Chapter 14 - Investment Banking.pdf

Investment Banking 14 CONTENT AREAS Institutional Businesses Investment Banking Underwriting Due Diligence The Research Department Financial Engineering LEARNING OBJECTIVES...

Investment Banking 14 CONTENT AREAS Institutional Businesses Investment Banking Underwriting Due Diligence The Research Department Financial Engineering LEARNING OBJECTIVES 1 | Describe the structure of an institutional business. 2 | Summarize the requirements for an institutional supervision program and the role that compliance plays. 3 | Explain the due diligence requirements for underwriters. 4 | Distinguish between marketing and research, and explain the specific requirements for writing research. 5 | Discuss financial engineering and the supervision program required for new products. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 3 INTRODUCTION In the previous chapter, we explored the supervision of retail and institutional trading activities. In addition to these activities, some dealer members engage in other business lines that focus on raising capital through underwriting, such as corporate finance, and providing advice to issuers regarding mergers and acquisitions. These areas are typically referred to as investment banking activities. Some investment dealers also engage in developing and publishing research about other reporting issuers. In this chapter, we explore these areas as well as other activities that are typically associated with investment banking. In this context, we examine the applicable rules and best practices that are considered the key elements of compliance and supervision for the institutional businesses of an investment dealer registered with CIRO. INSTITUTIONAL BUSINESSES 1 | Describe the structure of an institutional business. A dealer member’s institutional divisions consist of complex businesses, and each business requires its own policies and procedures. Those policies and procedures must be reasonably designed to ensure that the firm complies with all applicable rules and regulations. In addition, the compliance staff and supervisors for the different business units must have a sufficient understanding of their businesses and the resources to conduct appropriate supervision. The compliance department conducts oversight of the supervision program by independently monitoring business activities. However, compliance is the shared responsibility of all employees, partners, directors, and officers. INSTITUTIONAL PRODUCT LINES AND ACTIVITIES Institutional divisions (and a dealer member’s non-retail activity types in general) correspond to the following product lines and activities: Investment banking (e.g., corporate finance and mergers & acquisitions) Research Equity sales and trading Fixed income sales and trading Derivatives trading Foreign exchange Prime brokerage and securities lending Effective compliance in each division requires that supervisors understand their customers and the products and services they sell to them. They must know how the dealer member’s products are traded, sold, or offered, and they must know the rules, regulations, and risks associated with the products. INSTITUTIONAL CUSTOMERS A crucial concern for a compliance program for institutional business is the accurate categorization of clients, particularly regarding suitability obligations. It is important to note that, on the CIRO platform, all individuals are considered retail clients regardless of net worth, securities under management, or level of sophistication. © CANADIAN SECURITIES INSTITUTE 14 4 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 The following types of clients fall under CIRO’s definition of an institutional client: An Acceptable Counterparty (as defined in Form 1) An Acceptable Institution (as defined in Form 1) A Regulated Entity (as defined in Form 1) A Registrant (other than an individual registrant) under securities legislation A non-individual with total securities under administration or management exceeding $10 million Most institutional clients are sophisticated clients who evaluate the suitability of the products and services in which they transact and make their own investment decisions. However, not all institutional clients are sophisticated, and the ability of even sophisticated clients to make an independent investment decision can vary from product to product. Therefore, when dealing with an institutional client, a dealer member must determine the level of suitability owed to that client based on the client’s level of sophistication. If the firm has reasonable grounds to believe that the client is capable of independently evaluating investment risk and making independent choices, the firm’s suitability obligation is fulfilled for that transaction. DIVE DEEPER IDPC Rule section 3403, Institutional client suitability determination requirements, states: (2) When a suitability determination must be made for an institutional client pursuant to subsection 3403(1), a Dealer Member must make a determination whether the client is sufficiently sophisticated and capable of making its own investment decisions in order to determine the level of suitability owed to that institutional client. In making a determination whether a client is capable of independently evaluating investment risk and is exercising independent judgment, relevant considerations include: the general level of experience of the client in financial markets, the specific experience of the client with the type of instrument under consideration, and the complexity of the securities involved. For complete requirements see www.CIRO.ca Dealer members have no suitability obligation for institutional clients who are also permitted clients (as defined in NI 31-103) and who have waived the dealer members’ suitability obligations in writing, as permitted under CIRO rules. Dealer members also have no suitability obligation when executing a trade on the instructions of another dealer member, portfolio manager, investment counsel, exempt market dealer, bank, trust company, or insurer. Many, but not all, institutional clients fall within these categories. It is therefore crucial that firms have appropriate procedures in place to properly categorize and evaluate clients, and test for client sophistication. They should also ensure appropriate handling of clients that are owed suitability obligations. MINIMUM STANDARDS FOR INSTITUTIONAL ACCOUNT SUPERVISION Investment dealers that engage in institutional business must have their own policies and procedures designed to cover the unique risks that come with the complexity of the products and services offered. Compliance programs, including staffing, must take these risks into account. For example, a firm that structures derivative products requires specific compliance expertise to ensure that compliance oversight is effective. It may also require information technology support in developing exception reports that are designed to address the complexities of the products sold. The supervisory structure of an institutional business requires a registered supervisor for regulated products and services such as trading, underwriting, advising, and research. Each institutional business typically has its own © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 5 supervisor, who is often an executive of the dealer and may even supervise more than one business. Because the supervisor is an executive and may also be a producer, he or she often delegates supervision tasks to subordinates or administrators. The supervisor, however, cannot delegate responsibility. The compliance department may also play a separate monitoring and advisory role to the supervisor and business units, as well as to employees who have been delegated the supervisory functions. Institutional compliance staff members generally work closely with institutional supervisors in their