Canada: Setting A Strong Foundation: IIROC Publishes New Guidance For Underwriter Due Diligence

Last Updated: March 13 2014
Article by Stephen P. Robertson and Robyn Bourgeois

Most Read Contributor in Canada, September 2016

The Investment Industry Regulatory Organization of Canada (IIROC) believes  that its Dealer Members play an important role as one of the gatekeepers to the Canadian capital markets. Dealer Members and individuals performing due diligence investigations on their behalf should take an approach to due diligence that goes beyond the avoidance of liability and mitigation of risk to Dealer Members. IIROC's recently proposed guidance (the Guidance) for its Dealer Members in the context of public securities offerings is an effort to promote consistency and enhanced standards in the underwriting due diligence process.

In developing the Guidance, IIROC established an industry advisory committee to solicit input on the current and best practices for underwriting due diligence. The committee was comprised of senior industry representatives from 21 Dealer Members and reflected a cross-section of large, medium and small firms with regional representation across Canada. In addition, IIROC consulted with various other experts in formulating the Guidance. While the Guidance is intended to codify common practices and suggestions for underwriting due diligence, the Guidance has been prepared by and reflects the views of IIROC staff on what constitutes, or should constitute, common practice.

Details of the Proposed Guidance

The common practices and suggestions relate to nine different areas, each of which is described below. IIROC has set out a specific principle to apply to each of the nine areas as general guidance, with additional explanation, examples and clarification provided. The common practices and suggestions may not be relevant or appropriate in every case. In the Guidance, IIROC acknowledges that due diligence is a fluid and evolving process that should be customized to the particular circumstances of each offering and that underwriters are expected to exercise professional judgment to determine the appropriate level of due diligence in the particular circumstances. It should also be noted that the Guidance is not intended as a minimum or maximum standard of what constitutes reasonable due diligence or to create any new, or modify any existing, legal obligations.

  1. Dealer Members' 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. Due diligence in connection with a public offering should include the Dealer Member taking reasonable steps to ensure that all prescribed information is included in the prospectus, investigating the information provided by the issuer for inclusion in the prospectus and verifying key material facts, so that the Dealer Member can responsibly provide the certificate in a prospectus that, to the best of its knowledge, information and belief, the prospectus contains full, true and plain disclosure of all material facts relating to the securities being offered.

What constitutes "reasonable" due diligence involves a contextual determination in the circumstances of each underwriting, requiring consideration of the circumstances of the offering and the exercise of professional judgement. Due to this contextual nature, effective due diligence should go beyond prescriptive checklists alone, as such an approach would be superficial and often incomplete.

This first principle is the overarching principle of the Guidance, and the remaining eight principles are intended to supplement and be considered for inclusion in the policies and procedures that a Dealer Member establishes and maintains.

  1. 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.

IIROC expects that Dealer Members will have a thought-out approach to conducting due diligence investigations and that they should have an overall understanding of the business of the issuer and the issuer's industry in order to determine the scope and objectives of the due diligence investigation. The due diligence plan should be created in conjunction with underwriters' counsel (including local counsel in foreign jurisdictions, where applicable) and set out the lead underwriter's expectations with respect to the due diligence investigation. It would be appropriate to share these expectations with the issuer, so that they will be in a position to respond appropriately to due diligence inquiries.

Due diligence plans should be created in light of the context of the offering and the level of due diligence that will be reasonable in the circumstances. The Guidance indicates that potentially less extensive due diligence may be appropriate for a seasoned, significant and widely- followed issuer or where the Dealer Member has a long-standing relationship with the issuer. In addition, the due diligence plan may also reflect the type of offering such as IPOs and public offerings by emerging issuers which may require more extensive due diligence. With respect to "bought deal" offerings, while the timing of such offerings may not allow for extensive due diligence to be conducted prior to launch, it is expected that reasonable due diligence will be completed before the underwriters certify the final prospectus.

  1. 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.

