By Rodney F. Tonkovic, J.D.
The SEC has adopted amendments to its auditor independence rules relating to auditors' lending relationships with their clients. The amendments to Rule 2-01 under Regulation S-X concern 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 and are intended to identify debtor-creditor relationships that could impair an auditor's objectivity and impartiality. Among other changes, the amendments focus the analysis solely on beneficial ownership, and the existing 10 percent bright-line shareholder ownership test has been replaced with a "significant influence" test. Finally, the definition of "audit client" for a fund under audit has been amended 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. 33-10648, June 18, 2019).
The Rule 2-01 independence standard. Rule 2-01 of Regulation S-X sets forth the Commission's auditor independence standard, requiring auditors to be independent of their clients "in fact and in appearance." Under the rule, auditors are not recognized as independent if they are incapable of exercising objective and impartial judgment on all issues encompassed by the accountant's engagement. A non-exhaustive list of circumstances inconsistent with the independence 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 generally provides that an auditor is not independent if that auditor is in a lending relationship with its audit client.
When the Loan Provision was proposed, and later adopted, in 2000, the Commission noted its concern that a debtor-creditor relationship could create a self-interest that competes with the auditor's obligation to serve only investors' interests. This concern extended further to loans between the auditor and shareholders of the audit client having a "special and influential role" with the client. To identify that "special and influential" role, the Commission adopted a bright-line test for loans to or from record or beneficial owners of more than 10 percent of a client's equity securities.
The Commission said that it became aware that the existing rules did not function as intended and 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 were not affected. One side-effect is that firms felt obligated to devote time and resources to evaluating potential noncompliance, despite the auditor's objectivity and impartiality not being affected as a practical matter. The amendments to the Loan Provision are aimed at focusing the rules on lending relationships that reasonably may bear on external auditors' impartiality or objectivity and consequently benefitting investors while reducing compliance burdens.
"This rulemaking reflects the staff's extensive experience and judgment, and I thank them for their continued commitment to retrospective review," said SEC Chairman Jay Clayton. "The amendments we are adopting today will more effectively identify debtor-creditor relationships that could impair an auditor's objectivity and impartiality, as opposed to certain more attenuated relationships that are unlikely to pose such threats."
Loan Provision amendments. The amendments to the loan provision were adopted as proposed, with a few changes. The amendments now focus the independence analysis on beneficial ownership rather than on both record and beneficial ownership. The previous application of the rule to record owners was problematic in that it captured financial intermediaries that merely hold the audit client's equity securities as a holder of record on behalf of their beneficial owners and do not necessarily have control over whether they are "record" owners of more than 10 percent of the issuer's shares. The focus on beneficial owners, the Commission says will better identify shareholders with "a special and influential role with the issuer" and better capture those debtor-creditor relationships that may impair an auditor's independence.
Because the previous bright-line 10 percent shareholder ownership test was both over- and under-inclusive, it has been replaced with a "significant influence" test. While not specifically defined, the term is a reference to principles in the FASB's ASC Topic 323, which 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. ASC 323 itself, and the 20 percent rebuttable presumption, are however, not codified in the SEC's rules so as to avoid confusion if changes are made by the FASB. Audit firms are also now required to conduct a "reasonable inquiry" into whether a lender is also a beneficial owner of an audit client's securities.
Affiliates. Finally, the Commission amended the definition of "audit client" for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client. The previous definition encompassed, among others, each entity in an investment company complex of which the audit client is a part, even where an auditor does not audit that entity and there is no ability to influence. In response to comments, the definition of "fund" has also been expanded to exclude certain commodity pools and foreign funds.
The amendments will become effective 90 days after publication in the Federal Register.
The release is No. 33-10648.