United States: Added Comfort

In almost every capital markets securities offering, a significant amount of time and party resources are spent on conducting a thorough due diligence investigation into the affairs of the issuer.

This covers, among other things, its business, operations, financial status, legal affairs, management and controlling parties. The process has two principle purposes, one positive and the other more defensive. First, it helps the parties prepare a comprehensive offering document accurately conveying the issuer's strengths and potential. Second, it provides the basis for parties with potential exposure to securities fraud claims to establish a due diligence defence (if called upon to do so). This defence sees them produce sufficient background work to demonstrate that they used reasonable care to ensure the offering document did not include, and meaning they should not be legally responsible for, any material omission or misstatement.

One of the core elements of the due diligence defence is the auditors' comfort letter. This letter is addressed to the underwriters, and sometimes certain other persons, and provides positive and negative assurances regarding the issuer's financial position, the results of its operations, and the accuracy of reporting of financial information in the offering document.

However, many audit firms – for some time – have refused to address such letters to issuers. This is on the ground that issuers are strictly liable for material misstatements and omissions in their offering documents, cannot avail themselves of a due diligence defence, and therefore have no need for the protection of a comfort letter. There is also a great deal of inconsistency among and within audit firms (perhaps more so outside the US) on whether to address letters to issuers or their boards of directors, and whether either should be a formal addressee as opposed to simply being provided a copy of the letter.

Unregistered securities offerings, which rely on exemptions under rule 144A or section 4(a)(2) of the US Securities Act of 1933, create special considerations. As a result of (not all that recent) changes in the interpretation of US securities laws, issuers of securities in unregistered offerings should no longer be subject to strict liability for material misstatements or omissions in an offering document. They should also not be in a position that is structurally different from any other party with potential liability for securities fraud. In light of this, there is no longer any conceptual basis for auditors to decline to include their clients – the issuers – as addressees of their comfort letters. Therefore, issuers should try to insist on being so addressed.

Due diligence defence

More than any other provision in US law, section 11(b) of the Securities Act comes the closest to spelling out the details of the due diligence defence (without anywhere using the term). It is also clear on two other points: the issuer does not have such a defence; and the section relates only to registered offerings.

Like section 11, section 12 of the Securities Act deals with untrue statements of material fact and omissions to state such facts. But unlike section 11, section 12:

  • covers 'any person' who takes certain actions, rather than a specific laundry list of parties who may be sued;
  • refers to 'a prospectus or oral communication' rather than a registration statement; and
  • does not specifically exclude issuers from the parties that may take advantage of the limitation on liability set out in the section.

In addition, historically there were two widely held assumptions regarding section 12. First, while the language drew no distinction between issuers and other persons, as a practical matter issuers would have great difficulty proving they could not have known, in the exercise of reasonable care, of a material misstatement or omission about themselves. Second, the reference to 'prospectus' (rather than 'registration statement') meant section 12 also applied to exempt offerings rather than only registered ones. As such, the practical understanding was that section 12 effectively extended the gist of section 11 to offerings exempt from registration. This included private placements under section 4(a)(2), rule 144A offerings, and possibly even offshore transactions within Regulation S under the Securities Act.

The market's understanding of section 12 changed in 1995, with the US Supreme Court's decision in Gustafson v Alloyd Co, Inc, 513 US 561 (1995). In Gustafson, a company's shareholders sold all of its shares to a purchaser in a private transaction. The company's post-closing financial statements revealed variations between estimated and actual valuations, and the contract of sale entitled the purchaser to a price adjustment. However, rather than accept the adjustment, the purchaser raised a claim of securities fraud under section 12(a)(2) (then section 12(2)). This was based on the theory that breaches of representations and warranties in the purchase contract constituted material misstatements or omissions in a 'prospectus' for purposes of section 12, entitling the purchaser to rescission of the transaction (the statutory remedy) rather than a mere price adjustment (the contractual remedy). In its ruling, the Supreme Court held that 'prospectus' as used in section 12 referred to a statutory prospectus included in a registration statement (and that therefore the purchaser had no basis to claim that the contract of sale constituted a prospectus). From that date, it has no longer been the accepted view that section 12 applies to exempt offerings or, therefore, creates a strict liability standard for issuers in such offerings. And, of course, section 11 is explicitly inapplicable in this context.

Given they can't rely on sections 11 or 12 of the Securities Act to raise a securities fraud claim regarding an exempt securities offering, private plaintiffs are effectively left with only one option under federal securities law: a claim under rule 10b-5 under the US Securities Exchange Act. Rule 10b-5 makes it unlawful:

'for any person, directly or indirectly...(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...in connection with the purchase or sale of any security.'

