Are Your Underwriting Due Diligence Practices Consistent with IIROC’s Expectations? Release of Final Guidance Provides a Valuable Opportunity for an Internal Review

January 2015

Dealer Members of the Investment Industry Regulatory Organization of Canada (“IIROC“) may wish to consider conducting an evaluation of their due diligence policies and procedures in relation to prospectus offerings, to consider whether their practices are consistent with IIROC’s expectations. With the release of its “Guidance respecting underwriting due diligence” (the “Guidance“), IIROC has, for the first time, provided Dealer Members with a codification of common practices and suggestions, some of which may not reconcile with, or may represent a marked departure from, the perceived market standard. A re-examination of internal practices and procedures in relation to prospectus offerings may benefit Dealer Members by ensuring thorough and Guidance-compliant standards are in place. This may not only mitigate common law liability and reputational risk and protect a firm’s investor clients, but also foster fair and efficient capital markets and assist in creating and maintaining confidence in the markets.

As we reported in our article, “IIROC Issues Proposed Guidelines Respecting Underwriting Due Diligence“, in March of 2014, IIROC published proposed guidance with respect to underwriting due diligence and welcomed comments from Dealer Members and other interested parties. The final Guidance differs from the proposed guidance in that it acknowledges the role of judgment and contextual determinations, allowing Dealer Members the flexibility to structure due diligence procedures in accordance with the context of an offering. This recognizes that a “one size fits all” approach to due diligence is neither practical for Dealer Members, nor necessarily beneficial to those relying on Dealer Members to conduct appropriate due diligence.

The Guidance sets out nine principles respecting underwriting due diligence. These principles are set out below, together with related considerations from the Guidance, for consideration by Dealer Members.

1. Policies and Procedures for Underwriting Due Diligence

Principle: 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.

Dealer Members have an obligation to establish, maintain and apply policies and procedures that establish an effective compliance system, to ensure compliance with IIROC rules and applicable securities laws, and to manage business risk in accordance with prudent business practices. Determining what constitutes “reasonable” due diligence requires a contextual determination in the circumstances of the underwriting. Prescriptive checklists alone could fail to take into account the circumstances of the particular offering; policies and procedures should reflect the need for careful consideration and the exercise of professional judgment by senior investment banking and other professionals.

Additional considerations relating to the content and purpose of a Dealer Member’s policies and procedures are contained in the discussion below.

2. Due Diligence Plan

Principle: 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.

Dealer Members need an overall understanding of the business of the issuer and the industry in which it operates in order to determine the scope and objectives of the due diligence investigation. The due diligence plan should be prepared in conjunction with counsel, including counsel in foreign jurisdictions, as applicable, and should reflect the context of the offering and the level of due diligence that will be reasonable in the circumstances. Factors to consider could include matters such as the size, nature and sophistication of the issuer; a Dealer Member’s recent or historical dealings with, and knowledge of, the issuer; whether the issuer is from an emerging market, operates in a highly regulated industry, or is a frequent participant in capital market transactions; the timing of the completion of the financing relative to the issuance of the issuer’s most recent audited financial statements; and the nature of the intended investors in the offering. Care should be taken in the plan to distinguish between business due diligence and legal due diligence and to delegate such due diligence to the appropriate person(s), as discussed below.

The due diligence plan should set out the lead underwriter’s preliminary expectations of the scope of its due diligence investigation and these expectations should be shared with the issuer’s management, legal counsel and auditors. Further, the due diligence plan must be subject to change and should be revisited as due diligence unfolds.

3. Due Diligence Q&A Sessions

Principle: 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.

The due diligence plan should contemplate due diligence “Q&A” sessions at appropriate points during the offering process, providing all syndicate members with the opportunity to ask detailed questions of the issuer’s management, auditors, counsel and any other relevant subject matter experts. Underwriters should work with counsel in the preparation of questions, which should be provided to the issuer’s management, counsel and auditors early enough to allow such enquiries as are necessary for the preparation of thorough and accurate responses. Call participants should include those individuals in the best position to have the necessary information to respond to the enquiries and each syndicate member should be represented by investment banking professionals with an appropriate level of seniority.

A Q&A session is also an opportunity for red flags that arose during the due diligence process to be noted and to confirm, for the benefit of all syndicate members, that the issues have been addressed.

4. Business Due Diligence

Principle: 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.

Business due diligence should be conducted by underwriters, as opposed to legal due diligence, which is conducted by counsel on the underwriters’ behalf. Principal elements of business due diligence include visiting the issuer’s head office and principal operations sites; reviewing the issuer’s business plans, budgets and projections to understand the issuer’s strategy and competitive environment; reviewing the issuer’s key operational data, publicly available disclosure documents and material contracts (or a summary of the terms thereof, prepared by underwriters’ counsel); and reviewing relevant sources of external information relating to the issuer and its business environment, including industry surveys, trade journals, law firm publications, rating agency reports, research analyst reports, industry association/organization publications and internet searches.