oversight capacity. These supervisors are normally the major point of contact between compliance and the business. Compliance staff should make sure that supervisors are kept informed of compliance activities and of enquiries made directly to trading or capital markets staff. DOCUMENTING SUPERVISION It is essential that compliance staff and business supervisors document all issues that arise and all actions taken to address them. They must also document the outcome so that a regulator or other third party reading the record is able to conclude that the issues were appropriately identified and addressed. EMPLOYEE PERSONAL TRADING Investment dealer employees who work with institutional clients are frequently exposed to market moving information about large pending trades. They usually have immediate access to market events and news announcements, and to information about client strategies and firm positions. They are also in a position to receive material non-public information about public companies. For these reasons, dealer members generally impose personal trading policies on institutional employees that are more restrictive than those that apply to retail advisors. These policies often include hold periods, restricted lists, and pre-clearance requirements. Each business unit has its own specific policies and procedures based on the type of information that they have access to. These restrictions are designed to ensure that line employees do not take advantage of any information that comes into their possession by virtue of their role with the investment dealer. Ultimately, the restrictions are put in place to preserve the integrity of the capital markets. INVESTMENT BANKING 2 | Summarize the requirements for an institutional supervision program and the role that compliance plays. Supervisory controls and compliance with rules and regulations in investment banking divisions such as corporate finance, and mergers and acquisitions advisory groups is generally the responsibility of a business or administrative supervisor in the department. Additional monitoring is conducted by compliance or legal staff members, who are often physically located in the department. Typically, senior management reviews potential capital markets assignments for conflicts of interest before entering into discussions with, and being engaged by, an issuer. A conflicts review is conducted to determine whether any other conflicting engagements within the dealer exist. For example, a dealer member cannot provide advisory services to both an acquirer and the target. The conflicts review is also used to determine whether the dealer has a significant ownership stake in the target company or is in possession of material non-public information about the company. The result may be that certain people are excluded from a deal team. Other issues may require additional consideration, such as the continuation of research coverage of companies involved in a transaction. It is typical and appropriate for compliance staff to be directly involved in this exercise. © CANADIAN SECURITIES INSTITUTE 14 6 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 The mergers and acquisitions advisory groups provide advice and valuations services. Along with other corporate advisory services, they advise companies that are acquiring or disposing of companies or assets, or that are restructuring their capital base. Most of these services require some form of due diligence. The corporate finance supervisor is responsible for ensuring that due diligence materials are retained in compliance with the firm’s document retention policies. These documents may be later referred to by compliance, auditors, regulators, or litigators. Many dealer members standardize the content of engagement letters and due diligence procedures. These articles are subject to review by committees such as an underwriting or capital commitment committee. These committees also review decisions relating to the use of the firm’s capital in underwriting or financing. Levels of financial commitment may be subject to a hierarchy of required approvals set out in a capital commitment policy. An engagement letter includes information on the work to be done, the length of the engagement, the amount of fees, any indemnities or disclaimers, reference to any success fee or retainer, and disclosures to identify any conflicts of interest. An engagement letter is often treated as a contract between the advisors or investment bankers and their clients. It is essential, therefore, that the legal department review any changes or disclosures that could present a legal or business risk. UNDERWRITING AND SYNDICATION IDPC Rule section 3509, Premarketing, specifically prohibits the premarketing of bought deals. It also requires that dealer members underwriting bought deals file a certificate with CIRO certifying that no premarketing has occurred. Green sheets are one- or two-page summaries of a new issue (traditionally printed on green paper) intended for internal circulation only. Supervisors should monitor sales and trading areas to ensure that green sheets are not circulated to clients. Any discussions with clients about a particular new issue should be based on the information contained in an official offering document, such as a prospectus. Preliminary prospectuses prepared in anticipation of an offering of securities generally exclude pricing information. Preliminary prospectuses can be circulated to clients provided that they are subsequently sent a final prospectus. Investors who have not received a prospectus have specific rights. It is important, therefore, that a record be maintained of all clients who received preliminary prospectuses to ensure that they are sent a final prospectus. The rationale for this procedure is to ensure that clients making decisions on the purchase of an offering are doing so with all information available at the time, which is typically found in the final prospectus. INFORMATION BARRIERS AND RESTRICTED LISTS The investment banking department of a dealer member includes divisions on both the private and public sides of the dealer member. The private side includes those departments that often receive confidential information from private and public companies as part of their business activities. This confidential information may include material non-public information which, if made public, could have a material impact on the value of the company’s securities. The public side includes equity sales, trading, research, and other employees who have no business requirement to know this information. The safeguarding of confidential information is an issue for all dealer members. In addition to general privacy obligations, corporate finance and investment banking activities give rise to particular concerns about inappropriate trading based on such information. However, the issue of confidentiality is not limited to firms that engage in such business. All dealer members should identify the ways in which their staff may come into possession of material non-public information that could be used for insider trading. They may come by such information through trading by issuers, through research, or through their relationships with corporate insiders. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 7 Procedures should be implemented to bring this issue to the attention of management and determine how it will be dealt with. In general, appropriate written policies and procedures should address the following areas: Education of employees Containment of inside information Implementation of physical barriers and restricted access to relevant information Restrictions on certain activities and transactions Trading surveillance All investment dealers, in particular those that engage in investment banking or research activities, must have controls to safeguard material non-public information in the possession of the dealer and its employees. They must take steps to ensure that such information is not improperly used or disclosed. Restrictions include trading, advising, and dissemination of research material in relation to the relevant security. Guidance on specific procedures can be found in the following sources: CIRO’s Guidance Note 3500-21-001, Guidelines for Confidential Information Containment, Ontario Securities Commission Policy 33-601, Guidelines for Policies and Procedures Concerning Inside Information; and UMIR 7.7. The following discussion summarizes some of the salient considerations. INFORMATION BARRIERS Information barriers (or firewalls) are implemented to isolate employees who are privy to undisclosed material information from personnel who make trading and investment decisions and might be influenced by the information. Issuers that have approached a dealer member about involvement in a potentially material transaction, such as a possible offering, merger or acquisition, or other corporate assignment not publicly disclosed, are recorded on a grey list (or watch list). Grey lists generally have very restricted dissemination because the addition of an issuer to the list may signal that a material transaction is about to occur. Grey lists are maintained to monitor trading by employees on the private side who have been exposed to the relevant information and are therefore precluded from trading. Monitored employees include senior management, corporate finance, mergers and acquisitions personnel, and professional traders. Grey lists are also used to monitor trading and activities by public side personnel (including sales, research, and trading staff) for unusual activity indicating that information may have been disclosed. Any employee who becomes aware of the confidential information is said to have “crossed the wall”. Such incidents should be recorded and the employee’s activities constrained and monitored accordingly. RESTRICTED LISTS Restricted lists contain the names of issuers that are subject to trading and other restrictions when the reason for the restrictions is generally known. An issuer’s name is usually moved from the grey list to the restricted list after the dealer member has agreed, for example, to act as an underwriter or banking group member, or to represent the issuer in a merger or acquisition. In this case, the transaction has been generally disclosed but the firm still has, or may gain access to, inside information during the course of the transaction. Restricted lists are more broadly distributed than grey lists to ensure that sales and trading staff are aware of the restrictions. A security may be restricted for many reasons, and the nature of restrictions varies. Many dealer members have more than one restricted list for that reason. The restrictions in UMIR 7.7 are designed to prevent inappropriate price support while a firm is acting as an underwriter or selling agent in the course of a distribution. Other restrictions might include the imposition of a PRO hold period for a specified time immediately after a research recommendation to allow time for dissemination. © CANADIAN SECURITIES INSTITUTE 14 8 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Information barriers and restricted lists are often accompanied by trade pre-clearance policies and procedures for defined registrants. In such cases, employees who may be privy to confidential information, or who are otherwise in a sensitive position, must obtain approval before effecting a personal trade. This safeguard further ensures adherence to grey list and restricted list requirements. Such mechanisms can also apply to certain staff, such as research analysts, traders, and portfolio managers, who may be privy to confidential information that is not normally reflected in the lists. For example, certain proprietary or client trading programs may not be captured in a list, but nevertheless a heightened degree of control is warranted. Pre-clearance requirements are typically applied only to selected employees. They usually exclude securities such as mutual funds or highly liquid securities that are not susceptible to activities such as insider trading or frontrunning. CROSSING INFORMATION BARRIERS Communications between the investment banking and research departments are particularly problematic because of potential for conflicts of interest. Some firms prohibit communications between these departments, whereas others have detailed protocols for such communications. If a research analyst is brought over the wall to assist the investment banking division, he or she cannot provide any research commentary on the securities of the issuer involved. Furthermore, the securities are usually added to a restricted list. This issue should be addressed in the firm’s firewall policies. These situations should always be pre-approved by senior management who sit above the wall. They should evaluate the impact of any restrictions on the ability of the firm to continue to service its clients when an analyst is restricted from discussing or performing any trading-related activity in that issuer. PERSONAL TRADING RESTRICTION FOR INVESTMENT BANKERS Because investment bankers are commonly exposed to material non-public information about the companies that engage them, they are usually restricted from trading any securities of an issuer on the grey or restricted lists. Investment bankers are often subject to trade pre-approval requirements and may also have hold periods on securities ranging from one to six months. Some dealer members impose a complete prohibition on employee purchases of equities in sectors they cover, or of equities and equity options entirely. These restrictions are designed to prevent insider trading and to avoid any appearance of a potential conflict of interest. In many firms, the compliance department manages the pre-clearance process to limit the circulation of the grey list. UNDERWRITING DUE DILIGENCE 3 | Explain the due diligence requirements for underwriters. Underwriters at a dealer member, along with legal counsel, auditors, and other experts, are considered gatekeepers in the marketplace. When acting in this capacity, they carry out activities that are critical to maintaining the integrity of the underwriting process and to fostering fair and efficient capital markets. CIRO’S GUIDANCE RESPECTING UNDERWRITER DUE DILIGENCE Dealer members should incorporate certain considerations into their policies and procedures manual in order to properly discharge all of their regulatory and legal obligations when carrying out a corporate finance or underwriting function. In this regard, Guidance Note (GN) 3500-21-005, Guidance Respecting Underwriting Due Diligence, defines due diligence as “the process by which the underwriter takes reasonable steps to ensure that all prescribed information is included in the prospectus, to investigate the information provided by the issuer for inclusion in the prospectus and to verify key material facts.” © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 9 As the name suggests, the guidance note is intended as guidance only, rather than a strict standard of effective due diligence. It provides dealer members with policy direction and recommendations to apply to their due diligence processes in a way that is relevant to the particular dealer member. The dealer member’s policies, procedures, and practices must conform to its obligations as underwriter during the issuance of a prospectus by reporting issuers. Guidance Note 3500-21-005 also informs CIRO’s compliance reviews of dealer members’ underwriting policies and procedures. However, it does not impose concrete terms, requirements, or expectations and should not, therefore, be used as a simple checklist exercise. Used properly, the guidance note should assist in creating policies and