which more than doubled the $51 billion invested in 2020.[5] With this increasing demand, asset managers have continued to create and market ESG products.
Despite explosive growth, ESG investing in its current form has faced some criticism, including from politicians and regulatory entities. Some politicians have called ESG investing a “scam,” and others have expressed dissatisfaction with the ESG rating and evaluation process.[6] Accurately marketing ESG funds is more feasible when companies in fund portfolios make relevant ESG disclosures, but when the US Government Accountability Office conducted a review of ESG disclosures and investment practices for public companies in 2020, it discovered that while public companies generally disclosed information about many ESG topics, those disclosures lacked details and consistency, potentially limiting their usefulness to investors.[7] Additionally, the inconsistency of the voluntary ESG disclosure and reporting framework has increased investor skepticism toward ESG investments. The 2021 Edelman Trust Barometer on U.S institutional investors highlighted that 86% of US investors question the accuracy of ESG disclosures, noting that companies frequently overstate or exaggerate their ESG progress.[8] 53% of investors doubt the accuracy of information on progress made on companies’ diversity and inclusion goals, and 52% doubt disclosures on effective management of climate risk.[9] All this is attributed to lack of a common disclosure framework tailored to ESG investing, which has made it difficult for investors to understand the investment policies associated with specific ESG strategies to inform their investment decisions.
With these adverse trends, the implementation of the proposed ESG strategy disclosure rules will be a step forward to create a consistent standard for ESG disclosures, which will boost investors’ confidence in ESG investment and enhance sustainable development of the US economy.
In recent years, both the federal government and the private sector have taken initiatives to address ESG risks relating to climate change, social injustice, and corporate accountability. The federal government has enacted federal tax credit programs[10] and issued executive orders on climate-related financial risks,[11] protection of public health,[12] and advancing equity and racial justice.[13] Legislation such as the Fossil Free Finance Act has also been proposed.[14] Private sector interest in ESG investing has also greatly increased. For instance, in 2021, more than $600 billion went into ESG-focused funds worldwide according to Refinitiv Lipper data,[15] and a record $105 billion in private investments were made into clean energy assets, adding an unprecedented amount of renewable power capacity.[16]
While progress has been made, there is still much to be done to realize the US goals of lowering greenhouse gas emissions by 50–52 percent from 2005 levels by 2030 and reaching a net-zero emissions economy by 2050 set by President Biden.[17] Significant work also needs to be done to enhance corporate accountability, advance equity, and promote racial justice in our communities.
To realize the above goal and improve ESG investment efficiency across all sectors, the Commission should implement the proposed ESG disclosure rules as a means of exercising its mandate of investor protection and the maintenance of an orderly capital market. Investment advisers and funds play a critical role in providing investment advice and managing investment assets, which makes them an appropriate vehicle to address the current ESG disclosure challenges.
Impact
The implementation of the proposed ESG strategy disclosure rules by investment firms and advisers will improve information and allocation efficiency, which are critical for capital market growth. It will also increase confidence in the capital markets, a pivotal factor in attracting capital. This confidence may also attract capital from investors who are currently reluctant to invest due to knowledge gaps or information asymmetries. With the implementation of the proposed ESG disclosures, the Commission will be better able to promote a resilient economy and support an orderly, economy-wide transition towards the goal of net-zero emissions, social justice, and corporate accountability.
The SEC also proposed new requirements for public companies regarding climate-related disclosures in March 2022.[18] That proposal is largely beyond the scope of this article, but ESG disclosure rules for public companies would also enable investment advisers to more accurately market ESG funds, which would likely enhance the competitiveness of US capital markets and public companies. Similarly, the proposed ESG disclosure rules for Advisers and Registered Funds and the proposed rules for public companies together could also facilitate investment in companies that support gender equality and thus promote gender equality in the workplace, resulting into a boost in the US economy. The US economy would increase by $4.3 trillion by 2025 if true equality between men and women was achieved through improvements in women’s full participation in the workforce, the share of women’s jobs that are full time, and the mix of sectors in which women work.[19]
Despite the numerous benefits, mandatory ESG disclosures have been criticized by some who believe they will impose a significant cost burden on businesses, particularly smaller businesses, due to additional reporting requirements. Critics further assert that the cost of compliance burden may drive more companies from America’s publicly traded stock markets, which has fewer corporate listings today than in the mid-1990s.[20] Other criticisms include the notion that mandatory ESG disclosures will diminish the importance of material industry- and company-specific disclosures and may increase the likelihood of costly plaintiff-driven securities fraud litigation.
