On May 2, 2018, the Securities and Exchange Commission (the “Commission”) proposed amendments to its rule regarding the analysis of auditor independence with respect to lending relationships between the auditor and certain shareholders of an audit client.1 The proposed amendments would (1) focus the analysis regarding auditor independence solely on beneficial ownership rather than on both record and beneficial ownership; (2) replace the current 10 percent bright-line shareholder ownership test with a “significant influence” test; (3) add a “known through reasonable inquiry” standard when identifying beneficial owners of the audit client’s equity securities; and (4) change the definition of “audit client” for a fund to exclude funds that otherwise would be considered affiliates of the audit client.
The Commission is accepting comments on the Proposal until July 9, 2018.
Background
The Commission’s auditor independence standard in Rule 2-01 of Regulation S-X requires auditors to be independent of their audit clients both “in fact and in appearance.” The restriction on debtor-creditor relationships in Rule 2-01(c)(1)(ii)(A) (the “Loan Rule”) generally 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)2 to or from (i) an audit client, (ii) an audit client’s officers or directors, or (iii) record or beneficial owners of more than 10 percent of the audit client’s equity securities.3
The Proposal acknowledges that, in certain circumstances, the existing Loan Rule may not be functioning as intended and presents significant practical challenges. The Commission notes that there are situations where an auditor’s objectivity and impartiality are not impaired despite a failure to comply with the requirements of the Loan Rule.4
Proposed Amendments
The proposed amendments are designed to better focus the Loan Rule on those relationships that could threaten an auditor’s ability to exercise objective and impartial judgment.
Analysis Solely of Beneficial Ownership
The Loan Rule indicates that the auditor is not independent of the audit client when a lender to an auditor (or to a covered person of the auditor or an immediate family member of the covered person, as described above) holds more than 10 percent of the equity securities of that auditor’s audit client either as a beneficial owner or as a record owner. Under the proposed amendments, the Loan Rule would apply only to lenders that are beneficial owners of the audit client’s equity securities and not to those who merely maintain the audit client’s equity securities as a holder of record on behalf of beneficial owners. The Proposal indicates that focusing only on the beneficial ownership of the audit client’s equity securities would more effectively identify shareholders having a special and influential role with the audit client and therefore better capture those debtor-creditor relationships that may impair an auditor’s independence.
Replacement of 10 Percent Bright-Line Ownership Test with Significant Influence Test
Under the Loan Rule’s current 10 percent bright-line shareholder ownership test, the auditor is not independent of the audit client where a lender to an auditor holds more than 10 percent of the equity securities of that auditor’s audit client either as a beneficial owner or as a record owner.
The proposed “significant influence” test, which would replace the 10 percent bright-line shareholder ownership test, focuses on a lender shareholder’s ability to influence the policies and management of an audit client, based on a totality of the facts and circumstances. Specifically, under the significant influence test, an audit firm, together with its audit client, would be required to assess whether a lender (that is also a beneficial owner of the audit client’s equity securities) has the ability to exert significant influence over the audit client’s operating and financial policies.
Although not specifically defined, the Proposal indicates that the term “significant influence” already exists in the auditor independence rules, and that the Commission will refer to U.S. GAAP for guidance.5 Such guidance indicates that, under the proposed test, the ability to exercise significant influence over the operating and financial policies of an audit client would be based on the facts and circumstances and could be indicated in several ways, including board representation, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel or technological dependency. The guidance also includes a rebuttable presumption that a lender beneficially owning 20 percent or more of an audit client’s voting securities is presumed to have the ability to exercise significant influence over the audit client and that a lender beneficially owning less than 20 percent of such securities does not have such ability, unless it can be demonstrated otherwise.
The Proposal indicates that, in the fund context, 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 (collectively “portfolio management processes”). The Proposal further indicates that an audit firm could analyze whether significant influence over the fund’s portfolio management processes exists based on an initial evaluation of the fund’s governance structure and governing documents, the manner in which its shares are held or distributed, and any contractual arrangements, among any other relevant factors.
“Known Through Reasonable Inquiry” Standard
The Proposal recognizes that entities may encounter challenges in obtaining information regarding the ownership percentage of an audit client for the purposes of the current 10 percent bright-line test. For example, an institution that is the holder of record of shares in an audit client merely as custodian or as an omnibus account holder may have difficulty obtaining information about the underlying beneficial ownership.
Under a “known through reasonable inquiry” standard with respect to the identification of such owners, an audit firm, in coordination with its audit client, would be required to analyze beneficial owners of the audit client’s equity securities who are known through reasonable inquiry. The Proposal states 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. The Proposal indicates that this “known through reasonable inquiry” standard is generally consistent with regulations under other federal securities laws.6
Change in Definition of “Audit Client” to Exclude Funds That Otherwise Would Be Considered “Affiliates of the Audit Client”
The current definition of “audit client” in Rule 2-01 of Regulation S-X includes all “affiliates of the audit client,” which broadly encompasses, among others, each entity in an investment company complex of which the audit client is a part. The Proposal indicates that, in the fund context, this expansive definition of “audit client” could result in non-compliance with the Loan Rule as to a broad range of entities, even where an auditor does not audit that entity.
The Commission proposes, for purposes of the Loan Rule, to 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.
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If you have any questions regarding the matters covered in this memo, please contact Paul M. Miller (202-737-8833, millerp@sewkis.com), Anthony C.J. Nuland (202-661-7140, nuland@sewkis.com), Patricia A. Poglinco (212-574-1247, poglinco@sewkis.com), Keri E. Riemer (212-574-1598, riemer@sewkis.com), Lancelot A. King (202-661-7196, king@sewkis.com) or Anna C. Weigand (202-661-7148, weigand@sewkis.com).
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1 See Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018) (the “Proposal”).
2 There are exceptions for four types of loans: (1) automobile loans and leases collateralized by the automobile; (2) loans fully collateralized by the cash surrender value of an insurance policy; (3) loans fully collateralized by cash deposits at the same financial institution; and (4) a mortgage loan collateralized by the borrower’s primary residence provided the loan was not obtained while the covered person in the firm was a covered person.
3 The Loan Rule applies not only to an entity that the audit firm is auditing but also to those entities that are “affiliated” with the audit client. Currently, the auditor independence rules broadly define an “affiliate of the audit client” to include, among other things, both (a) an entity that controls, is controlled by, or is under common control with the audit client; and (b) each entity in an investment company complex when the audit client is part of that investment company complex.
4 The Proposal notes that a number of entities has expressed concerns about the Loan Rule. In June 2016, the Commission staff issued a no-action letter granting relief from the Loan Rule’s auditor independence requirements, provided that certain conditions were met. See Fidelity Management & Research Company et al., No-Action Letter (June 20, 2016).
5 The Proposal cites Financial Accounting Standards Board’s ASC Topic 323, Investments – Equity Method and Joint Ventures.
6 See, e.g., Rule 3b-4 under the Securities Exchange Act of 1934; Rule 144(g) under the Securities Act of 1933; and Item 18 of Form N-1A used by open-end investment companies to register under the Investment Company Act of 1940 (requiring the name, address, and percentage of ownership of each person who owns of record or is known by the fund to own beneficially 5% or more of any class of the fund’s outstanding equity securities).
