A UK nomad takes a US company public on the Alternative Investment M a rket (AIM) and is sued in the US by an investor under the anti-fraud provisions of Section 10(b) of the US Securities Exchange Act of 1934 and Rule 10b-5 thereunder. In the complaint, the investor alleges that the admission document failed to include an expert's warning that the oil exploration project might result in a dry well. Has this ever happened? Not to the best of the author's knowledge. Could it happen? It absolutely could.

US courts of the third, eighth and ninth circuits have assumed jurisdiction in a variety of Section 10(b) cases involving non-US plaintiffs suing US companies and non-US companies in connection with the sale of securities not listed on any US securities exchange, where the sales took place outside of the US.

Cases in point are Continental Grain (Australia), Kauthar SDN BDH v Sternberg, Securities and Exchange Commission (SEC) v Kasser and Grunenthal. In these cases the US courts found sufficient contact with the US to vest them with jurisdiction based on:

. the use of telephone and mail in communicating misrepresentations and omissions from the US to outside the US;

. the visit of non-US persons to the

US to discuss with the US company the documents containing such misrepresentations and omissions;

. the fact that the officers and directors resident in the US were the source of misrepresentations and omissions;

. the fact that the proceeds of the over-seas offering were sent to the issuer in the US; and

. the incorporation of the issuer in the US.

Indeed, the preliminary note to Regulation S under the US Securities Act of 1933 cautions that although Regulation S permits the distribution of securities to the public without registration under certain circumstances, it does not limit the applicability of the anti-fraud provisions of the US federal securities laws.

While the potential liability for the nomad arising out of a 10b-5 claim is not as large as that of the issuer, it can materially exceed the nomad's total compensation in the deal. In an attempt to protect themselves against these potentially large liabilities, underwriters routinely insert provisions in the placing agreement that require the issuer to indemnify them against liability they may incur to third parties in connection with misrepresentations and omissions.

However, the SEC is of the opinion that such indemnifications are unenforceable and against public policy. Courts too disfavour indemnification provisions of this type on the grounds that they frustrate the purpose of the US securities laws in assuring thorough and independent investigation by underwriters.

The nomad's defence to claims under the US anti-fraud provisions would be that, after conducting a "reasonable, independent, due diligence investigation" of the issuer, including verifying the contents of the offering documents, it was not aware of any material misstatement or omission associated with the offering. Total reliance by the nomad, however, on the due diligence investigation and report undertaken and produced by issuer's counsel, will, most likely, be insufficient to establish the reasonable due diligence investigation defence, even if the due diligence report is addressed to the nomad.

To better avail itself of the due diligence defence, the nomad should engage its own independent legal counsel to review the legal due diligence report produced by issuer's counsel and satisfy itself that the report is comprehensive and covers the relevant issues. A good starting point is to review the issuer's due diligence report against the account-ant's long-form report, to make sure that any issues mentioned in the latter are satisfactorily addressed by the former. To the extent that the nomad's counsel is dissatisfied with the comprehensiveness and quality of the due diligence report, the nomad's counsel will have to get more involved in the due diligence process by interviewing the issuer's counsel, or the issuer's management and where necessary, reviewing the issuer's underlying documents.

In certain instances, the issuer, eager to get the AIM financing closed as quickly as possible, might perceive the nomad counsel's wading into the due diligence as obstructive. One wonders whether the industry custom by which the nomad asks the issuer to approve the additional legal costs that arise out of the nomad counsel's deeper involvement in the due diligence process compromises the independence of the nomad's counsel and what effect this might have upon the success of the "reasonable, independent due diligence" defence in the event of a 10b-5 claim.

As additional protection against the possibility of a 10b-5 claim in the US, and to bolster its due diligence defence, the nomad might ask issuer's counsel to provide a '10b-5 negative assurance letter,' commonly referred to as a '10b-5 opinion,' which states that the counsel that conducted the due diligence investigation is not aware of any material misstatement or omission in the prospectus associated with such offering. While the 10b-5 negative assurance letter does not rise to the level of a legal opinion, it does add layers to the underwriter's due diligence defence.

Although such 10b-5 opinions are given as a matter of course when capital is raised in the US, the nomad will likely meet stiff resistance to the giving of such an opinion when capital is raised in a pure Regulation S offering outside of the US. Issuer's counsel might justify such refusal by claiming that:

. the detailed UK verification process of the admission document renders a 10b-5 opinion redundant;

. that the process involved in rendering it is too expensive;

. that the possibility of being sued in the US in respect of an offering that took place outside the US is remote and that in any event, issuer's counsel will provide the nomad with a comfort letter under Rule 39 of the AIM Rules.

Although each of these arguments has its merits, they also have their flaws. First, the verification process focuses on a line-by-line check of what is written in the admission document but, unlike the 10b-5 opinion, may not focus on what is omitted from the document. Second, unlike the 10b-5 opinion, the Rule 39 typically contains exculpatory language to the effect that the nomad may not use it against counsel that produced it.

What with the recent spate of profit warnings issued by US companies listed on AIM, perhaps it is time for the nomads to ask for 10b-5 opinions and to give their own counsel a broader mandate.

Raphael Grunfeld is a partner at Carter Ledyard & Milburn in New York.