Due diligence defense: Meaning, Criticisms & Real-World Uses

What Is Due Diligence Defense?

The due diligence defense is a legal protection available to certain parties involved in the issuance of securities, primarily against claims of misstatements or omissions in a registration statement. It falls under the broader umbrella of securities law and financial regulation, serving as an affirmative defense in cases alleging securities fraud. This defense asserts that a defendant conducted a reasonable investigation into the accuracy of the offering documents and had no reasonable grounds to believe, and did not believe, that the statements contained a material misstatement or a material omission. The rationale behind the due diligence defense is to incentivize thoroughness and transparency in securities offerings by limiting the liability of parties who genuinely perform their duty of care.

History and Origin

The concept of the due diligence defense gained prominence with the enactment of the Securities Act of 1933 in the United States. This landmark legislation was designed to protect investors by requiring issuers to disclose material information about publicly offered securities¹⁸. Section 11 of the Securities Act of 1933 specifically outlines the conditions under which parties involved in a registered offering can be held liable for inaccuracies in the registration statement¹⁷. However, it also provides the statutory foundation for the due diligence defense, allowing non-issuer defendants to avoid liability if they can demonstrate that they exercised "reasonable investigation" and had "reasonable ground to believe" in the truthfulness of the statements¹⁶.

A pivotal moment in the interpretation and application of the due diligence defense was the 1968 case Escott v. BarChris Construction Corp. This case significantly clarified the standards of care required for different parties—such as directors and underwriters—in preparing a registration statement. The court's ruling emphasized that simply relying on others was insufficient; each individual defendant had a distinct duty to investigate. The case underscored that an underwriter, by allowing their name on a prospectus, implicitly represents that they have investigated the accuracy of the material and are satisfied with its truthfulness. Th¹⁵is ruling cemented the practical importance of rigorous due diligence processes for all participants in a securities offering.

Key Takeaways

The due diligence defense is a statutory protection under Section 11 of the Securities Act of 1933.
It allows non-issuer defendants (e.g., underwriters, directors, experts) to avoid civil liability for misstatements or omissions in a registration statement.
To successfully assert the due diligence defense, a defendant must prove they conducted a reasonable investigation and had a reasonable belief in the accuracy and completeness of the statements.
The level of investigation required for the due diligence defense varies depending on the defendant's role and the portion of the registration statement in question (expertised vs. non-expertised).
Issuers of securities are strictly liable for inaccuracies in their registration statements and cannot assert the due diligence defense.

Interpreting the Due Diligence Defense

Interpreting the due diligence defense involves understanding the standard of "reasonable investigation" and "reasonable grounds for belief." While the Securities Act of 1933 defines this standard as "that required of a prudent man in the management of his own property," its application is objective and calibrated to the specific position of each defendant. Fo¹⁴r instance, the diligence expected from an underwriter or an expert (like an auditor for financial statements) differs from that expected of an outside director.

T¹³he defense essentially requires a defendant to demonstrate that they performed sufficient groundwork to reasonably conclude that the information presented was truthful and complete at the time the registration statement became effective. This involves more than a cursory review; it necessitates active inquiry, verification, and critical assessment of information.

Hypothetical Example

Consider a hypothetical scenario where "TechGen Innovations Inc." is preparing for an initial public offering (IPO). "Global Capital Partners," an investment bank, acts as the lead underwriter. During their due diligence process for the IPO, Global Capital Partners' team, including its legal counsel, scrutinizes TechGen's financial records, business operations, and contractual agreements. They interview key management personnel, review external auditor reports, and analyze market conditions.

Suppose, unbeknownst to Global Capital Partners, TechGen's CEO had secretly inflated a significant revenue figure in an internal, unaudited report that was mistakenly provided to the underwriters. The underwriters, as part of their standard procedures, obtained comfort letters from the independent auditors regarding the unaudited information and conducted their own review of the company's financial health, finding nothing inconsistent with the audited statements.

If, post-IPO, investors sue Global Capital Partners alleging a material misstatement regarding revenue, the investment bank would assert the due diligence defense. They would present evidence of their extensive investigation, including records of interviews, document reviews, reliance on audited financial statements, and the comfort letters from the auditors. If they can demonstrate that their investigation was reasonable and they had no reasonable basis to suspect the CEO's concealed inflation, they may successfully avoid liability under the due diligence defense.

