The Investment Industry Regulatory Organization of Canada recently published its final guidance on underwriting due diligence (the “Guidance”). Being IIROC’s first ever codification of this nature, the publication of the Guidance represents an opportunity for underwriters to review internal practices in light of IIROC’s expectations. As we discussed when IIROC’s draft guidance were published for comment, while the intention is to codify common practices, the guidance may represent a departure from what some may consider to be the market standard. This is an issue that may be of particular relevance given the role of due diligence in demonstrating that an underwriter has fulfilled its statutory obligations in respect of prospectus offerings.

A draft version of the guidance was originally published for comment in March of 2014, following which IIROC engaged in further industry consultations and consideration of comments. Similar to the draft version, the Guidance is organized into nine key areas spanning the entire underwriting due diligence process. However, it appears that IIROC has made some key adjustments in response to comments received, mainly affording a greater degree of flexibility to underwriters on certain significant matters. Of these, the most notable changes or clarifications are highlighted below, and otherwise discussed in context in our review of the nine principles that follows.

  • Written due diligence plan for each offering – IIROC has clarified that the decision to prepare a formal written due diligence plan is a contextual determination. Where an underwriter’s written policies and procedures adequately set out the matters to be considered, a specific written plan may not be required for all offerings.  
  • Relevant representation on Q&A sessions - IIROC has revised the Guidance to indicate that syndicate members should be represented during a due diligence “Q&A” session by an investment banking professional with an appropriate level of seniority (as opposed to the earlier requirement to have a “senior investment banking professional” that may have had an overly rigid application in certain circumstances).  
  • Materiality threshold for business due diligence - In determining the extent of appropriate business due diligence, taking contextual factors into account, IIROC expressly acknowledges that Dealer Members may choose to establish a materiality threshold in the due diligence plan from both a quantitative perspective (i.e. a dollar threshold considering the issuer’s financial position) and a qualitative perspective (e.g., the areas of business, operations, risk, etc. most relevant to the issuer).

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.

With respect to this main principle, IIROC notes that due diligence in connection with a public offering is the process by which the underwriter takes reasonable steps to ensure that all prescribed information is included in the prospectus, to investigate the information provided by the issuer for inclusion in the prospectus and to verify key material facts. Because of its contextual nature, due diligence should go beyond prescriptive checklists alone.

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.

A due diligence plan should be prepared in conjunction with underwriters’ counsel (including local counsel in foreign jurisdictions, as applicable), and set out the lead underwriter’s expectations relating to the scope of the investigation. Contextual matters to consider in developing a due diligence plan include the size, nature and sophistication of the issuer and the particulars of the offering.

Less extensive diligence procedures may be reasonable for seasoned, significant and widely-followed issuers, including those familiar to the Dealer Member due to an ongoing relationship, absent any unusual, complex or significant transaction. Conversely, more extensive due diligence procedures may be required where the Dealer Member has not previously performed due diligence for the issuer or where significant time has passed since the Dealer Member last undertook a due diligence investigation. Here, IIROC has clarified that in certain circumstances, it may be appropriate for a Dealer Member to rely on due diligence conducted on an issuer in a prior offering. For example, where the Dealer Member has maintained a relationship with the issuer (e.g., equity research coverage). However, IIROC suggests that the reasonableness of reliance on due diligence performed by another firm will depend on a wide range of factors, including the time that has passed since the previous offering, the nature of the previous offering, whether the Dealer Member was part of the syndicate on the previous offering, the degree of familiarity that the Dealer Member has with the other firm and its due diligence practices, and the amount of information available to the Dealer Member regarding the due diligence performed by the other firm.

Ultimately, while the plan may be less or more extensive depending on the type of offering, reasonable due diligence must be completed prior to the underwriters certifying the final prospectus, and appropriate supervision and compliance must be ensured in all circumstances, including compressed time-frames for bought deals. IIROC also stresses that irrespective of the nature of the public offering, underwriters have a duty to make an investigation that provides them with a reasonable basis for a belief that the prospectus contains full, true and plain disclosure of all material facts relating to the offering.

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 Q&A sessions at appropriate times (typically, for equity offerings, one prior to filing the preliminary prospectus and another update or bring-down session prior to filing the final prospectus), and the underwriters should participate with their counsel in preparing questions. Individuals in the best position to have the necessary information should participate in the Q&A session and questions should be circulated sufficiently in advance in order to allow for appropriate enquiries to be undertaken. Further, all syndicate members should be given an opportunity to participate in and ask questions at each Q&A session, and should be represented by investment banking professionals with an appropriate level of seniority.

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.

The due diligence plan should distinguish clearly between legal and business due diligence. Principal elements of business due diligence include visiting the issuer’s head office and principal operations, reviewing business plans, budgets, projections, key operational data, material contracts (or summaries prepared by underwriter’s counsel) and relevant external information, and reviewing public disclosure and comparing it to the issuer’s peers. IIROC also recommends conducting in-depth discussions with management and experts, but it expressly recognizes that limitations may be imposed on participants in the offering process by their governing rules (e.g., such as the parameters established by CPA Canada for auditors’ comfort letters and due diligence Q&A responses).

