Earlier today, the Investment Industry Regulatory Organization of Canada published a request for comments in regards to proposed guidance respecting underwriting due diligence. Noting that IIROC dealers play an important role as gatekeepers to the Canadian capital markets, IIROC’s stated purpose in developing the proposed guidance is to promote consistency and enhance standards among its Dealer Members.  

While intended to codify “common practices and suggestions” the proposed guidance may represent a departure from what some Dealer Members consider as the current market standard. In developing the proposed guidance, IIROC notes 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. However, while IIROC engaged in this and various other consultations, the proposed guidance has ultimately been prepared by and reflects the views of IIROC staff.  Given its comprehensive nature, the proposal offers a good opportunity for Dealer Members to generally revisit their underwriting practices with a view to identifying possible gaps and enhancing existing practices.

The proposed guidance is classified into nine key areas that relate to all aspects of the underwriting due diligence process (discussed in detail below). These are expressed as principles and accompanied by practical examples. 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 judgement. We have set out these nine principles below, with highlights of IIROC’s discussion and/or examples of practices that IIROC has identified as reflecting each principle.

  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.

  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.

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. 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.

  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.

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 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 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, reviewing public disclosure and comparing to the issuer’s peers and conducting in-depth discussions with management and experts.

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, high degree of reliance on a founder, CEO or government relationships, and recent ratings downgrades or significant changes in research analysts’ target prices.)

  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.

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. 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.

  1. 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.

  1. 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. 

  1. 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 notes that there does not appear to be any file retention policy that is universally adopted by Dealer Members but acknowledges 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.

  1. 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.

Request for Comments

In addition to comments generally on all aspects of the proposed guidance, IIROC also poses specific questions where feedback is requested, including in respect of whether any further practices should be included in the proposed guidance, whether there other considerations unique to specific types of public offerings, such as “bought deals” or debt offerings, or public offerings by issuers in specific types of industries (e.g., mining, oil and gas, technology) and whether the proposed guidance is useful for general application to private placements.

IIROC is accepting comments on the proposed guidance until June 4, 2014. For more information, see IIROC Notice 14-0058.