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A Primer on U.S.

Due Diligence and Disclosure Standards Applied in Rule 144A Offerings


With the welcome increase of IPO activity in the United Kingdom over the past few months, combined with the renewed prospect of accessing investors in the U.S. capital markets, we thought it might be helpful to revisit some essential U.S. regulatory concepts that, because of the financial crisis that began in 2008, many market participants may have either gleefully forgotten or blissfully never confronted.
Introduction To begin, there are two threshold issues that arise under the U.S. federal securities laws (defined below) in an offering of securities to investors in the United States: (i) (ii) in the absence of a statutorily available exemption, it is unlawful to offer or sell a security to investors within the United States unless a registration statement has been filed with, and declared effective by, the SEC; and when offering a security for sale to investors within the United States, it is unlawful to do so by means of fraud, misrepresentation or deceit.

With regard to the first issue, we will limit our discussion in this primer to private offerings of securities into the United States which are underwritten by one or more investment banks ("underwriters") and offered (a) on the basis of an offering document (a "prospectus") prepared by the company issuing the securities (the "issuer"), the underwriters and their respective advisers and (b) pursuant to a statutorily available exemption (in this case a "Rule 144A Offering"1). The aim of this primer is to deal with the second issue, however, by providing a summary description of the anti-fraud provisions under the U.S. federal securities laws and explaining the concepts and standards of "due diligence" and "disclosure" in the context of a Rule 144A Offering.
Sources of Applicable U.S. Federal Law The body of U.S. federal law that generally regulates securities offerings in the United States, as well as the activities of due diligence and disclosure, comprises the following: (i) (ii) (iii) (iv) the U.S. Securities Act of 1933, as amended (the "Securities Act") and the rules, regulations and guidelines promulgated thereunder; the U.S. Securities Exchange Act of 1934, as amended (the "Exchange Act") and the rules and regulations promulgated thereunder; the rulemaking, interpretations and guidance provided by the U.S. Securities and Exchange Commission (the "SEC"); U.S. federal case law.
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For the purpose of this primer, (i), (ii), (iii) and (iv), set out above, shall together be referred to as the "U.S. federal securities laws".

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Securities Act Rule 144A is an exemption from registration under the Securities Act for the resale of securities to qualified institutional buyers "QIBs" (as defined in Rule 144A) in the United States. In private placements into the United States, it is common practice for investment banks to agree both to procure subscribers for (pursuant to a reasonable efforts placement under Section 4(a)(2) of the Securities Act and/or Regulation D thereunder) and, failing that, to subscribe for themselves (a firm underwriting), the securities being offered. Rule 144A allows the underwriters to resell such underwritten securities, and is often used as a shorthand description of the U.S. offering. This note does not address the securities laws, or "blue sky" laws, of the individual U.S. states. The stated mission of the SEC is, among other things, to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.
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General Anti-Fraud Rule Exchange Act Rule 10b-5 is one of several iterations of the general anti-fraud principles under the U.S. federal securities laws and, as we explain below, it is applicable to Rule 144A Offerings. Rule 10b-5 provides that "[i]t shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (a) to employ any device, scheme, or artifice to defraud, (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, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." It would be fair to say that the language underlined in (b) above is less than eloquent; however, the SEC and federal court judges have generally agreed that the statutory language makes it unlawful knowingly or recklessly to offer and/or sell a security to an investor in the United States through fraud, misrepresentation or deceit in a prospectus or in any other form of communication. The prohibition set 4 out in Exchange Act Rule 10b-5 can be applicable, under the right circumstances, to any person, anywhere. Prospectus Liability Depending on the circumstances of a Rule 144A Offering (e.g., primary or secondary offering), if an investor (or the SEC) alleges a violation of the antifraud rules in a prospectus, it could bring an action against one or more of the following persons or entities involved in the preparation of a prospectus: the issuer of the securities; the selling shareholder; persons controlling the issuer; directors and certain officers of the issuer; experts providing expert information in a prospectus (e.g., accountants or appraisers); underwriters; and certain others who may have participated in the preparation of a prospectus.

Origins of the "Due Diligence Defence" in a Rule 144A Offering Under the U.S. federal securities laws, the fraud statutes are applied principally on the basis of a determination whether a securities 5 offering is public or private. In public offerings, the U.S. federal securities laws impute strict liability on the issuer unless it can show that the plaintiff knew of the material misstatement or omission giving rise to the cause of action at the time of the acquisition of the security in question; however, other persons or parties (including underwriters, controlling persons, directors and officers and any selling shareholder ("eligible defendants")) may avoid liability if they can prove the following: With regard to any information in the prospectus that was not provided by an expert, such person had, after reasonable investigation, reasonable grounds to believe, and did believe, that the information was true, accurate and complete in all material 6 respects ; With regard to information in the prospectus provided by an expert, such person (other than the expert) had no reasonable grounds 7 to believe, and did not believe, that such information was untrue, inaccurate or incomplete in any material respect.

