Holding: Although Barchris says that you can rely on expertised section, reliance must be reasonable. If there is a “red flag” it’s not reasonable to rely. where “red flag” regarding the reliability of an audited financial statement emerge, mere reliance on an audit will not be sufficient to ward off liability”. Red flag: any info that “strips a defendant of his confidence in the accuracy of those potions of a registration statement premised on audited financial statements is a red flag, whether or not it relates to accounting fraud or an audit failure….” The red flag here is the E/R ratio, line costs to revenue of WorldCom compared to that of other companies. Ct says that WorldCom’s low E/R ratio is a red flag. But actually it doesn’t look that suspicious: WorldCom – 43%, AT&T – 46.8%, Sprint 54.2%. This doesn’t seem so suspiciously low. Note that no one in the marketplace saw this as a red flag at all! Maybe the court is basically just trying to get past summary judgment stage and on to trial. Another thing going on in the background is that underwriters had some knowledge WorldCom changes the way everyone looks at the reliance defense, which made people think you need a hugely obvious smoking gun red flag. Court didn’t just accept industry practice Basically, court saying you should slow down the process. Problem is there is a business cost to slowing down the process What should underwriters do to satisfy the due diligence defense for non-expertised sections of the registration statement? Unclear. But the following things are not enough: Relying on a comfort letter alone (comfort letter is non-expertised) Limited number of conversations with the issuer or its auditor Cursory nature of the inquiries Failure to go behind any of the almost formulaic answers given to questions Failure to inquire into issues of particular prominence in the underwriter defendants’ own internal evaluations of the financial condition of the issuer or in the financial press. Reasoning in WorldCom For expertised part
Holding: Although Barchris says that you can rely on expertised section, reliance must be reasonable. If there is a “red flag” it’s not reasonable to rely. where “red flag” regarding the reliability of an audited financial statement emerge, mere reliance on an audit will not be sufficient to ward off liability”. Red flag: any info that “strips a defendant of his confidence in the accuracy of those potions of a registration statement premised on audited financial statements is a red flag, whether or not it relates to accounting fraud or an audit failure….” The red flag here is the E/R ratio, line costs to revenue of WorldCom compared to that of other companies. Ct says that WorldCom’s low E/R ratio is a red flag. But actually it doesn’t look that suspicious: WorldCom – 43%, AT&T – 46.8%, Sprint 54.2%. This doesn’t seem so suspiciously low. Note that no one in the marketplace saw this as a red flag at all! Maybe the court is basically just trying to get past summary judgment stage and on to trial. Another thing going on in the background is that underwriters had some knowledge WorldCom changes the way everyone looks at the reliance defense, which made people think you need a hugely obvious smoking gun red flag. Court didn’t just accept industry practice Basically, court saying you should slow down the process. Problem is there is a business cost to slowing down the process What should underwriters do to satisfy the due diligence defense for non-expertised sections of the registration statement? Unclear. But the following things are not enough: Relying on a comfort letter alone (comfort letter is non-expertised) Limited number of conversations with the issuer or its auditor Cursory nature of the inquiries Failure to go behind any of the almost formulaic answers given to questions Failure to inquire into issues of particular prominence in the underwriter defendants’ own internal evaluations of the financial condition of the issuer or in the financial press. Reasoning in WorldCom For expertised part
SurveyofSecurities_Choi_2016.docx