Similar to German public offerings, underwriters for a U.S.-registered offering perform a due diligence investigation of an issuer. This due diligence process serves several purposes.
Due diligence has the goal of developing the equity story based on which securities are to be sold as well as refining the underwriters’ valuation of the issuer. It also forms the basis for drafting accurate disclosure in the registration statement and the prospectus for an offering. Finally, due diligence and the “due diligence defense” (explained below) help underwriters avoid civil liability for claims raised by investors under U.S. securities laws.
The purpose of due diligence
The underwriters’ due diligence investigation aims at better understanding an issuer’s business, strengths and risks in order to, together with the issuer, develop its strategy and solidify its equity story. The scope, focus and approach of due diligence depend on the details of the issuer’s business, industry, stage of development, shareholder structure and international operations. For example, an earlier stage biotechnology issuer operating within a dense regulatory framework and planning to use the offering proceeds to fund its product development and drug approval process requires a due diligence process different from an established issuer operating renewable energy parks in Europe and planning to enter the U.S. market through acquisitions. In the first example, the due diligence focus might be on IP and proprietary rights, the issuer’s freedom to conduct its business and the regulatory framework in which it operates. In the second example, the focus might be on the issuer’s experience with acquiring, developing and operating renewable energy parks as well as its supplier relationships. In both scenarios, however, due diligence enables the underwriters to prepare the issuer for the offering process and allows them to get to know the issuer’s management team, which contributes significantly to the offering’s success. The underwriters also closely review and analyze the issuer’s business plan, financial projections and underlying assumptions to confirm and further refine their valuation of the issuer.
While not as common in German offerings, underwriters in U.S.-registered offerings, as part of their due diligence, often contact an issuer’s key customers (and, to a lesser extent, suppliers) to verify certain information regarding their relationships with the issuer. While customers are typically willing to participate in such calls, this requires a cautious approach to the selection of whom to contact, so as not to alert third parties of the pending offering.
The underwriters’ due diligence also helps them avoid civil liability under U.S. securities laws by establishing the “due diligence defense.” Liability generally attaches to offering participants when the registration statement contains an untrue statement of a material fact or omits a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading. The due diligence defense requires underwriters to show a “reasonable investigation,” which is demonstrated through a number of standard measures. Because a reasonable investigation requires independent verification, underwriters cannot rely on management’s representations or materials prepared by the issuer but must rather make a reasonable effort to independently verify any information received. This means investigating sources outside of the issuer (e.g., obtaining comfort letters from auditors and speaking with customers, suppliers, lenders and advisors). It can also mean investigating sources other than management within the issuer, such as by speaking with employees, reviewing internal documentation and conducting site inspections.