The Investment Industry Regulatory Organization of Canada (IIROC) published proposed guidance on March 6, 2014, setting forth nine key principles for underwriting due diligence.
The Role of Underwriters and the Due Diligence Defence
Underwriters may be liable for a claim of damages (to compensate for loss) or rescission (a return of purchase price) if there is a misrepresentation in a prospectus. However, an underwriter is shielded from liability if it conducted a reasonable investigation of the material facts underlying the disclosure in the prospectus. This is referred to as establishing the "due diligence defense". In a public offering, each underwriter communicates that it has undertaken a reasonable investigation by certifying that, to the best of its knowledge, information and belief, the prospectus constitutes full, true and plain disclosure of all material facts relating to the offered securities.
Provincial securities legislation across Canada recognizes that meaningful due diligence depends on the details of the issuer and the offering, and as a result provides no clear guidance on what constitutes a "reasonable investigation". While Canadian courts have addressed the due diligence defense in various judgements, the fact-specific nature of those cases do not lend well to a broad application of due diligence principles. IIROC acknowledges that the due diligence process is highly contextual. The proposed guidance is not intended to create an objective standard of what constitutes reasonable due diligence, nor does it create new, or modify existing, legal obligations. Nevertheless, the proposed guidance provides valuable direction for underwriters by addressing the appropriate level of due diligence required in order to discharge their role as gatekeepers of the capital markets, protect against reputational harm and establish the statutory due diligence defence.
Underlying the specific guidance is the theme that due diligence should be customized to the particular issuer, the industry in which it operates and the type of security being offered. Underwriters are expected to exercise professional judgment to determine the appropriate level of due diligence in each set of circumstances.
The proposed guidance sets out the following principles:
- Underwriters' policies and procedures for underwriting due diligence – Each underwriter is expected to have written policies and procedures relating to all aspects of the underwriting process. These policies and procedures should acknowledge that a reasonable investigation involves, for each offering, a contextual determination and the exercise of professional judgment. Prescriptive checklists are discouraged. The policies and procedures should establish the process to be followed where red flags indicate that heightened due diligence is required.
- Due diligence plans – The underwriter should have a deal-specific due diligence plan that reflects the context of the offering and the level of due diligence that will be reasonable in the circumstances. Further, a due diligence plan will, by necessity, be iterative and subject to change as circumstances change. The plan should address the unique challenge of conducting due diligence during the compressed time frame of a "bought deal" offering, particularly for non-lead members of the syndicate.
- Due diligence Q&A sessions – It is common practice for question and answer sessions to be held with management and its professional advisors at appropriate points during the offering process. However, there is concern that these sessions are overly formulaic and that meaningful and independent enquiries are not being made. Issuer and transaction-specific questions should be drafted after conducting significant business due diligence and reviewing the issuer's public disclosure records. Incomplete or evasive responses should trigger follow-up questions, which must be satisfactorily answered prior to certifying the final prospectus. All members of the underwriting syndicate should be empowered to participate in the due diligence process, and particularly at the Q&A sessions.
- Business due diligence – The underwriter should perform business due diligence sufficient to ensure that it understands the business of the issuer and the key factors affecting the issuer's business. Adequate diligence may include site visits, interviews with professional advisors, customers and third parties, review of operational data and, in the case of foreign or emerging market issuers, a study of the political and cultural environment. Enhanced due diligence may be required where there have been significant changes in the issuer's business, assets or operations, where accounting treatments are unusual or inconsistent with industry peers, where there has been unusual trading activity by the issuer or by insiders or where controversy surrounds the principals (including issues raised by institutional investors). Underwriters should be aware of red flags, including the failure to provide requested information, any undue delay or failure to facilitate a site visit and respondents that avoid or deflect direct questions. The underwriters, not management, should control the flow of information.
- Legal due diligence – The lead underwriter should discuss with underwriters' counsel the scope of the legal due diligence that counsel will perform, and the due diligence plan should clearly delineate the respective roles of the underwriters and their counsel. In addition, underwriters should provide adequate supervision of the legal due diligence performed by underwriters' counsel. All syndicate members should have access to underwriters' legal counsel to ascertain that sufficient legal due diligence has been completed.
- Underwriters' reliance on experts and other third parties – Securities legislation provides that underwriters are not liable for a misrepresentation with respect to any expertised portion of a prospectus provided the underwriters had no reasonable grounds to believe that there had been a misrepresentation. The proposed guidance cautions that the extent to which an underwriter may rely on an expert depends on that expert's qualifications, expertise, experience, independence and reputation. Even where expert qualifications have been verified, reliance shouldn't be blind in the face of red flags.
- Syndicate members' reliance on the lead underwriter – As each syndicate member is subject to the same liability for a prospectus misrepresentation, 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. The proposed guidance is not meant to re-allocate or result in a duplication of the responsibilities for due diligence as between the lead underwriter and a syndicate member. However, each syndicate member should receive copies of all letters, opinions or memoranda relating to the underwriters' due diligence investigation. Reliance on the due diligence conducted by the lead underwriter in a bought deal offering presents challenges for other members of the syndicate who have limited recourse if they conclude the lead's due diligence has not been adequate.
- Due diligence record keeping by underwriters – Each underwriter should document the due diligence process in order to be in a position 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. The underwriter's policies should describe which documents must be kept in the transaction file.
- The role of supervision and compliance in the underwriting process – Each underwriter is required under IIROC Dealer Member Rules 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. The supervisory function should be led by a senior investment banking professional who is ultimately responsible for the quality and extent of the due diligence undertaken or a committee of senior investment banking managers, internal counsel and/or compliance personnel who can exercise independent judgment.
- Grounds for Litigation – It is our view that while the proposed guidelines provide a useful framework, they also present plaintiffs with a benchmark against which they can evaluate the sufficiency of the due diligence performed by the underwriters.
- The Due Diligence Paradox – The obligation to perform more extensive business and legal diligence for junior, infrequent and emerging market issuers creates a "due diligence paradox", where smaller offerings with the greatest cost sensitivities require the most thorough level of diligence. Underwriters should undertake a risk/reward analysis prior to committing to underwrite an offering.
- The Due Diligence Dilemma – Underwriters also face a dilemma in the context of accelerated short form offerings where there is not sufficient time to complete a reasonable investigation. It has been suggested that underwriters can address this dilemma by performing continuous due diligence of an issuer and its industry even when the issuer is not "in distribution". However, such a requirement may be impracticable as underwriters will resist incurring such costs without assurances that they will participate in any upcoming offering, let alone be designated as the lead underwriter.
- Inadequate Underwriter Indemnity – A contractual indemnification agreed to in the underwriting agreement may be of limited value to the underwriters as it may be difficult in practice to enforce (if the underwriter failed to establish the due diligence defense) or worthless (if the issuer is left with nothing as a result of direct claims against it). In less serious cases, underwriters may be competing with other claimants for limited resources, and the issuer may be resisting all claims through litigation. Underwriters should not assume the indemnity provisions will provide total protection.
Time for Comment
IIROC has requested comments with respect to the proposed guidance by June 4, 2014.
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