Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP


Disclosure in an IPO is inextricably bound up with the issue of liability. Who, and under what circumstances, repays the investors if there has been a material misstatement or omission which impacts the post-offering price of the stock? The issuer is, for all practical purposes, absolutely liable under §11 of the '33 Act, but the issuer may be unable to respond. The directors, as signers of the registration statement, have a heavy burden, which stretches to all those who, under §12, may be considered "participants" in the sale (i.e., insiders and promoters who participate in the transaction). In fact, counsel may be liable if intimately involved in the preparation of the materials; even major shareholders can be caught.

Moreover, underwriters are expressly liable, subject to a "due-diligence defense", under §11, and experts (e.g., lawyers and accountants) are liable for errors in the "expertised" portions, meaning the legal opinions and certified financial statements. The issues are complicated by the fact that, in dealing with liability, plaintiffs have access to a multiplicity of liability-creating provisions: for example, Sections 11, 12(2) and 17(a) of the '33 Act and §10b and Rule 10b(5) under the '34 Act. The threat of liability bites, of course, most sharply in an initial public offering, when all the information about the issuer is being presented for the first time.

Due Diligence

Choking off liability if the stock price plunges after the effective date requires counsel and the underwriters to execute a defensive game plan, designed to convince a judge and jury that they had vetted the required disclosures with the requisite care. This due-diligence defense to an action, based on §11 and available to all but the issuer, depends on the defendant establishing he had reasonable ground to believe the registration statement was accurate after "reasonable investigation," the latter phrase having been equated in common parlance with the exercise of due diligence. There is no one source which will outline to the issuer and the underwriters how far the diligence of their management and advisers should proceed. Some law firms prefer to work from a checklist; indeed, the NASD once composed a 16-item list as a minimum standard, but it was never adopted. Those who believe that a checklist is a Christmas present to the plaintiff's lawyer, affording him an opportunity to inquire why certain items have been omitted, hold a contrary view. The widely cited BarChris decision is a learned opinion by a former partner of a prestigious Wall Street firm who set up standards that even the most diligent counsel would find hard to meet.

In the abstract, of course, elegant due diligence is a "motherhood" issue. Thus, one commentator suggests "counsel should consider making checks on the reputation and experience of its officers, including ordering Dun and Bradstreet and Proudfoots' reports. The Company's directors should be investigated as well as the management." Practitioners in the field, however, may find academic procedures beyond the practical.

One relatively inexpensive way to limit exposure is to write an expansive and gloomy "risk-factors" or "special-factors" section. Regulation S-K requires a risk-factors recitation "if appropriate" and specifies that, if one is included, it should appear immediately following the cover page or summary. In a venture-backed IPO (as in a private placement), such a section is almost always "appropriate." Language calculated to avoid lawsuits is also appropriate in the so-called MD&A section, in which Regulation S-K requires "Management's Discussion of and Analysis of Financial Condition and Results of Operations." Since that discussion calls for disclosure of "trends," "forward-looking information [such as] future increases in the cost of labor and materials" and an oxymoron such as "known uncertainties," the opportunity is squarely faced for throwing in cautionary language likely to help contain subsequent litigation by identifying all the possible negative contingencies. The artist will play the two-handed game: "on the one hand, competition is increasing, while on the other we think our product stands out."

The distinction between a public and a private offering in terms of the potential liability for the promoters and participants continues to broaden. Misstatements or omissions in publicly distributed prospectuses are, in the opinion of most practitioners, an occasion for strict liability, regardless of whether the purchase of the securities in fact was misled by the statement or omission. The law has not yet seen the case which definitively alters the very heavy burdens Judge MacLean, in his BarChris opinion, laid on a defendant sued under §11 of the 33 Act, except with respect to so-called forward-looking statements; in that context, the courts have been more likely to exculpate the issuer if the paragraphs are surrounded with language which "bespeaks caution." Indeed, in private offerings generally, particularly private placements to sophisticated investors, the investors are bound by the terms of the document, including particularly the risk factors enumerated therein, whether they read the pamphlet or not. Moreover, the courts have been eating away at the underpinnings of plaintiffs' actions based on Rule 10b(5) of the '34 Act. Rule 10b(5) is the avenue by which plaintiffs traditionally have traveled into federal court based on alleged misconduct in the private purchase or sale of securities. In recent years, that avenue has been narrowed by the imposition of a scienter standard; the stiffening of privity requirements; the shortening of the statute of limitations; and, finally, by cutting off the plaintiffs' access to alders and abettors, the deep-pocketed law and accounting firms who participate as advisers in the placement.


Introduction to Venture Capital and Private Equity Finance