Section 1 - Practising Law Institute



From PLI’s Course Handbook

How to Prepare an Initial Public Offering 2010

#25172

7

How to prepare an initial public offering: negotiating comfort letters

Deanna L. Kirkpatrick

Davis Polk & Wardwell LLP

March 2010

What is the Purpose of a Comfort Letter

Underwriting agreements for initial public offerings routinely require the delivery of one or more comfort letters from the issuer's accountants as a condition to closing the offering. The comfort letter constitutes an important part of the underwriters' due diligence review of the accuracy of the financial information contained in the registration statement. Consequently, the receipt and examination of a comfort letter is considered a key element in establishing a defense against liability under Sections 11 and 12(a)(2) of the Securities Act of 1933 (the "Securities Act") for the underwriters.

Section 11 of the Securities Act establishes liability on the part of the underwriters of a public offering to any purchaser of the offered security if such purchaser can prove that the registration statement relating to the offering contained "an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading". The underwriters may avoid this liability if they can sustain the burden of proving the "due diligence" defense contained in Section 11(b) of the Securities Act. Comfort letters require the issuer's accountants to perform their own review of the financial information in the registration statement and to report the results of this review to the underwriters. Comfort letters serve as an independent verification of certain information of a financial nature in the registration statement and, with respect to this information, can be a key element in establishing one of the requirements of the due diligence defense — the requirement that the underwriters' conducted a "reasonable investigation".[1] As contemplated by Section 11 itself and Rule 176 under the Securities Act, the level of investigation that constitutes a reasonable investigation and, consequently, the level of comfort that underwriters should require from the accountants with respect to the financial information contained in the registration statement, is a function of a number of factors, including the type of issuer and the type of security.

What is Statement on Auditing Standards No. 72

Statement on Auditing Standards No. 72 ("SAS 72") is designed to provide guidance to accountants in the preparation of comfort letters. First, it addresses whether it is proper for independent accountants to comment on specified matters in a comfort letter and, if so, the form such a comment should take. Second, SAS 72 offers practical suggestions on which form of comfort letter is suitable in a given circumstance, procedural matters, the dating of letters and ways to bring information requiring special mention to the attention of the letter's addressees. In this regard, SAS 72 sets forth the contents of sample letters that are very useful in reviewing draft comfort letters. In fact, comfort letters are usually drafted verbatim from the sample letters. As a result, a careful review of the draft comfort letter should be made against the examples to ensure that all items permitted to be addressed under SAS 72 are covered. Third, SAS 72 suggests ways of avoiding any uncertainty regarding the nature and extent of the accountants' responsibilities in connection with a comfort letter.

What are the Different Levels of Comfort that the Accountants May Provide on the Issuer's Financial Statements and Stub Period Information

The comfort letter sets forth the procedures the accountants performed as part of their review of the financial information contained in the registration statement and the results of these procedures. The procedures performed in reviewing any particular piece of financial information dictate the level of comfort the accountants are prepared to give on that information.

Audited Financial Statements

Audited financial statements are "expertised" within the meaning of Section 11 of the Securities Act. The Securities Act generally requires that each registration statement for an initial public offering include two years of audited balance sheet data and three years of audited income statement and cash flow data. Non- experts, such as the underwriters, are not liable with respect to "expertised" information if they "had no reasonable ground to believe and did not believe" that such information was untrue or that such information omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.[2] Underwriters satisfy themselves in this respect by obtaining a manually signed copy of the accountants' report on the audited financial statements and a manually signed consent to the use of that report in the registration statement, as well as by discussing the audited financial statements with the issuer's management and independent accountants which could include discussions with the audit committee or chair of the audit committee. Consequently, no additional procedures are required to be performed on the audited financial statements for purposes of preparing the comfort letter. The comfort letter, however, should affirm that the audited financial statements comply as to form in all material respects with the applicable accounting requirements of the Securities Act and related rules and regulations thereunder.[3]

Quarterly Financial Statements

If financial statements have not been audited, which is generally the case with quarterly financial statements, the highest level of comfort available for a public company is a review conducted in accordance with the PCAOB interim review standards for a public company, or Statement on Auditing Standards No. 116 ("SAS 116") for a private company. Although more limited than an audit, an interim review conducted in accordance with these standards permits the accountants to provide the underwriters negative assurance[4] on whether (i) any material modifications should be made to the quarterly financial statements for them to be in conformity with generally accepted accounting principles ("GAAP") and (ii) such financial statements comply as to form with the applicable accounting requirements of the Securities Act.

