IPO Due Diligence for Small and Mid-Sized Offers – What is required?
The answer, according to ASIC, is more than you might think...
ASIC recently issued a report on Due Diligence Practices in Initial Public Offerings (Report) which sets out the key findings from reviews ASIC conducted on the due diligence practices for twelve IPOs including ten small and mid-sized issuers, two large issuers and a sample of offers from emerging market issuers.
Why carry out due diligence?
The Corporations Act 2001 (Cth) (Act) requires a prospectus to contain all information that investors and their professional investors would reasonably require to make an informed assessment of:
- the rights and liabilities attaching to the securities offered; and·
- the assets and liabilities, financial position and performance, profits and losses and prospects of the body issuing the securities.
Under the Act, the issuer, its directors, any underwriters to the offer and each party that has consented to statements in the prospectus may be liable to an investor who suffers loss or damage if an offer is made under a defective prospectus. A prospectus will be considered defective if it contains statements that are misleading or deceptive, there is an omission of information in the prospectus that must be included or if a new circumstance arises after lodgement that the issuer would have been required to disclose if the circumstances had arisen before the prospectus is lodged and a supplementary or replacement prospectus has not been lodged.
The Act contains two key defences to liability for a defective prospectus:
- the due diligence defence, which requires a person to provide that they have made all reasonable inquiries and had reasonable grounds to believe that the statement was not misleading or deceptive or that there was no omission; or·
- the reasonable reliance defence which requires a person to prove that they placed reasonable reliance on information given to them by another person (other than their own director, employee or agent).
As noted in the Report, due diligence is not a process prescribed in the Act nor is there any legal requirement to conduct a due diligence process when preparing a prospectus. However, the practice has developed as a way to ensure that the prospectus is accurate and complete and complies with the requirements of the Act and to provide evidence to assist those liable for a prospectus to rely on the defences referred to above and demonstrate that all reasonable inquiries were made in the circumstances.
What does due diligence involve?
Due diligence for an IPO prospectus will usually entail:
- the appointment of a due diligence committee with delegated authority from the board of the issuer to oversee and co-ordinate the due diligence process;·
- delegation of key tasks to directors, management and advisers to the issuer to ensure the prospectus is properly prepared;
- regular meetings of the committee to review the prospectus and the due diligence activities;·
- carrying out a verification process in relation to each statement of fact or opinion in the prospectus using independent and objective evidence and source documents;·
- provision of reports from various committee members together with a final due diligence report to the Board; and·
- monitoring for new circumstances after the prospectus is lodged and if required, issuing a supplementary or replacement prospectus.
Members of the due diligence committee typically comprise directors (both executive and non-executive), legal advisers, investigating accountants, underwriters and lead managers and tax advisors1.
What were the key findings of the ASIC Report?
The Report sets out the following seven key findings:
- poor due diligence processes will generally result in defective disclosure in a prospectus;
- there is a wide variation in the quality of due diligence adopted by small to mid-sized issuers depending on the sophistication of the issuer and the advisers involved. Generally, small to mid-sized issuers adopted fewer due diligence processes and demonstrated less effort in, and consideration of, the due diligence process;
- a number of issuers took a "form over substance" approach to due diligence including a focus on checklists and completing the process rather than investigating, considering and documenting the consideration of material matters;
- superficial involvement by the issuer's board and a failure of directors to engage in and oversee the due diligence process and preparation of the prospectus;
- poor oversight by Australian legal advisers of due diligence conducted by foreign advisers and a failure to provide foreign directors with translated copies of important documents;
- inconsistent quality of contribution of legal advisers in the due diligence process; and
- cost-cutting during due diligence can lead to significant problems with the prospectus which may result in an ASIC stop order, consequential reputational damage to the issuer and the incurrence of additional costs correcting defective disclosure.
ASIC Recommendations for Effective Due Diligence
ASIC makes the following five key recommendations for conducting due diligence for IPOs:
- issuers should adopt a due diligence process that contains the
Oversight – establishing a due diligence committee to oversee and co-ordinate the due diligence process including providing a final report on the due diligence process and escalating material matters to the Board;
Investigations – including management interviews, director questionnaires and specific investigations by accounting, legal, tax and industry experts;
Record keeping – keeping a key or significant issues list that records all the issues and their resolution;
Verification – verifying all material statements in the prospectus; and
Continuation – continuation of due diligence throughout the offer period including regular meetings of the committee, ensuring new material matters are addressed by the committee and the board and considering whether supplementary disclosure is required;
- issuers and their advisers should conduct (and document) a thorough and investigative due diligence process that promotes informed decision-making by investors and their advisors, adopting a "substance over form" approach;
- directors are responsible for the contents of the prospectus and must make sure that a robust due diligence process has been undertaken, including by applying their own skills, knowledge and experience in assessing all statements in the prospectus, participating in the verification process and making sure all issues identified during due diligence are appropriately resolved;
- identification of material matters that will require an expert opinion and ensuring that appropriate advisers are engaged, including assisting expert advisers to obtain a thorough understanding of the issuer's business; and
- provision of effective oversight of the due diligence work carried out by foreign legal and other advisers in relation to emerging market issuers, including understanding the political and cultural environment in which the issuer operates, local business practices affecting the issuer, local laws affecting the issuer and the issuer's local expert advisers and ensuring that foreign directors are able to effectively participate in the due diligence process and provide informed consent to the lodgement of the prospectus.
A key message from the Report is that ASIC will apply the same standard of due diligence regardless of whether the issuer is a large company, a small to mid-sized company or an emerging market issuer. If you are planning an IPO we recommend you contact us sooner rather than later. As noted in the Report, quality legal advice on due diligence (particularly in the early stages) can save you time and cost in the long run.
1 For more information regarding the responsibilities of the committee and the roles of particular members of the due diligence committee, see pages 12 and 13 of the Report.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.