By Rodney F. Tonkovic, J.D.
The SEC has proposed to amend its auditor independence rules concerning the independence of an accountant who has a lending relationship with certain shareholders of an audit client. Among other changes, the proposed amendments to Regulation S-X Rule 2-01 would focus the analysis solely on beneficial ownership, and the existing 10 percent bright-line shareholder ownership test would be replace with a "significant influence" test. A "known through reasonable inquiry" standard with respect to identifying beneficial owners would also be added. Finally, the proposal would also amend the definition of "audit client" for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client (Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491, May 2, 2018).
The Rule 2-01 loan provision. Rule 2-01 of Regulation S-X sets forth the Commission's auditor independence standard, requiring auditors to be independent of their clients in both fact and appearance. Under the rule, auditors are not recognized as independent if they are incapable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. A non-exhaustive list of circumstances inconsistent with the independent standard may be found in Rule 2-01(c). In particular, Rule 2-01(c)(1)(ii)(A) (the "Loan Provision") covers debtor-creditor relationships and provides that an accountant is not independent when the accounting firm, or any covered person, has a loan to or from an audit client, or the client's officers, directors, or beneficial owners of more than 10 percent of the audit client’s equity securities.
The Commission says that it has become aware that under current market conditions, the Loan Provision may not be functioning as intended. There exist practical challenges, for example, the record ownership percentages of open-end funds may fluctuate within a given period for reasons beyond the control or knowledge of a lender who is also a fund shareholder of record. Also, the rules' broad definition of "audit client" can have adverse effects when applied in the context of the Loan Provision. Today, accounting firms have a wide array of lending arrangements, and this can multiple the number of lenders who may also be record or beneficial owners of securities in audit clients. As a result, a strict application of the Loan Provision would deem a firm's independence to be impaired when, as a practical matter, the auditor's objectivity and impartiality are not affected.
Firms nevertheless may feel obligated to devote time and resources to evaluating potential noncompliance. The Commission addressed some of these challenges in a no-action letter granting relief to certain entities that used audit firms that were not in compliance with the Loan Provision, so long as the audit firms concluded that they were objective and impartial.
Significant influence. The Commission proposes to amend Rule 2-01 by revising paragraph (c)(1)(ii)(A) in such a way as to identify debtor-creditor relationships that could impair an auditor’s independence while excluding certain extended relationships that are unlikely to present threats to objectivity or impartiality. The proposed amendments would focus the analysis solely on beneficial ownership rather than on both record and beneficial ownership. Also, the current bright-line 10 percent shareholder ownership test would be replaced with a "significant influence test. This test focuses on a lender shareholder's influence over the management and financial and operating policies of an audit client. The Commission noted that the concept of "significant influence" has long been a part of the auditor independence rules and accounting standards and that firms and their clients are thus already required to be familiar with its application. The proposed test establishes a rebuttable presumption that a lender owning 20 percent or more of an audit client's securities has significant influence over the client, but such influence can still exist where ownership is less than 20 percent. Finally, an audit firm is required to conduct a "reasonable inquiry" into whether a lender is also a beneficial owner of an audit client's securities.
Affiliates. The proposal would also amend the definition of "audit client" for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client. The current definition encompasses, among other entities, each entity in an investment company complex of which the audit client is a part. The Commission explains that in the fund context, this expansive definition of "audit client" could result in non-compliance with the Loan Provision as to a broad range of entities, even where an auditor does not audit that entity and there is no ability to influence.
Request for comment. The Commission is seeking comments on the proposed amendments, which should be received on or before 60 days after publication in the Federal Register. The Commission also asks for comments on potential changes to the Loan Provision and other parts of Rule 2-01 that it considered, but has not proposed at this time. These other items include: consideration of whether the lender's investment is material to the lender or to the audit client; amending the definition of "covered person"; evaluation of compliance with the Loan Provision; and whether secondary market purchases of debt should be taken into account.
The release is No. 33-10491.