IIROC sees due diligence "Q&A" sessions to be important parts of the due diligence process. The due diligence plan should contemplate such sessions at appropriate points during the offering process (typically, for equity offerings, one prior to filing the preliminary prospectus and a "bring-down" session prior to filing the final prospectus). Dealer Members should not just leave the questions to underwriters' counsel, but should also participate in their preparation. The questions should be provided to the issuer's management, counsel and auditors far enough in advance of the session so that representatives have sufficient time to conduct the necessary inquiries for them to be able to respond as thoroughly and accurately as possible. The individuals in the best position to have the necessary information should participate in such sessions. In addition, all members of the syndicate should be permitted to participate in  the sessions and should be represented by senior investment banking professionals.

  1. 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.

The due diligence plan should specifically distinguish between the matters the underwriters will address in their due diligence, which IIROC refers to as business due diligence, and the matters underwriters' counsel will address in their due diligence, which IIROC refers to as legal due diligence. Certain matters which IIROC considers to be the principal elements of business due diligence include: visiting the issuer's head office and principal operation sites; reviewing the issuer's business plan, budgets and projections; reviewing the issuer's public disclosure and comparing it to comparable issuers to identify any anomalies that may warrant further investigation; reviewing the issuer's key operational data; reviewing the issuer's material contracts, litigation and regulatory correspondence; and conducting in- depth discussions with the issuer's management, financial and accounting personnel, independent auditors and external legal counsel.

A key component of business due diligence is the independent verification of key material facts contained in the prospectus. The level  of independent verification is dependent on the circumstances and Dealer Members are expected to exercise their professional judgment in determining which factual statements will be verified independently. Independent verification may require Dealer Members to conduct background checks of the issuer's directors and management (including through local agents in foreign jurisdictions if any directors or members of management are located outside Canada) and to conduct interviews of the issuer's customers, suppliers and counterparties to material contracts where appropriate. Dealer Members should take appropriate measures to ensure that the information provided to such parties in the course of these inquiries does not constitute tipping.

A Dealer Member's policies and procedures should specifically address how to deal with any "red flags" that are identified. If any red flags are identified during the due diligence process, they should be followed up on by the Dealer Members, with independent experts or other third parties as appropriate, and a record of how the red flag was resolved should be maintained. IIROC provides examples of red flags including significant changes in the issuer's business during the past 12 to 24 months, unusual year-over-year growth and recent controversy surrounding the issuer or any of its directors or senior officers.

  1. 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.

Legal due diligence should be performed by underwriters' counsel at the direction of the lead underwriter pursuant to the due diligence plan. The lead underwriter should discuss with underwriters' counsel the scope of the legal due diligence and the due diligence plan should clearly delineate the respective roles of the underwriters and their counsel. The results of the legal due diligence should inform the ongoing business due diligence process and the Dealer Member should follow up on missing records or information discovered during the legal due diligence process that appears to contradict management's oral statements or the disclosure in the prospectus. As underwriters' counsel represents the entire syndicate, underwriters' counsel should be prepared to provide the results of the legal due diligence to  the entire syndicate, absent any special limitations in the retainer of underwriters' counsel. Dealer Members, when acting as lead underwriter, should also consider holding a preliminary meeting with the members of the syndicate and underwriters' counsel to discuss the scope of the business and legal due diligence and to report on the status and results of the due diligence process, prior  to any due diligence "Q&A" sessions. This would permit syndicate members to have an opportunity to comment on the adequacy of the due diligence plan.

  1. Dealer Members' 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.

In order to be able to rely on the "reliance on experts defence", Dealer Members should consider whether any purported expert who prepared a report, opinion or statement which is contained in the prospectus does in fact qualify as an expert. This would include reviewing the expert's reputation and qualifications, whether the expert has the necessary subject matter expertise and the independence of the expert. A similar process should be undertaken for foreign experts, including reviewing their credentials, knowledge and experience and assessing whether those qualifications are similar to what would be expected of a similar Canadian expert, including whether their professional governing bodies and standards of care those experts are held to, if any, are sufficient. Further, Dealer Members should obtain reasonable evidence that any expert has consented in writing to its report or opinion being used in the prospectus.

