Legal Definitions - due diligence defense

The due diligence defense is a legal protection available to certain parties involved in preparing a company's registration statement for a public offering of securities. This defense can shield them from liability if the registration statement is later found to contain a significant misrepresentation or omission, which could constitute securities fraud.

The core idea behind this defense is that if these parties conducted a reasonable and thorough investigation (known as "due diligence") into the information presented in the registration statement, they should not be held responsible for an undetected misstatement, provided they reasonably believed the information was accurate at the time.

Here's a breakdown of how it works:

• Context: This defense applies specifically to claims of securities fraud under Section 11 of the Securities Act of 1933, which governs the initial public offering (IPO) process.
• Who can use it: Underwriters (firms that help sell the securities), officers and directors of the company issuing the securities, and experts (like auditors, lawyers, engineers, or appraisers who contribute specific sections).
• Who cannot use it: The company issuing the securities (the "issuer") is held to a stricter standard and cannot use this defense.
• Key Factors: The availability and specific requirements of the defense depend on whether the party is considered an "expert" or "non-expert," and whether the problematic part of the registration statement was prepared by an expert (an "expertised" portion) or not (a "non-expertised" portion).

The level of investigation required varies:

• For non-experts (e.g., underwriters, most directors) regarding non-expertised portions: They must show they conducted a reasonable investigation and had reasonable grounds to believe, and did believe, that the statements were true and complete.
• For non-experts regarding expertised portions (e.g., financial statements audited by an accounting firm): They are not expected to re-investigate the expert's work. Instead, they must show they had no reasonable grounds to believe, and did not believe, that the expert's statements were untrue.
• For experts (e.g., an auditor) regarding their own expertised portions: They must demonstrate they conducted a reasonable investigation within their area of expertise and had reasonable grounds to believe, and did believe, that their statements were true and complete.
• For experts regarding non-expertised portions: Experts are generally not liable for portions of the registration statement outside their area of expertise.

Examples:

• Example 1: An Underwriter and a Non-Expertised Section

  Imagine "InnovateTech Inc." is preparing for its IPO, and "Capital Markets Group" is the lead underwriter. The registration statement includes a section on InnovateTech's future market projections and competitive landscape, which is a non-expertised portion. Before the IPO, Capital Markets Group's team conducts extensive interviews with InnovateTech's management, reviews industry reports, analyzes competitor data, and examines internal company forecasts. They document all their research and conclude that the market projections appear reasonable. If, after the IPO, these market projections are found to be significantly overstated due to an unforeseen market shift, Capital Markets Group could invoke the due diligence defense by demonstrating the thoroughness of their investigation and their reasonable belief in the accuracy of the projections at the time.

  This example illustrates how a non-expert (the underwriter) can use the defense for a non-expertised portion by showing they performed a reasonable investigation and held a reasonable belief in the truthfulness of the information.

• Example 2: An Environmental Consultant and an Expertised Section

  "CleanEnergy Solutions" is going public, and their registration statement includes a report from "Eco-Compliance Services," an independent environmental consulting firm. This report certifies that CleanEnergy's manufacturing facilities meet all current environmental regulations, which is an expertised portion. Eco-Compliance Services performed detailed site inspections, reviewed all permits and regulatory filings, and conducted specialized tests before issuing their report. If, months after the IPO, it's discovered that a specific manufacturing process was actually non-compliant due to a subtle technical detail missed by the consultants, Eco-Compliance Services could use the due diligence defense. They would present evidence of their comprehensive investigation, demonstrating that they reasonably believed their report was accurate based on their professional standards and expertise.

  This example shows an expert (the environmental consultant) using the defense for their own expertised portion by proving they conducted a reasonable investigation within their field.

• Example 3: An Outside Director and an Expertised Section

  Consider an outside director on the board of "Health Innovations Corp." during its IPO. The company's registration statement includes audited financial statements prepared by a reputable accounting firm. This is an expertised portion. The director, who is not an accountant, reviews the financial statements, attends meetings where the auditors present their findings, and asks clarifying questions about the company's financial health. She sees no obvious discrepancies or reasons to doubt the auditor's work. If, later, a sophisticated accounting fraud is uncovered within those audited financials that was extremely difficult to detect, the outside director could use the due diligence defense. She would argue that she had no reasonable grounds to believe, and did not actually believe, that the expert's (auditor's) report was untrue, without being expected to conduct her own independent audit.

  This example demonstrates how a non-expert (the outside director) can use the defense for an expertised portion by showing they had no reason to doubt the expert's work, without needing to perform an expert-level investigation themselves.