Canada: Underwriting Due Diligence: What’s "Reasonable"?

How do underwriters avoid prospectus liability?

An underwriter in a public offering of securities can avoid liability for a misrepresentation in the prospectus if it can establish the "due diligence defence", i.e. that it had a conducted a reasonable investigation so as to provide it with reasonable grounds for a belief that there had been no misrepresentation in the prospectus.

So what constitutes a "reasonable investigation" and "reasonable grounds"?

The Investment Industry Regulatory Organization of Canada (IIROC) has recently weighed in with its proposed guidance respecting underwriting due diligence, some of which may represent a departure from what some IIROC Dealer Members may consider as current market practice. Rather than providing specific guidelines, IIROC published key principles to inform the due diligence process while underlining its view that due diligence should be customized to the particular circumstances of the issuer and the offering, using the underwriter's professional judgment.

Despite the general nature of the proposed guidance, various practical considerations come out of IIROC's proposal. Perhaps the most important practical implication of the proposed guidance is that the guidance may be used by plaintiffs in prospectus misrepresentation cases or by securities regulatory authorities as a standard against which the due diligence performed by the underwriter may be evaluated.

Here are some of the key points for underwriters arising from the proposed guidance:

Written Policies and Procedures, Supervision and Compliance

IIROC expects underwriters to have written policies and procedures relating to the underwriting process, including due diligence. Such policies and procedures should recognize the contextual nature of due diligence. As well, IIROC Dealer Member Rules require underwriters 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 undertaken by a senior member of the investment banking department of the underwriter.

IIROC warns in the notice of the groposed guidance that its compliance examinations going forward will focus on the adequacy of a Dealer Member's policies and procedures and whether the process has been followed in sampled files. Dealer Members should revisit their current policies and procedures (of which IIROC has seen considerable variations) and supervisory framework for compliance, and make any necessary updates, so as to be ready if and when IIROC's Business Conduct Compliance personnel arrive to conduct a compliance examination. Underwriters would be wise to heed IIROC's warning and reconsider how they conduct due diligence in light of the proposed guidance, and how such procedures have been documented.

Due Diligence Plan and Record Keeping

IIROC suggests that underwriters should have a due diligence plan in place from the outset of an offering that reflects the context of the offering and the issuer's business so as to tailor the due diligence to the circumstances. For example, issuers in emerging markets may require more extensive due diligence than other issuers. Before committing to underwriting a particular offering, underwriters should consider the practical matter of balancing the need to conduct an appropriate level of due diligence for smaller or infrequent issuers with the fact that these tend to be the most cost sensitive issuers.

The goal of the due diligence plan should be to determine the approach in ensuring prescribed information is included in the prospectus, investigating information provided by the issuer and verifying key materials facts. The proposed guidance includes a list of contextual matters to consider in preparing a due diligence plan. Consideration should also be given as to what records are to be kept evidencing the due diligence conducted, as well as compliance with the underwriter's own policies and procedures, IIROC requirements and applicable securities laws.

Practical considerations also arise in the context of "bought deals" on a compressed time frame. Underwriters can plan ahead in these cases as the prospectus will incorporate most of the information about the issuer's business by reference to documents already publicly available ahead of the offering.

It would be reasonable to spend some time before or shortly after launching an offering planning the scope of due diligence required given the specific characteristics of the issuer and the offering and delineating the roles of the underwriters and legal counsel. It would be unreasonable to rely on standardized checklists to drive the due diligence process.

Business v. Legal Due Diligence, Red Flags

IIROC advises that underwriters should clearly understand and communicate 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. An Underwriter should perform business due diligence sufficient to ensure that the underwriter understands the business of the issuer and the key internal and external factors affecting the issuer's business and use its professional judgment when determining which material facts will be verified independently (in compliance with restrictions against "tipping") depending on the circumstances of the offering.

The results of the legal due diligence should inform business due diligence and the underwriter should follow up on missing records and any information that appears to contradict management's oral statements or the disclosure in the draft prospectus.

The underwriter should also diligently follow up on any potential "red flags" and document how red flags were addressed. Potential red flags identified by IIROC include significant changes in the issuer's business, financial information or other disclosure that is inconsistent with the issuer's peers or competitors, a high degree of reliance on certain individuals or relationships, or recent controversy, including criminal, regulatory or disciplinary proceedings, involving the issuer or any of its directors or senior officers. The proposed guidance also notes that for emerging market issuers, underwriters should understand the political and cultural environment in which the issuer operates, local business practices affecting the issuer, local laws affecting the issuer, local experts (including legal advisors and auditors) and the extent to which the issuer relies on local management, particularly in the context of an initial public offering or a subsequent offering by a smaller or infrequent issuer.

It would be reasonable for underwriters to select key material facts in the prospectus for independent verification. It would not be reasonable to rely solely on the issuer or underwriters' legal counsel to drive the due diligence process. Underwriters and their legal counsel should be in communication with each other throughout the due diligence process to ensure significant findings are investigated further in the appropriate context.

Reliance on Experts and Lead Underwriter

Securities legislation provides that underwriters are not liable for a misrepresentation with respect to any part of the prospectus purporting to be made on the authority of an expert, provided certain conditions are met. However, IIROC warns against undue reliance on experts. Underwriters should consider whether an expert is qualified to give its report or opinion.

The proposed guidance reminds underwriters that syndicate members are subject to the same liability as the lead underwriter (subject to statutory caps for the amount underwritten) for any misrepresentation under securities legislation. Although IIROC acknowledges that the proposed guidance is not intended to duplicate due diligence responsibilities as between the lead underwriter and a syndicate member, such 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. It is acknowledged that the lead underwriter may bear additional reputational and regulatory risk.

It would be reasonable for underwriters to investigate the qualifications of purported experts having regard to the expertise, experience, independence and reputation of the expert and for each syndicate member to receive copies of all letters, opinions or memoranda relating to the underwriters' due diligence investigation, and to invite all syndicate members to and to give each the opportunity to participate in Q&A sessions. It would not be reasonable to blindly rely on the work of experts, other third parties or the lead underwriters in the case of syndicate members.

Private Placements

IIROC notes that its proposed guidance is not meant to apply to private placements, although some of the principles may be useful in conducting due diligence for private placements. In one respect due diligence for private placements is less structured as there is no prospectus to focus the due diligence. However, private placement subscription agreements typically require an investor to represent that its investment decisions is based on the public disclosure of the issuer. In that regard, the conduct of due diligence has some similarities to short form prospectus offerings that rely on previously publicly filed disclosure, although without the need to certify the disclosure.

In such cases it would be reasonable to focus due diligence on the public record. It would not be reasonable to conduct no or very limited due diligence for a private placement given the potential common law liability and reputational risk involved in such offerings.

Going Forward

Much of IIROC's proposed guidance addresses issues of procedure rather than substance, although IIROC advises that underwriters must not put "form over substance". Underwriters are reminded that reasonable due diligence requires the exercise of professional judgment in planning and following through on the due diligence plan. Legal counsel can play an important role in assisting with the due diligence process, but underwriters need to take the time to focus appropriate resources to conduct "reasonable" due diligence in the circumstances.

IIROC's proposed guidance is open for comments until June 4, 2014. Dealer Members and interested parties are encouraged to provide their input to IIROC, including responses to specific questions posed by IIROC in its notice of the proposed guidance (e.g. red flags, application to specific public offerings and private placements, etc.). No indication is provided as to when IIROC is seeking to adopt such proposed guidance.

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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