Unlike the annual financial statements included in the registration statement, which are required to be audited, the quarterly financial statements included therein are not required to be subjected to an interim review. If the accountants do not perform an interim review of the quarterly financial statements, their comfort letter will recite that they have read the quarterly financial statements, compared the amounts contained therein with the issuer's accounting records and found them to be in agreement. (Despite the language of SAS 72, the accountants, as a practical matter, may be unwilling to agree all quarterly amounts with the accounting records.) In addition, the accountants will state that they made certain inquiries of the issuer's accounting staff and that such staff has informed them that the quarterly statements are in conformity with GAAP and comply as to form with the applicable accounting requirements.[5]

In the context of an initial public offering, the issuer may not be familiar with an interim review and may not have requested their accountants to perform one. Depending upon the issuer's business, an interim review of the quarterly financial statements included in a registration statement can be very time consuming and potentially costly. Consequently, the underwriters or their counsel should discuss with the issuer at the organizational meeting the underwriters' requirements regarding comfort on the quarterly financial statements and should not accept less than an interim review without careful consideration of the potential consequences of the accountants' failure to perform such a review.

Monthly Financial Statements

The procedures the accountants perform on any available monthly financial statements (which cover the period from the end of the last fiscal quarter for which quarterly financial statements have been prepared through the date of the most recent monthly statements available) are even more limited than a SAS 100 review.[6] The accountants will read the monthly financial statements and make certain inquiries of management regarding those statements. Based on these procedures, the accountants will generally compare (i) certain balance sheet items set forth in the most recent monthly balance sheet to the corresponding items set forth in the most recent balance sheet included in the registration statement and (ii) certain income statement items set forth in the most recent monthly income statement(s) to the corresponding items set forth in the income statement(s) covering the comparable period of the prior year and, in each case, comment on changes in these items.[7] The line items typically covered include capital stock, long-term debt, consolidated net current assets, stockholders’ equity, net sales, total or per-share amounts of income before extraordinary items and total or per-share amounts of net income. Other line items may be particularly relevant to a financial analysis of the issuer in addition to or in place of those listed. Underwriters' counsel should always discuss the exact line items to be covered with their client. Furthermore, if the accountants report an adverse change in any of these line items, the underwriters or their counsel should immediately request that the change be quantified so that they and the issuer and their counsel can determine whether the magnitude of the change requires additional disclosure in the registration statement.[8] To avoid a "fire drill" at the time of pricing, underwriters' counsel should encourage the accountants to report their findings on changes as early as possible.

Stub Period Information

The comfort provided on any numbers available for the remaining stub period — that is, from the date of the latest available quarterly or monthly financial statements through to the "cut-off" date — is the most limited. At best, the accountants will cover those line items addressed in their comfort on the monthly financial statements. Based on detailed written representations from management and their review of the issuer's minutes, the accountants will typically compare (i) those stub period balance sheet items being comforted to the corresponding items set forth in the most recent balance sheet included in the registration statement and (ii) those stub period income statement items being comforted to the corresponding items for the comparable period of the prior year and, in each case, comment on changes in these items. As with the monthly financial statement line item comparisons, adverse changes should be quantified if possible, reported to the underwriters' counsel as early as possible and, if material, disclosed in the registration statement.

Some issuers, particularly, less experienced issuers, may initially refuse or claim it is impossible to make the representations to the accountants necessary for the accountants to give comfort on stub period financial information. In some cases, their refusal results from the detail or definitiveness of the wording of the representation letter requested by the accountants. In other cases, their refusal results from their reluctance to be responsible for the information in the representation letter. Still other issuers will claim that they have no more current financial information available than the latest monthly financial statements. In such cases the underwriters' counsel and the accountants should explain that financial statements are not the only source of financial information and in order to manage the issuer's business on a day-to-day basis management typically has access to the type of information necessary to enable management to provide appropriate representations to the accountants to provide comfort on the stub period.

Recently, the auditors have increasingly insisted that management does not have a reasonable basis for making the necessary representations and that therefore no negative assurance can be given on the stub period. In 2005, the major auditing firms, through the American Institute of Certified Public Accountants Center for Public Company Audit Firms, issued a White Paper that prohibits the giving of negative assurance if the stub covers all or substantially all of the fourth quarter. Many firms are now applying the same principal to all quarters.

What Other Numbers in the Registration Statement Should be Comforted

In addition to the issuer's financial statements and related information, the accountants will also provide comfort on many of the other numbers included in the registration statement. The underwriters' counsel should identify early in the transaction the other numbers they expect the accountants to comfort and obtain agreement from the accountants to do so. This process should, preferably, be completed prior to the filing of the registration statement with the Securities and Exchange Commission and in any event prior to the printing of the preliminary prospectus in order to avoid having to make corrections in the disclosure that has been publicly circulated. Counsel does so by providing the accountants with a copy of the registration statement marked to indicate (generally by circling) the numbers on which the underwriters will expect comfort.