Practical Applications

The due diligence defense is critically important in the world of investment banking and corporate finance. Its primary application is in public securities offerings, particularly IPOs, where various parties play a role in preparing and disseminating the registration statement and prospectus.

Underwriters: Underwriters routinely engage in extensive due diligence to establish this defense. Their efforts involve reviewing financial records, interviewing management, examining legal documents, and understanding the issuer's business and industry. This detailed review helps them form a "reasonable basis" for recommending municipal securities to investors, which is crucial for meeting their obligations under federal securities laws.
¹² Directors: Both inside and outside directors of an issuer must demonstrate that they conducted a reasonable inquiry into the accuracy of the statements in the registration statement. The standard for outside directors is generally less stringent than for insiders, but it still requires active engagement and a reasonable belief in the truthfulness of the information.
¹¹ Experts: Professionals like accountants and lawyers who provide "expertised" portions (e.g., audited financial statements) of the registration statement also have their own due diligence obligations for the sections they certify.

T¹⁰hese rigorous compliance measures are not merely protective; they also contribute to market integrity by ensuring that the information provided to investors is thoroughly vetted. The Securities and Exchange Commission (SEC) actively monitors and provides guidance on the expectations for due diligence to ensure compliance with antifraud provisions of federal securities laws.

#⁹# Limitations and Criticisms

While the due diligence defense is a powerful tool, it has limitations and faces certain criticisms. One significant limitation is that it is generally unavailable to the issuer of the securities, who faces strict liability for any material misstatements or omissions in the registration statement. Th⁸is means the issuer cannot claim they performed a reasonable investigation to escape liability, regardless of their efforts.

Another challenge lies in the subjective nature of "reasonableness." What constitutes a "reasonable investigation" can be debated and is often determined retrospectively in court. The burden of proof for establishing the due diligence defense rests squarely on the defendant, requiring them to provide compelling evidence of their efforts and the reasonable basis for their beliefs. Th⁷is can be particularly complex when dealing with vast amounts of information and tight deadlines, especially for parties like non-expert directors.

C⁶ritics sometimes argue that the defense might lead to a "checklist" mentality, where parties focus on fulfilling minimum requirements rather than truly uncovering potential issues. Furthermore, the defense does not protect against all forms of securities fraud, particularly those involving intentional deception (scienter) under other securities laws like Rule 10b-5, where a higher standard of intent must be proven by the plaintiff.

#⁵# Due Diligence Defense vs. Due Diligence

The terms "due diligence defense" and "due diligence" are closely related but distinct.

Due Diligence: This is the broader concept of conducting a thorough investigation or exercising a level of care that a reasonable business or person would typically undertake before entering into an agreement or transaction. It is a proactive process of information gathering, risk assessment, and verification aimed at making informed decisions and mitigating risks in various contexts, from mergers and acquisitions to purchasing a home.
Due Diligence Defense: This is a specific legal defense available primarily under Section 11 of the Securities Act of 1933. It is a reactive measure invoked after a lawsuit has been filed, where a non-issuer defendant seeks to avoid liability for alleged inaccuracies in a registration statement by demonstrating that they met the statutory standard of a "reasonable investigation" and held a "reasonable belief" in the accuracy of the disclosures. Essentially, the due diligence defense is the legal shield that arises from having properly performed the act of due diligence.

The confusion often arises because the defense relies on the prior performance of due diligence. One cannot assert the defense without having first engaged in the underlying investigative work.

FAQs

What parties can use the due diligence defense?

The due diligence defense is available to non-issuer defendants in Section 11 cases under the Securities Act of 1933. This typically includes underwriters, company directors (both inside and outside), and experts (such as accountants or engineers) who consented to be named as having prepared or certified a portion of the registration statement.

#⁴## Why is the issuer unable to use the due diligence defense?
The issuer of the securities is held to a standard of strict liability under Section 11 of the Securities Act of 1933. This means they are automatically liable for any material misstatement or material omission in the registration statement, regardless of whether they exercised due diligence. The rationale is that the issuer has ultimate control over the information presented and bears the primary responsibility to investors.

#³## How does the level of due diligence vary for different parties?
The standard of a "reasonable investigation" for the due diligence defense is generally tailored to the specific role and expertise of the defendant. For example, an underwriter is expected to conduct a more extensive financial and business review than an outside director who might rely more on management and expert opinions, provided such reliance is reasonable. An² expert is held to a higher standard for the "expertised" portions of the registration statement they prepared, but a lesser standard for non-expertised portions.¹