On June 18, 2019, the Securities and Exchange Commission (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.1 The amendments help to address compliance concerns of investment companies (among others) and accounting firms stemming from the application of the auditor independence standards to lending relationships in which the auditor’s objectivity and impartiality do not appear to be affected as a practical matter. Rule 2-01(c)(1)(ii)(A) of Regulation S-X (the “Loan Rule”) currently provides in general that an accounting firm is not independent if the firm, any covered person in the firm or any of the covered person’s immediate family members have a loan to or from an audit client or the record or beneficial owners of more than 10% of the audit client’s equity securities. The amendments are effective on October 3, 2019.
The Amendments. The amendments refocus the current auditor independence analysis to attempt to more effectively identify lending relationships that could impair an auditor’s objectivity and impartiality. To accomplish this end, the amendments: (1) focus the analysis on beneficial ownership rather than on both record and beneficial ownership; (2) replace the 10 percent bright-line shareholder ownership test with a “significant influence” test; (3) add a “known through reasonable inquiry” standard to identify 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 fund that otherwise would be considered an affiliate of the audit client.
Beneficial Ownership Test. The Loan Rule currently applies to both beneficial and record ownership of an audit client’s equity securities. The amendments limit the application of the Loan Rule solely to beneficial ownership. The Commission believes that the focus on beneficial ownership will more effectively identify shareholders that have “a special and influential role with the issuer” and therefore better capture lending relationships that may impair an auditor’s independence. The Commission also provided guidance on the term “beneficial owner,” stating, among other things, that financial intermediaries who hold shares as record owners and who have limited authority to make or direct voting or investment decisions on behalf of underlying shareholders of audit clients are not beneficial owners for purposes of the Loan Rule.
“Significant Influence” Test. The amendments replace the 10% bright-line shareholder ownership test in the Loan Rule with a “significant influence” test similar to that referenced in other parts of the auditor independence rules and based on the concepts applied in the Financial Accounting Standards Board’s ASC Topic 323, Investments – Equity Method and Joint Ventures (“ASC 323”).2 In the fund context, the Commission noted that the operating and financial policies relevant to the significant influence test would include the fund’s investment policies and day-to-day portfolio management processes, including those governing the selection, purchase and sale, and valuation of investments, and the distribution of income and capital gains.
Known Through Reasonable Inquiry Standard. The amendments add a “known through reasonable inquiry” standard with respect to the identification of beneficial owners. An audit firm, in coordination with its audit client, would be required to assess beneficial owners of the audit client’s equity securities only for those who are “known through reasonable inquiry.” The Commission indicated that auditors and their audit clients could conduct the reasonable inquiry analysis by looking to the audit client’s governance structure and governing documents, Commission filings about beneficial owners, or other information prepared by the audit client that may relate to the identification of a beneficial owner.
Excluding Other Funds That Would Be Considered Affiliates of the Audit Client. The amendments exclude from the definition of “audit client,” for a fund under audit, any other fund (e.g., a “sister fund”) that otherwise would be considered an affiliate of the audit client. The amendments also broaden the definition of “fund” to include not only investment companies and private funds relying on an exclusion from registration as an investment company under the Investment Company Act of 1940 but also (1) commodity pools that are not investment companies and do not rely on an exclusion and (2) foreign funds that are part of an investment company complex.
S&K Observations
The Commission stated that the amendments are intended to more effectively identify lending relationships that could impair an auditor’s objectivity and impartiality. The amendments provide clarification to the Loan Rule by addressing many of the underlying causes of violations of the Loan Rule. Audit clients and their audit firms will need to work together in developing a new framework for analyzing ongoing compliance with the new Loan Rule provisions.
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1 See Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Investment Company Act Release No. 33511 (June 18, 2019), available at https://www.sec.gov/rules/final/2019/33-10648.pdf.
2 The Commission did not codify in the amendments either the (1) specific considerations described in the significant influence test in ASC 323 or (2) ASC 323’s rebuttable presumption of significant influence once beneficial ownership meets or exceeds 20% of an issuer’s voting securities.