Generally, the accountants will only provide comfort on and, consequently, the underwriters' counsel should only circle numbers that can be traced to or derived from the issuer's internal accounting records.[9]

In addition to circling numbers, underwriters' counsel should generally also circle statements without numbers that are quantitatively based, such as statements in the MD&A that explain why a particular line item on the income statement or balance sheet increased or decreased (i.e., net income increased in the first quarter of the current year as compared to the first quarter of the prior year as a result of a material increase in the sales of widgets). While the accountants will typically refuse to comfort these types of statements in the abstract, they should be willing to quantify the amount of the increase or decrease and then describe the procedure performed to verify the number allowing the underwriters and their counsel to draw their own conclusions about the consistency of the data and the statement made. Coverage of these statements is far more helpful from a due diligence point of view than coverage of numbers directly traceable to the financial statements because the underwriters and their counsel are seldom otherwise able to verify independently the accuracy of the statements.

Many issuers include in their registration statements operating statistics that are used to measure operating performance which may not be traceable to or derivable from their internal accounting records, such as backlog in the case of manufacturers, occupancy rates in the case of hotels or prices per pound or tons shipped in the case of steel companies. Under certain circumstances, the accountants may nevertheless be prepared to comfort these numbers after a thorough investigation of the source of these numbers.[10] In discussing with the accountants whether they are prepared to provide comfort, underwriters' counsel should know whether comfort has been obtained on similar statistics for other issuers in the same industry. If the accountants refuse to comfort these types of numbers, underwriters' counsel, as part of their due diligence, must understand how they were compiled and, depending on the circumstances, review the source material or require officer's certificates regarding the accuracy of their derivation.[11]

As noted above, the level of investigation that constitutes a reasonable investigation and, consequently, the level of comfort that underwriters should require from the accountants with respect to the financial information contained in the registration statement, is a function of a number of factors, including the type of issuer. Consequently, when circling numbers for comfort, underwriters' counsel should consider a number of factors, including the type of issuer. The extent of the circling reflects a recognition both that some numbers are more important than other numbers and that certain issuers are riskier than others. In the context of an initial public offering every number that can be comforted typically should be comforted. Finally industry practice should be considered prior to circling any numbers. For example, the amount of comfort typically requested from the accountants for a foreign private issuer may be less than that requested from the accountants for a company incorporated in the United States.

What are the Different Levels of Comfort that the Accountants May Provide on the Circled Numbers

Once the accountants have received the marked registration statement, they will typically provide a draft comfort letter to the underwriters and their counsel indicating the procedures they will perform and, consequently, the level of comfort they will be prepared to give on each of the circled numbers. Ideally the accountants would trace all circled numbers back to the audited financial statements, the unaudited financial statements on which they have performed a SAS 100 review or the issuer's "internal accounting records". The "internal accounting records" encompass those accounting systems that are subject to the issuer's internal controls, such as the general ledger. As part of the audit process, the accountants routinely review the integrity of the issuer's internal controls and, if such controls are considered weak or otherwise problematic, the accountants typically note these problems in a report to the issuer's board of directors or the board's audit committee.[12] Consequently, knowing that numbers are traceable to or derivable from any system subject to the issuer's internal controls provides comfort that the accountants have reviewed that system and themselves relied on that system for purposes of conducting their audit. Tracing numbers back to sources that are not themselves comforted, provides meaningless comfort.

In a number of instances, the accountants will trace circled numbers back to schedules and analyses prepared by the issuer. Such a level of comfort is appropriate if all of the information on the schedules or analyses is itself traced back to the issuer's accounting records (which, many accountants will claim is implicit in the language in which case they should agree to make it explicit).[13] Such a level of comfort is also acceptable if a circled number is derived from a combination of data that can and data that cannot be traced back to the issuer's accounting records, such as sales per square foot data for a retailer. The sales information is part of the issuer's accounting records but the square footage of its stores typically is not. The appropriate procedure then is to tie the number back to a schedule prepared by the issuer and to trace back to the issuer's accounting records the information in the schedule that can be traced back. Finally, if tracing all of the information back to the issuer's accounting records is prohibitively expensive, it may be appropriate to "audit" certain circled numbers by tracing them back to schedules or analyses and then tracing back a limited number of the items on the schedule or analyses directly to the accounting records.[14]