procedures that are flexible and robust enough to allow a dealer member to discharge all regulatory expectations. This approach is consistent with principle-based regulation, which permits dealer members to tailor their approach to compliance in a manner that best suits their business model and size. IMPORTANCE OF UNDERWRITER DUE DILIGENCE Due diligence is a critical aspect of any business undertaking in any industry to ensure that actions taken are correct and effective. In many cases, it also serves to mitigate risks and limit or eliminate liability should something go wrong. Proper due diligence during the underwriting process allows the dealer member to certify that, to the best of its knowledge, the prospectus in question fully and plainly discloses all material facts regarding the securities offered. In issuing a prospectus certificate, the dealer member discharges its obligation as underwriter to the issuer. If done improperly, however, the dealer member may have regulatory, legal, and contractual liability under the prospectus, as well as under applicable provincial securities legislation. DID YOU KNOW? Exercising due diligence in the issuing of a prospectus is mandated by statute. For example, section 56(1) of the Ontario Securities Act provides that a “prospectus shall provide full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed and shall comply with the requirements of Ontario securities law”. Due diligence is also required to comply with national regulation. National Instrument 41-101 General Prospectus Requirements requires a prospectus certificate to be issued by the underwriters. This prospectus certificate must be signed by the underwriters and must include the following statement: To the best of our knowledge, information, and belief, this prospectus constitutes full, true, and plain disclosure of all material facts relating to the securities offered by this prospectus as required by the securities legislation of [insert jurisdictions of issue]. By issuing this statement, the underwriter is asserting that the prospectus does not contain a misrepresentation, based on the knowledge and information available to the underwriter. A misrepresentation can take one of the following three forms: An untrue statement of a material fact The omission of a material fact that must be stated The omission of a material fact that is necessary to make a statement not misleading, in light of the circumstances in which it was made The successful execution of the due diligence function serves not only to comply with the laws and regulations but also to establish a due diligence defence under both criminal and civil law. Documentation of proper due diligence provides support in the event that the dealer member’s role is questioned during litigation or other regulatory enquiries. Some legislation provides that underwriters can be exempted from liability for misrepresentation, if they can prove that they did not and could not have known that it was a misrepresentation after taking appropriate and reasonable due diligence measures. © CANADIAN SECURITIES INSTITUTE 14 10 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Proper due diligence has the added benefit of providing the best product possible in the form of a complete prospectus. When the prospectus provided is true and contains all material information, to the best of the underwriter’s knowledge, the issued security is likely to be sound and unlikely to cause problems for subsequent investors. Proper due diligence also serves to enhance the issuer’s reputation, not only by ensuring that the prospectus meets regulatory expectations, but also by assisting the investor in making an informed decision. One of CIRO’s objectives in calling for effective due diligence among underwriters is to promote consistent processes and enhanced standards at all of its dealer members. In fact, GN 3500-21-005 was developed after CIRO identified variations in the due diligence and recordkeeping practices of dealer members during its business conduct examinations. The guidance note is therefore an important tool used in formulating any dealer member’s policies and procedures, and overall approach to a successful due diligence process. COMPONENTS OF UNDERWRITER DUE DILIGENCE The purpose of due diligence is to ensure that the information contained within a prospectus is complete and correct. How this purpose is achieved varies from firm to firm and from situation to situation. For this reason, no strict rules for creating a due diligence program can be provided; a procedure must be tailored to each set of circumstances. However, GN 3500-21-005 does outline key items to include in the program that can be modified as needed. CIRO also requires that each dealer member review its underwriting due diligence program regularly to ensure that the program is consistent with regulatory expectations. When exercising professional judgment to ensure that the underwriting process is completed appropriately in each set of circumstances, the dealer member may identify items to include in its program over and above those recommended in the guidance note. CIRO provides detailed expectations for what should be included in an underwriting due diligence program. The content that follows explores some of those details. UNDERWRITING DUE DILIGENCE POLICIES AND PROCEDURES Dealer members are generally obliged to create, maintain, update, and apply policies and procedures that promote and establish an effective system of compliance. This system should ensure that the firm and its registrants comply with applicable CIRO rules and securities legislation. It should also identify the level of business risk that the firm is prepared to accept in its day-to-day operations. Finally, the written policies and procedures regarding a dealer member’s function as an underwriter must reflect the firm’s specific circumstances and the range of activities that it engages in. In this vein, GN 3500-21-005 suggests that a dealer member’s approach to underwriting should contemplate the following concepts: Due diligence Reasonable steps must be taken to ensure that the underwriting process results in the prospectus containing all prescribed information. In addition, the process must ensure that information provided to the underwriter by the issuer is thoroughly investigated before it is included in the prospectus. In other words, at the conclusion of the underwriting process, the prospectus must contain full, true, and plain disclosure of all material facts relating to the securities being offered. Context The context and circumstances of each underwriting are carefully considered to determine what is reasonable with respect to the due diligence undertaken. The underwriter and its senior investment banking staff must exercise professional judgment in making such decisions. