What is 15c2-12 “Reasonable Diligence” For Competitive Deals or Where a Firm Acts
as Co-Manager, Syndicate Member or Selling Dealer?

December 7th, 2015

As a provider of services and solutions to the municipal market, Lumesis has the opportunity to gain the perspective of market participants on a variety of subjects.  Since the introduction of our DIVER Underwriter platform, we have heard different opinions and perspectives regarding regulatory standards for municipal underwritings and the SEC’s MCDC initiative (many of which cannot be repeated here).

While the SEC’s MCDC Initiative has provided some clarity with regard to materiality and confirmed that the reasonable diligence standard of Rule 15c2-12 applies to both negotiated and competitive deals, no clarity has been offered with regard to the extent of the reasonable diligence obligations of those participating in competitive deals, as co-managers, syndicate members or selling dealers.  In this area we have heard divergent perspectives as to what level, if any, of diligence is required.

To date, the SEC’s Cease and Desist Orders (“Orders”) have cited examples making clear that the diligence requirements extend to assessing:

  • A failure to file or a late filing of annual and/or audited financials
  • Missing operating data
  • No “failure to file” filings
  • Failures to cross reference with EMMA for an OS incorporating financials
  • Missing filings for an issue or CUSIPs and
  • No statement in an OS regarding prior compliance/non-compliance notices including failure to disclose late filings.

In the past, some market participants might have excused one or more of the above as immaterial.  In fact, some have opined that the examples cited in the Orders indicate that the SEC’s view of materiality is more stringent than the market had previously believed. Thus, we continue to gain a greater understanding of “materiality” and hope that the third round of MCDC Orders will provide additional clarity.

The Orders also confirmed, as they had in the 2012 National Examination Risk Alert (“Risk Alert”), that the reasonable diligence standard of Rule 15c2-12 applies to both negotiated and competitive deals.  In the same citation to the SEC’s 2010 Exchange Act Release, the Risk Alert also confirms that the reasonable diligence standard of Rule 15c2-12 applies to managers, syndicate members and selling dealers.  The Risk Alert provides, in part:

[T]he Commission has provided a non-exclusive list of six factors it believes generally would be relevant in determining the reasonableness of the underwriter’s basis for assessing truthfulness of key representations in a final official statement.  These factors are:

… the role of the underwriter (e.g., manager, syndicate member, selling dealer) …

Thus, an underwriter is subject to 15c2-12 irrespective of their role.  Yet, the Orders to date have not distinguished what level of diligence is appropriate (or reasonable) for different roles of underwriters and have simply provided that:

Respondent failed to form a reasonable basis through adequate due diligence for believing the truthfulness of the assertions by these issuers and/or obligors regarding their compliance with previous continuing disclosure undertakings pursuant to Rule 15c2-12. 

Market participants are left with the question of “what level of diligence is ‘reasonable’ when it comes to competitive deals and deals where we are the co-manager, syndicate member or selling dealer?”  Another relevant question raised by the market: “is it reasonable for me to rely on the lead’s diligence?”

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For deals where diligence is performed by a co-manager or syndicate member, we hear differing views from market participants with regard to the scope of diligence performed.  In an effort to gain clarity, we recently asked the SEC to provide a response but were told they could not comment on the issue.

While the 2010 Exchange Act Release and the Risk Alert do not address the scope of diligence required, they do note the factors that “would be relevant in determining the reasonableness of an underwriter‘s basis for assessing the truthfulness of key representations in the official statement.”

The Risk Alert, citing a 1991 case, provides that a “municipal underwriter’s due diligence obligation has been held to be primary and an obligation that cannot be delegated away (in terms of liability) to underwriter’s counsel” and that “an underwriter’s belief should be based on its independent judgment, not solely on representations of the issuer or obligated person as to materiality of any failure to comply with any undertaking.”

The Risk Alert makes clear that an underwriter’s scope of diligence may be influenced by their role.  While the Risk Alert does not directly address the underwriter’s ability to rely on the diligence performed by the lead, it makes clear that the obligation – in terms of liability – cannot be delegated away.

Accordingly, a conservative approach to reliance on third party assessment seems warranted.  Until the SEC provides clarity or guidance on the question of the scope of diligence required by those participating in competitive deals, or those acting in the role of co-manager, syndicate member or selling dealer, it seems prudent, at a minimum, to perform some level of diligence to confirm the work done by the lead or other third party is accurate.  This diligence may include spot-checking, cursory or substantive review of the work; and/or asking the lead to provide a report documenting their diligence including links to (or copies of) all relevant documents reviewed as part of their diligence.

Whatever approach you take, make sure it’s supported in your policies and procedures, and make sure you can demonstrate with documentary proof your diligence and related supervisory oversight on every deal.

Have a Great Week,

Gregg Bienstock

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