Proposed IIROC Guidance on Underwriting Due Diligence Will Focus Dealers on Policies, Procedures and Record-Keeping

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IIROC (Investment Industry Regulatory Organization of Canada) has issued for comment its long-awaited guidance to underwriters carrying out due diligence in connection with public offerings of securities. This initiative was one of several items recommended by the Ontario Securities Commission as an area for further work following its emerging markets issuer review, although IIROC’s proposed guidance is not limited to emerging markets issuers and would apply to an investment dealer’s involvement in a public offering of securities by any issuer. The proposal reflects the views of IIROC staff following extensive industry consultation and a review of benchmarking of regulatory requirements and guidance from international jurisdictions.

We believe the guidance is a helpful reference that describes common practices and suggestions with respect to underwriting due diligence without being overly prescriptive. IIROC’s guidance is generally consistent with market practice, although dealers will need to consider whether to update existing policies and procedures in order to capture some of the specific concepts contained in the guidance.

In this Update, we highlight some key aspects of IIROC’s proposal.

  1. Expect that due diligence policies and procedures and records may be reviewed by IIROC during compliance examinations.

IIROC has indicated its intention to review samples of underwriting due diligence as part of its compliance examinations of member firms. In particular, IIROC will focus on the adequacy of due diligence policies and procedures and whether the processes referred to in those documents have been followed in sampled files. This is not a new initiative on the part of IIROC, but suggests that underwriting due diligence will become more of a focus for IIROC in the future. Dealers will need to be prepared with up-to-date policies and procedures and proper records of due diligence for public offerings, whether they are acting in a lead underwriter or co-manager role.

  1. Consider whether to update existing policies and procedures relating to due diligence and the underwriting process.

IIROC’s guidance refers to nine key principles, seven of which are specific matters that investment dealers should consider in developing policies and procedures for underwriting due diligence. Many of these areas, such as due diligence Q&A sessions, the distinction between business and legal due diligence and when a dealer may rely on expert opinions, will be familiar to anyone with experience in the public offering process. However, firms will need to consider whether to update existing policies and procedures in order to capture some of the specific concepts contained in the guidance. For instance, IIROC’s guidance recommends that due diligence policies and procedures reflect that “reasonable” due diligence involves a contextual determination for each underwriting, and that effective due diligence should go beyond prescriptive checklists alone. We presume IIROC’s intention here is to emphasize the fact that due diligence is not intended to be a superficial matter of “checking the box.” Dealers will need to consider whether their written policies and procedures should more closely reflect IIROC’s guidance even if dealers currently follow the principles recommended by IIROC as a matter of practice.

  1. Dealers will need a due diligence plan that reflects the context of the offering and the level of due diligence that will be reasonable in the circumstances.

IIROC’s guidance refers to dealers having a “due diligence plan” for an offering that would generally include a list and description of matters to be investigated. The concept of a due diligence plan appears to be more extensive than the typical due diligence request list prepared by underwriters or their counsel for an offering of securities, and also appears to be different from the due diligence reports or memos sometimes prepared by underwriters’ counsel. We expect that existing due diligence request lists for an offering will need to be retooled and expanded upon in order to serve as due diligence plans as contemplated in the guidance, although it would be helpful for IIROC to clarify what its expectations are in this area and perhaps provide samples of due diligence plans for different types of offerings. The idea of a due diligence plan is not new, but IIROC’s guidance may change practice in terms of the way a due diligence plan is formally documented since IIROC is suggesting that a due diligence plan should clearly delineate the roles of the underwriters and their counsel. Specifically, a due diligence plan should distinguish between the matters that will be addressed in business due diligence (to be conducted by the underwriters) and the matters that will be addressed in legal due diligence (to be conducted by underwriters’ counsel). This could result in a new practice of having underwriters’ counsel prepare a due diligence plan that covers both business and legal due diligence. As is the case with due diligence reports today, we expect there to be different approaches to preparing and keeping records of a due diligence plan.

