The SEC has posted a new rule proposal that would modify the analysis of auditor independence in the context of lending relationships between the auditor and certain shareholders of an audit client during the audit or professional engagement period. Under the current loan provision of Rule 2-01(c) of Reg S-X, some debtor-creditor relationships between an auditor and its audit client are viewed to taint auditor independence. However, the SEC now believes that some of the provisions of this Rule are not as effective as they could be and may present unnecessary practical challenges. The release indicates that the proposed amendments are designed to better focus the loan provision "on those relationships that, whether in fact or in appearance, could threaten an auditor's ability to exercise objective and impartial judgment." As Wes Bricker, SEC Chief Accountant, told Bloomberg, "[w]e're trying to right-size" the Rule. The SEC is also soliciting comment on other potential changes to the loan provision or other provisions of Rule 2-01. Comments are due 60 days after publication in the Federal Register.
Rule 2-01 of Reg S-X requires auditors to be independent of their audit clients both "in fact and in appearance," capable of "exercising objective and impartial judgment on all issues encompassed within the accountant's engagement." Rule 2-01(c) provides a nonexclusive list of circumstances considered by the SEC to be "inconsistent with the independence," including certain financial relationships. Debtor-creditor relationships between an auditor and its audit client (which includes any affiliate of the entity being audited and shareholders of the audit client that have a "special and influential role" with the audit client) can reasonably be viewed to taint independence because they could create "a self-interest that competes with the auditor's obligation to serve only investors' interests." Under current Reg S-X Rule 2-01(c)(ii)(A), an accountant is not independent when the accounting firm, any covered person in the firm (i.e., partners, principals, shareholders and employees of an accounting firm, such as the audit engagement team and those in the chain of command) or any of his or her immediate family members has any loan (including any margin loan) to or from an audit client, or an audit client's officers, directors or record or beneficial owners of more than 10% of the audit client's equity securities. There are exceptions for certain types of loans, such as fully collateralized car loans and home loans (provided the home loan was not obtained while the covered person in the firm was a covered person) or similar collateralized loans obtained from a financial institution under its normal lending procedures, terms and requirements. The bright line 10% test was considered a proxy for identifying a "special and influential role" at the audit client. Accordingly, an accounting firm is not independent under the current loan provision "if it has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of the equity securities of either (a) the firm's audit client; or (b) any entity that is a controlling parent company of the audit client, a controlled subsidiary of the audit client, or an entity under common control with the audit client," or if it has a lending relationship with an entity having record or beneficial ownership of more than 10% of any entity within an investment company complex, regardless of which entities in the ICC are audited by the accounting firm.
However, the SEC now believes that the current loan provision may not function as intended, might be overly broad in capturing certain situations that do not really impair independence and may also present significant practical challenges. For example, financial intermediaries may own, on a record basis, more than 10% of an audit client's shares and also be lenders to public accounting firms, but these intermediaries are not beneficial owners and may not even control whether they are record owners of over 10%. Similarly, mutual funds may face practical challenges because their record ownership percentages fluctuate greatly without the control or knowledge of a shareholder/lender (e.g., the percentage ownership of a lender that is a financial intermediary holding fund shares for customers could fluctuate as a result of activities of other investors).
In addition, the SEC believes the definition of "audit client" may be too broad and capture distant related entities that are not being audited and may not even be forthcoming with necessary information. These challenges can be compounded by the fact that accounting firms use loans to help finance their core business operations, and these financing methods may be deemed to taint independence or require substantial and costly compliance efforts under the Rule (including reporting to audit committees) even though, "in most cases the auditor's objectivity and impartiality do not appear to be affected as a practical matter." The release notes that the staff has already provided some flexibility with regard to these issues through a no-action letter to Fidelity Management & Research.
The SEC believes that the proposed amendments "would effectively identify those debtor-creditor relationships that could impair an auditor's objectivity and impartiality, yet would not include certain extended relationships that are unlikely to present threats to objectivity or impartiality." As Bloomberg quotes Bricker, "'[i]ndependence is not susceptible to a bright line, mathematical calculation. Independence is a state of mind....Whether it's 1 percent or 11 percent, what we're asking auditors and audit committees to look for are the areas of influence in their relationship where that influence could be significant and undermine independence.'"
More specifically, the SEC proposes to make four key changes:
- focus the analysis solely on beneficial ownership of the audit client's equity securities, not mere record ownership, and thus identify more effectively those shareholders that have "a special and influential role with the issuer";
- replace the existing 10% bright-line shareholder ownership test with a more qualitative "significant influence" test; the test would require the audit firm and its audit client "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," based on the totality of facts and circumstances, including board representation, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, technological dependency, as well as the level of beneficial ownership (i.e., establishing rebuttable presumptions that a lender beneficially owning at least 20% of an audit client's voting securities has the ability to exercise significant influence and that owners of less than 20% do not have significant influence, unless it could be demonstrated otherwise, as under ASC 323);
- to address the difficulty of accessing records or other information about beneficial ownership of the audit client's equity securities, add a "known through reasonable inquiry" standard that would require an audit firm, in coordination with its audit client, to analyze beneficial owners of the audit client's equity securities that are known through reasonable inquiry; if not identified through that process, the SEC believes it unlikely that the auditor's objectivity and impartiality would be compromised by its debtor-creditor relationship with the lender; and
- amend the definition of "audit client" for a fund under audit to exclude from the loan provision funds that otherwise would be considered "affiliates of the audit client."
The SEC notes that "the proposed amendments would apply broadly to entities beyond the investment management industry, including operating companies and registered broker-dealers."
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