On Friday, the SEC announced adoption of final amendments to the auditor independence rules, largely as proposed at the end of 2019 (see this PubCo post). The changes to the rules make adjustments to address certain recurring fact patterns that came to light in the course of myriad staff consultations in which “certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality. These relationships either triggered non-substantive rule breaches or required potentially time-consuming audit committee review of non-substantive matters, thereby diverting time, attention, and other resources of audit clients, auditors, and audit committees from other investor protection efforts.” According to SEC Chair Jay Clayton, although “far-reaching and restrictive” auditor independence rules are necessary to maintain market confidence—as “even the appearance of inappropriate influence can undermine confidence”—they can still have “unintended, negative consequences” as markets evolve. The changes are designed to address these issues by “more effectively focus[ing] the analysis on relationships and services that may pose threats to an auditor’s objectivity and impartiality.” As noted in the adopting release, both auditors and audit clients “have a shared responsibility to monitor independence,” and it is important to keep in mind that violations of the auditor independence rules can have serious consequences not only for the audit firm, but also for the audit client. For example, an independence violation may cause the auditor to withdraw the firm’s audit report, requiring the audit client to have a re-audit by another audit firm. As a result, in most cases, inquiry into the topic of auditor independence should be a menu item on the audit committee’s plate. The amendments will be effective 180 days after publication in the Federal Register.
In their joint dissent, Commissioners Allison Lee and Caroline Crenshaw set the stage by observing that the auditor independence rules are the central method of addressing and mitigating the inherent conflict of interest that arises as a result of the “issuer pays” model in which companies select and pay for their own watchdogs, their auditing firms. Because auditor independence rules “underpin public trust and confidence in our capital markets[,] that trust must be carefully guarded and nurtured.” But now, they argue, with these amendments, the SEC is replacing
“a clear standard with one that provides auditors greater discretion when assessing their own independence and presents greater risk of mistaken or inconsistent application of that standard. What’s more, under the final rules, there is no mechanism for ensuring that the SEC and the investing public have visibility into how effectively auditors are making these assessments. And, as has too often been the case in recent years, these changes are disfavored by investors—those who actually rely on auditor assurances.”
In their view, these new rules blur lines that were previously clear by incorporating a new materiality analysis—in fact a “double materiality” analysis—into the definition of “audit client,” introducing “more opportunity for uncertainty and error.”
Acknowledging that the amendments were prompted by staff experience in the consultation process, the two dissenters argued that the staff’s expertise in assisting auditors to analyze and make these judgments is invaluable as part of that process. With these amendments, however, that expertise will be largely replaced with the auditors’ own subjective determinations about impairments of their independence, notwithstanding “the fact that people and organizations are so often inept at perceiving their own conflicts of interest and/or understanding if or how such conflicts may affect their own judgment.” Recalibrations of rules, they maintain, are sometimes necessary, but, in their view, these changes go too far.
The comprehensive framework of rules governing auditor independence identifies principles and relationships that would cause an auditor not to be independent of its audit client. The framework was initially adopted in 2000 and amended in 2003, but, except for the change last year in connection with debtor-creditor relationships, has otherwise not been reexamined since then, notwithstanding changes in market conditions and industry practices. Under Rule 2-01(b), the SEC “will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.” In addition, in determining whether an auditor is independent, the SEC “will consider all relevant circumstances, including all relationships between the accountant and the audit client.” Rule 2-01(c) provides a nonexclusive list of financial, employment, business and non-audit service relationships that the SEC views to be inconsistent with the independence standard in Rule 2-01(b).
To illustrate the point, the adopting release provides examples of relationships that would technically violate the current independence rule but that the staff has viewed to not impair independence or objectivity include:
- An audit partner has outstanding student loans that predate her joining the audit firm, and a different audit partner audits the large student loan company that provided the loans. Under the current rules, the student loan would still lead to an independence violation even though the audit partner is not part of the audit of the lender; that would not be case under the amended rules.
- A portfolio Company X of an investment fund is audited by an auditor that also has provided non-audit services to other otherwise unrelated immaterial portfolio companies of the same fund, Companies Y and Z. Under the current rules, the audit firm would not be independent of Company X as a result of the services provided to either Company Y or Z because the other portfolio companies would be consider entities under common control with the audit client, are considered affiliates and therefore fall within the definition of the “audit client.” As a result,
“Company X would be required: (1) to replace Audit Firm A with another audit firm; (2) to wait to register with the SEC for up to three years after termination of the services provided to Company Y and Company Z; or (3) to make a determination, likely in consultation with Commission staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality. In some situations, the existing audit firm cannot be replaced as a practical matter because all other qualified audit firms have themselves provided services or established other relationships with portfolio companies of [the investment fund] that triggered a breach of our independence rules.”
