The due diligence defense is a defense against claims of securities fraud under Section 11 of the Securities Act. The rationale for the due diligence defense is that parties involved in drafting the registration statement who conducted sufficient investigation should not be liable, even though they did not uncover the misrepresentation.
Which Parties Can Take Advantage of the Due Diligence Defense
Under Section 11, issuers, underwriters, officers and directors of the issuer, and any expert who helped prepare the registration statement may be liable for securities fraud if the registration statement contains a misrepresentation. Section 11 creates defenses which exonerate certain parties from liability depending on the party’s status. The issuer is strictly liable, so the due diligence defense is unavailable for them. For other parties, the due diligence defense hinges on whether the party was an expert or non-expert, and whether the misrepresented part of the registration statement was prepared by experts or not, i.e. expertise.
Standards to Meet Based on Expert Status
While Section 11 does not specify which parties are experts and non-experts, top executive officers of the issuer, underwriters, and outside directors of the issuer with some specific role in the offering (e.g. an attorney-director) are considered non-experts. Experts are individuals who gave professional authority to a statement in the registration statement, and include auditors, lawyers, engineers, or appraisers. Expertised portions of the registration statement are those prepared by experts, and non-expertised portions are any other portion. For example, an audited financial statement would be expertised, and the auditor would be an expert for that portion, while an underwriter would be a non-expert for that portion. See the following for the standard that individuals must meet to satisfy the due diligence defense based on their expert status and the expertise status of the registration statement.
- Non-experts’ standard for non-expertised portions: Under Section 11(a)(4), non-experts must have reasonably investigated the non-expertised portions of the registration statement, and had reasonable ground to believe and actually did believe the misrepresentation in those portions.
- Non-experts’ standard for expertised portions: Under Section 11(b)(3)(C), non-experts do not have any duty to investigate expertised portions. Rather, they must only have no reasonable grounds to believe that the portion was untrue and did not actually believe it was untrue.
- Experts’ standard for expertised portions: Under Section 11(b)(3)(B), experts have a duty of reasonable investigation in their expertised portions and must have a reasonable ground to believe and actually did believe the statement.
- Experts’ standard for non-expertised portions: Under Section 11(a)(4), experts have no liability for non-expertised portions.
[Last updated in February of 2022 by the Wex Definitions Team]