The Securities and Exchange Commission (Commission) recently proposed amendments to the auditor independence requirements of Rule 2-01 of Regulation S-X to modernize certain aspects of its auditor independence framework (Proposal).1 Comments on the Proposal are due on March 16, 2020.
Key aspects of the Proposal are highlighted below.
Definitions of “Affiliate of the Audit Client” and “Investment Company Complex.” Under current requirements, entities under common control with the audit client (sister entities) are considered affiliates and fall within the definition of audit client. In addition, each entity in an investment company complex (ICC) is considered an affiliate when the audit client is part of the ICC. As a result, in complex organizational structures, such as large ICCs, the requirement to identify and monitor for potential independence-impairing relationships and services currently applies to affiliated entities, including sister entities, regardless of whether the sister entities are material to the controlling entity.
To more effectively focus the definition of affiliate of the audit client on those relationships and services that are most likely to threaten auditor objectivity and impartiality, the Proposal would, among other things, amend the definitions of affiliate of the audit client and ICC to include materiality qualifiers in the respective common control provisions. As a result, the Proposal would focus the independence analysis on sister entities that are material to the controlling entity.
Loans or Debtor-Creditor Relationships. Recognizing that not all creditor or debtor relationships threaten an auditor’s objectivity and impartiality, the Proposal includes changes to the current independence requirements regarding such relationships. Under current requirements, an auditor is not independent if specified persons at the audit firm or their family members have a lending relationship with an audit client, with the exception of particular loans (e.g., certain automobile loans and mortgage loans) and certain credit card debt. The Proposal would add specified student loans and de minimis consumer loans to the categorical exceptions.
Business Relationships Rule. Currently, the “Business Relationships Rule” prohibits the audit 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 Proposal would replace the reference to “substantial stockholders” in the Business Relationships Rule with the concept of beneficial owners (known through reasonable inquiry) with significant influence over the audit client. The Commission notes that this change would make the rule more clear and less complex.
Inadvertent Violations Due to Mergers and Acquisitions. The Proposal would provide relief to audit firms with respect to violations of independence standards that arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of such corporate event. The Proposal would establish a transition framework for mergers and acquisitions (based on an effective system of quality controls) to address inadvertent violations related to such transactions so the auditor and its audit client could transition out of prohibited services and relationships in a timely and orderly manner.
Definition of “Audit and Professional Engagement Period.” The Proposal would amend the definition of the audit and professional engagement period, which is currently defined differently for domestic issuers and foreign private issuers with respect to situations in which a company first files, or is required to file, a registration statement or report with the Commission. The Proposal would shorten the look-back period for assessing compliance with the independence requirements for domestic first-time filers to match the one-year look-back period for first-time filers that are foreign private issuers (regardless of the period of financial statements included in the registration statement).
S&K Observations
If adopted, the Proposal would more effectively focus the independence analysis by audit firms and audit committees on those relationships or services that are more likely to pose threats to an auditor’s objectivity and impartiality. Furthermore, the Proposal could reduce non-material rule violations and potentially lengthy audit committee reviews of non-material matters. The Proposal also could increase the number of auditors who could be considered independent and thus available to issuers, under certain circumstances.
In June 2019, the Commission adopted amendments to its auditor independence rules that change the analysis used to determine whether an auditor is independent when it has a lending relationship with certain shareholders of an audit client during an audit or professional engagement period.2 For more information, see our memorandum “SEC Adopts Amendments to Auditor Independence Rules Regarding Loans.”
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1 Amendments to Rule 2-01, Qualifications of Accountants, Release No. 33-10738 (Dec. 30, 2019), available at https://www.sec.gov/rules/proposed/2019/33-10738.pdf.
2 Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Investment Company Act Release No. 33511 (June 18, 2019).
