The SEC has adopted final amendments to the auditor independence rules relating to lending relationships between the auditor and an audit client or certain shareholders of the audit client. As noted in the press release, the SEC had become aware of circumstances where the existing rules captured attenuated “relationships that otherwise do not bear on the impartiality or objectivity of the auditor. The amendments are intended to focus the rules on those lending relationships that reasonably may bear on external auditors’ impartiality or objectivity and, in so doing, improve the application of the Loan Provision for the benefit of investors while reducing compliance burdens.” Although the issues associated with this independence rule have created the severest compliance challenges for companies in the investment management industry, the final amendments will apply to entities beyond that industry, including operating companies and registered broker-dealers. The final amendments will become effective 90 days after publication in the Federal Register.
Rule 2-01(b) of Reg S-X provides generally that the SEC will not recognize an accountant as independent with respect to an audit client if the accountant is not capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. Rule 2-01(c) sets forth a nonexclusive list of circumstances that the SEC considers to be inconsistent with that independence standard, including the restriction on debtor-creditor relationships in Rule 2-01(c)(1)(ii)(A) (the “Loan Provision”). As stated in the release, the Loan Provision currently provides that “an accountant is not independent when (a) the accounting firm, (b) any covered person in the accounting firm (e.g., the audit engagement team and those in the chain of command), or (c) any of the covered person’s immediate family members has any loan (including any margin loan) to or from (x) an audit client, or (y) an audit client’s officers, directors, or (z) record or beneficial owners of more than 10 percent of the audit client’s equity securities.”
Accounting firms regularly use loans to help finance their core business operations. As a result, as reported in this article from ComplianceWeek, a number of large mutual funds, investment banks and other investment companies with intricate structures had consulted with the SEC staff regarding their difficulties in identifying any of the big accounting firms that had adequate expertise and bandwidth to perform their audits and could avoid independence problems under the Loan Provision. That conundrum led the SEC to address the issue through the no-action process, at least initially.
According to the release, it had “become clear that there are certain fact patterns in which an auditor’s objectivity and impartiality are not impaired despite a failure to comply with the requirements of the Loan Provision.” As the SEC notes, just because an auditor has a loan from a holder of under 10% of the client’s securities doesn’t necessarily mean the auditor is impartial or objective any more than a loan from a more than 10% holder necessarily means that the auditor isn’t. In addition, in many cases, audit firms experienced significant difficulty in accessing information about the ownership percentages of its audit clients. To address the significant practical challenges associated with the current Loan Provision, the SEC adopted amendments to Rule 2-01 that it believes will “more effectively identify those debtor-creditor relationships that could impair an auditor’s objectivity and impartiality, yet would not include certain attenuated relationships that are unlikely to present threats to objectivity or impartiality.”
The final amendments provide that an accounting firm would not be independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has any “loan (including any margin loan) to or from an audit client, or an audit client’s officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client (except for the specified types of ordinary loans from financial institutions). The changes:
- focus the analysis solely on beneficial ownership rather than on both record and beneficial ownership, so that the rule would not apply to those who merely hold the audit client’s equity securities as a holder of record on behalf of their beneficial owners;
- replace the existing 10% bright-line shareholder ownership test with a “significant influence” test, so that an accountant would not be independent when there is a loan from beneficial owners of the audit client’s equity securities where the beneficial owner has significant influence over the audit client, determined based on the concepts set forth in ASC Topic 323, Investments – Equity Method and Joint Ventures;
- added a “known through reasonable inquiry” standard with respect to identifying beneficial owners, which would involve “looking to the audit client’s governance structure and governing documents, Commission filings about beneficial owners, or other information prepared by the audit client which may relate to the identification of a beneficial owner,” reflecting the view that, “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, including because that lender invests in the audit client indirectly through one or more financial intermediaries, the auditor’s objectivity and impartiality is unlikely to be impacted by its debtor-creditor relationship with the lender”; and
- amended the definition of “audit client” for a fund under audit to exclude other funds (e.g., sister funds) that otherwise would be considered affiliates of the audit client, as well as commodity pools that are not investment companies and foreign funds.
The release indicates that the Chair has directed the staff to formulate recommendations for possible additional changes to the auditor independence rules in future rulemakings.