Apparently, these types of scenario have arisen several times just in the past few years, and the staff “did not object to the auditor’s and the audit committee’s conclusion that the auditor’s objectivity and impartiality would not be impaired.” Under the rules as amended, Company X would be able to engage the audit firm for audit services.
More specifically, the final amendments will effect the following changes:
- “Amend the definitions of ‘affiliate of the audit client,’ in Rule 2-01(f)(4), and ‘investment company complex,’ in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control.” An “audit client” means “the entity whose financial statements or other information is being audited, reviewed or attested” and “any affiliates of the audit client,” which includes entities under common control. To address one of the issues identified above, the final amendments will incorporate a “dual materiality threshold,” with the result that “a sister entity will be included as an affiliate of the audit client if the sister entity and the entity under audit are each material to the controlling entity.” [emphasis added] To illustrate the application of dual materiality threshold, the adopting release includes a number of examples. The adopting release also highlights the importance of management’s monitoring and notifying the auditor “in a timely manner of changes in circumstances that may affect the population of potential affiliates,” such as acquisitions. Companies and their audit committees “may want to consider having their own policies and procedures to identify, consider, and monitor the provision of services by and relationships with the issuer’s independent accountant, which may help supplement the audit firm’s system of quality control.” Note that the general standard in Rule 2-01(b) would continue to apply “to those relationships and services that previously were, but are no longer, covered by Rule 2-01(c) as a result of the final amendments.”
- “Amend the definition of ‘audit and professional engagement period,’ specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements.” As a result, the one-year look-back period for first-time filers will apply to all first-time filers, providing parity between domestic issuers and foreign private issuers for purposes of the independence requirements under Rule 2-01. The final amendment will apply to both existing and new audit relationships. The shorter look-back will also apply to a company undergoing a reverse merger similar to an IPO. In addition, where a company withdraws an initial registration statement, the re-filing of a new registration statement would be considered the company’s first-time filing.
- “Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.” The student loan must have been incurred prior to the person’s becoming a “covered person.” In a change from the proposal, the exception will cover student loans to the covered person’s immediate family. The amendments also clarify that the exclusion could apply to multiple mortgage loans on a primary residence. The proposal would replace the current reference to “credit card loans” with de minimis “consumer loans”; i.e., consumer financing where the outstanding balance is $10,000 or less on a current basis.
- “Amend Rule 2-01(c)(3) to replace the reference to ‘substantial stockholders’ in the business relationships rule with the concept of beneficial owners with significant influence.” Currently, Rule 2-01(c)(3) “prohibits, at any point during the audit and professional engagement period, the accounting firm or any covered person from having ‘any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors, or substantial stockholders….’” The final amendments replace the term “substantial stockholders” with “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the entity under audit.” With regard to an audit client’s officers and directors, the amendments clarify that the rule will apply to relationships with “an audit client’s officers or directors that have the ability to affect decision-making at the entity under audit.”
- “Replace the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions.” The final amendments introduce a new transition framework to address “inadvertent independence violations where the independence violation arises as a result of a corporate event, such as a merger or acquisition, and the services or relationships that are the basis for the violation would not have run afoul of applicable independence standards prior to the corporate event.” The new transition framework includes compliance with applicable independence standards from inception of the relationship, correction of the violation as promptly as possible (with corrective action expected no later than six months after the effective date) and the audit firm’s having in place “procedures and controls to identify independence-impairing services and relationships before the transaction has occurred in order to allow for post-transaction identification.” The transition framework will not apply to merger or acquisition transactions that are in substance similar to IPOs.
- Make certain other miscellaneous updates, such as certain conforming changes and elimination of certain provision.
As noted above, the final amendments will become effective 180 days after publication in the Federal Register. The SEC is permitting voluntary early compliance (after publication in the Federal Register) so long as the final amendments are applied in their entirety from the date of early compliance. Retroactive application is not permitted for relationships and services in existence prior to the effective date or the early compliance date if selected by an audit firm.