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 11 External factors Depending on the specific circumstances, additional steps outside of the basic due diligence process are required to effect a complete review. This requirement contemplates that underwriters depart from a strict checklist approach in all circumstances and that they evaluate additional information as required, before executing the prospectus certificate. In developing a complete set of underwriting due diligence policies and procedures, the topics described below should be considered. DUE DILIGENCE PLAN A due diligence plan is a written description of the matters to be investigated by the underwriter. It must reflect the context of the offering, the type of issuer involved, and the level of due diligence that is reasonable in the circumstances. The plan should also represent an overall understanding of the business and industry of the issuer. With respect to emerging market issuers, dealer members may enhance their due diligence planning, given the special circumstances that issuers in emerging markets typically raise. The dealer member should evaluate the decision to prepare a formal due diligence plan, in light of the circumstances of the offering. If the firm’s policies and procedures address all relevant topics in a correct and comprehensive manner, a separate and specific plan may not be required. In addition, a plan may not be required for an established and well-known issuer. On the other hand, if a plan is required, it must be extensive enough to effectively encompass all necessary components. Guidance Note 3500-21-005 recommends that a due diligence plan be created in at least the following cases: An initial public offering A reverse takeover A small or infrequent issuer Equity offerings An unusual, complex, or significant transaction A situation in which a significant amount of time has passed since a dealer member last performed a due diligence investigation The issuer being located in a foreign or emerging market The contents of a due diligence plan must be flexible and based on the facts of the case. For example, with a small or infrequent issuer, the size of the offering may be small, but the dealer member must nevertheless devise a plan that reflects its concerns in bringing the deal to the marketplace. The plan must be flexible enough to allow for modifications and iterations, as the need arises. It should be developed in conjunction with the underwriters’ counsel and, if more than one underwriter is involved, it should reflect the lead underwriter’s preliminary expectations of the scope of its due diligence investigation. Appendix B of Guidance Note 3500-21-005 provides specific items that a dealer member should consider when developing an underwriting due diligence plan. DUE DILIGENCE Q&A SESSIONS Question-and-answer sessions should be held for everyone involved in issuing the prospectus and in the due diligence process. The session may include the issuer’s management, auditors, counsel, and other relevant subject matter experts, as well as members of the syndicate. All members of the syndicate should have representation present and be given the opportunity to address any concerns they may have. Those people who are present on © CANADIAN SECURITIES INSTITUTE 14 12 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 behalf of syndicate members must have an appropriate level of seniority to properly represent the syndicate member in question. To have an effective and efficient Q&A session, underwriters should provide a list of questions in advance of the session to the issuer’s management, counsel, or auditors. Those people who are required to answer the questions are thus able to prepare in advance and avoid a lengthy back-and-forth process. For equity offerings, a Q&A session is often held at least twice: once prior to filing the preliminary prospectus and once prior to filing the final prospectus. Given the broad range of people involved, the sessions provide an opportunity to address any outstanding issues in the offering process through questioning and discussion. It is again recommended that questions to be asked by the underwriters or counsel be provided to management prior to the meeting. This step allows management to provide a complete and accurate response and allows the people best suited to answer the questions to be in attendance. One crucial purpose of a Q&A session is to allow the underwriters to identify to the issuer any warning signs of trouble that may have arisen during the underwriting process so that the issuer and its counsel or auditors can address them. Furthermore, the underwriter should evaluate the responses it receives regarding potential problems. An incomplete or evasive response may trigger additional enquiries by the underwriter or syndicate member. BUSINESS DUE DILIGENCE Business due diligence requires that the underwriter have a working knowledge and understanding of the business of the issuer, including key internal and external factors. Due diligence in this regard should include the following elements with respect to the issuer: Independent verification of key material facts in the prospectus Visits to principal locations, including the head office and major operation sites Review of business plans, budgets, and projections Assurance that documents for review are not chosen solely by the issuer’s management Retention of local agents to assist with assessment of any senior members of management or directors located outside of Canada In-depth consultation with management, financial and accounting personnel, independent auditors, and external legal counsel Review of publicly available disclosure documents and comparison of the documents to those of similar issuers Review of key operational data Review of material contracts, litigation, regulatory correspondence, and other key documents Review of relevant external information as available The following business due diligence activities may also be applicable, depending on the context and transaction: Consulting research analysts, industry experts, and other third parties related to the issuer and its industry Establishing a materiality threshold on both a quantitative perspective (in regard to dollar value) and qualitative perspective (in regard to area of business, operations, risk, and other factors) Holding background checks on the board of directors, senior executives, and other key members of management Interviewing customers, suppliers, and counterparties to material contracts The extent of the due diligence will vary depending on the circumstances. A more intensive due diligence process may be required with initial public offerings or with the involvement of foreign entities or markets. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 13 Also critical to the business due diligence function is the independent verification of key material facts in the prospectus. Similar to other aspects of the process, the extent to which the material facts require independent verification depends on the particular set of circumstances. Dealer members are expected to exercise their professional judgment in making such a determination. RED FLAGS A red flag is any indication that heightened due diligence or enhanced disclosure is required. Consideration should be given to whether a prospectus should include additional risk factor disclosure where a red flag is identified. The policies and procedures manual should state what constitutes a red flag in the opinion of the dealer member. The manual should then set out a process to be followed when a red flag is discovered during underwriting. This process should include follow-up and escalation to appropriate parties or independent experts for resolution. Although the following list is not exhaustive, it provides various different examples of common red flags: In the context of the underwriting process, the underwriter receives verbal information from management that is materially inconsistent with the issuer’s written documentation. In the past 12 to 24 months, the issuer has had a significant change in business, financial position, senior management, auditor, or legal counsel. Financial information or other disclosure is inconsistent with that of comparable issuers. There is a high degree of reliance on the founder, chief executive officer, or government relationships. Directors or senior officers have experienced controversy or disagreement in their relationship with institutional shareholders or corporate governance advisory organizations. The issuer, its directors, senior officers, or controlling shareholders have been involved in fraud, or have been targets of investigations or proceedings related to improper conduct. There are significant shareholdings by the founder or senior management and related party transactions involving the issuer. Any of the following issues are discovered: Inconsistent grants of