What Other Forms of Comfort Should be Requested

Comfort on Regulation S-K Disclosure Requirements

In addition to providing comfort on the circled numbers, the accountants will, in certain circumstances, provide negative assurance regarding the conformity of certain quantitative disclosure with the disclosure requirements of Regulation S-K. Accountants typically give this type of comfort with respect to selected financial data (Item 301 of Regulation S-K), supplementary financial information (Item 302 of Regulation S-K), executive compensation information (Item 402 of Regulation S-K), and the ratio of earnings to fixed charges (Item 503(d) of Regulation S-K).[15]

Comfort on Financial Statements of Entities other than the Issuer

In the event that financial statements of an entity other than the issuer, and information derived from the financial information of such entity, will be included in the registration statement, the underwriters' counsel should notify the issuer that the underwriters will expect comfort on those financial statements. If the accountants for that entity are different from the accountants for the issuer, the underwriters will receive two separate comfort letters. Ideally, the comfort letter covering the other entity's financial statements and information should provide the same level of comfort as the comfort letter covering the issuer's financial statements and information provided with respect to the issuer.

In the context of an acquisition, financial information about the acquired company may only appear in the pro forma financial statements. In this context, the accountants for the acquired company may not be willing to provide a separate comfort letter to the underwriters. In such event, the accountants for the issuer should be required to agree the financial information of the acquired company set forth in the pro formas with the audited or quarterly financial statements of the acquired company, if possible.

Comfort on Pro Formas

With respect to any pro forma financial statements appearing in the registration statement, the accountants will typically provide only negative assurance regarding the compliance as to form of those statements with the requirements of Regulation S-X and the application of the adjustments to the historical numbers.[16] The accountants will not address whether the adjustments themselves are reasonable. In rare circumstances, the accountants may be asked to perform a "review" of the pro formas, which is less than an audit but considerably more than the procedures prescribed by SAS 72.[17]

Who is Responsible for Negotiating the Comfort Letter

As is probably abundantly clear by now, the underwriters' counsel is generally responsible for negotiating the comfort letter. Typically the underwriters' counsel is responsible for consulting with the client on the extent of comfort requested, for circling the relevant documents, for obtaining drafts and completed letters in a timely manner, for reviewing drafts, for determining whether the level of comfort is appropriate and for keeping the underwriters fully informed regarding the timing and content of the comfort letter. Any issues on the comfort letter should be discussed with the underwriters as soon as they arise. If the accountants refuse to provide the level of comfort on any number that the underwriters' counsel expects to receive, counsel should discuss the reasons for their refusal. Often the accountants' concerns can be addressed by changing the language of a sentence in which the number appears (e.g., "due to" becomes "primarily due to") or allowing the accountants to disclaim in the comfort letter responsibility for a specific characterization of financial information (e.g., "We express no opinion on the beneficial ownership of the shares."). In general in negotiating the scope of the comfort letter, it is important to remember that the underwriters are trying to establish that they made a "reasonable investigation". As a result, it is important to consider various factors including the nature of the issuer, the past practice, industry practice, cost and timing in determining whether the comfort letter is in an acceptable form.

Who is Eligible to Receive a Comfort Letter

Persons with a Statutory Due Diligence Defense

SAS 72 permits accountants to provide comfort letters to underwriters or to other parties participating in a registered public offering with a statutory due diligence defense under Section 11 of the Securities Act.

Board of Directors

Comfort letters are also addressed to the issuer's Board of Directors who, like the underwriters, may assert a ‘due diligence defense" in any action under Section 11 of the Securities Act. If the issuer or issuer's counsel should complain about the cost of providing the type of comfort letter requested by the underwriters, underwriters' counsel should remind them that the Board is an addressee of that letter and, consequently, a beneficiary of any increase in the comfort provided as a result of the negotiations between the underwriters' counsel and the accountants.

When Should Comfort Letters be Delivered

Typically, the underwriters receive two comfort letters in connection with the closing of an initial public offering, one dated the date of pricing which covers the preliminary prospectus and a second "bring- down" letter dated the closing date which covers the final prospectus.[18] If the underwriters are concerned about the quality of the financial statements, they can request the accountants to deliver a third letter at the time of the circulation of the preliminary prospectus.[19] Sometimes another "bring-down" comfort letter is required on the closing date for the exercise of an over-allotment option. Since this requirement varies depending on the lead underwriter involved in the offering, underwriters' counsel should always check with their client prior to requesting such a "bring-down" comfort letter.[20]

What "Cut-Off" Date Should the Accountants Use for the Purpose of Preparing the Comfort Letter

Every comfort letter contains a "cut-off" date — the date through which the accountants performed their procedures. As a rule of thumb, the "cut-off" date for a bring-down comfort letter should be the date of the underwriting agreement to ensure that the procedures were performed through the pricing date.