The exercise of independent judgment and verification of material facts may require independent background checks (including through local agents where necessary) as well as interviewing the issuer’s customers, suppliers, and counterparties. It may also be appropriate to consult research analysts and other industry experts within a member’s affiliates.

Further, the Dealer Member’s policies and procedures should address how to deal with “red flags” where heightened due diligence and/or enhanced disclosure may be required. (Examples of red flags cited by IIROC include recent significant changes in the issuer’s business over the last 12-24 months, financial information or other disclosure that is inconsistent with its peers, a high degree of reliance on a founder, CEO or government relationships, recent ratings downgrades or significant changes in research analysts’ target prices or the issuer’s board of directors recently establishing a special committee of independent directors to investigate allegations of fraud or other improper conduct.) While certain red flags may be addressed by additional risk factor disclosure, IIROC notes that other red flags may require that an issuer undertake remedial action or implement safeguards before a preliminary prospectus is filed.

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.

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. This should include enhanced due diligence for foreign and emerging market issuers, including how counsel propose to address issues relating to local business practices and laws, the issuer’s government relationships, issues relating to asset ownership within the issuer’s jurisdiction and retention of local experts. IIROC notes that enhanced due diligence may be required where a material business is held in a subsidiary incorporated or organized under the laws of an emerging market country, such as asking local counsel to explain how those laws differ from applicable Canadian law, including with respect to the issuer’s effective control and management of the subsidiary and its assets.

Counsel should be prepared to communicate the results of legal due diligence to the entire syndicate, including by briefing the entire syndicate on the scope of the due diligence conducted and reporting on the status and results of any due diligence completed prior to any management Q&A session. Further, IIROC observes that underwriters should instruct their counsel to inform them 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.

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.

Underwriters should consider whether experts are properly qualified for the task for which the experts are retained (i.e. to give a report or opinion), and should obtain reasonable evidence that experts have consented in writing to expert reports (or any extract or summary) being used in the prospectus. The credentials, knowledge and experience of experts in emerging markets should be considered and assessed in light of standards as would be expected in Canada for similar experts and, where appropriate, dealers should consider obtaining corroboration by other experts.

Here IIROC acknowledges that a Dealer Member or its legal counsel may experience difficulties in conducting due diligence with respect to areas requiring technical expertise where the issuer operates in an industry requiring specialized knowledge. If it is not reasonable or economically feasible for a Dealer Member to retain its own experts in such a situation, it may be appropriate for a Dealer Member to rely on the issuer’s third party experts, supplemented by appropriate checks and balances.

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 the lead may bear additional reputational and regulatory risk, each member of the underwriting syndicate is subject to the same liability for misrepresentation in a prospectus (subject to provisions capping the statutory civil liability to the amount underwritten) and should be prepared to establish its own due diligence defence. As such, each syndicate member should satisfy itself that the lead underwriter performed the kind of due diligence that it would have performed if it were the lead underwriter. To this end, while IIROC indicates 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 and given the opportunity to ask questions of the issuer and its counsel and auditors during the Q&A session, it is not necessary for syndicate members to prepare their own due diligence plans where the lead underwriter has done so.

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.

A dealer should maintain records of its due diligence process in order to demonstrate that it followed its own policies and procedures as well as IIROC’s requirements and record keeping obligations under applicable securities laws. IIROC recognizes that the Dealer Member acting as lead underwriter may keep more detailed information than those Dealer Members acting as syndicate members. IIROC has reiterated in the final Guidance that it is not specifying the nature of the records to be kept, only that file retention policies should balance the legitimate considerations in favour of “pruning” the due diligence file with the need to document compliance and, while not all documents need to be retained, the dealer’s policies and procedures in this respect should be clearly established.

By way of example, a record should be kept of any committee meetings (and attendance), as applicable and the Q&A session with issuer’s management, auditors and legal counsel. Meanwhile, if a specified document is not contained in the file, there should be an explanation for its absence.

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.

While the performance of due diligence may be delegated to a range of personnel, including junior personnel as part of the team, a senior member of the dealer member’s management team must be involved throughout the process and is ultimately responsible for the quality and extent of the due diligence. While supervision may be based on a committee structure, typically composed of senior investment banking managers, internal counsel and/or compliance personnel who can exercise independent judgment, the use of a committee structure depends on the size, nature and extent of the Dealer Member’s business activity.

Further, a compliance framework involving any one or a combination of the compliance, in-house legal or internal audit departments is acceptable so long as the applicable individuals have a clear mandate to identify and monitor issues relating to non-compliance with policies and procedures in respect of securities offerings, and to report and escalate such matters in accordance with such internal policies and procedures.

Addressing the New Guidance

While presenting these “common practices,” IIROC is careful to note that due diligence, by its nature, is a fluid and evolving process and should be customized to the particular circumstances based on the underwriter’s exercise of professional judgment. In developing the Guidance, IIROC previously noted that its process began by soliciting input on current practices from an industry advisory committee composed of senior industry representatives from a cross-section of firms in terms of size and regional representation. Given its comprehensive nature, this offers a good opportunity for Dealer Members to generally revisit their underwriting practices with a view to identifying possible gaps and enhancing existing practices.

For more information see IIROC Notice 14-0299 Guidance respecting underwriting due diligence published on December 18, 2014.