Focus on private placements

By John Kirkwood
Illustration: Susanna Denti

In light of the growing popularity of private placements, governing legislation has been amended

For many years, provincial securities legislation permitted securities to be issued, in certain defined circumstances, without the preparation of a prospectus. Typically, such offerings were exempted from prospectus requirements based on specific criteria such as: the nature of the issuer (a Canadian government organization); the nature of the purchaser (a person or entity recognized as an exempt purchaser); or the nature or size of each transaction (a rights offering to existing shareholders, or an issue having a minimum subscription price to each individual investor).

Generally there was a substantial “hold” period in which the securities could not be resold otherwise except by a prospectus. The benefits of private placements as compared with prospectus offerings include reduced cost, as well as a reduction in the length of time required to bring securities to market. Private placements have become increasingly popular in recent years, and the governing legislation has been amended such that it is often possible for securities to be offered to “accredited investors” without a disclosure document such as an offering memorandum, without a minimum subscription, and with a hold period as short as four months. The Auditing and Assurance Standards Board (AASB) has revised Section 7200 of the CICA Handbook – Assurance, Auditor Assistance to Underwriters and Others, in light of the increased use of private placements in these circumstances. The new recommendations are effective for comfort letters issued and for due diligence meetings held on or after March 1, 2005.

Prospectus offerings
When securities are offered by a prospectus, directors and management of the issuer have a responsibility under securities legislation to ensure that the prospectus contains full, true and plain disclosure of all material facts relating to the proposed issue. An underwriter, or agent, assumes a similar responsibility. Since an underwriter does not have the ongoing knowledge of the issuer’s business possessed by the issuer’s management, the underwriter would be expected to conduct a reasonable investigation into the affairs of the issuer. Conducting such an investigation furnishes the underwriter with the basis for a due diligence defence provided for in the legislation. In these circumstances, it is customary for the issuer to request the auditor to provide a comfort letter to the underwriter and to attend a due diligence meeting to respond to questions asked by the underwriter, in order to assist the underwriter in its investigation.

It is in the interests of potential investors, as well as the issuer and the underwriter, that the underwriter conduct a reasonable investigation into the affairs of the issuer. Accordingly the auditor, with the issuer’s consent, would want to cooperate with the underwriter by providing assistance in the investigation.

When the auditor is to consent to the use of the auditor’s report in an offering document such as a prospectus, professional standards require the auditor to perform extensive procedures before issuing the consent. Such procedures are set out in Section 7110 of the Handbook – Assurance, Auditor Involvement with Offering Documents of Public and Private Entities. As a result, when the issuer asks the auditor to provide a comfort letter to the underwriter and/or to attend a due diligence meeting with the underwriter, the auditor's knowledge of the issuer’s business is up to date, and the auditor is in a position to agree to the request.

Private placements
Because the auditor is commonly asked to provide a comfort letter and attend a due diligence meeting in connection with a prospectus offering, the auditor may like-wise be asked to assist the underwriter in connection with a private placement. How- ever, the position of the auditor in a private placement differs from that under a prospectus offering. First, the underwriter has no statutory due diligence defence. Second, there may be no offering memorandum.

No due diligence defence
In a private placement, the underwriter does not have the same statutory liability nor the same due diligence defence from such liability under securities legislation as in a prospectus offering. As a result, the auditor cannot assume that the underwriter is requesting the auditor’s participation only for the purpose of assisting it in conducting its own due diligence investigation of the issuer. The auditor would not be prepared to assist the underwriter if the auditor believes that, instead of performing its own due diligence assessment, the underwriter intends to rely only on the audited financial statements or the auditor’s assistance.

 Accordingly, Section 7200 provides that if the underwriter does not have the statutory due diligence defence that would be available in a prospectus offering, the auditor must obtain a satisfactory representation letter from the underwriter before agreeing to issue a comfort letter. A representation letter would state:

• the underwriter is knowledgeable with respect to a due diligence investigation;
• the underwriter is or will be performing an investigation similar to that which it would carry out if it had a statutory due diligence defence.

Normally, the underwriter would request a comfort letter only in connection with a prospectus or other offering memorandum. However, a private placement may be made without the use of an offering memorandum. In these circumstances, the auditor may nevertheless be requested to attend a due diligence meeting with the underwriter. Accordingly, Section 7200 has now been revised to extend the requirement for a representation letter from the underwriter to situations in which the auditor is requested to attend a due diligence meeting.

No offering memorandum
When there is no offering memorandum, the issuer and the underwriter will not have to devote the time and attention required in preparing the document and will normally wish to proceed without delay. However, since there is no document containing the auditor’s report and consent, the auditor will not have been engaged to perform the procedures otherwise required by Section 7110.

Auditors are frequently asked, at short notice and without performing any procedures such as a subsequent events review or a review of interim financial statements, to attend a due diligence meeting and answer questions directed by the underwriter and its legal counsel. Yet without being engaged to perform such procedures, the auditor would not normally have appropriate current knowledge of the issuer and its operations to serve as a basis on which to answer the underwriter’s questions. There would be a serious risk that the underwriter would misunderstand the basis (or lack of it) on which the auditor might answer the underwriter’s questions. Even if the auditor were to explain carefully that he or she has done no work since the completion of the latest audit, there is a risk that the auditor’s mere attendance at the meeting would impart an unwarranted degree of assurance.

The AASB therefore concluded that un- less the auditor is engaged to perform the appropriate procedures, he or she should decline to attend the due diligence meeting. Section 7200 has been revised to describe these procedures, which are essentially those that would be required by Section 7110 when there is an offering document. If the auditor has been engaged to perform, but has not yet completed the required procedures at the time of a due diligence meeting, the auditor could attend the meeting, but before responding to questions should state clearly that he or she has not completed the appropriate procedures, and that the responses given are subject to change.

Other changes
Section 7200 has been reorganized to make the guidance easier to use, by presenting general comments on auditor assistance, followed by more specific guidance concerning comfort letters and due diligence meetings. The central part of the section (largely dealing with the content of a comfort letter) remains essentially unchanged. As well, five new examples have been added to Section 7200, and an appendix containing two new examples has been added to Section 7110.