Key Notes:

  • In May 2017, the SEC proposed amendments to the auditor independence rules under Rule 2-01 of Regulation S-X.
  • The amendments address the debtor-creditor relationship between an auditor and shareholders of audit clients.
  • As proposed, the amendments will refocus the Rule to look at beneficial ownership, not record ownership, relationships that would truly threaten an auditor’s independence.

Rule 2-01(c)(1)(ii)(A) of Regulation S-X (Rule) provides that an audit firm is not independent when the firm or its covered personnel (including immediate family) has a loan to or from an audit client, a client’s officers or directors, or a record or beneficial owner of more than 10 percent of a client’s equity securities. For the purposes of the Rule, the term “audit client” includes any affiliate of the client, with “affiliate” meaning any entity that controls, is controlled by or is under common control with the client.

In a no-action request letter to the SEC staff, Fidelity Management and Research Company raised concerns that the record ownership of Fidelity funds could cause a technical violation of the Rule if an auditor’s lender held more than 10 percent of a Fidelity fund’s shares for the benefit of the lender’s clients. In response, the SEC issued a no-action letter in June 2016 that provided that a fund could use the services of an audit firm that did not meet the Rule’s requirements under the following conditions:

  • The audit firm has provided the fund’s audit committee with written disclosure regarding relationships between the audit firm and the fund that may impact the audit firm’s independence and has discussed those relationships’ potential impact on audit independence with the audit committee at least annually.
  • The audit firm’s noncompliance is with respect to certain lending and ownership relationships.
  • Notwithstanding such noncompliance, the audit firm has concluded that it is objective and impartial with respect to the issues encompassed within its engagement.

The relief provided by the no-action letter was set to expire in December 2017, but the SEC issued another letter in September 2017 extending the relief until it amends the Rule to address the issues raised in the no-action letter.

Proposed Amendments

The proposed amendments focus the Rule on beneficial shareholders, rather than record owners, who have a significant influence on an audit client. Record ownership would no longer be a violation. The amendments would also eliminate the 10 percent ownership threshold. In its place, the SEC proposes using the “significant influence” test, a term used in other sections of the auditor independence rules. The SEC also states in the proposed amendments that the significant influence test would adhere to the rebuttable presumption under ASC 323 that a 20 percent owner of an audit client’s equity securities has significant influence over the client, absent predominant evidence to the contrary.

Though the significant influence test would be a facts-and-circumstances determination, the SEC did provide a non-exhaustive list of factors that could determine that a shareholder has significant influence over an audit client, including:

  • representation on the board of directors;
  • participation in the policy-making process;
  • material intra-entity transactions;
  • interchange of managerial personnel; or
  • technological dependency.

In the context of registered funds, the SEC states the operational and financial policies relevant for the purposes of the significant influence test would include the fund’s investment policies, day-to-day portfolio management process, valuation, and distribution of income and capital gains. The SEC also indicates that a shareholder’s ability to vote on a pro rata basis on a fund’s advisory contract or fundamental policies should not lead to a determination of significant influence.

The proposed amendments also establish a “known through reasonable inquiry” standard for audit firms and their clients in determining the beneficial owners of an audit client’s equity securities. In the proposing release, the SEC states that it is unlikely that an audit firm’s objectivity would be impacted if the firm, after reasonable inquiry, did not know that one of its lenders is also a beneficial owner of a client’s equity securities.

Currently, the Rule considers funds in a series trust to be affiliates of each other. The amendments to the Rule revise the definition of “audit client” to eliminate this concept. Thus, the audit firm and its client fund need not inquire into the beneficial ownership of other funds in a client’s fund trust.

Outlook

If adopted, the amendments should simplify a fund audit committee’s approach to evaluating beneficial ownership that may impact its audit firm’s objectivity and independence. Audit committees should have regular dialogues with their audit firms to continue to look for any issues that may impact the audit firm’s objectivity and independence.