Underwriting Due Diligence – IIROC Proposed Guidance
March 17, 2014
On March 6, 2014, the Investment Industry Regulatory Organization of Canada published a Rules Notice and Request for Comments in connection with the release of proposed guidance respecting underwriting due diligence (Proposed Guidance). The purpose of the Proposed Guidance is to promote consistency and enhance due diligence process standards among IIROC Dealer Members.
Comments on the Proposed Guidance have been requested by IIROC by June 4, 2014.
Existing Due Diligence Process
In the context of a public securities offering, due diligence is undertaken by the underwriters to ensure that all required information is included in the prospectus, that the information provided by the issuer included in the prospectus is accurate and that all material facts are clearly presented. This process is also undertaken in order for the underwriters to be comfortable signing the prospectus certificate, which provides that to the best of the underwriter’s knowledge, information and belief, the prospectus constitutes full, true and plain disclosure of all material facts relating to the securities offered by the prospectus.
The scope of due diligence carried out by an underwriter is informed by the liability that exists under securities legislation for any misleading or untrue statement or omission to state a material fact in a prospectus and the defence available from such liability if the underwriter did not know, and in the exercise of reasonable diligence could not have known, that the prospectus contained a misrepresentation. This defence is generally referred to as the "due diligence defence" and is available if an underwriter has conducted such reasonable investigation as to provide reasonable grounds for a belief that there was no misrepresentation in the prospectus. Securities legislation does not prescribe what due diligence is required for a particular financing, and aside from court decisions, securities regulatory settlement agreements and the focused recommendations of the Ontario Securities Commission’s March 2012 Emerging Markets Issuer Review (EMIR), little recent guidance exists relating to underwriters’ due diligence standards.
Due Diligence Standards and the Proposed Guidance
In light of the foregoing, IIROC established an industry advisory committee (Industry Committee) comprising senior representatives from numerous Dealer Members in order to solicit input into the current and best practices for underwriting due diligence. The Industry Committee was also tasked with identifying any gaps or deficiencies in current due diligence practices and ways to address such gaps or deficiencies. IIROC’s dialogue with the Industry Committee was informed by the Investment Industry Association of Canada’s 2006 Corporate Finance Due Diligence Guidelines (IIAC Due Diligence Guidelines), as well as IIROC’s benchmarking of regulatory requirements/guidance from international jurisdictions. After its conversation with the Industry Committee, IIROC staff also consulted with the National Advisory Committee, the Executive of the Compliance and Legal Section advisory committee, a group of western Dealer Members with specific experience in the venture market, the IIAC Small Dealers/Introducing Firms Committee and a group of senior securities lawyers who represent Dealer Members in public offerings. The community appears to have been well canvassed.
IIROC’s Regulatory Expectations and Best Practices
The Proposed Guidance emphasizes the importance of the due diligence process, highlighting that Dealer Members, as "gatekeepers to the capital markets," should take an approach to due diligence that goes beyond the avoidance of liability and mitigation of risk. IIROC believes that due diligence must not put "form over substance" and expects its Dealer Members to exercise professional judgment to determine the appropriate level of due diligence in each particular circumstance.
To foster the foregoing, the Proposed Guidance underlines the baseline principle that each Dealer Member is expected to have written policies and procedures in place relating to all aspects of the underwriting process and to have effective oversight of these activities. The Proposed Guidance continues by providing additional principles and commentary to guide Dealer Members in the creation of and adherence to acceptable policies and procedures. Following a selection of important implications of the Proposed Guidance for Dealer Members, the full text of each principle set forth in the Proposed Guidance, as well as certain key considerations raised in IIROC’s commentary on the principles, are provided below.
Implications of the Proposed Guidance
- Dealer Members, compliance teams and counsel should review the principles and commentary in the Proposed Guidance against existing due diligence policies and procedures as the Proposed Guidance will likely be used by IIROC in its due diligence compliance reviews in the future;
- Dealer Members should have written policies and procedures as to what due diligence will be undertaken in particular circumstances;
- Each financing requires a due diligence plan appropriate to the particular transaction;
- Dealer Members should have a comprehensive and effective supervisory and compliance framework to ensure compliance with the policies and procedures;
- If a Dealer Member determines that it should diverge from its policies and procedures in any respect as a result of the circumstances of a transaction, that divergence should be subject to an appropriate supervisory framework and the reasons for that divergence should be clearly documented in the Dealer Member’s record-keeping;
- Record-keeping on the due diligence process should be consistently applied by the Dealer Member for each deal;
- Syndicate members should satisfy themselves that the lead underwriter performed appropriate due diligence, and there should be open communication within the syndicate about the diligence findings;
- The Proposed Guidance is not intended to apply to Dealer Members participating in private placements, although IIROC has indicated that some aspects of it may be helpful to Dealer Members participating in exempt offerings; and
- The Proposed Guidance, when published in its final form, will likely become the reference point (superseding the IIAC Due Diligence Guidelines and the EMIR) for not only compliance reviews by IIROC, but also for any court or regulatory action surrounding offerings gone bad and steps taken by underwriters to ensure proper disclosure.
