The SEC’s Division of Investment Management provided temporary relief from the headache created for funds when the failure to meet the provisions of the so-called “loan rule” may disqualify fund auditors from being independent.
In a no-action letter issued to Fidelity Management and Research, the staff said it would not recommend enforcement action if a fund’s auditor fails to meet the independence requirements of Rule 2-01(b) of Regulation S-X because it has a lending relationship with an entity that owns (beneficially or of record) more than 10 percent of the fund’s equity securities (the “loan rule”).
But the relief is only temporary: the staff’s no action position expires in 18 months.
Under Regulation S-X, the SEC may not recognize an accountant as independent if the accountant is not, or a reasonable and knowledgeable investor concludes that they are not, capable of exercising objective and impartial judgment in the audit engagement. Among other things, violation of the loan rule is a non-exclusive example of a circumstance that the SEC considers inconsistent with independence.
Several large fund managers recently created a kerfuffle when they disclosed that their funds’ auditors may not qualify as independent because they may have technically violated the loan rule. These disclosures prompted funds and their independent auditors to scramble into action to stop a potential cascade of consequences, including calling into question the validity of fund audits and related pressure on fund audit committees.
What is the loan rule? In relevant part, it states: “An accountant is not independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has … [a]ny 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 ten percent of the audit client’s equity securities….”
Generally speaking, auditors maintain that simply having a lending relationship with a 10 percent owner of a fund client’s shares does not call into question their ability to be objective and fair in an audit engagement. And, with appropriate disclosures, the funds’ audit committees can reach the same conclusion.
The SEC staff agreed, for the time being. It said that it would not object if the funds rely on an audit opinion from an audit firm “that has identified a failure” to comply with the loan rule, provided three conditions have been satisfied:
- The audit firm has complied with PCAOB Rule 3526(b)(1), which provides, in substance, that the auditor must describe in writing any relationships between the auditor and the fund that may be reasonably be thought to bear on independence; and PCAOB Rule 3526(b)(2), which requires the auditor to discuss with the fund’s audit committee the potential effects of its relationships on its independence;
- The non-compliance of the auditor is with respect only to the lending relationships; and
- Notwithstanding non-compliance with the loan rule, the auditor has concluded that it is objective and impartial with respect to other issues encompassed within its engagement.
The staff clearly stated that the no-action assurances are temporary and expire in 18 months.
Can other fund groups rely on this no-action letter? Although the letter was addressed to only one fund complex, it would appear that any fund group with similar facts may also rely on it.
The staff’s no-action position applies only to investment companies that file financial statements certified by auditors who may not be independent by virtue of the loan rule, and only for 18 months. On its face, the relief does not extend to the auditors themselves. In the short term, the letter provides a soft landing to a potentially explosive and intractable problem for funds.
With the threat of potential future non-compliance hanging over their heads, auditors and funds may be encouraged to find an alternative solution that does not require regulatory intervention by the SEC staff. This will require some time – and creativity.