Due
Diligence and Initial Public Offerings Corporate
Officers are Now Criminally Liable
Company directors
and underwriters potentially face severe civil and criminal liability
for the failure to verify information and data used in conducting a
securities offering, whether public or private. Complete, thorough and
proper due diligence is no longer just a "good idea" for issuers,
but it is now mandatory in order to avoid a financial catastrophe or
even a stiff jail sentence.
Due diligence is
a free flowing process that is unique to every offering. The directors
and underwriter are required to exercise good judgment throughout the
process. They must take steps to ensure that all essential information
is true and correct to their best of their ability. In addition, they
must enact procedures to establish the experience and trustworthiness
of the internal employees and outside counsel responsible for compiling
and verifying the essential data and information.
Although checklists
provide some guidance and can be helpful, they should never be relied
upon solely and exclusively as a complete due diligence undertaking.
In many cases the opposite is the case; the list itself is either outdated
or too general to be effective to that particular offering. In this
instance completing an inappropriate check list only provides the offeror
with a false sense of security and opens the door to a tidal wave of
liability.
In yet other instances
some aspects of the checklist may be helpful, but from an overall perspective
it is typically incomplete and overlooks important elements that must
be evaluated. In addition to overlooking key aspects of due diligence,
precious time can be wasted reviewing irrelevant data.
For these reasons,
neither the NASD nor SEC have any rules in place affirmatively requiring
underwriters or outside directors to take any particular steps in conducting
due diligence investigations, other than for those involving direct
participation programs. Rather, counsel should recommend viewing the
basic SEC registration forms, together with related guides and interpretative
releases, as a form of checklist for conducting due diligence.
It is critical
to retain experienced legal counsel who is seasoned in the practice
of due diligence. Since legal counsel acts as the point person in the
due diligence process, there is no time to allow inexperienced counsel
to use your offering as a "learning experience." Also, be
sure the firm retained not only has sufficient experience but also ample
time to dedicate towards your offering. A hurried due diligence is a
breeding ground for mistakes.
The underwriter
and/or director should also have confidence in the company's auditors,
who are critical in the performance of financial due diligence. If company
employees are forwarding incorrect or incomplete information to outside
counsel, there is no way to for them to conduct an accurate evaluation.
Directors and underwriters
should be careful not to accept the word of management at face value,
no matter how honest their intentions may be. Management tends to be
optimistic by nature. The Sarbanes-Oxley Act of 2002 requires public
companies to establish and maintain disclosure controls and procedures
to assure the material accuracy and timeliness of information contained
in periodic reports. The CEO and CFO must personally certify to these
procedures, and the accuracy of all reported information. Underwriters
and directors performing due diligence for the preparation of a prospectus
and registration statement likewise should ensure that such procedures
are in place, after all, following the closing of the IPO, the company
will be public and subject to these certification requirements.
For liability reasons, due diligence should be conducted through and
including the date of effectiveness of a registration statement and
the date that the prospectus is used. There are differing opinions as
to the maintenance of detailed documentary evidence of due diligence,
including marked up drafts of registration statements. Some believe
that such evidence can be manipulated and used against defendants in
litigation, while others believe such evidence will provide the proof
needed for the defense. Securities counsel plays a key role in determining
the extent of documentation to be retained in any given offering circumstance.
Outside counsel
typically begins by educating themselves on the company and their particular
industry. They may review journals, files that have been accumulated
by other counsel for that company, records with banks and credit agencies
and even go as far as interviewing competitors. Internal corporate records,
minutes, charters, authorized stock, restrictions on stock, stock transfer
records, bylaws and the like should be evaluated thoroughly for the
issuing company, all parent companies, subsidiaries and affiliates.
An examination
of the company's business includes the principle lines of business,
distribution and supply sources, competitive position, dependence on
products, customers, or suppliers, and intellectual property such as
trademarks and patents. Management, officers and directors should be
interviewed in writing and in person. Of course, all financial information
should be thoroughly reviewed and outside counsel should meet with and
discuss financial information with the auditors.
Important company
documents including contracts, leases, mortgages, financing arrangements,
employment agreements, stock options and warrants, and pending litigation,
all need to be reviewed. The director or underwriter should have outside
counsel explain the meaning of these documents and point out material
provisions that could have a future impact on the company.
Of course, the
underwriter or director, together with outside counsel, should make
a physical inspection of business premises, facilities, major assets
and inventory. Materials prepared by marketing, engineering or similar
professionals, by or on behalf of the company must be reviewed.
