Emerging and frontier market issuers have enjoyed more constructive financial conditions over recent years as dovish fiscal policies from the US Federal Reserve and European Central Bank have allowed issuers to access foreign currency debt capital markets at increasingly low rates. Notwithstanding uncertainties caused by global trade pressures, volatile commodity prices and levels of debt sustainability, new debt from these markets is expected to remain in high demand as investors search for yield. This demand, coupled with investigations by enforcement agencies arising from certain high-profile debt capital market transactions, highlight the importance of thorough due diligence from a legal, risk and reputational perspective.
Against this backdrop, below are due diligence practice tips for international debt capital markets offerings with a US-tranche, whether they involve corporate, financial institution or sovereign/SSA issuers.
Due diligence is the term used to describe various investigatory and verification procedures performed by the issuer, the mandated underwriters and legal counsel in connection with debt offerings. The purpose of conducting due diligence is varied and includes:
- To ensure that general duties of disclosure are satisfied, such as those prescribed by Section 80 of the Financial Services and Markets Act 2000 (as amended).
- To confirm that the information disclosed or incorporated by reference in the offering documents does not contain an untrue statement of a material fact or omit to state a material fact.
- To reduce the risk – legal and reputational – to parties participating in the offering.
- To ensure there are no obstacles to an issuer consummating a debt offering, such as borrowing covenant restrictions or limitations in corporate authorizations or capacity.
- To allow underwriters to (i) establish a due diligence defense under Sections 11 and 12(a)(2) of the Securities Act of 1933 (as amended) (the Securities Act) and (ii) negate the inference of fraud under Rule 10b-5 under the Securities Exchange Act of 1934 (as amended).1
The scope and adequacy of the due diligence review is typically determined by factors including:
- The characteristics of the issuer – size, operating history, prospects and jurisdiction of incorporation.
- The type of business conducted by the issuer and the markets in which it operates – certain sectors (for example, the extractive and banking industries)2 and certain markets (for example, activities in emerging and frontier markets) should inform the scope of the review.
- The security being offered – an equity offering almost always warrants more enhanced investigation than a ‘vanilla’ debt offering, and high-yield offerings routinely warrant more due diligence given the credit story of the issuer.
- The offering – a seasoned issuer with existing public disclosure should warrant less stringent investigation than a debut issuer.
Since debt offerings involving issuers incorporated, situated or operating in emerging and frontier market are more likely to have certain hallmarks warranting more enhanced due diligence, in order for underwriters to prove that they performed a diligent investigation and had reasonable grounds to believe, and did believe, that there were no material misstatements or omissions in the offering documents, the practice tips below can guide market participants in organizing and conducting the due diligence review.3
Participate in management due diligence meetings and calls
It is customary for legal counsel to participate in due diligence meetings with management (in the case of a corporate/financial institution issuer) and government officials (in the case of a sovereign issuer) to understand the risks associated with the issuer, its sector and its business/operations. In-person meetings are typically appropriate, accompanied by drafting sessions. Such meetings can be supplemented by way of teleconferences and this format might also be considered to be appropriate where due diligence has already been conducted in connection with a recent offering by the same issuer.
The underwriters, with the assistance of its legal counsel, should prepare a list of questions categorized by topic (for example, for a corporate/financial institution issuer, questions relating to strategy, financial performance and prospects, compliance and general risk function and legal) which have been informed by the review of existing public disclosure and commentary, and documentary due diligence (in each case, see below). Thought should be put into who should represent the issuer at meetings and whether such persons have suitable seniority and sufficiently detailed knowledge to be able to respond comprehensively to the questions. A list and contact details of issuer representatives should be produced following the meetings, and any gaps in responses should be noted and addressed.
In the case of a corporate/financial institution issuer, this wide-ranging due diligence exercise should be supplemented by auditor diligence meetings or calls. At appropriate times during the offering process – including immediately prior to launch of the offering, pricing of the debt securities and financial settlement – bring-down diligence calls should take place to supplement the initial due diligence meetings.
Consider public disclosure and commentary
In drafting or reviewing the offering documents, it is useful to be familiar with credit rating agencies’ commentary on the issuer, the issuer’s existing publicly available information (if any) and third-party industry reports – for example from trade associations and the IMF (in the case of sovereign issuers).
Many African sovereign issuers – for example, Ghana, Kenya and Angola – have offered debt while participating in IMF-led financing/technical assistance programs. The detailed reports published by the IMF include data and commentary on the fiscal and monetary policies of the relevant issuer and key risks associated with the economy and the specific IMF program(s). Such reports should be considered in detail when preparing the offering documents, and appropriate disclosure included and contextualized. It should be remembered that the IMF’s economic and financial models might be different from those of the relevant issuer (for example, the methodology of calculating GDP and public debt levels) and the IMF statistics and projections should not be adopted as the issuer’s disclosure without extensive discussion with the issuer.