  1. IIROC’s guidance reiterates the fact that syndicate members should satisfy themselves that the lead underwriter performed adequate due diligence on an offering.

Syndicate members are subject to the same liability as the lead underwriter(s) for misrepresentation in a prospectus. In recent years, we have seen increased dialogue between syndicate members and the lead underwriters on due diligence matters, often in the form of discussions between syndicate members and the underwriters’ counsel. While IIROC’s guidance does not introduce new due diligence obligations for dealers acting as syndicate members on a public offering, we expect it to stimulate further debate on the way a syndicate member should go about satisfying itself as to the adequacy of the lead underwriter’s due diligence. Will this result in more calls and emails from syndicate members to underwriters’ counsel? More requests from syndicate members for due diligence back-up materials rather than just summaries and memos? We expect that communications with syndicate members on due diligence matters will continue to increase, particularly on initial public offerings and other significant transactions. 

  1. Dealers will need to consider whether more scrutiny of technical report authors and other experts is needed.

The idea that an underwriter cannot solely rely on an expert report or opinion without having the required “reasonable grounds” is enshrined in Canadian securities law. How this applies in practice with respect to expert reports and opinions such as NI 43-101 reports, engineering reports and even auditors’ reports accompanying annual financial statements has always been less clear. IIROC has attempted to provide some guidance to assist underwriters in determining whether an expert is qualified to give a report or opinion referred to or summarized in a prospectus. Specific examples of factors to be considered include the reputation and qualifications of the firm or individual acting as an expert; whether the firm or individual has the relevant subject-matter expertise and, if applicable, regional knowledge and expertise; the independence of the expert and whether any red flags have been identified in the due diligence process. IIROC provides additional considerations for experts in foreign (and especially emerging) markets, and even goes as far as to say that, in some cases, underwriters should consider whether corroboration by other experts is warranted (suggesting the underwriters should consider whether to engage their own experts to review the reports of the issuer’s experts). This can be a sensitive topic when the issuer is paying for the expenses of the underwriters, as would be the case on an initial public offering. While these are not new considerations, dealers will need to focus on how to appropriately document their determinations with regard to the qualifications of experts and the appropriateness of relying on a particular expert’s report.

  1. IIROC’s guidance will lead to continued debate about how a dealer should maintain records of its due diligence reviews.

The guidance states that a dealer should maintain records of its 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. IIROC’s guidance makes a point of saying that this documentation should be available for IIROC compliance examinations. The guidance states that a dealer’s policies and procedures should describe which documents must be kept in a transaction file, but does not provide specific details other than indicating that there should be a record of committee meetings (and attendance), as applicable, and the Q&A session with the issuer’s management, auditors and legal counsel. We expect that IIROC’s discussion of record-keeping together with its clear signalling of its intention to review due diligence files will lead to continued debate about matters such as the types of documents that should be kept in a transaction file, whether handwritten notes should be destroyed, how to document responses to Q&A sessions and what areas should be covered in due diligence summaries.

  1. IIROC has indicated that it is reviewing the registration regime as it relates to individuals involved in investment banking and corporate finance activities.

Although not directly related to due diligence practices, as a next step, IIROC has suggested that it is considering changes to the registration regime and will separately publish any proposed changes for public comment. From a registration perspective, it is not clear whether IIROC is focused only on investment banking and corporate finance professionals who perform a supervisory function or whether IIROC is considering more globally whether investment banking and corporate finance professionals should be registered or approved in some capacity. Either would be a departure from the current registration regime. IIROC notes that some dealers have sought approval in the “Supervisor” category for individuals overseeing investment banking and corporate finance activities at their firms, but this approach has not been consistently pursued by all firms.

Comments on the proposal are due by June 4, 2014. There is no indication of when the guidance will be adopted by IIROC.

Topics:  Canada, Due Diligence, Underwriting

Published In: Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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