Due diligence by underwriters
serves two basic purposes:
Protection against potential liability
Preparation for the effective marketing of the issuing company's
securities.
Due diligence by
underwriters also enforces the rule of "know your investment banking
client." Proper due diligence allows an underwriter to perform
its investment banking obligations of raising capital in the marketplace
for issuers while protecting its customers who purchase the issuers
securities.
Due diligence by
underwriters is based upon basic common sense which is defined by the
test of reasonableness. That is, the standard of a prudent man in the
management of his own affairs. If adverse information surfaces, the
underwriter must either investigate the information further or immediately
make the decision not to proceed with the offering. As it becomes more
and more difficult for an underwriter to back away from a deal as the
time of filing the registration statement becomes closer, the underwriter
should concentrate its early due diligence efforts on ferreting out
"red flags" or indications of potential problems.
From a practical
standpoint, the underwriter should start by meeting with and performing
background checks on the issuer's management. If the underwriter is
not comfortable with what is discovered, there is no reason to continue
further. Following this initial background check an underwriter should
investigate the issuer's industry. An investigation of the issuer's
industry includes the issuer's place vis a vie the competition and the
overall industry structure. The investigation should go back at least
five (5) years. The underwriter must not only look at the issuer's place
in the industry, but the industry itself, including potential problems
and changing economic factors such as technology and intellectual property
issues such as patents. The underwriter should also review financial
information on the issuer, competitors and the industry, inventory methods,
accounting standards, and labor relations.
The most substantive
and in-depth segment of the underwriter's due diligence will be an investigation
of the company itself, its business, management and financials. The
underwriter must be sure to conduct an in-depth investigation of all
specific areas of due diligence, a brief discussion of which is in the
preceding section. The underwriter should not feel limited in its investigation,
which can include personal interviews with the issuer's management and
employees as well as suppliers, customers, competitors, distributors,
previous counsel and accountants and anyone who may provide relevant
information.
The underwriter
has an obligation to verify the intended use of proceeds. This process
will include identifying and verifying costs, pricing, including mark-ups
and mark-downs, inventory controls, income and projections. Company
financials should be carefully reviewed and analyzed, including among
other things, profit margins and trends, working capital requirements,
cash flow, accounting principals, acquisitions, tax elections, inventory
levels, budgeting, and off balance sheet transactions.
Balance sheet trickery
is common but is also easily caught by experienced legal counsel. Accounting
gimmicks include, but are not limited to…
recognizing revenues early, such as when the transaction is not
final, or when future services are still due;
recording revenues that are not genuine, such as "round trip"
or "wash" contracts, exchanges of similar assets or recording
refunds as revenues;
increasing income with one-time gains and failing to distinguish
those gains as nonrecurring;
shifting expenses to a later period, such as failure to write off
doubtful or worthless assets or capitalizing costs rather than recognizing
them on a current basis;
failing to record or disclose all liabilities, such as failure to
disclose commitments and contingencies such as guarantees, derivatives
and transactions intended to deep debt off the balance sheet;
over-valuing assets, such as obsolete inventory;
shifting income to a later period through the creation of reserves
or otherwise;
shifting future expenses to the current period, such as accelerating
depreciation costs and write-offs;
restrictions on sources of and burdens on liquidity; and related
party transactions.
Although the Sarbanes-Oxley
Act now requires disclosures for non-GAAP financial information, and
more in-depth management discussion and analysis, the issuer in an IPO
is not subject to these requirements until after the offering. As part
of the process of due diligence, it is critical for the underwriter
to be thoughtful in its choice of underwriter's counsel. Legal counsel
is invaluable in helping the underwriter identify the sources of information
for a due diligence investigation.
As stated, IPO
due diligence is best left in the hands of skilled and experienced legal
professionals. There is no margin for error and no time to reinvent
the wheel, especially when the stakes are high and the clock is ticking.
As dramatic as it sounds, fortunes and careers hang in the balance.
Legal & Compliance,
LLC can provide numerous options in regards to company financing. If
indeed an Initial Public offering is the way to go, our team will work
closely with company management to create and implement the best possible
strategy for taking your company public. We will undertake all aspects
of due diligence and work closely with management to ensure that the
task is completed in a timely and cost effective manner.
Over the years
our firm has developed key relationships with established professionals
in the investment banking community including underwriters, investor
relations experts, marketing and corporate image entities and stock
promotion companies. We are accustomed to preparing registration statements
in a timely fashion while communicating with key personnel at the Securities
and Exchange Commission. These relationships allow us to move aggressively
on behalf of our clientele when bringing an exciting new issue to the
market.