In light of the aforementioned benefits, however, the impact of implementing the proposed mandatory disclosure rules regarding ESG will not only benefit investors seeking to invest in ESG-focused funds but also contribute to the sustainable development of the US economy. Furthermore, it will serve as a benchmark for future ESG-related legislation, as well as a guide for companies in developing their ESG strategies, a critical step in building a sustainable economy.
In conclusion, the sustainable development of the US economy requires the participation of all stakeholders. Focus should not be restricted to only positive outcomes, but address shortfalls as well to help build a more robust economy that is inclusive. The implementation of the proposed ESG disclosure rules will be a recognizable milestone that can attract more global investment funds to US corporations and drive the US economy to more sustainable development.
Mergers and Acquisitions (M&A) attorneys representing buyers, and their private equity and strategic clients, have long felt comfortable that the courts would uphold restrictive covenants in an acquisition. Even if the restrictive covenant at hand was perhaps somewhat broader than necessary, buyers and their counsel believed that the courts would judiciously apply their “blue pencil” to reform an overbroad covenant to make it enforceable. They also believed that by picking Delaware law and Delaware courts to hear any dispute, their restrictive covenants would be upheld by a court that has a well-deserved reputation for enforcing contracts.
In a recent opinion on October 6, 2022, by the Delaware Chancery Court, Kodiak Building Partners, LLC v. Adams, Vice Chancellor Zurn ruled that the restrictive covenants imposed on a stockholder in an acquisition were overbroad and unenforceable. In addition, the court declined to apply its blue pencil to reform the overbroad restrictive covenants on the basis that to do so would not be equitable. In this article, the authors—a non-compete litigator and an M&A attorney—will discuss the background of this case, the ruling that has surprised many M&A attorneys, and some key takeaways for the future.
The Parties
As described on its website, Kodiak Building Partners, LLC (“Kodiak”) was founded in 2011 to acquire family-run businesses in the building material sales and distribution industries. It was founded by a group of investment bankers who had analyzed the construction industry and wanted to build a decentralized and entrepreneurial consolidator in the building materials industry. In the June 2, 2020, press release announcing the transaction that is the subject of the Kodiak opinion, it stated that Kodiak had acquired more than eighty-one locations in sixteen states through twenty-five acquisitions. Kodiak operates four business lines: (i) lumber and building materials which, depending on the location, may or may not include roof trusses; (ii) gypsum, which includes drywall and related supplies; (iii) construction supplies, which are primarily steel, rebar, and structural steel; and (iv) kitchen interiors, such as kitchen appliances, flooring, cabinets, and countertops.
For seventeen years, Philip Adams (“Adams”) was a general manager of a truss manufacturer, Northwest Building Components, Inc. (“Northwest”). Founded in 2004, Northwest has only one line of business, the manufacture and sale of roof trusses and other mostly lumber-based building supplies. As a general manager, Adams was responsible for the overall performance of the business unit, such as scheduling and handling certain customer accounts. What is very important to the outcome in this case is that Northwest operated out of a single location in Rathdrum, Idaho, which is approximately thirty miles northeast of Spokane, WA. Northwest’s customers are primarily located within thirty to sixty minutes of its one location.
The Acquisition
On June 1, 2020, Kodiak entered into a stock purchase agreement with Northwest and Mandere Construction, Inc. (“MCI”). MCI is an Idaho corporation that sells, manufactures, and delivers roof trusses. Kodiak acquired all of Northwest and MCI’s assets, including goodwill and Adams’ 8.33 percent interest in Northwest. Adams received approximately $900,000 for his 8.33 percent interest in Northwest, meaning that Northwest had an enterprise value of approximately $10 million. In connection with the acquisition, Kodiak entered into a restrictive covenant agreement with Adams and the three other Northwest stockholders which included non-competition and non-solicitation restrictive covenants that restricted Adams for thirty months after closing.
The Dispute
Adams resigned from Northwest on October 11, 2021. Approximately two and one-half months later, on December 27, 2021, he joined a competitor of Northwest, Builders FirstSource, Inc. (“BFS”), as its general manager. BFS supplies building materials, such as lumber, roof trusses, I-joists, and provides design services for roof trusses. BFS has two locations in Spokane, Washington, and the location Adams worked at was only twenty-four miles from Northwest’s one location in Rathburn, Idaho. On April 5, 2022, Kodiak filed a lawsuit against Adams, ultimately seeking both a preliminary injunction for Adams’ alleged violation of the non-competition and non-solicitation covenants, and damages.
