SEC Adopts Amendments to Auditor Independence Rule
On June 18, 2019, the Securities and Exchange Commission (the “SEC” or the “Commission”) adopted amendments to the auditor independence rules to “refocus the analysis” that must be done in order to conclude that an auditor is independent when such auditor “has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period.” In the adopting release (“Adopting Release”), the Commission noted that the amendments (1) focus the analysis on beneficial ownership rather than on both record and beneficial ownership; (2) replace the existing ten percent bright-line shareholder ownership test with a significant influence test; (3) add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities; and (4) exclude from the definition of audit client, for a fund under audit, any other funds that otherwise would be considered affiliates of the audit client under the rules for certain lending relationships.
Rule 2-01 of Regulation S-X requires auditors to be independent of their audit clients both “in fact and in appearance,” capable of “exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.”
The bright-line 10% test means that an accounting firm is not independent under the current loan provision “if it has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of the equity securities of either (a) the firm’s audit client; or (b) any entity that is a controlling parent company of the audit client, a controlled subsidiary of the audit client, or an entity under common control with the audit client,”
The staff of the SEC’s Division of Investment Management first addressed the “loan rule” issue in 2016, when the Fidelity Management & Research Company requested no-action relief
II. Amendments to Auditor Independence Rule
The final amendments make four amendments to the Loan Provision:
Focus the analysis solely on beneficial ownership. This would alleviate concerns related to record ownership. The SEC believes that tailoring the Loan Provision to focus on the beneficial ownership of the audit client’s equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor’s independence.
Replace the 10% rule with a “significant influence” test. Rather than a bright-line rule, this test would assess whether a lender has the ability to exert significant influence over an audit client’s operating and financial policies, based on the totality of the facts, including board representation, participation in policy-making process, material intra-entity transactions, interchange of managerial personnel, technological dependency, as well as the level of beneficial ownership (i.e., establishing rebuttable presumptions that a lender beneficially owning at least 20% of an audit client’s voting securities has the ability to exercise significant influence and that owners of less than 20% do not have significant influence, unless it could be demonstrated otherwise).
Add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities. Auditors would be required to analyze beneficial owners of the audit client’s equity securities who are known through reasonable inquiry. If an auditor does not know after reasonable inquiry that one of its lenders is also a beneficial owner of the audit client’s equity securities, the auditor’s objectivity and impartiality is unlikely to be impacted by its debtor-creditor relationship with the lender.
Amend the Loan Provision’s definition of “audit client” to exclude funds that would currently be considered “affiliates of the audit client.” Consistent with the proposed release, the inclusion of certain entities in the ICC as a result of the definition of “audit client” is in tension with the Commission’s original goal to facilitate compliance with the Loan Provision without decreasing its effectiveness. Auditors often have little transparency into the investors of other funds in an ICC (unless they also audit those funds), and therefore, are likely to have little ability to collect such beneficial ownership information. Investors in a fund typically do not possess the ability to influence the policies or management of other “sister” funds and that this does not depend on whether the funds are investment companies or other types of pooled investment vehicles. The SEC noted that expanding the definition of “fund” to encompass commodity pools is consistent with its intent to exclude for a fund under audit any other funds that otherwise would be considered an affiliate of the audit client.
It is also worthwhile to note that the Final amendments differ in certain respects from the Proposal. For example, the final amendments define “fund” for these purposes to also exclude commodity pools and the SEC clarified that foreign funds
III. Looking Ahead
The Adopting Release also notes that the Chairman has directed the staff to formulate recommendations to the Commission for possible additional changes to the auditor independence rules. The Chairman directive comes as a result of certain comments submitted in connection with the Proposal, specifically comments (1) relating to the Loan Provision, but not the significant compliance challenges that need to be immediately addressed (e.g., other types of loans that commenters suggested should be excluded from the Loan Provision, such as student loans); (2) relating to the “covered person” and “affiliate of the audit client” definitions; or (3) to narrow the look-back period for domestic initial public offerings so that the period is similar to that for foreign private issuers.
These amendments will become effective 90 days after they are published in the Federal Register.
The SEC’s press release can be found
The SEC’s Adopted Rules can be found at the following links: