On September 23, 2016, the ICI addressed several questions raised by its members regarding the temporary no-action relief provided by the staff of the SEC’s Division of Investment Management in June with respect to auditor independence and the so-called “Loan Rule” under Rule 2-01 of Regulation S-X.

As a reminder, under the SEC staff’s interpretation of the Loan Rule in the no-action letter, an auditor’s independence may be impaired if the audit firm or certain of its personnel has an outstanding loan from, or the audit firm has issued debt held by, an institution that:

  • holds of record for the benefit of its customers or clients greater than 10% of the shares of an entity within an investment company complex that is audited by the audit firm;
  • holds greater than 10% of the shares of an entity within an investment company complex that is audited by the audit firm through a separate account that it maintains on behalf of its insurance contract holders; or
  • acts as an authorized participant or market maker to an ETF which is audited by the audit firm and holds more than 10% of the shares of the ETF (each of the foregoing, a lending relationship).

The SEC staff issued the no-action letter to Fidelity on June 20, 2016,1 assuring that, for at least the next 18 months from issuance, and subject to certain conditions set forth in the letter, the staff would not recommend enforcement action to the SEC against an entity within the Fidelity funds complex (a Fidelity Entity) if the Fidelity Entity employs an audit firm that has a lending relationship causing non-compliance with the Loan Rule (the Relief).

The SEC staff conditioned the Relief on the following requirements:

  1. the audit firm has complied with PCAOB Rule 3526(b)(1) and (2) (i.e., provided required communications concerning independence) or, with respect to any Fidelity Entity to which Rule 3526 does not apply, has provided substantially equivalent communications;
  2. the non-compliance of the audit firm is with respect to the specified lending relationships; and
  3. notwithstanding such non-compliance, the audit firm has concluded that it is objective and impartial with respect to the issues encompassed within its engagement.

Among the representations cited by the SEC staff that appeared to be significant in granting of the Relief was the undertaking by the Fidelity Entity that if certain matters are submitted to vote of shareholders (such as election of trustees, appointment of auditors or other matters that could influence the impartiality or objectivity of the independent auditor), the Fidelity Entity will make “reasonable inquiry” as of the record date about the impact of the lending relationships.

In the form of a series of frequently asked questions (FAQs), the ICI responded to questions concerning the foregoing “reasonable inquiry” that a fund must make if it seeks shareholder approval on a matter that could influence the objectivity and impartiality of the independent auditor. Citing a footnote in the SEC staff’s letter, the ICI stated that the fund has flexibility to develop policies and procedures best suited to its organization in conducting this inquiry to identify greater than 10% record and beneficial owners that serve as lenders to the fund’s auditor and whether such an owner could exercise discretionary voting authority as of the matter’s record date. The ICI advised that, depending on the results of the reasonable inquiry, “it may be appropriate for the fund or its auditor to consult with the SEC’s Office of Chief Accountant.”

Other matters or guidance addressed in the FAQs include:

  • While not addressed specifically in the no-action letter, the ICI suggested that if less than a majority of a fund’s board is up for election (such as with a staggered board election), a fund may want to conduct an inquiry as of the record date about the impact of the Loan Rule since the SEC staff could view each board member as having the ability to “influence the objectivity and impartiality of the independent auditor,” which triggers the requirement under the letter to conduct a reasonable inquiry.
  • It is reasonable for funds to mail “negative consent” letters in an effort to confirm that an owner does not own more than 10% of fund shares and/or to ascertain whether such owner will exercise discretionary voting authority, provided such letters are mailed with sufficient time for the entity to respond.
  • A fund may be able to rely on the Relief when an institution in a lending relationship with the fund’s auditor owns more than 10% of fund shares if the institution limits its voting discretion through the use of “mirrored voting,” votes in accordance with an independent, third-party proxy advisory firm, holds shares in an irrevocable voting trust, or otherwise relinquishes its right to vote by the record date.
  • An intermediary (such as a broker or a bank) holding a stock in street name and voting the stock on behalf of a client in reliance on NYSE Rule 452 is considered to have discretionary voting authority. However, a fund could rely on the Relief if the intermediary sufficiently limits its voting discretion as discussed above.
  • With respect to closed-end funds, if Cede & Co. holds of record all of a closed-end fund’s shares and no shareholder has filed a Form 3, Schedule 13D, or Schedule 13G reporting beneficial ownership in excess of 10%, the fund should, nonetheless, conduct a reasonable inquiry since there may be instances “when broker-dealers might be deemed record owner of more than 10% of a closed-end fund’s shares and vote those shares with some discretion.”