The Court’s Rulings on the Restrictive Covenants
Vice Chancellor Zurn ruled that the non-competition and non-solicitation covenants were overbroad, and accordingly unenforceable. She further declined to blue pencil the restrictive covenants to make them reasonable.
To reach these rulings, Vice Chancellor Zurn first laid out Delaware law for non-competition and non-solicitation covenants:
Delaware courts “carefully review” these covenants to ensure they are (i) reasonable in geographic scope and duration, (ii) advance a legitimate economic interest of the party seeking enforcement, and (iii) survive a balancing of the equities.
Delaware courts have favored the public interest of competition in their review of these restrictive covenants.
Non-competition covenants in the context of a business sale are subject to a “less searching” inquiry than if they were in an employment agreement.
Where restrictive covenants are unreasonable, Delaware courts are hesitant to blue pencil such agreements to make them reasonable.
Vice Chancellor Zurn first focused her review of the restrictive covenants on the second prong of the Delaware standard of review, that the restrictive covenants must advance a legitimate business interest of the party seeking enforcement. In the context of a sale of a business, the buyer has a legitimate business interest to protect the assets and goodwill it acquired in the sale. Kodiak, however, went far beyond trying to protect the business that it had acquired from Northwest. Instead, the non-competition and non-solicitation Covenants extended to:
any member of Kodiak’s extended operating units and locations (i.e., multiple operating units with eighty-one locations), rather than the one location operated by Northwest in Rathburn, Idaho; and
an expanded definition of “Business” that encompassed all of Kodiak’s lines of business, rather than Northwest’s single line of business focused on roof trusses.
Kodiak argued that it had a legitimate interest in protecting not only Northwest’s goodwill, but also that of Kodiak and its extended operating units and locations. Vice Chancellor Zurn disagreed by stating that Delaware law did not recognize a legitimate business interest in protecting all of Kodiak’s goodwill that existed prior to the Northwest acquisition. Instead, she said, “Restrictive covenants in connection with the sale of a business legitimately protect only the purchased asset’s goodwill and competitive space that its employees developed or maintained.” In discovery, Kodiak admitted that only six of its operating units, including Northwest, made and sold roof trusses. Kodiak had a legitimate interest to protect the business purchased from Northwest, but that interest did not extend to restricting Northwest’s employees from competing in other Kodiak businesses unrelated to roof trusses.
Vice Chancellor Zurn then focused on the geographic scope of the non-competition and non-solicitation covenants. The non-competition covenant prohibited Adams from competing anywhere in the states of Idaho and Washington, and within a 100-mile radius of any other location outside of those states in which Kodiak or any of its operating units had sold products or services in the twelve months prior to closing. The non-solicitation covenant prohibited Adams from soliciting customers of Kodiak or any of its operating units. Vice Chancellor Zurn found that these restrictions were geographically overbroad since they restricted Adams from seeking employment in geographic areas around Kodiak’s operating units other than Northwest. Further, the non-solicitation covenant was overbroad because it covered customers of Kodiak’s operating units other than Northwest. Finally, both restrictive covenants were overbroad because the definition of “Business” encompassed more than Northwest’s industry segment of roof trusses and were unreasonable because they were broader than necessary to protect the goodwill purchased from Northwest.
Kodiak argued that the balance of equities weighed in its favor because Adams received approximately $900,000 in the sale, was a senior executive of Northwest, and went to work for a competitor only twenty-four miles away from Northwest that sold roof trusses just like Northwest. Vice Chancellor Zurn was unpersuaded, ruling that the restrictive covenants were more restrictive than Kodiak’s legitimate interests justified, so it would not be equitable “to enforce these unreasonable covenants against Adams.”
Vice Chancellor Zurn declined to apply her blue pencil even though Adams appeared to have violated the portions of the restrictive covenants that were supported by Kodiak’s legitimate business interests—he was working for a Northwest competitor only twenty-four miles away that also sold roof trusses. She stated that where non-competition or non-solicitation covenants are unreasonable, Delaware courts “are hesitant to ‘blue pencil’ such agreements to make them reasonable.” To support that statement, she approvingly cited in a footnote cases and law review articles that had argued that the discretion of courts to blue pencil an overbroad non-competition covenant creates a “no-lose” incentive for employers. They can ask for an overbroad covenant because if it goes to court, the employer will at least get a narrowed non-compete from the blue pencil process. In Kodiak, since the restrictive covenants were overbroad and unreasonable, she felt that the inherent inequities in blue penciling a non-compete did not require her to do so in this situation.
