The Due Diligence Defense Under Section 11 of the Securities Act of 1933

Abstract

Section 11 of the Securities Act of 1933 imposes civil liability for misstatements or omissions of material facts in a securities offering registration statement. Potential section 11 defendants include the issuer, directors, underwriters and accountants. Although section 11 was designed to have an in terrorem effect on these parties, section 11 liability is not absolute. Among various affirmative defenses available to a defendant (other than the issuer) is the due diligence defense. Specifically, a non-issuer defendant avoids liability under section 11 if he can prove as to non-"expertized" portions of the registration statement that "he had, after reasonable investigation, reasonable ground to believe and did believe" there were no misstatements or omissions of material facts in such portions of the registration statement. As to "expertized" portions of the registration statement (such as audited financial statements), a non-issuer defendant avoids liability if he can prove that he "had no reasonable ground to believe and did not believe" that such portions of the registration statement contained misstatements or omissions of material facts. Hence, a reasonable investigation standard applies to non-expertized portions and a reasonable reliance standard applies to expertized portions.

Because the frequency of pre-trial settlements has limited case law on the subject, Escott v. BarChris Construction Corporation remains the leading case on the due diligence defense to section 11 liability even though it was decided nearly 40 years ago. The recent WorldCom Securities Litigation, however, has provided several opinions that address in detail various aspects of the due diligence defense. The article brings the due diligence defense literature up to date through WorldCom. It explores the reasonable investigation standard of the defense as applied to five different types of defendants: inside directors/management, outside directors, lead underwriters, participating underwriters, and accountants. It concludes that the standard varies by defendant type based on a sliding scale which takes into account the defendant's involvement with the company and the defendant's involvement with the offering. As for the reasonable reliance standard applicable to expertized portions of the registration statement, the article posits that the current "red flag" approach as applied to publicly available information should be informed by teachings of the efficient capital market hypothesis. It also asserts that a narrower "smoking gun" approach is more appropriate with respect to audited financial statements.

Keywords: section 11, due diligence, reasonable investigation, reasonable reliance, expertized, expertised, non-expertized, non-expertised

JEL Classification: K22, K23