SEC Releases Proposed Rule to Ease Auditor Independence Standard In Certain Situations
Hinckley Allen Securities Alert
May 16, 2018
By: Margaret D. Farrell, Matthew E. Waters
On May 2, 2018, the Securities and Exchange Commission (SEC) released a proposed rule (“Proposed Rule”) regarding auditor independence standards that aims to ease compliance burdens currently in place when an auditor maintains loans and/or debtor-creditor relationships with lenders that have an ownership interest in the auditor’s client. The Proposed Rule also aims to improve the quality of SEC-approved audits in the same context. The SEC is accepting public comments on the Proposed Rule until July 9, 2018.
The Loan Provision of Regulation S-X
The SEC considers auditor independence essential to reliable financial reporting and critical to the effective functioning of the U.S. capital markets. The SEC’s auditor independence standard, which is set forth in Rule 2-01 of Regulation S-X, requires auditors to be independent of their audit clients both “in fact and in appearance.” In subsection (c) of Rule 2-01, the SEC identifies a non-exhaustive set of circumstances under which it assumes (without giving opportunity for rebuttal) that an auditor does not satisfy the standard of independence.
One of the circumstances under which the SEC assumes non-independence is when there are lending and/or debtor-creditor relationships between the auditor and persons associated with the auditor’s client. The “Loan Provision” of Rule 2-01, as currently in effect, reaches very broadly. It stretches from the auditor, any covered person in the auditor’s firm, and any auditor-related immediate family members, on the one hand, to record and beneficial owners of more than 10 percent of an audit client’s equity securities, an audit client’s board of directors and officers, and an audit client’s “affiliates,” on the other. Under Rule 2-01, “affiliates” include (1) all entities under common control with the audit client, and (2) in the investment fund context, each entity in an investment company complex (ICC) when the audit client is an entity that is part of the ICC.
Under the Loan Provision, auditor independence has been difficult to obtain even where the debtor-creditor relationship is very unlikely to affect an auditor’s objectivity and impartiality. For example, an audit firm is not considered independent from the audit client when the lender to the audit firm is also the record owner of more than 10 percent of the audit client’s securities. Record ownership by a lender is common in areas such as the mutual fund industry, where a financial institution holds fund shares on behalf of customers who are the beneficial owners of the shares. In such situations, the financial institution holds no power over the shares and is unable to control whether its record ownership is above or below the 10-percent threshold on any given day. However, if an auditor party maintains a lending relationship with a financial institution that holds record ownership of the audit client in such manner, the auditor cannot be considered independent from the audit client under the Loan Provision.
A similar situation arises in the context of ICCs, where an auditor will often be asked to perform an audit of a single fund in a series of funds sponsored under an ICC. Under the Loan Provision, an auditor party cannot be independent of any of the funds in an ICC if the auditor party maintains a lending relationship with the record owner of a single fund in the ICC. In putting forth the Proposed Rule, the SEC has acknowledged that the compliance burden associated with the Loan Provision can be overwhelming and ineffective in delineating auditor independence.
Modifications to the Loan Provision under the Proposed Rule
The SEC’s Proposed Rule would modify the Loan Provision in four principal ways:
- Elimination of an audit client’s “record ownership” by lenders as a condition upon which auditors can automatically lose independence. The analysis of auditor independence under the Loan Provision would be focused solely on beneficial ownership rather than on both record and beneficial ownership.
- Replacement of the 10-percent bright-line ownership threshold with the concept of “significant influence.” This would effect a more judgment-based evaluation of the lender’s relationship to the audit client when making assumptions about auditor independence. The concept of “significant influence” already exists in the SEC rulemaking context and should be familiar to auditors. In addition, the “significant influence” test would incorporate rebuttable presumptions (as opposed to rigid assumptions) with respect to auditor independence.
- Addition of a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client. This modification is intended to help ease the compliance burden of auditors who, for example, might otherwise be compelled to make extensive and intrusive information requests to record owners of open-end mutual funds. The SEC believes 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 securities, then the auditor’s objectivity and impartiality is unlikely to be affected by its debtor-creditor relationship.
- Exclusion of non-audited ICC funds from the definition of “affiliate” in the ICC context. The SEC hopes that removing non-audited ICC funds from the definition of “affiliate” in cases where only a single ICC fund is audited will eliminate unnecessary compliance challenges. The SEC believes that in the investment management context, investors in a fund typically do not possess the ability to influence the policies or management of another fund in the same complex. In addition, the SEC believes that an investor with a substantial investment in one series fund would be unlikely to have a controlling percentage of voting power over the company as a whole. As a result, this modified definition of “affiliate” is intended to reinforce the SEC’s original goal of facilitating compliance with the Loan Provision without decreasing its effectiveness.
This article has been prepared by Hinckley Allen’s Corporate & Business Group. For any questions, please contact Matthew, Margaret, the Hinckley Allen attorney with whom you regularly work, or another of our Securities attorneys.
Rule 2-01(c)(1)(ii)(A) of Regulation S-X.