Running throughout this case seemed to be the court’s concern for the uneven power dynamic between Kodiak and Adams. Kodiak had argued that Adams was a sophisticated senior executive, who was the second in charge at Northwest and one of only four stockholders. As a result, Kodiak argued that Adams should be held to the contract that he had signed. The court was unpersuaded and noted situations in which unsophisticated parties might need protection. Vice Chancellor Zurn also noted that that the record did not reflect that Adams had been personally represented by separate counsel for either the transaction or the restrictive covenants.
Takeaways for M&A Attorneys
Injunctive relief by definition is equitable relief. The Kodiak decision is more than a cautionary tale for M&A attorneys to ensure that restrictive covenants are reasonable in order to be enforceable; rather, it reflects an unmistakable trend for courts to use their equitable power to strike down restrictive covenants unless they are narrowly tailored to protect the legitimate business interest of the requesting party. This judicial trend is also being reflected in state legislatures, which have adopted new laws to restrict the enforceability of restrictive covenants—especially non-competition agreements. Here are some takeaways for future deals.
Restrict non-competition and non-solicitation covenants to the goodwill of the business being acquired. For Kodiak to attempt to extend its restrictive covenants to all its operating business units and multiple locations was a blatant overreach with no justification. Restrictive covenants should be narrowly tailored to the geographic locations and business of the acquired company, which is the protectable business interest of the buyer that courts will recognize.
Consider bifurcating restrictive covenants between principal stockholders and small minority stockholders. One size does not always fit all situations or all stockholders. There is a difference between the principal stockholders who ran the business and received the bulk of the consideration, and the smaller stockholders who had more limited control of the business and received a smaller portion of the proceeds from the sale. If Kodiak had narrowly tailored the restrictive covenants for Adams to apply only to a radius around Rathburn, Idaho, or even to the states of Idaho or Washington, and only to the business of making and selling roof trusses, the court probably would have upheld them. Also likely is that Adams never would have challenged the enforceability of the restrictive covenants in the first place.
Don’t take any comfort in the power of courts to blue pencil overbroad restrictive covenants. Courts are unlikely to take the time and effort to completely rewrite a clearly overbroad restrictive covenant. The court in Kodiak had no patience for Kodiak’s request to blue pencil the restrictive covenant, saying that to do so would be inequitable. Instead, courts would be more inclined to “tweak around the edges” of a restrictive covenant that was generally fair, but only needed minor changes to make it enforceable under the circumstances.
Consider insisting on separate counsel for small minority stockholders. This case may have turned out differently if Adams had separate counsel to advise him on the restrictive covenants. The judge in Kodiak pointed to Adams’ lack of separate counsel as a possible factor to show that Adams was an unsophisticated party who deserved protection in a court of equity.
The legal industry has invested less, relative to other industries, in technology for day-to-day work.[1] A variety of factors traditionally have contributed to a law firm’s hesitancy to adopt technology: security concerns, cost, fear that technology could reduce firm profits (in an industry that traditionally bills by the hour), belief that a lawyer’s work is always bespoke, and the need to build technical literacy within workforces. As a result, the role that data analytics technologies (big data, machine learning, artificial intelligence, automation, etc.) can play in many legal functions is yet to be fully explored.
The pandemic forced legal organizations to get past some of these fears and, out of necessity, adopt tools for remote collaboration and practice management. Not surprisingly, legal technology had a record year of investments in 2021, totaling an estimated $9.1 billion through funding or mergers and acquisitions.[2] With the influx of money into the industry, legal technology capabilities are advancing dramatically, and their potential value to the legal industry grows ever greater. Accelerated adoption of legal technology in law firms continues as clients demand both excellent results and efficiency from their outside counsel.[3] (In fact, the demand for efficiency at a low cost spurred, in large part, the growth of alternative legal service providers.)[4]
Legal technology is key to allocating a firm’s resources more wisely, yielding better outcomes and lower costs for clients. If even one organization manages to leverage technology to that end, the pressure on others to stay competitive is on. Entrepreneurs and legal organizations alike have taken notice, and the opening for advanced technology in law is being targeted by small companies introducing cutting-edge capabilities.[5]
But is the adoption of the latest technology the right choice for every organization, and, if so, how does an organization choose between the spate of new options entering the field? Fortunately, because the legal industry is one of the last to grapple with technology adoption, we can look at how other industries have dealt with the introduction of new technologies to illustrate patterns and help the legal industry navigate its own period of innovation.