-----------------------

[1] In addition to obtaining a comfort letter, the underwriters, as part of their due diligence review of the financial data contained in the registration statement, will confer with the issuer's accounting, financial and executive personnel which may include its audit committee or chair of the audit committee, study financial statements (past and pro forma, audited and unaudited) and confer with the issuer's independent accountants.

[2] The US District Court for the Southern District of New York’s decision in the In Re Worldcom, Inc. Securities Litigation has raised concerns about what it means to have “no reasonable ground to believe”.

[3] Generally, other financial data contained in the registration statement is not "expertised" and the underwriters rely to a great extent on the comfort letter to establish the "reasonable investigation" component of their due diligence defense.

[4] According to SAS 72, negative assurance consists of a statement by accountants that, as a result of performing specified procedures, nothing came to their attention that caused them to believe that specified matters do not meet a specified standard. These procedures may bring to the accountants' attention significant matters affecting the financial information, but they do not provide assurance that the accountants will become aware of any or all significant matters that would be disclosed in an audit. Accordingly, there is necessarily a higher risk that the accountants may have provided negative assurance of the absence of conditions or matters that may prove to have existed than with audited information.

[5] The level of comfort available on any monthly financial statements, stub period financial information and certain other numbers contained in the registration statement will also be adversely affected by the accountants' failure to perform an interim review. For an example of the type of comfort letter that the accountants will deliver if they have not performed an interim review of quarterly financial information, see Example O of the Appendix to SAS 72.

[6] Monthly financial statements may not always exist. In some instances, the issuer may prepare "flash" reports or other financial reports that, from the accountants' perspective, do not rise to the level of "financial statements".

[7] It may not always be appropriate to compare line items set forth in the most recent balance sheet to those set forth in the most recent balance sheet included in the registration statement or items set forth in the most recent income statement to those set forth in the income statement covering the comparable period in the prior year. For example, in a high growth company or a company that recently completed a significant acquisition, the income statement comparison is typically made to the comparable period in the prior quarter.

[8] For an example of such quantification, see Example M of the Appendix to SAS 72

[9] Example of numbers that typically are not derived from the issuer's accounting records include square footage, backlog, number of employees (except as related to a given payroll period).

[10] If the underwriters desire any operating statistics to be comforted, the underwriters should discuss the accountants' ability to provide this comfort very early in the transaction. For certain types of issuers, such as real estate investment trusts, comfort on these types of numbers may be more common.

[11] Accountants will never comfort industry statistics. The underwriters and their counsel are therefore typically responsible for investigating the source of any industry statistics and the reliability of that source.

[12] As part of their due diligence, underwriters' counsel should always review any reports prepared by the accountants on the issuer's internal controls. These reports are referred to as "Management Letters" as well as any presentations to the audit committee.

[13] Even if all of the numbers on the schedules or analyses are traced backed to the issuer's accounting records, this form of comfort can be more limited than tracing the numbers directly back to the accounting records. The accountants typically will not make any representations regarding the completeness or method of compilation of the schedules or analyses which concerns would not arise if the numbers were traced directly to the accounting records.

[14] If, for any reason, the accountants refuse to give comfort on any circled number and the underwriters and their counsel cannot otherwise verify the accuracy of that number to their satisfaction, then the underwriters and their counsel should consider deleting the number from the registration statement.

[15] For an example of this type of comfort, see Example F of the Appendix to SAS 72.

[16] For an example of this type of comfort, see Example D of the Appendix to SAS 72.

[17] To the extent that the pro formas include historical financial statements of the issuer or the acquired company, comfort must be separately requested on those historical financial statements. The wording of Example D does not address the historical components of the pro formas. For a discussion of the issues raised when the accountants for the acquired company are different from the accountants for the issuer, see "Comfort on Financial Statements of Entities other than the Issuer" above.

[18] For an example of a typical "bring down" comfort letter, see Example C of the Appendix to SAS 72. Sometimes the comfort letter dated the pricing date covers both the preliminary and final prospectus. In these circumstances, as a practical matter, the actual comfort letter is agreed upon but not actually delivered until the day after the pricing date.

[19] In connection with public offerings of securities of Latin American issuers, such third comfort letters are occasionally requested.

[20] Underwriters that are comfortable with the analysis that their potential liability under the Securities Act arose as of the date of effectiveness of the registration statement (for Section 11 purposes) and the time of sale (for Section 12 purposes) and that whether there is any misleading statement or omission as of the closing date for any over-allotment option is irrelevant do not require the delivery of a bring-down comfort letter. Those that are uncomfortable with the foregoing analysis do.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download