The law has developed in such a way that bringing a successful rule 10b-5 claim is a complicated matter. But it is also the case that: the rule covers 'any person', and does not distinguish between issuers and other parties; and it relates to 'the purchase or sale of any security', so is clearly not influenced by whether a transaction is registered or exempt from registration. Therefore, unlike sections 11 or 12, rule 10b-5 seems broad enough to cover claims of securities fraud in connection with exempt transactions under section 4(a)(2) and rule 144A. It even seems to cover offerings within the safe harbour for offshore offerings of Regulation S, although the possibility of raising a successful claim in a US court – in relation to an offshore offering – is highly uncertain. This has become even more uncertain recently as a result of Morrison v National Australia Bank Ltd 561 US 247 (2010). In this case, the US Supreme Court specifically declined to extend the reach of rule 10b-5 to cover statements by non-US companies whose securities are listed solely on non-US stock exchanges in the context of offshore purchases of securities by non-US investors.

Rule 10b-5 claims

The significant jurisdictional and merit-related requirements of a successful claim under rule 10b-5 are well documented in US court proceedings. In terms of substance, to succeed a plaintiff must plead, and prove, a number of elements of a claim. These include: the existence of a material misstatement or omission; reliance on such misstatement or omission; the misstatement or omission's causation of harm to the plaintiff; the extent of the loss or damage; and scienter, the defendant's knowledge of the deceit or recklessness in allowing it to occur.

There is no formal due diligence defence to a rule 10b-5 claim. However it has been noted that if a defendant is able to show it exercised reasonable care, then it is highly unlikely that a plaintiff will be able to prove recklessness or, barring actual intent to deceive, scienter. One could argue that an issuer defendant's difficulty in refuting recklessness (regarding a material misstatement or omission) is similar to its task in proving it exercised reasonable care (notwithstanding such misstatement or omission) in defending a section 12 claim. This would, as a practical matter, be akin to strict liability. But there is not a wide body of precedent or legal scholarship suggesting an issuer would be unable to defeat the element of scienter merely because its offering document did, in fact, contain a material misstatement or omission. If this were the case, scienter would not need to be an element of a rule 10b-5 claim brought against an issuer. In other words, it appears that there is a space along the spectrum between recklessness and exercising reasonable care/doing due diligence, and an issuer whose activities fall into this space would not be liable in a rule 10b-5 action. As such, even without the per se due diligence defence, it is clearly in a defendant's best interest to be able to show that it endeavored to avoid any material mistake or omission in an offering document.

Since rule 10b-5 relates to activity by 'any person', there is no basis for an assumption that issuers are somehow in a different position than other participants in an offering. All defendants in a rule 10b-5 action have an interest in refuting their scienter and showing that they acted without recklessness. Whether it is easier to prove recklessness on the part of an issuer (the 'owner' of most of the material information) than on the part of a third party (such as a director or underwriter) has little to do with whether an issuer defendant is entitled to use all available means to defend against a claim of recklessness. A comfort letter is obtained to defend against any rule 10b-5 claim, and support the view that the party did not act recklessly by seeking assurance about the accuracy of financial disclosure. It also shows the absence of material adverse changes in the issuer's financial position or results since the last audit or review. This purpose is the same irrespective of the party's identity.

SAS 72 and analogous Standards

While comfort letters in securities offerings can take many different forms, they generally originate from the Statement on Auditing Standards No 72, issued by the Auditing Standards Board of the American Institute of Certified Public Accountants in February 1993.

Registered offerings were clearly foremost in the minds of SAS 72's authors, though the Statement also clearly contemplates the delivery of comfort letters in the context of exempt offerings. In light of it being pre-Gustafson, it focuses on Securities Act liability (principally section 11, and since it does cover exempt transactions and was issued pre-Gustafson, presumably section 12 also) and not on the Securities Exchange Act or rule 10b-5. However, as noted above, rule 10b-5 is now the primary expression of the US antifraud standards with respect to an exempt transaction. As such, the scope of SAS 72 needs to be viewed in this light. Paragraph 24 of SAS 72, 'Addressee', states: 'The letter should not be addressed or given to any parties other than the client [(usually, but not always, the issuer)] and the named underwriters, broker-dealer, financial intermediary or buyer or seller'. The remainder of the Statement contains no discussion whatsoever as to the propriety of addressing a letter to an issuer or the value to such issuer of being such an addressee. But given the text of paragraph 24 and its accompanying footnote (which illustrates a form of address that includes the issuer as addressee), it is hard to see how an auditor could argue that the issuer is an inappropriate addressee of the comfort letter. The fact that it may now be more likely that a comfort letter can be of actual assistance to an issuer in defending against a securities fraud claim is hardly a reason to reject the original willingness to make issuers addressees.


Many of the world's largest audit firms are trying to limit and control their potential risks while simultaneously expanding their businesses, both geographically and in absolute terms. As a result, they are certainly not looking to increase their risk, such as by making a global policy change to add issuers as addressees of comfort letters in capital markets offerings exempt from registration under the Securities Act. Nevertheless, it seems that there is both reason for issuers to request this, and scope within the auditors' own standards for them to meet such requests. The importance of being a comfort letter addressee in defeating a rule 10b-5 securities fraud claim is uncertain, but there should be some value, and there is no reason to avoid pressing the point. Issuers and their counsel should begin to make these requests in exempt offerings.

Originally published in IFLR - July/August 2014

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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