In 1995, Gartner, a leading market research firm, introduced the “Hype Cycle” to represent the maturity and adoption of emerging technologies.[6] The Hype Cycle has five phases: (1) Innovation Trigger, (2) Peak of Inflated Expectations, (3) Trough of Disillusionment, (4) Slope of Enlightenment, and (5) Plateau of Productivity. The first phase represents the introduction of new technology that generates significant publicity, though commercial viability is still unproven. In the second phase, in reaction to publicity, firms willing to innovate adopt the new technology—with some stories of great success but many more of failure. In the third phase, when results do not meet expectations, both technology providers and adopters alike shake out of the new field, and only some early adopters remain to continue investing. The fourth phase is where expectations become more realistic, technology improves in response to failures, and the potential benefits of the technology to firms is more clearly understood. In this phase, adoption of the technology restarts with only conservative organizations staying on the sidelines. The final phase is widespread adoption of the new technology, as well as broad understanding of how to differentiate between providers and incorporate the new technology into businesses for maximized benefit.
The maturity of legal technology varies by its functionality. For example, the value proposition of technology-assisted review in e-discovery is well established and mature in comparison to newer technology such as advanced contract analytics. Gartner’s own 2021 analysis of the legal tech field in relation to its Hype Cycle confirms much of our intuition: certain tools have become commonplace in law firms and are reaching their Plateau of Productivity.[7] However, most legal technologies have yet to come down from elevated expectations—including those with potentially the largest impact. Stories of big successes (or failures) in the real world are sure to increase over the coming years as progressive organizations look to adopt technology to keep themselves on the cutting edge.
So, how do we handle the inevitable journey through the Trough of Disillusionment and keep making progress? The key is asking the right questions to ensure utility and streamline validation.[8] As technology grows in complexity, its explainability often suffers. The potential reward becomes greater, but the risk of adoption grows in kind. For example, leveraging predictive analytics for case outcomes can have a huge impact on a firm’s bottom line by indicating which clients and matters the firm should accept, but the criteria determining the algorithm’s prediction are somewhat of a black box.[9] Asking questions prior to adopting a technology, and having the measurements and mechanisms for validation in place, can help minimize associated risks:
What problem does the technology solve (not only in terms of determining whether a technology works but also in terms of whether a technology works for a particular organization)?
What is the investment, beyond investing in the technology itself, that an organization will have to make to leverage that technology?
What are the tangible benefits that the organization hopes to achieve?
Is the organization willing to dedicate the resources to both implement and maintain that technology successfully?[10]
The legal technology field is likely to continue growing and shifting due to the large potential for revenue. Technologies will mature, new companies will enter the field, and law firms will have to be selective.[11] Being able to discern between reality and hype and adopting the technology responsibly will allow innovators to push forward. The reward for doing so is significant—organizations that adopt technology early in a way that suits the business will differentiate themselves from competitors and stand to reap huge benefits. In turn, legal tech start-ups that understand how to generate real value will generate massive revenues. At this point, the limits of legal technology are limited only by our imagination.
Daniel Martin Katz, Michael J. Bommarito II & Josh Blackman, A General Approach for Predicting the Behavior of the Supreme Court of the United States, 12(4) PLoS One (Apr. 12, 2017) (e0174698), https://doi.org/10.1371/journal.pone.0174698; Masha Medvedeva, Martin Wieling & Michael Vols, Rethinking the Field of Automatic Prediction of Court Decisions, A.I. & L. (Jan. 25, 2022), https://doi.org/10.1007/s10506-021-09306-3. ↑
The Centers for Medicare and Medicaid Services (CMS), a division of the Department of Health and Human Services (HHS), is responsible for administering the Medicare program. CMS has many roles, which include protecting the Medicare Trust Fund, reporting and correcting improper payments, and targeting healthcare fraud. To complete its numerous statutory requirements, CMS has established the Medicare Review and Education Program. Under this program, it uses a variety of contractors to complete medical and improper payment reviews. Targeted probe and educate (TPE) reviews, a major part of the CMS Medicare and Review and Education Program, combine claim reviews and provider education. As part of those reviews, CMS permits Medicare Administrative Contractors (MACs) to exercise wide discretion in determining the design and scope of TPE audits; the percentage decrease in billing errors required to be excused from subsequent rounds of reviews; and the benchmarks for measuring the program’s success. Each MAC independently determines those areas most vulnerable to improper payments.