In light of the burden of proof set out above, market participants involved in U.S. public offerings developed the "due diligence defence," the purpose of which being to demonstrate, in a cause of action brought against an eligible defendant, that such defendant had conducted a reasonable investigation and had otherwise conducted itself reasonably under the circumstances. Because Rule 144A Offerings are private offerings, plaintiffs must rely on Exchange Act Rule 10b-5 to allege securities fraud. The federal courts have, however, held that such plaintiffs may not rely merely on a determination that the issuer or other eligible
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In 2010, the U.S. Supreme Court held in Morrison Et Al. v. National Australia Bank Ltd. Et Al., 130 S. Ct. 2869 (2010) that Section 10(b) and Rule 10b-5 under the Exchange Act apply only to purchases and sales of securities in the United States. The holding limits the extraterritorial application of the U.S. antifraud laws in so-called "foreign cubed" cases where, formerly, redress may have been available for non-U.S. plaintiffs suing U.S. and non-U.S. defendants in relation to a non-U.S. securities transaction on the basis either (i) that the securities fraud had an effect on the United States or on U.S. persons, or (ii) that a significant and material part of the fraudulent conduct occurred in the United States. Please note, however, that the holding by the U.S. Supreme Court does not appear in any way to impair the application of Section 10(b) or Rule 10b-5 to conduct that these laws explicitly prohibit. In 1995, the U.S. Supreme Court held in Gustafson v. Alloyd, 513 U.S. 561 (1994) that Section 12(2) of the Securities Act applies only to a prospectus used in connection with a public offering of securities in the United States. In addition, Section 11 of the Securities Act applies solely to registration statements filed with the SEC and Section 17 is not available for private causes of action. Paraphrasing Securities Act Section 11(b)(3)(A) Paraphrasing Securities Act Section 11(b)(3)(C)
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defendants have failed to meet the burden of proof applicable in public offerings, as set out above; they must also affirmatively show 8 that such defendants knowingly or recklessly made the misstatement or omission (proving so-called "scienter"). Recklessness has been defined by U.S. federal courts as "an extreme departure from the standards of ordinary care [] which presents a danger of 9 misleading buyers or sellers that is either known to the defendant or is so obvious that the defendant must have been aware of it." In light of the higher burden of proof set by the U.S. federal courts in the application of Rule 10b-5, many market participants outside the United States concluded in the mid-1990's that the "due diligence defence" was not necessary in Rule 144A Offerings. That misapprehension was appropriately dispelled by the U.S. securities bar, which recognized the strong likelihood that a U.S. federal judge would find a way to impute liability under Rule 10b-5 to underwriters who offer and sell securities in the United States "without 10 knowing, or apparently caring, whether the disclosures regarding those securities are accurate," as surely such behaviour would be regarded as reckless. As a result, and despite the higher burden of proof in Rule 10b-5 liability cases, underwriters, market participants and the U.S. securities bar will normally prepare the prospectus in a Rule 144A Offering applying the same standard of due diligence and disclosure that is found in offerings registered with the SEC. No Small Comfort? Because of its critical role as intermediaries between the issuer and the securities markets and investors, an underwriter's reasonable investigation must be extensive, more so perhaps than any other eligible defendant. As a consequence, the due diligence process, described more fully below, has been developed by and among underwriters, U.S. legal counsel, independent accountants/auditors and other experts. In particular, as market practice has evolved, underwriters have required that certain parties provide written "comfort" to support their due diligence defence: "10b-5 letters" (sometimes called "negative assurance" or "disclosure" letters) are provided by U.S. securities lawyers engaged by the issuer and the underwriter. A 10b-5 letter provides generally that nothing has come to the attention of the U.S. securities lawyer that would cause her or him to believe that the prospectus is not accurate and complete in all material respects. A 10b-5 letter can only be given by U.S. counsel, however, if: (i) fulsome management and documentary due diligence has been conducted on the issuer's group with the involvement of the U.S. securities lawyers, (ii) the U.S. securities lawyers have been involved in the drafting and vetting of the prospectus and, most importantly, (iii) nothing has, in fact, come to the U.S. lawyer's attention that would cause her or him to believe that the prospectus is not complete and accurate in all material respects; and "Comfort letters" are provided by the issuer's independent accountant/auditors and generally state that: (i) they are independent, (ii) they have audited year-end (and perhaps interim) consolidated financial statements of the issuer and, under certain circumstances (iii) they may also have subjected interim consolidated financial statements to limited review, reviewed certain principal line items in the issuer's consolidated financial statements prepared by the issuer for periods subsequent to the interim period and spoken with certain officials of the issuer about such financial information. Under those circumstances, the comfort letter would also then indicate whether anything has come to the independent auditor's attention to cause it to believe that (a) any material amendment to the interim financial statements is necessary or the interim financial statements do not conform with the applicable accounting principles, or (b) such principal line items have changed materially since the date of the last audit or limited review.