stock options Material sales of securities by insiders A recent ratings downgrade or similar situation Identical interview answers given by customers and other third parties Deflection or avoidance of interview questions Withholding of requested information Undue delay or denial of a site visit As a good business practice, underwriters should retain documentation that identifies any red flags raised and explains how they were discovered, what actions were taken to resolve them, and what the outcomes were. LEGAL DUE DILIGENCE Legal due diligence, a key aspect of the due diligence process, includes matters that should appropriately be reviewed by the underwriter’s legal counsel. Legal due diligence may include such tasks as contract review, examination of local laws, government relations, and issues related to asset ownership in each jurisdiction. Legal counsel may prove invaluable in conducting due diligence with respect to these aspects in foreign and emerging markets. A dealer member’s policies and procedures should always be developed in consultation with its legal counsel. The policies and procedures should also delineate and define the roles of the underwriters and their counsel. The © CANADIAN SECURITIES INSTITUTE 14 14 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 involvement of legal counsel in the due diligence process must be properly managed. The underwriter should assign appropriate tasks to counsel but should not overuse them. The underwriter is responsible for supervision of counsel and is ultimately the party that is liable to purchasers. If multiple underwriters are present, counsel must communicate the results of legal due diligence to all members of the syndicate. RELIANCE ON EXPERTS AND OTHER THIRD PARTIES An industry expert may be involved in the issuance of a prospectus by way of a report, opinion, statement, or other disclosure of information. CIRO’s definition of an expert includes a lawyer, auditor, accountant, engineer, appraiser, and any other person or company with the authority to provide a statement. The involvement and extent to which experts are involved depends on the circumstances surrounding the prospectus. To determine the extent to which experts should be relied upon, the dealer member must consider their qualifications, expertise, experience, independence, and reputation. Underwriters must also assess whether they believe an expert to be qualified as an expert, even if the person being considered meets the National Instrument 41-101 criteria. In making this assessment, the expert’s reputation, qualifications, knowledge of relevant subject matter, regional knowledge and expertise, and independence, as well as any signs of red flags, should be considered. A common red flag is the fact that the expert is resident in a foreign jurisdiction or emerging market. In such cases, additional due diligence should be taken. The expert’s credentials, knowledge, and expertise should also be compared to those of a Canadian expert. Securities legislation provides that a liability exception exists regarding reliance on experts in certain cases. Guidance Note 3500-21-005 essentially states that underwriters are not liable for any misrepresentation in a prospectus that is based on an expert’s authoritative opinion, providing that the underwriter had no reason to believe that the expert’s opinion was wrong or that the prospectus misstated the expert’s opinion. One specific area that must be given particular attention as part of the due diligence process is that of the issuer’s financial statements. The dealer member should review both the issuer’s financial statements and the long-form comfort letter (i.e., the external auditor’s solvency opinion). The issuer’s auditor should be requested to participate in the Q&A sessions, especially in the case of emerging market issuers. RELIANCE ON A LEAD UNDERWRITER If the prospectus has more than one underwriter, a lead underwriter should be designated. By law, each syndicate member is subject to the same liability for misrepresentation; however, the lead underwriter takes on additional responsibilities and risks. A particular risk is the risk to reputation and regulatory standing. The lead underwriter also takes on the responsibility of issuing a certificate with respect to the securities offered in the prospectus. By doing so, the underwriter signifies that the proper due diligence has been performed. Because each underwriter in a syndicate bears the same liability, each of the underwriters must ensure that they are satisfied with the due diligence undertaken by the lead underwriter. To meet this requirement, the syndicate members should each request a copy of all documentation prepared by the lead underwriter to ensure that due diligence was conducted to their satisfaction. This exercise helps to support a due diligence defence by the members of the syndicate who rely on the due diligence conducted by the lead underwriter. DUE DILIGENCE RECORDKEEPING Records of the due diligence process should be kept as proof that adequate due diligence was carried out, should a disagreement or issue arise. Documentation of every step of the process must be retained by either the dealer member or its counsel. The type of documentation retained varies depending on the context and application. The policies and procedures for underwriting due diligence should establish the recordkeeping requirements. At a minimum, the records maintained by the dealer member should demonstrate compliance with its own policies and procedures, applicable CIRO rules, and provincial securities legislation. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 15 As part of the recordkeeping process, the firm should identify the type of information that is to be destroyed or culled and explain the circumstances for doing so. SUPERVISION AND COMPLIANCE Supervision and compliance are both essential requirements to an effective underwriter due diligence process and are both required under securities regulation. Supervision and compliance take different forms with different dealer members, and may be performed by different people, groups, or committees. Those people responsible could include junior personnel, in-house or external legal counsel, senior investment bankers, internal auditors, and other experts, as necessary. However, it is recommended that a senior investment banking professional be involved throughout the process. That person is ultimately responsible for the due diligence performed. In that regard, any person executing a prospectus on behalf of a dealer member should seek confirmation that the firm’s policies and procedures have been followed and that any red flags have been appropriately addressed. Supervision of the underwriting process may also be done by a committee established by the dealer member. The compliance function associated with underwriting due diligence may be carried out by the compliance department or another department of the firm, such as the legal or internal audit department. Compliance may also occur during the underwriting process, with the department or person responsible participating on a committee that supervises the process. Compliance with a dealer member’s underwriting due diligence function, as contained in its policies and procedures manual, may take many forms. However, it is expected that the dealer member will put an appropriate structure in place that reflects the firm’s size, function, and business model. THE RESEARCH DEPARTMENT 4 | Distinguish between marketing and research, and explain the specific requirements for writing research. IDPC Rule 3600, Part B, provides details of the requirements for establishing a supervision program for a research department. It also sets out the standards that analysts must follow when publishing research reports or making recommendations and addresses conflicts of interest. One of the