Although the TPEs are intended to improve claim accuracy, their definition of claim types most vulnerable to improper payments has significant consequences for providers that are difficult to overturn. Rather than focusing appeals of MAC decisions on individual claim denials, a broader attack on the lack of oversight of MACs by CMS and HHS as a whole would be more effective. This article asserts a basis for challenging targeted probe and educate reviews by arguing that the MACs’ wide discretion to design, implement, and define the metrics of the program’s success is inconsistent with CMS’s statutory duty to oversee its provider education program.[1]
The duties and scope of review conducted by Medicare contractors have expanded. Originally, when the process was implemented, TPE reviews were limited to home health providers and short stay hospital claims. Over time, the scope of reviews has expanded to the point where reviews now cover all Medicare services and items. The TPE review process is intended to improve the accuracy of providers’ billing and coding, through a combined claims review and education process. However, a provider’s failure to achieve a reduction in the percentage of billing errors defined by the MAC can result in administrative penalties that include pre-payment review and revocation of participation in the Medicare program.
TPE audits involve up to three rounds of review conducted by a MAC. The process may be conducted as either a pre-payment or post-payment review of a sample of twenty to forty claims. At the end of each round of reviews, providers’ billing performance is re-evaluated to determine whether their error rate has been reduced to meet the benchmark set by the MAC. A subsequent increase in their error rate above the MAC-determined acceptable rate will result in further reviews.[2] Providers who are not compliant after three reviews are referred to CMS for further action.[3]
The strategy currently taken to overturn adverse outcomes of the reviews takes two forms: an appeal of individual claims, or, where extrapolation of the error rate has occurred, an appeal of the individual sampling amounts to either require recalculation of the error rate or to require readjustment of the overpayment.[4] However, the timeline for appeals of denied claims, even if pursued on an expedited basis, may not be concluded prior to administrative penalties being imposed.[5] Additionally, there are certain areas where no appeal is permitted: the Final Results letter issued by the MAC at the end of each round of reviews, and the decision by CMS to impose pre-payment review of provider claims or revoke provider participation in Medicare. The structure of the TPE review program presents an opportunity for another strategy for appealing adverse outcomes. Challenging CMS’s lack of oversight of its MACs is an alternate strategy with potential to be more effective than appealing individual claims denials.
Although CMS has stated in a frequently asked questions (FAQ) fact sheet that favorable outcomes will be considered after referral of the provider for further action,[6] where pre-payment review has been put in place or revocation of participation in Medicare has already occurred, there is no recognized right of appeal, and no CMS regulation or policy that provides otherwise. A provider placed on pre-payment review will be reassessed by the MAC on a quarterly basis to determine if the provider’s behavior has improved sufficiently. There is no defined standard for measuring the provider’s improvement.[7] Revocation of a provider’s participation from the Medicare program can only be reviewed after one year from its imposition, and it can extend as long as ten years, depending on the severity of the offense. After the revocation period has ended, the provider is required to reapply to the program.[8]
By law, the Secretary of HHS is required to provide effective oversight of its contractors’ TPE programs.[9] The Secretary’s lack of oversight of MACs’ provider education efforts, and the manner in which MACs identify risks vulnerable to improper billing, falls short of its duties.[10]
The article outlines a statutory challenge to the current TPE review process. The Secretary of HHS’s failure to tie the TPE activity of the MACs to measurable agency standards has resulted in an inability to assess the effectiveness of the MACs’ performance, as well as an inability to ensure agency resources are appropriately allocated to those areas most vulnerable to improper payments consistent with the agency’s education and outreach program goals. The oversight requirement applicable to the Secretary of HHS, set out in 42 USC Section 1395kk-1(b)(3)(A), requires the Secretary to “develop standards for measuring the extent to which a contractor has met the requirements” of the HHS education and outreach program. Though it is true the MACs perform an administrative function of the agency, that activity is required to meet clearly defined performance metrics, and those standards are required to be established by the Secretary of HHS, not the MACs.