It is nevertheless incumbent upon the underwriters to conduct their own reasonable investigation of the issuer and its group companies (e.g., its business, results of operations, financial condition, prospects and operating and legal risks), as the SEC and federal courts warn against undue reliance on 10b-5 letters or comfort letters, and even on information provided by experts, such as an audit 11 opinion . It is, in fact, not entirely clear to what extent a 10b-5 letter and/or a comfort letter would constitute a significant part of a due diligence defence; but the involvement of U.S. securities lawyers and the issuer's independent accountants in the due diligence and disclosure process is viewed by market participants as a key component of best practice. Due Diligence and Disclosure Defined Therefore, the term "due diligence" embodies the obligation under the U.S. federal securities laws of any underwriter, controlling person or any selling shareholder, director or officer of an issuer and certain other individuals engaged in the preparation of an offering document to conduct a reasonable investigation of the issuer and its group companies (e.g., its business, results of operations, financial condition, prospects and operating and legal risks).

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Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) Franke v. Midwestern Okla. Dev. Auth., 428 F. Supp. 719, 725 (W.D. Okla. 1976) David W. Bernstein, "Due Diligence and the Legacy of Gustafson" in International Financial Law Review (August 1995). For a fairly recent and thorough explanation of the duty of underwriters to conduct a reasonable investigation, see In re Worldcom, Inc. Securities Litigation, 346 F. Supp.2d 628 (S.D. New York 2004)
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The U.S. federal securities laws provide that, for the purposes of determining what constitutes a reasonable investigation, the standard of reasonableness shall be that required of a prudent man in the management of his own propertybut as mentioned above, the underwriter's role as intermediary between the issuer and the securities markets and investors, as well as its level of sophistication and experience, mean that the reasonableness of its behaviour will very likely be heavily contextualized by a U.S. federal judge. The term "disclosure" refers to any information that is provided by an issuer, its subsidiaries or affiliates, and any of its or their directors, officers, employees or agents, to potential investors, current shareholders or bondholders, securities analysts, the press, or to any regulatory body or stock exchange in the context of a securities offering or in the context of ongoing regulatory compliance. The principal disclosure document in the context of an offering of securities is the prospectus, in which underwriters may also provide a very limited amount of information relating to their legal names, business names, addresses and roles in the Rule 144A Offering (this is sometimes referred to as "blood letter" information). Conducting Due Diligence and Proper Disclosure in a Rule 144A Offering As a preliminary matter, it is important to establish parameters by which the issuer, its subsidiaries and other affiliates, its or their directors, officers and employees (the "Issuer's Group") can facilitate the disclosure of all material information to the underwriters, underwriters' counsel, issuer's counsel, the auditors and any other party engaged for the purpose of preparing the prospectus and, more generally, for the purpose of conducting a Rule 144A Offering (together with the Issuer's Group, the "Working Group"). The disclosure of material information by the Issuer's Group generally occurs under the following circumstances: the preparation, maintenance and updating of a documentary "data room" until the completion of the transaction; the participation in meetings and discussions with the Working Group (kick-off meetings, management presentations and management due diligence meetings, drafting sessions and conference calls) where matters relating to the Rule 144A Offering, the securities, the business, results of operations, financial condition, material economic and other contractual relationships and business risks relating to the Issuer's Group and the prospectus are disclosed and discussed; and the preparation, drafting, review, amendment, verification and updating (and perhaps even supplementing) of the prospectus.

Identifying Material Information Under the U.S. federal securities laws, a fact is material if there is a substantial likelihood that proper disclosure of that fact would have been viewed by a reasonable investor as having significantly altered the "total mix" of information made available to the investor at the time the investment decision was made. This is a "qualitative" evaluation that is difficult to apply at the beginning of the Rule 144A Offering, when many parties in the Working Group may know very little about the Issuer's Group. As a practical solution to assist the due diligence process, and in part based on standards applied by the accounting profession and 12 guidance provided by the SEC , market participants have developed a "quantitative" threshold by which materiality may be determined on a preliminary basis. However, the quantitative threshold is put in place solely to facilitate the preparation and updating of the data room and the ongoing management due diligence. At the end of the day, the qualitative determination of what information is material, as defined in the preceding paragraph, governs the detail and depth of disclosure that must be provided in the prospectus in order to meet the standards established by the U.S. federal securities laws. The documents that should be prepared for review should regard any obligation (or series of related obligations), occurrence (or series of related occurrences), or agreement (or series of related agreements) that, individually or in the aggregate, has a value or impact (potential or actual) that exceeds the materiality threshold described below. It is possible that documents that do not meet such threshold may nevertheless be material because they contain information that a buyer or seller of the companys shares would want to know, or if known, would affect the market value of the shares. For example, facts, circumstances or documents that reflect on the integrity of key managers or that would restrict or prohibit the company from selling company shares or conducting its business may be material regardless of the amounts involved. In addition, debt obligations will be relevant if they exceed any cross-default thresholds in the Issuer Groups primary lending agreements, and change of control clauses or clauses otherwise triggered by the contemplated securities offering may be material. Material Documents

