Regulators Step Up Examination of Underwriter Due Diligence


[authors: Daniel J. Malpezzi and Timothy J. Horstmann]

In recent months the U.S. Securities and Exchange Commission (SEC) has announced that it will soon begin regular examinations of broker-dealers in an effort to improve compliance with their due diligence obligations when participating in an underwriting of municipal bonds. In response, the Financial Industry Regulatory Authority, the largest independent regulator for securities firms in the United States (FINRA), has announced that it will begin conducting examinations to confirm broker-dealers’ compliance with such obligations. For issuers preparing for an offering of municipal securities, this likely will entail a significantly increased due diligence exercise, including greater or expanded due diligence memoranda, conference calls, checklists, requests for documents and records, on-site review sessions and other methods of information gathering, in an effort by underwriters and their counsel to document compliance.

The announcements by both the SEC and FINRA follow a March 19th, 2012 risk alert by the SEC (Alert), in which the Commission reminded broker-dealers of their due-diligence obligations under SEC Rule 15c2-12 (Rule). The SEC stated as the basis for issuing the Alert its finding through the examination process that a number of underwriters had failed to meet their due diligence obligations under the Rule. Such failure may result in violations of the anti-fraud provisions of the federal securities laws, the Rule and rules promulgated by the Municipal Securities Rulemaking Board (MSRB).

The SEC appears particularly concerned that the underwriter community has failed to comprehend the SEC's prior interpretive guidance concerning the fundamental duties of underwriters in municipal securities offerings. The SEC’s guidance had been most recently affirmed in 2010 in SEC Exchange Act Release No. 34-62184A (2010 Release), which also adopted final amendments to the Rule to tighten exclusions and provide enhanced transparency for certain variable rate demand obligations. The 2010 Release particularly foreshadowed greater SEC oversight of the municipal securities markets by emphasizing the SEC's view that an underwriter has a duty to review an issuer’s disclosures for accuracy and completeness, and must evaluate the likelihood that an issuer will comply with its continuing disclosure undertakings. In making this evaluation, the underwriter should at a minimum review the historical filings of the issuer with the MSRB's Electronic Municipal Market Access system (EMMA) for timeliness and completeness.

The SEC explains in the Alert that these duties flow from the role of an underwriter in an offering of municipal securities. By participating in the offering, the underwriter makes an implied recommendation about the securities it is underwriting. By holding itself out as a securities professional, the underwriter also makes a representation that it has a “reasonable belief” in the truthfulness and completeness of the key representations made in any disclosure documents used in the offering. Specifically, under the Rule an underwriter, prior to bidding for or purchasing municipal securities, must review a final (or “deemed final”) official statement prepared by the issuer in connection with the offering, and “reasonably determine” that the issuer has undertaken in writing to provide the MSRB with certain specified continuing disclosures. In the SEC's view, the underwriter must then make its reasonable determinations before it participates in the offering, and may not rely solely on an issuer's statements and representations in the official statement.

The duty of broker-dealers to ensure compliance with the Rule is also required under applicable rules of the MSRB. Specifically, under MSRB Rule G-27, broker-dealers have a duty to supervise the conduct of their municipal securities activities to ensure compliance with the rules of the MSRB and applicable securities laws and regulations. This supervisory obligation extends to the Rule. The SEC interprets these requirements in the Alert to mean that a broker-dealer is liable for a violation of the Rule by its employees unless the broker-dealer was able to demonstrate that it has in place, and effectively implements, reasonable systems to prevent and detect securities law violations. Establishment of procedures is not sufficient to discharge a broker-dealer's supervisory responsibility. It is necessary to implement measures to monitor compliance and an appropriate system of follow-up and review if red flags are detected. By logical extension, lack of such systems, policies and procedures would also result in a violation of MSRB Rule G-27 for MSRB enforcement purposes and the MSRB has jurisdiction to bring its own actions in response to a violation.

In light of these concerns, the SEC has provided in the Alert a number of examples gleaned from the examination process of what it deemed to be acceptable practices (either alone or in conjunction with other practices) by which an underwriter may demonstrate compliance with its “reasonable determination” obligations. The SEC notes with approval the following practices:

  • Clear Explanation of Regulatory Requirements and firms' expectations. The use of written policies and procedures explaining the Rule's due diligence requirements, the underwriter's duty to determine whether adequate due diligence was performed, and the underwriter's expectations as to how their personnel may develop a reasonable basis for offering any municipal new issue securities.
  • Commitment Committees. The use of a senior level committee to review and approve certain underwritings. Such a committee is generally charged with reviewing the due diligence that has already been performed by the underwriting team prior to the sale of the securities pursuant to the official statement. Such committees are best used as an additional step in the due diligence process, and should not serve as a substitute for the initial due diligence review by the underwriting team prior to submission for approval by the committee. Review by the committee may be unnecessary for certain offerings. For example, it may not be necessary to require committee approval where the offering is by an issuer who recently was approved by the committee in connection with another offering.
  • Due diligence checklists. The use of checklists to assist underwriting personnel in recording the various due diligence steps taken. Such checklists should include substantial narrative and a review of the official statement and EMMA filings. The checklist may, where appropriate, include a summary of past dealings with the issuer, which are often relevant in the due diligence review.
  • Due diligence memoranda. The use, in conjunction with a due diligence checklist and commitment committee, of memoranda summarizing due diligence calls, issues noted and how they were resolved, and the review of the official statement.
  • Outlines for due diligence calls. The creation of outlines describing potential issues for discussion during due diligence calls.
  • On-site examination activities. The practice of conducting on-site meetings with municipal officials, facility visits and examinations of records and economic data to assist in the due diligence determination. 
  • Record-keeping checklists. The practice of keeping checklists to assist personnel in the maintenance of records evidencing how the due diligence review was performed. The use of such checklists also is beneficial in tracking due diligence documents once closing has occurred.

The SEC notes that it is not attempting to create a “one size fits all” approach for determining compliance during the examination process. Rather, various factors should be considered, and the SEC will not look for the adoption of any specific, preferred activity as evidencing compliance. Nevertheless, the SEC's “best practices” examples do show that the Commission values the preparation of written documentation during the due diligence review process, and it is likely that underwriters will consider the adoption of one or more of the examples to document compliance.

In addition to the announced intentions of the SEC and FINRA, it is reasonable to expect that other industry regulators will ramp up their oversight or examination processes in response to the Alert. Consequently, issuers should expect greater focus by underwriters on the due diligence process, including the confirmation of issuer compliance with existing continuing disclosure obligations. Issuers, working with bond counsel, their solicitors and special disclosure counsel, when utilized, should carefully review their continuing disclosure policies, identify weaknesses in their compliance efforts, and approve new policies and procedures if so advised. Issuers and other obligated persons having continuing disclosure obligations under outstanding bond issues should take care to make required disclosure filings on EMMA and other submissions in a timely and complete manner. Issuers and other obligated persons having such duties may want to consider contracting with a third party dissemination agent to assist in the monitoring and fulfillment of their continuing disclosure obligations. Such arrangements are particularly useful for issuers and other obligated persons that are relatively inexperienced in such matters or who do not possess adequate internal staff resources. 

Reprinted with permission from the November 1, 2012 issue of The Legal Intelligencer. © 2012 ALM Media Properties, LLC. Further duplication without permission is prohibited.


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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