key issues is to first determine which material should be covered under research policies and procedures, and which material should be identified as marketing material. The key difference between these two areas is that research makes a recommendation to buy, hold, or sell a security, whereas marketing material (which includes advertising and sales literature) promotes the sale of the firm’s products and services. Research requires additional disclosures to address the inherent conflicts of interest that arise when the same dealer provides advisory (i.e., investment banking) and trading services to companies that it covers with research. EXAMPLE Many conflicts of interest came to light during the tech boom and subsequent crash of 2000–2001. It was determined at that time 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. The compliance program for marketing and research should not only review departmental policies and procedures; it should also include a regular sampling of work product. This sampling should include the use of clippings services and internet searches to identify marketing materials that have not flowed through proper channels. © CANADIAN SECURITIES INSTITUTE 14 16 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 DIVE DEEPER IDPC Rule section 3621, Relationship with investment banking, states: 1. 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. 2. The policies and procedures must specifically address, at a minimum: i. prohibiting the approval of research reports by the investment banking department, ii. limiting the investment banking department’s involvement in the production of research reports solely to the correction of factual errors, iii. prohibiting and preventing the investment banking department from receiving advance notice of new ratings or rating changes on covered issuers, and iv. 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. For complete requirements see www.CIRO.ca SPECIFIC REQUIREMENTS FOR WRITING RESEARCH Most research departments have a director or supervisor responsible for compliance with industry regulations. In addition, appropriately trained staff should be assigned to 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 rumours. A research report should never exclude information known to the analyst that would be 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. The supervisor and compliance department are usually responsible for pre-clearing of any personal trades for research analysts and approving any requests to cross the wall. After a research report is completed by the research analyst, it must be reviewed and approved by the research supervisor. The report must also disclose any of the following information about relationships with the subject issuer that might indicate conflicts of interest: Any holdings (i.e., long or short derivative positions) that the analyst has in the subject company (because most dealers have policies that prevent their analysts from holding positions in companies they cover) Whether the dealer has provided investment banking services for the issuer within the past 12 months Whether the analyst or any partner, director, or officer of the dealer has provided services to the issuer for remuneration, other than normal course investment advisory or trade execution services, within the past 12 months The name of any partner, director, officer, employee, or agent of the dealer who is an officer, director, or employee of the subject issuer, or who serves in an advisory capacity Whether the dealer beneficially owns 1% or more of any class of the issuer’s equity securities Whether the dealer makes a market in an equity or equity-related security of the issuer General information about the research department’s rating system and recommendations Control of the flow of information between research and other departments is generally guided by the dealer member’s firewall policies. Research reports must be free from any influence by the investment banking department or the issuer. No research publication should be subject to the approval of the investment banking department. If a draft report is shared with investment banking, it must be under the supervision of compliance. The investment © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 17 banking department’s input should be limited to the correction of factual errors. No other divisions of the firm should be provided advance notice of ratings or rating changes on covered companies. Any sharing of information, including wall crossings, should be approved and recorded by compliance. Research analysts and staff in the research department should be subject to strict personal trading policies, including trading restrictions of up to 30 days before the publication of research and up to five days after. It is generally appropriate to require research staff to seek pre-approval of trades. If the subject security is not exempt from the UMIR market stabilization rules, research only can be published 10 calendar days after an initial public offering and three calendar days after a secondary offering. The research department must also have policies and procedures to prevent the dealer employees outside of the department from having knowledge of rating changes or other information contained in a research report that could have an effect on the price of a security. For research reports with multiple securities that are electronically distributed, disclosures can be in the report or accessed through hyperlinks. FINANCIAL ENGINEERING 5 | Discuss financial engineering and the supervision program required for new products. Financial engineering is the term used to describe an investment banker’s creativity in innovative security design. The rapid pace of financial innovation is driven by the competition among investment bankers in response to increased price volatility, tax and regulatory changes, demand for new funding sources, arbitrage, and yield enhancement. The application of mathematical and statistical modelling, together with advances in computer technology, provides the necessary infrastructure for financial engineering. Financial engineering helps investment banking professionals meet the needs of borrowers and investors, such as hedging, funding, arbitrage, yield enhancement, and tax purposes. It drives the explosive growth in the structured and derivatives markets. The development of the high yield bond and asset-backed markets provides borrowers additional funding sources at lower costs. Structured notes add another dimension in the funding and investment spectrum. Transactions in repurchase agreements provide lower funding costs for borrowers and legal title to the collateral to lenders. Through swap contracting, borrowers and investors obtain a high degree of flexibility in asset-liability management at better terms. Credit derivatives have widespread applications in hedging credit risks. DERIVATIVES AND COMPLEX PRODUCTS COMPLIANCE AND SUPERVISION PROGRAM Supervision of a dealer member’s derivatives transactions requires designated and proficient staff at both the compliance and department level. Derivatives, as a product category, include a number of separate products that require specific policies and procedures. The rules and requirements vary for exchange-traded options, exchange- traded futures, and options on futures, commodities, over-the-counter derivatives, and structured products. Exchange-traded options include equity and index options traded on the Montreal Exchange for Canadian options, and on the various U.S. or international exchanges, such as the Chicago Board Options Exchange. 