Using subscriptions to news services and routinely conducting broad internet searches can also garner useful and topical information on the issuer.
Investigate red flags
A red flag represents something that affects the reliability, accuracy and completeness of the information. Examples of events that could be characterized as a red flag include issues raised in letters to management from auditors, late publication of financial information, restatement of financial information, unexpected or frequent changes to management officers/government officials, inconsistent data provided by different representatives of the issuer (relative to third-party reports), and material swings in fiscal data.
Where a potential red flag is identified, best practice should be to investigate the matter further using more enhanced due diligence procedures, consider the materiality of the matter and, where material, include disclosure in the offering documents, providing appropriate context and prominence following discussion with the issuer and the underwriters.
Conduct documentary due diligence
At the outset of the due diligence exercise, legal counsel to the underwriters should prepare a documentation request list. Customarily, the issuer provides the requested documents for legal counsel to review by sharing them in a virtual data room. The scope of documents that should be reviewed by legal counsel is broad but generally covers constitutional documents, board and committee papers for the issuer and material subsidiaries, material agreements (including material financing agreements), corporate policies and procedures, documents relating to material legal proceedings and investigations, management questionnaires, and auditor management letters and responses. The data room should be updated during the offering process.
Whether a subsidiary, financing agreement or legal proceeding is ‘material’ in the context of the offering will depend on the characteristics of the issuer and the sector and jurisdiction in which it operates. Care should be taken to set appropriate thresholds (for example, a material subsidiary might be a subsidiary whose consolidated net assets constitute 10 percent. of total assets of the issuer group) and time periods (at least three years of financial information and other data), so material agreements are shared rather than all agreements (whatever the materiality). This is to ensure that the due diligence exercise is as efficient as possible.
Obtain appropriate negative assurance confirmations from auditors and international legal counsel
In relation to corporate/financial institution issuers, the issuer’s auditors should be engaged and briefed at an early state of the offering process to ensure that they can provide the customary comfort letter. This auditor’s comfort letter confirms to the underwriters that the auditor is independent, that financial information has been properly extracted from audited/reviewed financial statements or accounting records (accompanied by the auditor circle-up of the offering documents) and there has been no adverse change in specified balance sheet items from the date of the issuer’s last audited/reviewed financial statements up to a certain number of days prior to the date of the comfort letter (typically two to three business days). While, in relation to certain income statement items, the comfort letter should confirm the absence of a change from the date of the last audited/reviewed financial statements up to the ‘cut-off’ date compared to same period in the previous financial year.
These balance sheet and income statement items should be agreed with the underwriters early in the offering process. It is also useful, particularly for a debut offering, for the capital markets team at the auditor to be engaged by the issuer, to assist the primary audit team in preparation of the comfort letter.
International legal counsel to the issuer and the underwriters should provide a 10b-5 (disclosure) letter stating that the due diligence investigations have not revealed any material misstatements in, or omissions from, the offering documents, excluding financial statements, other financial and accounting information and (sometimes) certain statistical information. The 10b-5 letter from underwriters’ counsel is only addressed to the underwriters.
Local counsel in the issuer’s home jurisdiction are also integral to the due diligence exercise and should be engaged at the beginning of the offering process, to ensure that all governmental and corporate authorisations and approvals are in place. This is particularly important in those emerging and frontier markets where issuers have little track record of accessing the international capital markets.
Work with the issuer to ‘backup’ information included in the offering documents
The process of obtaining backup and officers’ certificates is important to verify information such as estimated or preliminary data, KPIs and industry statistics. Auditors are not able to provide comfort for certain non-IFRS information and, therefore, if such information is a KPI of the issuer and disclosed in the offering documents, a chief financial officer’s certificate should be put in place, confirming the accuracy of such information.
In the context of a sovereign issuer, an officers’ certificate (with a circle-up) from an appropriate government minister (for example, the finance minister) is routinely put in place to supplement the due diligence investigation.
Section 11 of the Securities Act only applies to registration statements filed with the Securities and Exchange Commission (the SEC) and Section 12(a)(2) of the Securities Act has been held by US Federal courts to apply only to public offerings. Therefore, these liability provisions do not technically apply to offerings conducted under Section 4(a)(2) or Rule 144A of the Securities Act. However, in such offerings a similar due diligence process is undertaken in practice.
The SEC has published industry disclosure guides for certain issuers, such as those engaged in mining operations and bank holding companies.
The ‘due diligence defense’ under the Securities Act does not technically extend to Rule 10b-5. However, the exercise of due diligence procedures to establish ‘reasonable care’ or ‘reasonable investigation’ are probative in determining whether a person has satisfied one key element for Rule 10-b5 liability – ‘scienter’ (or fault).
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