The Guidance considers numerous factors in relation to business due diligence, including the establishment of materiality thresholds, from both quantitative and qualitative perspectives; the need for, and extent of, independent verification of material facts; the retention of foreign agents to conduct searches and the potential limitations of such searches; the need for a Dealer Member’s policies and procedures to establish the process to be followed where “red flags” indicate that heightened due diligence and/or enhanced disclosure is required; examples of such “red flags” and how a Dealer Member should respond when “red flags” arise; and matters for Dealer Members to consider when dealing with a foreign issuer or an emerging market issuer

5. Legal Due Diligence

Principle: 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 underwriters should discuss with their counsel the scope of the legal due diligence that counsel will perform, and the due diligence plan should clearly delineate the respective roles of underwriters and their counsel, including the scope of any enhanced legal due diligence that is appropriate in connection with foreign and emerging market issuers. The results of legal due diligence should inform business due diligence and the Dealer Member, with counsel keeping the Dealer Member apprised of any difficulties counsel experiences in obtaining any information requested from the issuer as part of legal due diligence or in obtaining appropriate legal opinions from the issuer’s counsel.

The Guidance suggests that, where it is practical to do so, underwriters’ counsel and the lead underwriter may wish to convene a meeting or conference call with underwriters’ counsel and the entire underwriting syndicate, prior to the Q&A session, to brief the syndicate on the scope of business and legal due diligence and to report on the status and results of any due diligence completed prior to such meeting or call.

6. Reliance on Experts and Other Third Parties

Principle: 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.

While underwriters’ liability in respect of “expertised portions” of a prospectus is limited, underwriters should nonetheless consider whether any such expert is qualified to give its report or opinion and should obtain reasonable evidence that such expert has consented in writing to its report or opinion being used in a prospectus. The Guidance discusses factors that may assist an underwriter in making this determination, including the reputation and qualifications of the firm or individual acting as an expert; whether the firm or individual has the relevant knowledge and expertise; and considerations relating to experts in foreign and emerging markets (in which case corroboration by other experts may be warranted).

Auditors are also experts and audit reports are expert opinions; however, underwriters should review an issuer’s financial statements and the issuer’s auditor should be asked to provide a customary long-form “comfort letter” concerning the financial information contained in a prospectus.

7. Reliance on Lead Underwriter

Principle: 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.

While a lead underwriter may bear additional reputational and regulatory risk, each member of an underwriting syndicate is liable for any misrepresentation in a prospectus and each member of the syndicate must be in a position to establish its own due diligence defence. The lead underwriter typically assumes primary responsibility for conducting and supervising the due diligence investigation, including the preparation of a due diligence plan. The Guidance provides that the preparation of the plan should be done in consultation with syndicate members, that the lead underwriter is responsible for ensuring that syndicate members are updated on the status and results of the due diligence process and that each syndicate member should receive, on request, 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.

8. Due Diligence Record Keeping

Principle: A Dealer Member should document the due diligence process to demonstrate compliance with its policies and procedures, IIROC requirements and applicable securities laws.

Every Dealer Member should maintain records of its due diligence process in order to demonstrate that it 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, all of which must be available for review in an IIROC compliance examination. The Guidance acknowledges that there does not appear to be any file retention policy that is universally adopted by Dealer Members and suggests that a Dealer Member’s policies and procedures should describe which documents must be kept in the transaction file and provide that, if a specified document is not contained in the file, there should be an explanation for its absence.

Some Dealer Members’ policies and procedures require confirmation from senior investment banking professionals that all aspects of the due diligence process have been completed and were in compliance with the firm’s policies and procedures, IIROC rules and applicable securities legislation. If taking this approach, the Guidance provides that it is expected that a Dealer Member’s policies and procedures are comprehensive and set out a robust supervision and compliance process.

9. The Role of Supervision and Compliance

Principle: 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.

Effective due diligence requires both effective supervision and effective compliance.

The role of supervision in underwriting due diligence is to ensure that the business unit itself takes responsibility for the oversight of due diligence activity on an ongoing basis. There should be a senior investment banking professional who is involved throughout the due diligence process who is ultimately responsible for the quality and extent of the due diligence for each offering of securities underwritten by a Dealer Member. For example, if an individual signing a prospectus on behalf of a Dealer Member was not the senior supervisor of the due diligence process, the individual signing the prospectus should seek confirmation from the senior supervisor and underwriters’ counsel that the Dealer Members’ policies and procedures have been followed and that all red flags and difficult or unusual disclosure issues have been appropriately addressed. Supervision may also involve one or more committees of a Dealer Member, typically composed of senior investment banking managers, internal counsel and/or compliance personnel, each of whom can exercise independent judgment.

The underwriting due diligence compliance function may be performed by a Dealer Member’s compliance department, in-house legal department, internal audit department or a combination of such departments. The applicable individuals should have a clear mandate to identify and monitor issues relating to non-compliance with the Dealer Member’s policies and procedures in respect of securities offerings, and to report and escalate such matters in accordance with the Dealer Member’s internal policies and procedures.

Conclusion

The publication of the Guidance provides Dealer Members with clear direction with regards to IIROC’s expectations in relation to underwriting due diligence, which affords Dealer Members with the opportunity to ensure that their policies and procedures in relation to prospectus offerings are in keeping with such expectations. We highly recommend that Dealer Members conduct a review to determine if their policies and procedures should to be updated and revised in light of the Guidance, as we expect that IIROC will focus on this area in its future compliance audits of Dealer Members.

Disclaimer

This publication is provided as an information service and may include items reported from other sources. We do not warrant its accuracy. This information is not meant as legal opinion or advice.

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