Policies and Procedures Required
Each Dealer Member is expected to have written policies and procedures in place relating to all aspects of the underwriting process and to have effective oversight of these activities. These policies and procedures should reflect that what constitutes reasonable due diligence involves, for each underwriting, a contextual determination.
Internal policies and procedures are a critical component of an effective compliance, supervisory and risk-management framework; What constitutes "reasonable" due diligence requires a careful consideration of the particular offering and the exercise of professional judgment by senior investment banking and other professionals within the Dealer Member, as a result, beyond certain basic elements, effective due diligence should go beyond prescriptive checklists alone.1
A Dealer Member’s policies and procedures should also establish the process to be followed when circumstances that may constitute "red flags" indicate that heightened due diligence and/or enhanced disclosure is required.
A Plan for the Transaction
Due Diligence Plan: The Dealer Member should have a due diligence plan that reflects the context of the offering and the level of due diligence that will be reasonable in the circumstances.
Plan should be prepared in conjunction with underwriters’ counsel and will generally include a list and description of the matters to be investigated; Plan will, of necessity, be iterative and subject to change as circumstances change, and may be tailored to reflect the Dealer Member’s structure and operations; In creating a plan, contextual matters such as those highlighted in Appendix B to the Proposed Guidance should be considered; Plan may reflect that less extensive due diligence procedures may be reasonable for seasoned, significant and widely followed issuers, in particular those with whom the Dealer Member is familiar as a result of an ongoing relationship (as lender, investor, financial advisor or financier); Plan may also reflect the type of offering, with certain offerings, such as initial public offerings or offerings of emerging market issuers, generally requiring enhanced due diligence, and other offerings, such as "bought deals," where reasonable due diligence procedures may not be completed until prior to the certification of the final prospectus by the underwriters.2
Due Diligence Q&A Sessions: Due diligence "Q&A" sessions should be held at appropriate points during the offering process and are an opportunity for all syndicate members to ask detailed questions of the issuer’s management, auditors and counsel.
Business Due Diligence: The Dealer Member should perform business due diligence sufficient to ensure that the Dealer Member understands the business of the issuer and the key internal and external factors affecting the issuer’s business. A Dealer Member should use its professional judgment when determining which material facts will be verified independently depending on the circumstances of the transaction.
Dealer Members are expected to exercise professional judgment taking into account all relevant factors in determining which factual statements in the prospectus will be verified independently; Files, documents or other information that are selected to be reviewed or verified by the Dealer Member should not be chosen solely by the issuer’s management; For equity offerings, best practices also include consulting research analysts and other industry experts with respect to the issuer within the underwriters’ affiliates, subject to applicable regulatory requirements and confidentiality rules; Where appropriate (and taking into account applicable securities laws against "tipping"), Dealer Members should consider conducting their own background checks on an issuer’s board of directors, executive officers and other key members of management as well as interviewing the issuer’s customers, suppliers and the counterparties to an issuer’s material contracts to better understand the issuer’s market and to confirm representations and other information included in the prospectus; Dealer Members should also consider issues specific to emerging market issuers, such as those raised in the EMIR and the Ontario Securities Commission’s Staff Notice 51-720 – Issuer Guide for Companies Operating in Emerging Markets, including retaining experts or professional advisors with expertise in dealing with foreign issuers; Any red flags should be followed up on with requests for additional information or involvement by independent experts or other third parties, as applicable; The Dealer Member should be satisfied with the results of any additional due diligence before completing the offering and should maintain a record that details how the issue was resolved.
Legal Due Diligence: Dealer Members should clearly understand the boundary between business due diligence and legal due diligence, to ensure that matters that should be reviewed by the underwriters are not delegated to underwriters’ counsel. Dealer Members should provide adequate supervision of the legal due diligence performed by underwriters’ counsel.
Lead underwriter should discuss with underwriters’ counsel the scope of the legal due diligence that counsel (including any specialized and/or foreign local counsel) will perform, and the due diligence plan should clearly delineate the roles of the underwriters and their counsel; The Dealer Member should review any summaries of the issuer’s material contracts prepared by counsel as part of the business due diligence process; Underwriters’ counsel should be prepared to communicate the results of legal due diligence to the entire underwriting syndicate; Where it is practical, underwriters’ counsel and the lead underwriter may wish to convene a meeting or conference call to update the underwriting syndicate on the status of due diligence matters prior to the management Q&A session.3
Reliance on Experts and Other Third Parties: The extent to which a Dealer Member should rely on an expert opinion is a contextual determination, having regard to the qualifications, expertise, experience, independence and reputation of the expert.