An issuer's auditor is an expert for the purposes  of securities legislation and accordingly, an auditor's report is an expert opinion that is subject to the reliance on experts defence. However, Dealer Members should obtain a customary long-form comfort letter from the issuer's auditor concerning the financial information contained in the prospectus. Auditors should also be required to participate in the due diligence "Q&A" session so that questions can be asked of them.

While not expressly stated by IIROC, Dealer Members should consider the role of other experts in the preparation of the prospectus and the information contained therein, and make a determination as to whether the other experts should be required to attend the due diligence "Q&A" session.

  1. Syndicate members' reliance on the 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.

As each member of the syndicate is subject to the same liability for any misrepresentation in a prospectus (subject to provisions capping the statutory civil liability to the amount underwritten), each underwriter has its own obligation to establish its own due diligence defence.

The lead underwriter is typically expected to assume primary responsibility for conducting and supervising the due diligence process, including the preparation of the due diligence plan in consultation with the members of the syndicate, and for keeping the other members of the syndicate appraised of the status and results of the due diligence investigation. IIROC expects that as a result of this ongoing consultation and reporting, each member of the syndicate should be able to satisfy itself that the lead underwriter has performed the kind of due diligence investigation that the syndicate member would have performed on its own behalf as lead underwriter. However, each syndicate member should be provided with copies of all letters, opinions or memoranda relating to the due diligence investigation and be given the opportunity to ask questions of the issuer and its counsel and auditors during the due diligence "Q&A" session.

  1. Due diligence record-keeping by Dealer Members

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

Each Dealer Member is responsible for keeping its own records of the due diligence process,  to be kept by either the Dealer Member or its legal counsel as set out in the Dealer Member's policies and procedures. The information should be made readily available in the event that IIROC conducts a compliance examination. The Dealer Member's policies and procedures should also contain a list of all the documents the Dealer Member should be maintaining on file, or alternatively have a comprehensive and robust supervision and compliance process in place if the Dealer Member is relying on a senior investment banking professional to confirm that all due diligence aspects have been completed and were in compliance with its policies and procedures, IIROC rules and applicable securities laws. IIROC suggests Dealer Members maintain, at a minimum, a record of any committee meetings (and attendance) and a record of the due diligence "Q&A" session. IIROC does not require a specific retention policy to be implemented.

  1. The role of supervision and compliance in the due diligence process

Principle: IIROC Dealer Member Rule 38 requires each Dealer Member to have a comprehensive and effective supervisory and compliance framework inplace to ensure compliance with policies and procedures, IIROC requirements and applicable securities laws. A Dealer Member's execution of the prospectus certificate should signify thatthe Dealer Member has participated in the due diligence process through appropriate personnel and internal processes.

In order for there to be effective supervision over the entirety of the due diligence process, a senior investment banking professional should be involved throughout the entirety of the due diligence process and should ultimately be responsible for the quality and extent of the due diligence. All difficult or unusual matters should be escalated to this senior person for resolution. If the person signing the prospectus on behalf  of the Dealer Member was not the senior person responsible for the due diligence process, the signatory should confirm with the senior person that the Dealer Member's due diligence policies and procedures were properly complied with and that all red flags have been appropriately addressed.

Application to Private Placements

Currently, the Guidance is not proposed to apply to private placement offerings. However, we would suggest that a Dealer Member that strays substantially from the Guidance in connection with a private placement offering could expose themselves to potential common law liability and reputational risk if effective due diligence is not conducted. Accordingly, Dealer Members may wish to consider the Guidance in light of all financings they conduct. One of the specific requests for comment that IIROC sets out is whether the Guidance should apply to private placement offerings.

Request for Comments

The Guidance is currently out for comment until June 4, 2014. The Guidance includes a specific set of questions that IIROC is posing to Dealer Members that it is seeking responses to, as well as comments on the Guidance as a whole. For more information regarding the proposed Guidance, or if you would like input or assistance with respect to  a submission to be made to IIROC, please contact one of the authors below or your usual BLG lawyer.

About BLG

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.

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