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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) 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

(ii) 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 law2 that generally regulates securities offerings in the United States, as well as the activities of due diligence

and disclosure, comprises the following:

(i) the U.S. Securities Act of 1933, as amended (the "Securities Act") and the rules, regulations and guidelines promulgated

thereunder;

(ii) the U.S. Securities Exchange Act of 1934, as amended (the "Exchange Act") and the rules and regulations promulgated

thereunder;

(iii) the rulemaking, interpretations and guidance provided by the U.S. Securities and Exchange Commission3 (the "SEC");

(iv) U.S. federal case law.

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".

1 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.

2 This note does not address the securities laws, or "blue sky" laws, of the individual U.S. states.

3 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

out in Exchange Act Rule 10b-5 can be applicable, under the right circumstances, to any person, anywhere.4

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

offering is public or private.5 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

respects6;

• With regard to information in the prospectus provided by an expert, such person (other than the expert) had no reasonable grounds

to believe, and did not believe, that such information was untrue, inaccurate or incomplete in any material respect.7

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

4 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.

5 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.

6 Paraphrasing Securities Act Section 11(b)(3)(A)

7 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

that such defendants knowingly or recklessly made the misstatement or omission (proving so-called "scienter").8 Recklessness has

been defined by U.S. federal courts as "an extreme departure from the standards of ordinary care […] which presents a danger of

misleading buyers or sellers that is either known to the defendant or is so obvious that the defendant must have been aware of it."9

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

knowing, or apparently caring, whether the disclosures regarding those securities are accurate,"10

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

opinion11

. 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).

8

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) 9 Franke v. Midwestern Okla. Dev. Auth., 428 F. Supp. 719, 725 (W.D. Okla. 1976)

10 David W. Bernstein, "Due Diligence and the Legacy of Gustafson" in International Financial Law Review (August 1995).

11 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 property—but 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

guidance provided by the SEC12

, 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 company’s 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 Group’s 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

12 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 Group’s 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.