## Facts

- WorldCom publicly disclosed in June 2002 that it had materially overstated earnings by improperly capitalizing line-cost expenses, inflating reported profits and cash flow in violation of GAAP.
- Investors brought a consolidated securities class action arising from purchases of WorldCom securities between April 29, 1999 and June 25, 2002.
- The claims at issue concerned § 11 liability for alleged misstatements and omissions in registration statements used for two major WorldCom bond offerings conducted through shelf/short-form registration incorporating prior filings by reference.
- The principal defendants in this opinion were investment banks that served as underwriters for the bond offerings.
- The registration materials included audited financial statements and auditor-related materials (including audit opinions and comfort letters), and also included non-audited and narrative disclosures.
- Plaintiffs asserted the underwriters ignored warning signs, conducted only limited verification, and failed to probe issues reflected in internal assessments and public reporting about WorldCom’s financial condition.
- Plaintiffs also alleged omissions relating to underwriter conflicts of interest connected to relationships with WorldCom.

## Issues

1. Whether WorldCom’s 2001 financial statements concerning line-cost accounting, incorporated into the registration statements, were materially false or misleading for purposes of Securities Act § 11.
2. Whether the underwriters were entitled to summary judgment on the § 11 due diligence defense by showing a reasonable investigation and reasonable grounds for belief in the truth and completeness of the registration statements.
3. How the “reasonable investigation” obligation applies to underwriters in accelerated shelf/short-form offerings that incorporate prior reports by reference, including reliance on audited financials and auditor comfort letters in the presence of warning signs.
4. Whether alleged omissions concerning underwriter conflicts of interest presented triable questions of materiality and due diligence.

## Decision

- The court granted plaintiffs’ motion for partial summary judgment establishing the falsity of WorldCom’s 2001 line-cost financial statements incorporated into the offering registration materials.
- The court denied the underwriters’ summary judgment motions on the § 11 due diligence defense, holding that substantial fact disputes existed as to the reasonableness of the underwriters’ investigation.
- The court treated the adequacy of underwriter verification efforts, the significance of warning signs, and the materiality of alleged omissions (including conflicts) as matters requiring factfinder resolution.

## Legal Principles

- Under Securities Act § 11, underwriters may avoid liability only by proving they conducted a reasonable investigation and had reasonable grounds to believe, and did believe, the registration statement was true and not misleading.
- The use of shelf registration and incorporation by reference may compress offering timelines, but it does not eliminate the statutory duty of reasonable investigation; reasonableness is assessed in context.
- Reliance on audited financial statements and auditor-related assurances is not absolute; warning signs can require greater inquiry and can preclude summary judgment on due diligence.
- Underwriters have an independent obligation to verify non-expertised portions of offering materials, including unaudited interim financial information and narrative disclosures, through reasonable investigation.
- Materiality and due diligence commonly present fact-intensive questions turning on how a reasonable investor would view the information and how a prudent underwriter would respond.

## Conclusion

The court established as a matter of law that WorldCom’s line-cost accounting rendered key incorporated financial statements materially false, but held that the underwriters’ claimed § 11 due diligence—particularly their reliance on audited materials amid alleged warning signs and omissions—presented triable issues for the factfinder.


In re WorldCom, Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004)