Written By J. Paul Barbeau and Eric Chernin
On December 18, 2014, the Investment Industry Regulatory Organization of Canada (IIROC) published, with immediate effect, Rules Notices 14-0299 and 14-0300 in connection with the release of final guidance (Final Guidance) with respect to underwriting due diligence.
The Final Guidance incorporates limited changes from the draft guidance previously published on March 6, 2014, to reflect comments received from market participants. This article summarizes the key changes in the Final Guidance and outlines certain implications of the Final Guidance.
For a detailed summary of the proposed guidance, please refer to our article, IIROC Proposes Guidance for Underwriting Due Diligence, published on March 18, 2014.
The Role of Underwriters and the Due Diligence Defence
As noted previously, underwriters may be liable for a claim of damages (to compensate for loss) or rescission (a return of purchase price) if there is a misrepresentation in a prospectus. However, an underwriter is shielded from liability if it conducted a reasonable investigation of the material facts underlying the disclosure in the prospectus. This is referred to as establishing the "due diligence defense". The Final Guidance and the associated rules are not intended to create an objective standard of what constitutes reasonable due diligence, nor does it create new, or modify existing, legal obligations. However, the Final Guidance provides valuable direction for underwriters by addressing the appropriate level of due diligence required in order to discharge their role as gatekeepers of the capital markets, protect against reputational harm and establish the statutory due diligence defence.
The Final Guidance continues the theme that due diligence should be customized to the particular issuer, the industry in which it operates and the type of security being offered. Underwriters are expected to exercise professional judgment to determine the appropriate level of due diligence in each set of circumstances.
Material Changes in Final Guidance from Proposed Guidance
The following material changes and clarifications are reflected in the Final Guidance:
- Underwriters' "Gatekeeper" Obligations – The use of the term "gatekeeper" throughout the Final Guidance refers to underwriters' existing statutory obligations and does not introduce a new and undefined standard of responsibility.
- Due Diligence Plans – The decision to prepare a formal written due diligence plan is a contextual determination rather than a mandatory prescription. If the underwriter's policies and procedures adequately set out the matters to be considered, a separate written plan may not be required for all offerings. In addition, each syndicate member does not require an individual plan.
- Participation of Syndicate Members – While each syndicate member should be involved in the due diligence process, the lead underwriter is only required to provide copies of due diligence materials to those syndicate members who have requested such materials. The role played by syndicate members and the manner in which syndicate members are involved in the specific aspects of the due diligence process is a contextual determination dependent upon a variety of factors, including the type of offering. The Final Guidance notes that the lead underwriter may keep more detailed documentation than other syndicate members. However, the specific record keeping required of syndicate members is a contextual determination.
- Business Due Diligence – The underwriter should perform business due diligence sufficient to ensure that it understands the business of the issuer and the key factors affecting the issuer's business. With respect to business due diligence, the Final Guidance has been revised to contemplate the potential use of materiality thresholds in the due diligence plan (from both quantitative and qualitative perspectives) and sampling (in the context of large and complex issuers where the volume of due diligence matters may make it relatively impracticable, if not impossible, to review all documentation). The Final Guidance further notes that the extent of independent verification of material facts for any offering depends on the context. In particular, underwriters are expected to exercise professional judgment taking into account all relevant factors in determining which factual statements will be verified independently, including the firm's familiarity with the issuer, the nature of the issuer's business, the issuer's history, size, complexity, financial position, management and reporting history and the type of security being offered.
- Underwriters' Reliance on Experts and Other Third Parties – Securities legislation provides that underwriters are not liable for a misrepresentation with respect to any expertised portion of a prospectus provided the underwriters had no reasonable grounds to believe that there had been a misrepresentation. The Final Guidance expressly acknowledges that, in specific industries (such as mining, oil and gas and technology) and in circumstances where it is not reasonable or economically feasible for an underwriter to retain its own experts, it may be appropriate for an underwriter to rely on the issuer's third party experts in the absence of a reason to suspect that such experts are providing improper, incorrect or biased information.
- Reliance on Due Diligence Conducted in Prior Offerings – IIROC declined to explicitly recognize the ability of an underwriter to rely on due diligence investigations performed in respect of any prior offerings by an issuer. In particular, IIROC noted that the appropriate degree of reliance on a prior due diligence investigation is highly contextual and dependent upon a variety of factors, including the relationship between the issuer and the underwriter. Where the underwriter considers relying on due diligence performed by another firm in a prior offering, the reasonableness of such reliance will depend on a wide range of factors, including the time that has passed since the previous offering, the nature of the previous offering, whether the underwriter was part of the syndicate on the previous offering, the degree of familiarity that the underwriter has with the other firm and its due diligence practices, and the amount of information available to the underwriter regarding the due diligence performed by the other firm.
Practical Concerns
- Grounds for Litigation – Notwithstanding IIROC's view that the Final Guidance should not be interpreted as creating new requirements, we reiterate our view that while the guidelines provide a useful framework, they also present plaintiffs with a benchmark against which they can evaluate the sufficiency of the due diligence performed by the underwriters.
- Business Diligence – The Final Guidance expressly permits an underwriter, in appropriate circumstances, to manage its business due diligence through the use of materiality thresholds and sampling. This acknowledgement should ease, though not eliminate, the difficulties associated with the "due diligence paradox" (i.e., underwriters are obligated to perform more extensive business and legal diligence for cost-sensitive junior, infrequent and emerging market issuers) and the "due diligence dilemma" (i.e., accelerated short form offerings inhibit the ability to complete a reasonable investigation).