A report issued by the Government Accountability Office (GAO) in March 2017[11] first raised the argument that CMS failed to provide effective oversight of MACs’ efforts involving TPE audits. It determined that CMS’s decision to avoid being “overly prescriptive regarding MACs’ provider education efforts” was inconsistent with its duty to oversee its provider education program and address areas vulnerable to improper payments.[12]
CMS’s oversight of targeted probe and educate reviews is limited, with MACs exercising a wide range of discretion and control over the design and implementation of the audits. The MACs determine which provider/suppliers to target for TPE review; the appropriate percentage decrease in claims denials that is required before a provider is excused from further review; and the metrics for assessing the success of its audits.[13]
Physicians are targeted for TPE audits based on MACs’ error rate calculation. TPEs target those providers who have a high rate of claim denials, unusual billing practices, or bill with greater frequency those codes that CMS has determined are more likely to be improperly billed.[14]
Each MAC independently identifies the risks that render their jurisdiction vulnerable to a higher rate of improper payments.[15] Rates are calculated by MAC, by service, and by provider type.[16] There is no requirement that the twelve Part A/B MACs[17] be consistent in their method of calculating improper payment rates. The sources of data the twelve MACs use to calculate the error rate, and the weight they give each particular data source, is not subject to any standard.[18]
MACs exclusively determine the percentage decrease in billing errors providers must meet to be excused from further rounds of one-on-one educational sessions. CMS does not disclose how that percentage is determined. It states in Chapter 3 of the Medicare Program Integrity Manual, “A provider/supplier may be removed from TPE after any round if they demonstrate low error rates or sufficient improvement in error rates, as determined by the MAC.” The MAC sets the percentage rate decrease required, and in Chapter 7 of the Medicare Program Integrity Manual, CMS admits that it does not establish or set improvement rate goals.[19]
CMS’s failure to oversee the benchmarks independently set by MACs for the reduction of denied claims has a significant impact on providers whose denial rates fail to meet the MAC-determined rate. If providers continue to have high error rates after the three rounds of review, they may be referred to CMS for 100% pre-payment review, extrapolation of their error rates, and/or referral for revocation of enrollment in the Medicare program.[20] Lack of alignment of MAC-implemented rate reductions creates inconsistency in remedies imposed on providers.
The measure of the success of MAC activity is reflected in the annual Improper Payment Reduction Standards (IPRS) reports MACs must submit to CMS.[21] They report the savings achieved through claims denial rates, charge denial rates, and provider denial rates.[22] While the IPRS reports identify program savings, they provide insufficient detail to CMS and the Secretary of HHS to determine whether the education efforts of each MAC are focused on those areas most vulnerable to improper payment. CMS’s assessment is made more difficult because of the discretion exercised by each MAC in designing and implementing audits, and evaluating the success of their own programs. The validity of this framework is subject to challenge as part of a broader challenge based on CMS’s failure to exercise oversight of its contractors conducting TPE reviews.
Given the increased scope and impact of these reviews, providers should move beyond a defensive strategy of appealing specific claim denials, and consider a broader argument focused on CMS’s inadequate oversight of the TPE review.
Following 42 U.S.C. Section 1395hh(a)(2), the Medicare Act requires the Secretary to follow a notice-and-comment procedure for any “rule, requirement, or other statement of policy that establishes or changes a substantive legal standard governing… the payment for services.” Azar v Allina Health Services 139 S Ct 1804(2019); Agendia v. Becerra, ___F 4th__ , 2021 WL 3011482 (9th Cir. 2021), cert. den’d ___US __(2022). The MACs, as part of the TPE process, are not carrying out an administrative function based on an agency defined controlling legal standard. The MACs define their own performance metrics and the design and implementation of the reviews. By statute, CMS is required to develop the performance requirements of its contractors. 42 USC 1395kk-1(a)(4), (b)(1)(C), and (b)(3)(A). ↑
Chapter 3, Section 3.1, 3.2.1, and 3.2.5, Medicare Program Integrity Manual. ↑
Chapter 8, Medicare Program Integrity Manual, Section 8.4.9.1–8.4.9.2. ↑
MACs are permitted to commence a new round of targeted probe and educate reviews forty-five days after each post-probe session, at the earliest. The Medicare appeals process permits a provider appealing denied claims or extrapolation of overpayments to reach federal district court, assuming expedited appeals, six months after the initiation by a provider of their filing of appeal. Medicare Parts A and B Appeals Process, MLN 006562 (August 2022). ↑
