Sections 11 and 12 are the main liability provisions under the Securities Act of 1933, as amended (the "Securities Act"). Section 11 covers misstatements or omissions in registration statements, while Section 12 imposes liability with respect to misstatements or omissions in prospectuses. Other sources of liability under the federal securities laws include the antifraud provision of the Securities and Exchange Act of 1934, as amended, found in Section 10b and Rule 10b-5 adopted thereunder. Underwriters can be held liable for these misstatements or omissions, but have a potential defense from liability if they can demonstrate that after performing appropriate due diligence procedures, they were unaware of the misstatement or omission. In addition, prior to making a recommendation with respect to a debt security, FINRA expects brokers to assess the credit quality of an issuer, and to ensure that its registered representatives are duly advised of that assessment, and any changes to it.1

In this article, we summarize some of the main practical steps that these broker-dealers take to establish a due diligence defense under the Securities Act, and to assess issuer credit quality.

Broker-dealers that are in privity of contract with the issuer, such as under a program distribution agreement or similar document, will have a variety of contractual rights that help them to assess the issuer. The broker-dealer receives representations and warranties from the issuer under the applicable agreement about its business and finances, and the adequacy of the disclosures in the offering documents, which are typically "brought down" at the time of each offering. The agreement will also entitle the broker to periodic comfort letters, legal opinions and officer’s certificates. The broker will maintain a file containing the periodic bring-down documents that it receives under the program agreement or similar documents.

Additional procedures, including for broker-dealers that do not have a direct contractual agreement with the issuer, may include:

  • Maintaining a summary of the termination provisions in the distribution/selling agent agreement.
  • Scheduling periodic or quarterly business due diligence calls with the issuer, or participating in any periodic or quarterly business due diligence calls arranged by the issuer.
  • Reviewing the issuer’s periodic filings with the SEC, including its Form 10-Ks, Form 10-Qs and proxy statements filed with the SEC.
  • Establishing an alert system to track the issuer’s press releases, earnings releases, any ratings agency actions, any significant acquisitions/dispositions, any management changes or any other events triggering a Form 8-K filing.
  • Regularly conducting due diligence on the distributors/broker-dealer network used in connection with the relevant program or offering.
  • Monitoring the issuer’s credit rating and CDS spreads.
  • Listening to the issuer’s earnings calls and reviewing the issuer’s investor presentations made publicly available.

These procedures are all designed to help ensure that a broker can assess an issuer’s credit quality, and the accuracy of its disclosures. In addition, particularly if the broker’s view of the issuer’s credit quality or prospects decrease, it must ensure that any such conclusions are properly conveyed to its sales force, so that these conclusions can help inform any recommendations that are made as to that issuer’s securities. Brokers will maintain a system to inform their registered representatives of these changes.

A variety of additional steps may be appropriate, depending upon the circumstances. For example, the broker may wish to consider whether changes in the issuer’s disclosure documents for the offering are advisable. If the broker on-sells the products to other brokers, it may wish to ensure that those third-party brokers are aware of the relevant changes (which they may well be, due to their own similar practices). In some cases, more significant steps may be appropriate, including contacting individual offerees to ensure that they are aware of the relevant changes and are still interested in participating in the transaction, reviewing the issuer again under the broker’s new product approval committee process, or even postponing or cancelling the proposed offering or offerings.