By Amanda Maine, J.D.
Deloitte, PricewaterhouseCoopers, KPMG, and Grant Thornton largely support the SEC’s efforts to amend its rule on auditor independence with respect to certain loans or debtor-creditor relationships. They agree that the rule (“the Loan Provision”) as currently written is not functioning as originally intended given changes in the capital markets and the business environment, especially for funds. The SEC issued its proposing release on May 2, 2018. The comment period closed on July 9, 2018.
Proposal. The proposal would amend Rule 2-01(c)(1)(ii)(A) of Regulation S-X to refocus the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period. The proposed amendments would: (1) change the focus of analysis from both record and beneficial ownership to beneficial ownership only; (2) replace the current 10 percent “bright-line” ownership test with a “significant influence test”; (3) include a “known through reasonable inquiry” standard for identifying ownership of securities; and (4) amend the definition of “audit client” to exclude affiliate funds of an audit client for purposes of the Loan Provision.
Ownership. In support of shifting the analysis of ownership to beneficial ownership, the four firms are in agreement that record owners of securities are typically holders or custodians of securities that generally lack the ability to exert influence over the issuer audit client. KPMG stated in its letter that it “is not aware of ever having encountered a situation where the record owner has tried to influence the firm or an audit engagement team in any manner.” PwC wrote that shifting the focus to beneficial owners would also help ease the significant burdens of complying with the existing rule.
Significant influence over bright-line test. All four firms were also in agreement about eliminating the 10 percent “bright-line” threshold for beneficial ownership. Deloitte noted that “significant influence” is a well-established concept in FASB’s Accounting Standards Codification Topic 323, Investments-Equity Method and Joint Ventures. While supportive of a significant influence test, KPMG advised that instead of ASC 323’s significant influence test, the SEC should adopt a decision framework based on the beneficial owner’s ability to exert significant influence based on the totality of the facts and circumstances and avoid exclusive reliance on ASC 323’s framework. PwC also believes that ASC 323 may not be appropriate for independence considerations in a fund environment and suggested that in determining significant influence, various factors be taken into account, including governance structure, the manner in which shares are held or distributed, contractual arrangements, and advisory agreements.
Known through reasonable inquiry. The firms also support the SEC’s proposed amendment providing that an auditor’s objectivity and impartiality would not be considered impaired if, after a reasonable inquiry, the auditor is unaware that a lender is also a beneficial owner of an audit client’s equity securities. Grant Thornton suggested that the Commission consider additional parameters regarding the performance of a “reasonable inquiry”; the firm stated it should be reasonable to conclude that an accounting firm could review publicly available information to determine ownership information that would need to be considered. KPMG also suggested that the Commission consider “grandfathering” provisions for immaterial and secured lending relationships that the accounting firm or covered persons had with their lender prior to becoming subject to the Loan Provision.
Affiliates. The final part of the proposal would amend the term “audit client,” which currently encompasses entities that are “affiliates of the audit client.” The proposed amendment would exclude affiliates in the fund environment as it relates to the Loan Provision. The four firms not only support this change, but also urge the Commission to expand the scope of the exception to affiliates of all audit clients, not just limited to fund environments. Deloitte observed that the same rationale noted by the Commission for the proposed change for affiliates in the fund context—investors in a fund typically do not possess the ability to influence the policies or management of another fund in the same fund complex—can also be applied to other affiliates of the audit client. KPMG said it supports extending the exclusion to other affiliates of the audit client so the significant influence test is focused only on those entities that have significant influence over the audited entity.
Materiality. Finally, the proposing release requested comments on whether a provision for assessing materiality should be included in a final rule. KPMG advised that this would not be necessary because the existing independence rules include a materiality component for identifying significant influence situations. PwC, on the other hand, supports incorporating a materiality qualifier in the Loan Provision as it relates both to the lender’s investment in the audit client and to the loan’s significance to the auditor. Grant Thornton believes that a materiality may not be necessary, but it could assist in reducing compliance costs for accounting firms and audit clients. Deloitte recommends that the SEC consider adding a materiality threshold as a factor to consider in determining whether the lending relationship with a beneficial owner that has significant influence over an audit client impairs the firm’s independence.