www.cms.gov, FAQs on TPEs. This fact sheet states that CMS has discretion to suspend its review of the provider, where the provider is successful on all appeals, before CMS takes action. It also removes all program penalties imposed, where the provider wins all appeals after the imposition of administrative penalties. CMS’s discretion, it concedes, is outside the appeals process and grants relief from decisions that are not appealable. It is only outlined in a fact sheet. It does not appear in any Medicare Program Integrity Manual, Claims Processing Manual, or any CMS regulation. The relief granted is an after-the-fact attempt to reverse the results of a TPE process that wasestablished contrary to the requirements of 42 USC Section 1395kk-1(b)(3)(A). It is the direct result of CMS’s failure to acknowledge and perform its regulatory duty to design, implement, and establish standards for the TPE process. A direct challenge to CMS’s lack of oversight not only relieves providers successful on appeals from incurring the expense of multiple appeals, it also protects those providers who cannot meet the MACs’ standards from administrative program penalties that arise from decisions that are currently not subject to appeal. ↑
Medicare Program Integrity Manual, Chapter 3, section 3.2.2.1(A). ↑
Government Accountability Office (GAO), Standards for Internal Control in the Federal Government, The Green Book, 2017. (GAO-14-704G), Washington, D.C. 2017. Internal control is a process effected by an entity’s oversight body, management, and other personnel that provides reasonable assurance that the objectives of an entity will be achieved. See also OV2.15, p. 12; external auditors and the Office of Inspector General (OIG) are not considered part of CMS’s internal controls. “While management (CMS and the Secretary of HHS) may evaluate and incorporate recommendations from external auditors and the OIG, responsibility for an entity’s internal control system resides with management (CMS and the Secretary of HHS).” ↑
42 USC Section 1395kk-1(a)(4) and (b)(1)(C), (b)(3)(A)(i)-(iv). “The Secretary shall develop contract performance requirements to carry out the specific requirements applicable under this subchapter to a function described in subsection (a)(4) and shall develop standards for measuring the extent to which a contractor has met such requirements. Such requirements shall include specific performance duties expected of a medical director of a Medicare administrative contractor.” See also, 42 USC Section 1395kk-1(A)(iii)-(iv). ↑
Chapter 3, Medicare Program Integrity Manual, section 3.2.5. ↑
Chapter 3, Medicare Program Integrity Manual, section 3.2.1. The Secretary of HHS provides the MACs with a list of improper payments identified by the Recovery Audit Contractor (RAC) within the MAC’s region. While the scope of the education program is determined by the MAC (42 USC Section 1395kk-1(h)(4)), it must be consistent with clearly defined performance metrics, so that the outcome of the activity is consistent with the Secretary of HHS’s program goals. See 42 USC Section 1395kk-1(b)(3)(A) (requiring the Secretary to “develop standards for measuring the extent to which a contractor has met the requirements” of the HHS education and outreach program). ↑
Medicare Program Integrity Manual, Chapter 3, section 3.2.5. “The MACs shall target their efforts at error prevention to those services and items that pose the greatest financial risk to the Medicare program and that represent the best investment of resources. This requires establishing a priority setting process to assure MR (medical review) focuses on areas with the greatest potential for improper payment. The MACs shall develop a problem-focused, outcome-based medical review (MR) strategy and Strategy Analysis Report (SAR) that defines what risks to the Medicare trust fund the MAC’s MR programs will address and the interventions that will be implemented during the fiscal/option year. The MACs shall focus their edits where the services billed have significant potential to be non-covered or incorrectly coded.”
The MACs have the discretion to select target areas because of:
– high volume of services;
– high cost;
– dramatic change in frequency of use;
– high risk problem-prone areas; and/or,
– Recovery Auditor, Comprehensive Error Rate Testing, OIG, or GAO data demonstrating vulnerability. ↑
GAO Report, pp. 6-8, Chapter 3, Medicare Program Integrity Manual, 3.2.B. (pre-payment edit capabilities). ↑
Twelve MACs perform Part A/B audits, and of those twelve, four audit home health and hospice providers. An additional four audit DME suppliers. ↑
Unlike MACs, Medicare Recovery Auditors (RACs) and Unified Program Integrity Auditors (UPICs) are required to use a strict random sampling methodology as part of their post-payment claims reviews to ensure that the universe selected is appropriate. Chapter 8, Medicare Program Integrity Manual, Sections 8.4.1.1–8.4.1.5; Sections 8.4.2–8.4.4.3. In TPE audits, the claims designated to be audited are the result of a data-driven selection process, with the attributes of the audit determined by data selected on a problem-focused risk basis. Though the probe itself is subject to a medical review of the sample claims, it is intended to validate the data-driven findings.
In instances where overpayments are identified by data analysis alone, Chapter 8 specifically states that “the contractor shall consult with its Contracting Officer’s Representative COR/Business Function Lead (BFL) as defined in the PIM Chapter 4, Section 4.7-Investigations. In addition, if CMS approves the data driven overpayment, the contractor shall also consult with its COR/BFL on whether statistical sampling and extrapolation are necessary to identify the overpayment.” Chapter 8, Section 8.3.3.2, Medicare Program Integrity Manual. ↑
Medicare Program Integrity Manual, section 7.1.2.4. ↑
Chapter 3, Medicare Program Integrity Manual, Section 3.2.5. D. ↑
Each MAC is required to submit annually an IPRS report to CMS, to identify the results of its medical review activities, including provider outreach, targeted probe and educate reviews, and other payment interventions. Chapter 7, Medicare Program Integrity Manual, section 7.1.1.-7.1.2; section 7.2.4. ↑
