The Australian Securities and Investments Commission (ASIC) recently released a report1 detailing the findings of a review it conducted between November 2014 and January 2016 on due diligence practices leading up to an initial public offering (IPO). The review focussed mainly on practices among small to mid-sized issuers.
Key points to take away from the report are:
- the issuer’s board of directors and management need to be actively engaged in the due diligence process in order for it to be more than a “tick-a-box” exercise; and
- a “budget” due diligence process may actually end up costing the issuer more, by causing delays in the fundraising process and forcing the issuer to incur additional costs of rectifying disclosure in the prospectus.
What is due diligence and why is it so important?
In the context of an IPO, due diligence is the process adopted by an issuer to ensure that its prospectus contains all the information required to be included under the Corporations Act 2001 (Cth) (Corporations Act). This extends to all information that investors and their professional advisers would reasonably require to make an informed assessment of the key aspects of both the securities offered and the issuer. 2
Conducting a rigorous due diligence process is essential because, as ASIC found, poor due diligence often leads to defective disclosure. Defective disclosure occurs when an issuer’s prospectus contains a misleading or deceptive statement, or omits material required to be included under the Corporations Act. This may expose the issuer, its directors and other persons who consent to be named in the prospectus (amongst others) to statutory liability and/or liability by way of an action brought by an investor.
Where a person can prove that they took part in a thorough and rigorous due diligence process, however, they may be relieved from statutory liability for defective disclosure in a prospectus.3
What are the dangers of cost-cutting during the due diligence process?
It can be tempting to allow costs to dictate the parameters of the due diligence inquiries to be made, particularly where the issuer is relatively small and has a limited budget. However, where cost-cutting results in a “form over substance” approach, this can ultimately end up costing the issuer more.
ASIC has warned that it may intervene in an issuer’s fundraising by requiring an amendment to be made to the prospectus, extending the exposure period, or issuing a stop order, where disclosure is inadequate. This can result in delays in the fundraising process, as well as additional costs to the issuer and even reputational damage to the issuer and the IPO.
ASIC has been very proactive in this area. In the past year, ASIC has:
- raised disclosure concerns with 31% of the documents lodged;
- extended the disclosure period 80 times; and
- issued 61 interim stop orders.
What does this mean for directors and senior management of issuers?
ASIC was highly critical of directors of issuers limiting their involvement in the preparation of the prospectus to providing a few comments on the final draft, if at all. As ASIC repeated throughout its report, directors are responsible for the contents of the prospectus.
In this regard, ASIC noted, even if an issuer conducts an expensive and extensive due diligence process, its quality may not be guaranteed if the directors do not thoroughly engage with the process. Often, particularly in the case of a small to mid-sized issuer, the directors will have an intimate understanding of the issuer’s business. They are, moreover, the persons best placed to identify and address material issues raised during the due diligence process.
ASIC listed Five Key Attributes for an effective due diligence framework, which will assist directors and management to ensure the integrity of the contents of the company’s prospectus:
- Oversight: Provide effective oversight to ensure that a proper due diligence process is implemented and followed. In particular, devise a due diligence plan and establish a due diligence committee, which includes at least one executive and one non-executive director, to coordinate and supervise the process and report regularly back to the board. A “substance over form” approach should be adopted. The process should not be just a form filling exercise.
- Investigations: Carry on a robust dialogue with management and expert advisers involved in the due diligence in order to flush out and address all material issues. Directors and expert advisers should each bring an independent and inquiring mind to the due diligence process. Local legal advisers should provide oversight of the work done by foreign legal advisers.
- Record-keeping: Keep a list of significant issues identified during the course of the due diligence process and ensure that any “red flag” issues are followed up and resolved.
- Verification: Actively participate in the drafting and verification of the prospectus. In particular, have recourse to independent and objective evidence wherever possible to back up statements in the prospectus.
- Continuation: Continue the due diligence process after lodging the prospectus. This is important so that the issuer can address new circumstances which may arise after lodgement as well as any concerns raised by ASIC after reviewing the prospectus.
As recommended in ASIC’s report, the due diligence process should be fashioned to harness the knowledge of the issuer’s directors. This will improve the effectiveness of the process and potentially reduce its cost and duration.
ASIC has advised that it will be conducting further reviews, focusing on different aspects of fundraising processes by public companies, in the 2017 financial year.