Underwriters should consider whether an expert is qualified to give a report or opinion and should obtain reasonable evidence that such expert has consented in writing to the inclusion of its report or opinion in the prospectus; With respect to experts resident in foreign markets, the Dealer Member should consider an expert’s credentials, knowledge and experience (with the assistance, where appropriate, of Canadian experts from the same field) and assess whether they are similar to what would be expected of an expert in the same field in Canada; Underwriters should read the issuer’s financial statements contained in a prospectus and the issuer’s auditor should be asked to provide a customary long-form "comfort letter" concerning the financial information contained in the prospectus, as well as to participate in the Q&A sessions conducted by the underwriters; For third parties not clearly recognized as "experts" under securities legislation, Dealer Members should take into account the expertise, experience and reputation of such experts in determining the appropriate level of reliance.
Reliance on Lead Underwriter: Each syndicate member is subject to the same liability for misrepresentation under securities legislation. A syndicate member should satisfy itself that the lead underwriter performed the kind of due diligence investigation that the syndicate member would have performed on its own behalf as lead underwriter.
Lead underwriter will typically assume primary role in conducting and supervising the due diligence investigation, including preparing the due diligence plan in consultation with the syndicate, and in ensuring the syndicate is updated on the status and results of the due diligence process; Each syndicate member should receive copies of all letters, opinions or memoranda relating to the underwriters' due diligence investigation, and should be invited to and given the opportunity to ask questions of the issuer and its counsel and auditors during the Q&A session.
Due Diligence Record-Keeping: A Dealer Member should document the due diligence process to demonstrate compliance with its policies and procedures, IIROC requirements and applicable securities laws.
A record of the due diligence process should be maintained in order to be in a position to demonstrate that the Dealer Member conducted a reasonable due diligence investigation, followed its own policies and procedures and complied with IIROC requirements and record-keeping obligations under applicable securities laws; The applicable documentation may be kept by the Dealer Member or by its counsel.4
Role of Supervision and Compliance
IIROC Dealer Member Rule 38 requires each Dealer Member to have a comprehensive and effective supervisory and compliance framework in place to ensure compliance with policies and procedures, IIROC requirements and applicable securities laws. A Dealer Member’s execution of the prospectus certificate should signify that the Dealer Member has participated in the due diligence process through appropriate personnel and internal processes.
Appropriate approaches to supervision and compliance may differ among Dealer Members depending on the nature of the activities and/or the characteristics of the Dealer Member; There should be a senior investment banking professional who is involved throughout the due diligence process (not just at the conclusion of the process) and is ultimately responsible for the quality and extent of the due diligence for each offering of securities underwritten by the Dealer Member; Any difficult or unusual disclosure issues should be escalated to a senior investment banking professional; Supervision may involve one or more committees of the Dealer Member, and the use of a committee structure depends on the size, nature and extent of the Dealer Member’s business activity; A compliance framework involving any one or a combination of the compliance, in-house legal or internal audit departments of a Dealer Member is acceptable so long as the applicable individuals have a clear mandate to identify and monitor issues relating to non-compliance and to report and escalate such matters in accordance with the Dealer Member’s internal policies and procedures.
1 Many Dealer Members, some acting on the advice of counsel, have been reluctant to use prescriptive checklists to define the scope of a reasonable due diligence investigation out of a recognition that no two offerings are identical and that professional judgment needs to be applied in the context of each offering.
2 In our experience, aside from initial public offerings, it is fairly unusual for underwriters to prepare a written due diligence plan. Unless this aspect of the Proposed Guidance changes before it is finalized, we would anticipate that Dealer Members will change their practices to require some form of written due diligence plan to be prepared in consultation with underwriters’ counsel for each public offering. Ultimately, we would expect any such plan to be iterative, as circumstances will develop over the course of completing a due diligence investigation in the context of any particular offering that may necessitate modifications to the original due diligence plan, some of which may not be captured in writing.
3 In our experience, it is not currently a routine practice to convene a separate syndicate call or meeting with underwriters’ counsel to discuss the due diligence plan and results of the due diligence investigation in advance of the management Q&A session. Unless this aspect of the Proposed Guidance changes before it is finalized, we would anticipate that at least some Dealer Members will make such calls or meetings part of their standard due diligence procedures for public offerings.
4 Many Dealer Members, some acting on the advice of counsel, have been reluctant to keep copies of all draft documents, call reports, memoranda, margin notes and other due diligence records in their permanent files and have document-retention policies that require the culling of all non-essential documents in the absence of any legal or regulatory proceeding. In our experience, the lead underwriter and underwriters’ counsel typically retain the bulk of due diligence documentation on behalf of the entire syndicate and little real benefit would be obtained from providing duplicate copies of the entire due diligence file to syndicate members. The Proposed Guidance is not entirely clear with respect to IIROC’s expectations concerning due diligence record-keeping, although it appears that IIROC is unsatisfied with the wide range of approaches to due diligence record-keeping currently taken by Dealer Members. Dealer Members and other market participants may seek to clarify IIROC’s expectations on due diligence record-keeping as part of the public comment process concerning the Proposed Guidance.