Background

On December 18, 2014, the Investment Industry Regulatory Organization of Canada (IIROC) published its final guidance note outlining common due diligence practices and suggestions for IIROC dealer members (Dealer Members) in underwritten public offerings of securities.  The guidance note follows IIROC’s March 6, 2014 proposed guidance and a three month public comment period.

The guidance note urges Dealer Members to take an approach to due diligence that goes beyond the mere avoidance of liability and mitigation of risk to the underwriter as Dealer Members play a role in protecting investors, fostering fair and efficient capital markets and creating and maintaining confidence in the capital markets.

The guidance note was prepared specifically to address Dealer Members involved in public offerings of securities. Although the March 6, 2014 proposed guidance indicated that some aspects of the guidance may be helpful to Dealer Members in the context of private placements, such reference to private placements was removed in the final guidance note.

Nine Principles of Underwriting Due Diligence

The guidance note is designed to promote consistency and enhanced underwriting due diligence standards among Dealer Members.  It sets out nine principles which underwriters should consider in the context of their due diligence of the issuer. These are:

  • policies and procedures;
  • due diligence plans;
  • the Q&A session;
  • business due diligence;
  • legal due diligence;
  • reliance on experts;
  • reliance on a lead underwriter;
  • record-keeping; and
  • the role of supervision and compliance.

Policies and Procedures

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 such activities. These policies and procedures should acknowledge that a “reasonable” level of due diligence is a contextual determination in the circumstances of each underwriting.

Due Diligence Plan

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. Less extensive due diligence procedures may be reasonable for seasoned and widely-followed issuers, particular where the underwriter is familiar with the issuer as a result of an ongoing relationship. The due diligence plan should also reflect the type of offering. For example, initial public offerings or reverse take-overs will typically require more due diligence than offerings by existing reporting issuers.

Due Diligence Q&A Session

The due diligence question and answer sessions or “due diligence calls” 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. Any responses that appear incomplete or evasive should be considered a red flag that triggers follow-up questions or further review.

Business Due Diligence

The Dealer Member should perform business due diligence sufficient to ensure that it understands the business of the issuer and the key internal and external factors affecting the issuer’s business. While the extent of appropriate business due diligence is a contextual determination, the central element of the business due diligence is independent verification of key material facts in the prospectus.  The due diligence plan should delineate legal versus 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 and the issuer’s public disclosure; and conducting in-depth discussions with management and experts.

Legal Due Diligence

Dealer Members should clearly understand the boundary between business due diligence and legal due diligence to ensure that matters which should be reviewed by underwriters are not delegated to underwriters’ counsel. The dealers should provide adequate supervision of the legal due diligence performed by underwriters’ counsel. The results of the legal due diligence should inform business due diligence investigations.

Reliance on Experts and Other Third Parties

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.  Dealer Members should consider whether experts are properly qualified for the task for which the experts are retained and should obtain reasonable evidence that such experts have consented in writing to their expert reports being used in the prospectus.

Reliance on Lead Underwriter

Each member of the syndicate 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.

Due Diligence Record Keeping

The Dealer Member should document the due diligence process to demonstrate compliance with its policies and procedures, IIROC requirements and applicable securities laws. The due diligence policies and procedures should describe which documents must be kept in the transaction file.

Role of Supervision and Compliance

IIROC Dealer Member Rule 38 requires each dealer 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. 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 team must be involved throughout the process and is responsible for the quality and extent of the due diligence. The Dealer Member’s execution of the prospectus certificate page as an underwriter should signify that the Dealer Member has participated in the due diligence process through appropriate personnel and internal processes.

Implications

While IIROC does state that the guidance note is not intended to create new legal obligations or modify existing ones, the publication is an opportunity for underwriters to review their internal practices in light of IIROC’s newly published expectations.

As the guidance note is IIROC’s first codification of what constitutes reasonable due diligence, it will also likely become the reference point  for any court or regulatory action relating to an underwriter’s due diligence defence under Section 122 (2) of the Securities Act (Ontario).