For most issuers, a general rule of thumb is to consider 5% of pre-tax income as the overall materiality threshold. Given that the disclosure in the prospectus must contain all material information, generally speaking, the documents reviewed in connection with the diligence exercise should be limited to material documents only. Therefore, with respect to contracts, assets or liabilities (including tax

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See 17 CFR Part 211 [Release No. SAB 99] SEC Staff Accounting Bulletin No. 99
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or other litigation, environmental liabilities, etc.), the review is generally limited to those that, unless otherwise material, exceed the quantitative materiality threshold. Counsel for the underwriters normally will furnish the issuer with a document request list that indicates what documents are being sought. It is likely that such a request list will be geared to the particular business activity or activities that the issuer is engaged in, and will be guided by precedent securities offerings by comparable businesses. Such lists may not, however, specifically request all documents that may be material to the issuer's business, so it will be incumbent upon the Issuer's Group to help guide the documentary review in such instances. Finally, with respect to the period of review, it is generally expected that materials for the Groups last three full fiscal years and for the interim period subsequent to the full fiscal year, through the closing of the offering, should be made available (n.b. there may be some circumstances where the look-back period should be up to 5 years). Material Subsidiaries

A general rule of thumb is to treat Issuer Group companies as material for the purposes of the due diligence if their contribution to the Issuer Group is greater than 5% of either total assets or pre-tax income on a consolidated basis. The due diligence exercise will most likely need to include documentation from such companies. Disclosing Material Information: Sources of Form and Substance There are a number of sources in the U.S. federal securities laws that provide guidance on what information is required to be disclosed in a prospectus, and how such information is required to be disclosed, principal among which are the following: Regulation S-X, which provides guidance on the disclosure of financial information in a prospectus; Regulation S-K, which provides guidance on the contents of a prospectus, including a description of the business and the securities of the issuer, the presentation of certain financial information, disclosure on management and certain security holders, and risk factors; Industry Guides 3 through 7 under the Securities Act (dealing generally with disclosure on bank holding companies, oil and gas programs, real estate, insurance and mining, respectively); Form 20-F, which is used by foreign private issuers who file a registration statement with, or report annually to, the SEC; The Plain English Rules under the Securities Act, which provide those preparing a prospectus with guidance on diction and the presentation of information concisely and clearly; and SEC guidance on drafting risk factors and the Operating and Financial Review section of a prospectus.

In the preparation of a prospectus in a Rule 144A Offering, some or all of these resources may have to be taken into consideration in order to meet the disclosure standards under the U.S. federal securities laws. Conclusion The due diligence and disclosure process in a Rule 144A Offering is iterative, requires a significant commitment of time and effort from all members of the Working Group and has been known to engender no small measure of consternation in certain circumstances. We believe, however, that given the high level of securities litigation in the United States, the evolving liability thresholds and the willingness of U.S. federal courts to ensure that underwriters observe standards of behaviour that support the legislative intent of the U.S. antifraud rules, the process will continue to be worthwhile. If you require any further details, please contact Charles Casassa or Dan McNamee.

Travers Smith LLP 10 Snow Hill London EC1A 2AL T: +44 20 7295 3000 F: +44 20 7295 3500 www.traverssmith.com

Charles Casassa Tel: 020 7295 3202 Email: charles.casassa@traverssmith.com

Dan McNamee Tel: 020 7295 3492 Email: dan.mcnamee@traverssmith.com

Travers Smith LLP is a limited liability partnership registered in England and Wales under number OC 336962 and is regulated by the Solicitors Regulation Authority. The word "partner" is used to refer to a member of Travers Smith LLP. A list of the members of Travers Smith LLP is open to inspection at our registered office and principal place of business: 10 Snow Hill, London, EC1A 2AL. We are not authorised under the Financial Services and Markets Act 2000 but we are able, in certain circumstances, to offer a limited range of investment services because we are members of the Law Society of England and Wales and regulated by the Solicitors Regulation Authority. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide. The information in this document is intended to be of a general nature and is not a substitute for detailed legal advice.