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 such as gold and silver. Commodity futures typically have physical settlement, so care must be taken to ensure that any expiring futures are closed out before expiry. © CANADIAN SECURITIES INSTITUTE 14 18 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Over-the-counter derivatives include interest rate swaps, equity swaps, collateralized debt obligations, credit default swaps, and any other non-standard derivatives, with the terms negotiated under an International Swaps and Derivatives Association agreement. Structured products are notes that combine the elements of exposure to an underlying asset, such as an equity index, with the protection of the principal. The typical construction of a structured product includes two components: the discount coupon or strip bond to provide the principal amount at maturity; and an over-the- counter derivative that provides the exposure to the index or other asset. Structured products have been popular with retail clients because of the principal protection. However, large institutions may also purchase these products, which can be customized for their purposes. A designated derivatives supervisor is responsible for approving new derivatives accounts, reviewing client and firm trading activity, and ensuring that all regulatory, large position reporting is completed on a timely basis. Because of the leverage, increased risk, and complexity of derivatives, the suitability of accounts and transactions should be assessed by the designated supervisor. Credit risk plays a large part in this assessment. In addition, dealers must review and approve all new products made available to both retail and institutional clients. Product knowledge, on the part of salespersons and designated supervisors, must also be sufficient to ensure that they can evaluate suitability and provide continued support. After-sales support may include provision of liquidity and valuation, as well as currency with the evolution and regulation of the products. CIRO also expects dealers to continuously monitor the suitability of the products sold and traded. NEW PRODUCT APPROVALS AND KNOW YOUR PRODUCT Under NI 31-103, a registered firm must not make securities available to clients unless the firm has taken reasonable steps to assess their relevant aspects and has approved them for use. Furthermore, the firm must monitor the securities for significant changes. Registered firms must establish, maintain, and apply policies, procedures, and controls relating to the know-your- product process, in accordance with the firm’s business model, the types of securities offered, the proficiency of its registered individuals, and the nature of the relationships that the firm and its registered individuals have with clients. These policies, procedures, and controls should include appropriate processes for assessing and approving securities that are made available to clients, as well as monitoring for significant changes to them. CIRO Guidance Note 3300-21-001, Product Due Diligence and Know-Your-Product, provides guidance to dealer members regarding the due diligence that must be conducted on all securities they make available to clients. CIRO expects a dealer member’s product due diligence procedures to include the following elements: 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 the following details (among others): Whether the product is new or is 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 that advisors and supervisors can judge the suitability of the recommendations and sales to clients, and the development and implementation of the necessary training © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      INVESTMENT BANKING 14 19 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 restriction placed on the sale of the product Periodic reassessment of the suitability of the product 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 and the impact of those costs. As articulated in CSA Staff Notice 31-336, Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations (January 9, 2014) registrants should have an in-depth understanding of each of the following items before recommending a product to clients: General features and structure, including return, use of leverage, conflicts of interest, time horizon, and overall complexity of the product Risks, including the possibility that clients may lose some or all of the principal invested, liquidity risk, redemption risk, risks from underlying derivatives or structured products, and risk of conflicts of interest Costs, including fees paid to registrants or other parties such as commissions, sales charges, trailer fees, management, incentive fees, referral fees, embedded fees, or executive compensation Parties involved, including issuer’s financial position and history, qualifications, and reputation and track record regarding key aspects of the product Legal and regulatory framework, including frequency, completeness, and accuracy of the issuer’s disclosure © CANADIAN SECURITIES INSTITUTE 14 20 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 SUMMARY In this chapter, we discussed the activities of a dealer member that are typically associated with investment banking. In this context, we examined the applicable rules and best practices that are considered the key elements of compliance and supervision for the institutional businesses of a CIRO investment dealer. First, we discussed the different product lines and activities related to the institutional division of a dealer member. We also discussed the different categories of institutional clients and the responsibilities of a dealer member regarding the accounts of those clients. In focusing on investment banking in particular, we discussed the importance of safeguarding sensitive information by maintaining information barriers and restricted lists. By now you should be able to explain the difference between the two types of barriers. Specifically, information barriers are designed separate employees who are privy to undisclosed material information from traders who might be influenced the information. Restricted lists, on the other hand, contain the names of employees who are restricted from trading for a known reason, such as a pending transaction. A key aspect of investment banking is the process of underwriting and the crucial necessity for due diligence in that area. An important point to remember regarding underwriting due diligence is that adherence to disclosure requirements protects not only the investor, but also the dealer member itself, in the event of litigation. We discussed that an important area of investment banking is the research department. Research requires additional disclosures to address the inherent conflicts of interest that arise when the same dealer provides advisory and trading services to companies that it covers with research. Strict supervision of this department is necessary to prevent employees outside of the research department from having knowledge of rating changes or other information contained in a report that could have an effect on the price of a security. Finally, we explored about the rapid pace of product innovation (known as financial engineering) and the importance of having a compliance and supervision program in place to monitor trading and sales in complex new products. CIRO expects that its registrants understand these products and continually monitor trading and sales activities in this area to ensure that they are suitable for the clients they are sold to. This chapter brings us to the end of the section covering the different areas of a CCO’s responsibility and the skills that the CCO needs to effectively do the job. In the next chapter, we move on to a new section in which we discuss the CCO’s obligations to the board of directors and to entities outside the firm, in regard to breaches of policy and procedure or the law. We begin that section by discussing the types of situations that might require an internal investigation and explaining the guidelines for conducting such an investigation. © CANADIAN SECURITIES INSTITUTE