Chapter 14 - Investment Banking (v1.2)

Underwriting Red Flags

• Red flags that underwriters should document:
  • Inconsistent grants of stock options
  • Material sales of securities by insiders
  • Recent ratings downgrades
  • Identical interview answers from customers and third parties
  • Deflection or avoidance of interview questions
  • Withholding of requested information
  • Undue delay or denial of a site visit

Legal Due Diligence

• Legal due diligence is reviewed by the underwriter’s legal counsel
• Responsibilities may include:
  • Contract review
  • Examination of local laws
  • Government relations
  • Issues related to asset ownership in each jurisdiction
• Legal counsel plays an important role in due diligence in foreign and emerging markets
• Underwriters should assign appropriate tasks to legal counsel but should avoid overusing them
• The underwriter is ultimately liable to purchasers
• When multiple underwriters are present, the legal counsel communicates the results of legal due diligence to all syndicate members

Reliance on Experts

• An industry expert may be involved in the issuance of a prospectus through a report, opinion, statement, or other disclosure
• An expert can be a lawyer, auditor, accountant, engineer, appraiser, or any person or company authorized to provide a statement
• The level of expert involvement depends on the specific circumstances surrounding the prospectus
• Individuals executing a prospectus on behalf of a dealer member should confirm that the firm’s policies and procedures have been followed and that any red flags have been addressed

Supervision of Underwriting

• Supervision of the underwriting process can be done by a committee established by the dealer member
• Compliance with underwriting due diligence can be carried out by the compliance department, legal department, or internal audit department
• Compliance can occur during the underwriting process with the department or person responsible participating in a committee that oversees the process
• The dealer member should put in place a structure that reflects the firm’s size, function, and business model

The Research Department

• IDPC Rule 3600, Part B outlines the requirements for establishing a supervision program for a research department
• The rule sets out standards for analysts when publishing research reports or making recommendations and addresses conflicts of interest
• One of the key issues is defining what material should be covered under research policies and procedures and what is considered marketing material
• The key difference is that research makes a recommendation to buy, hold, or sell a security, while marketing material promotes the sale of the firm’s products and services
• Research requires additional disclosures to address inherent conflicts of interest that arise when the same dealer provides advisory and trading services to companies they cover with research
• The compliance program for marketing and research should review departmental policies and procedures, including a regular sampling of work product
• Marketing and research should utilize clipping services and internet searches to identify marketing materials that have not flowed through proper channels

Derivatives and Complex Products

• Supervision of a dealer member’s derivatives transactions requires designated and proficient staff at both the compliance and departmental levels
• Derivatives include a number of separate products that require specific policies and procedures
• The rules and requirements vary for exchange-traded options, exchange-traded futures, options on futures, commodities, over-the-counter derivatives, and structured products
• Exchange-traded options include equity and index options traded on the Montreal Exchange and on various U.S. or international exchanges
• Futures and options on futures cover broad-based product and sector indexes, government debt, short-term treasuries, long-term bonds, and commercial paper
• Commodity futures include agriculture futures, oil and gas futures, and metal futures
• Commodity futures typically have physical settlement, so care must be taken to ensure that any expiring futures are closed out before expiry
• Over-the-counter derivatives include interest rate swaps, equity swaps, collateralized debt obligations, credit default swaps, and any other non-standard derivatives with terms negotiated under an International Swaps and Derivatives Association agreement
• Structured products are notes that combine exposure to an underlying asset, such as an equity index, with principal protection

Derivatives and Complex Products Supervision

• A designated derivatives supervisor is responsible for approving new derivatives accounts, reviewing client and firm trading activity, and ensuring regulatory, large position reporting is completed on time
• Product due diligence procedures should include the following:
  • A standardized process that requires a written proposal for new products
  • A preliminary assessment of a proposed product or concept by the dealer member, or a department designated in the firm’s policies and procedures, to determine:
    • Whether the product is new or a material modification of an existing product
    • The appropriate level of internal review
  • For new products or material modifications to existing products, a detailed review by a committee or working group made up of representatives from all relevant sectors of the firm, including compliance, legal, finance, marketing, sales, and operations
  • A formal decision to approve, disapprove, or table the proposal by a new product committee or other decision-making group that includes members of the firm’s senior management
  • An assessment of the extent of training in product features and risks necessary to ensure advisors and supervisors can judge the suitability of recommendations and sales to clients, and the development and implementation of the necessary training
  • If the product is approved, a determination of the appropriate level of, and process for, post-approval and follow-up, including consideration of the following aspects:
    • Monitoring of customer complaints and grievances related to the product
    • Reassessment of training needs on a continuing basis
    • Monitoring of compliance with restrictions placed on the sale of the product
    • Periodic reassessment of the suitability of the product

Research Supervisor

• Most research departments have a director or supervisor responsible for compliance with industry regulations
• Appropriately trained staff should review all research products prior to distribution
• The research supervisor is responsible for reviewing and approving research reports and ensuring that those reports contain information based on facts, not rumors
• A research report should never exclude information relevant to an investor making an investment decision
• The supervisor also works with compliance on research that may be about issuers on the grey or restricted lists

Conflicts of Interest

• Many conflicts of interest came to light during the tech boom and subsequent crash of 2000–2001
• At that time, it was determined that a number of research analysts produced reports that were in conflict with their true opinions, or that were influenced by the desire to please the subject companies so that investment bankers could win more of their business

Preventing Conflict of Interest

• IDPC Rule section 3621, Relationship with investment banking, states:
  • A Dealer Member’s policies and procedures must specifically address preventing recommendations in research reports from being influenced by the investment banking department or the issuer.
  • The policies and procedures must specifically address, at a minimum:
    • Prohibiting the approval of research reports by the investment banking department
    • Limiting the investment banking department’s involvement in the production of research reports solely to the correction of factual errors
    • Prohibiting and preventing the investment banking department from receiving advance notice of new ratings or rating changes on covered issuers
    • Establishing systems to control and record the flow of information between analysts and investment banking department staff regarding issuers that are the subject of current or prospective research reports

Registered Individual Responsibilities

• A registered individual must not purchase or sell securities for a client or recommend securities to a client unless the registered individual takes steps to understand the securities, including:
  • The securities’ structure
  • Features
  • Risks
  • Initial and ongoing costs
  • The impact of those costs