As part of a private securities transaction, the seller or placement agent of a security may often ask the buyer to enter into a letter agreement whereby the parties acknowledge certain representations and warranties prior to entering into the transaction. This letter, sometimes referred to as a "big boy" letter, seeks to allocate risks among the parties, in particular when one party may have access to material non-public information regarding the issuer that has not been shared with the counterparty. The buyer is typically asked to acknowledge that it has made its decision to invest in the security based on its own investigation and knowledge, often obtained through due diligence, and that it has otherwise relied exclusively on representations contained in the big boy letter or a purchase agreement, without regard to anything that the seller may have said or provided outside of these documents.

A recent Ohio federal court decision, Pharos Capital Partners, L.P. v. Deloitte & Touche, LLP1(Pharos), although decided in the context of state, rather than federal, securities claims, provides support that big boy letters can be an effective means to allocate the risks between counterparties in a private securities transaction.

This article provides a short summary of the clauses that often appear in big boy letters, the US courts' views on big boy letters in general (including from the Pharos case) and recommendations regarding the use of big boy letters in a private securities transaction.

Common clauses appearing in a big boy letter

A big boy letter often contains the following acknowledgements/ representations:

  • buyer is a sophisticated investor and is fully aware of the risks involved in the transaction
  • buyer acknowledges that it is relying exclusively on its own due diligence
  • buyer is aware that the seller may possess material non-public information on the issuer that may affect the value of the securities
  • buyer is not relying on the disclosures of the seller when making a decision to complete the transaction
  • buyer is relying on representations only expressly set forth in the big boy letter or the transaction's underlying definitive agreement  
  • buyer waives all claims against the seller arising from non-disclosure of the material non-public information
  • buyer is aware of the effects of this waiver and is willing to proceed with the transaction.

The form and scope of acknowledgements/representations are negotiated among transaction parties.

Enforceability of big boy letters

The enforceability of big boy letters has focused on the questions of whether (i) negotiated non-reliance clauses (or clauses restricting reliance to explicit representations in an agreement) improperly conflict with the anti-waiver provisions of US federal securities laws and (ii) non-reliance clauses preclude an investor from successfully claiming reliance on extra-contractual representations2.

The waiver issue arises under Section 29(a) of the Securities Exchange Act of 1934, as amended (Exchange Act), which voids any express waiver of compliance with US federal securities laws as a matter of public policy. US Second and Seventh Circuits courts, however, have held that in specific circumstances (involving, among other things, sophisticated parties, explicitly negotiated representations and exclusions and due diligence rights) a negotiated non-reliance clause may will violate federal policy and may be enforced because reliance on representations expressly excluded from the negotiated scope of the contract terms is unreasonable3. In contrast, US Third Circuit courts have held that a non-reliance provision, even when negotiated between sophisticated parties, may be evidence of unreasonable reliance but not per se preclusive of such reliance (and thus a securities claim) in deference to the policy goals of Section 29(a) of the Exchange Act4.

The Pharos case deals only with the effectiveness of non-reliance clauses to block claims based on alleged extra-contractual representations. In Pharos, the plaintiff, Pharos Capital Partners, filed suit alleging securities fraud under Ohio state securities laws in connection with its $12 million equity investment in National Century Financial Enterprise, Inc. (NCEF), an investment which lost its full value upon NCEF's filing for bankruptcy. In its complaint, the plaintiff alleged that the defendant, serving as co-placement agent in connection with an equity offering, failed to disclose material information that would have impacted the plaintiff's investment decision. The co-placement agent centred its defence on the provisions of a big boy letter, in which the investor acknowledged it was a "sophisticated institutional investor", was relying exclusively on its own due diligence, would bear the risk of an "entire loss" of its investment and was aware that the co-placement agent may be in possession of material non-public information on NCEF, which the investor would not require to be disclosed.

In its decision, the US District Court for the Southern District of Ohio pointed to the clear language of the big boy letter in granting summary judgement, holding that one of the critical underpinnings of a successful common law or statutory securities fraud claim, that of reasonable or justifiable reliance on an alleged misrepresentation or omission, was not present and thus did not support a claim for fraud or negligent misrepresentation. The application of Section 29(a) of the Exchange Act was not at issue, as Pharos dealt only with Ohio state law claims.

Recommendations for big boy letter provisions

In determining whether a plaintiff reasonably or justifiably relied on an alleged misrepresentation or omission to support a securities fraud claim, US courts have considered several important factors:

  • the sophistication of the plaintiff in similar financial and securities matters
  • the existance of long standing business or personal relationships
  • access to relevant information
  • the existence of fiduciary relationship
  • concealment of the fraud
  • opportunity to detect the fraud
  • whether the plaintiff initiated the transaction or sought to expedite the transaction
  • the generality or specificity of the alleged misrepresentations
  • the content of any agreements the parties have entered into.

Pharos demonstrates, at least under state securities laws, the effective use of carefully crafted big boy letters to protect sellers against fraud claims. In order to minimise any potential liability, it would be advisable that the seller of securites:

  • ensure the big boy letter is the product of arms-length negotiation between the parties, and avoid the use of boilerplate provisions  
  • ensure that it has good reason to believe that the buyer of the securities is sophisticated, which would require that the seller be comfortable with its know-your-customer procedures  
  • include an acknowledgement that the buyer has had the opportunity to conduct its own due diligence while providing access to any relevant requested informaion upon which the buyer can rely  
  • include a clause that the buyer is aware that the seller may possess material non-public information concerning the relevant company, but still wishes to proceed with the transaction  
  • acknowledge that the seller/placement agent is not acting as a fiduciary or financial advisor to the buyer.