The U.S. Securities and Exchange Commission (SEC or the Commission) recently announced proposed amendments to Rule 2-01 of Regulation S-X intended to modernize its auditor independence rules, in part by codifying certain positions the SEC staff (Staff) has taken in consultations over the years with respect to questions involving student loans and portfolio companies of funds.1
In connection with the proposing release, Chairman Jay Clayton stated that “[t]he proposal is consistent with the Commission’s long-recognized view that an audit by an objective, impartial, and skilled professional enhances both investor protection and market integrity, and, in turn, facilitates capital formation. In practice, the proposed amendments also would increase the number of qualified audit firms an issuer could choose from and permit audit committees and Commission staff to better focus on relationships that could impair an auditor’s objectivity and impartiality.”
The proposed amendments represent a shift by the SEC away from a more static, prescriptive regime toward a more principles-based approach to auditor independence, in which audit firms would have more discretion in navigating potential conflicts of interest in their relationships with clients. Auditor independence was one of the five most common deficiencies found in the inspections conducted by the Public Company Accounting Oversight Board (PCAOB) over the past year, and the PCAOB has indicated that it will continue to be a key focus of attention for inspections in the year ahead.
In 2000, the SEC adopted a comprehensive framework of rules governing auditor independence, laying out governing principles and describing certain specific financial, employment, business and nonaudit service relationships that would cause an auditor not to be independent of its audit client. The 2000 adopting release set forth the standard for analysis to determine whether an auditor is independent.2 In 2003, the SEC adopted additional amendments as required under the Sarbanes-Oxley Act of 2002.3
Many of the current independence requirements have not been updated since their initial adoption in 2000 or amendment in 2003.
Rule 2-01(b) of Regulation S-X4 provides that the “Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement” and further states that the “Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client,” in determining whether an auditor is independent.
As market conditions and industry practices have changed, the Staff has gained a lot of experience interpreting and applying the independence rules and assessing the efficiency and effectiveness of the independence requirements. The proposed amendments to Rule 2-01 are designed to reflect the Staff’s experience administering the independence requirements and incorporate consideration of the feedback received from the public. The proposed amendments were inspired primarily by common fact patterns presented to the Staff through consultations. In certain consultations, the Staff has found that while the relevant facts and circumstances represented a technical violation of the current independence rules, they also involved a relationship with, or services provided to, an entity that has little or no relationship with the entity under audit and no relationship to the engagement team conducting the audit. In these scenarios, the Staff regularly observes that the audit firm is objective and impartial and, as a result, does not object to its continuing the audit relationship with the audit client. The proposed amendments seek to codify certain of the Staff’s common conclusions.
Among other changes, the proposed amendments would
- amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships
- amend the definitions of “affiliate of the audit client” in Rule 2-01(f)(4) and “investment company complex” in Rule 2-01(f)(14) to address certain affiliate relationships in common control scenarios
- amend the definition of the “audit and professional engagement period,” specifically Rule 2-01(f)(5)(iii), to shorten the look-back period for domestic first-time filers to the most recently completed fiscal year, which would result in treating all first-time filers (including domestic issuers and foreign private issuers) similarly for purposes of assessing compliance with the independence requirements under Rule 2-01
- amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence
- replace the outdated transition and grandfathering provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that arise only as a result of merger and acquisition transactions
These proposed amendments are discussed in more detail below.
Student Loans and De Minimis Consumer Loans
Rule 2-01(c)(1)(ii)(A) currently provides that an accountant is not independent when the accounting firm, any covered person or any of his or her immediate family members has any loan to or from an audit client or an audit client’s officers, directors or beneficial owners of the audit client’s equity securities where such beneficial owner has significant influence over the audit client, except for certain enumerated exceptions (including automobile loans collateralized by the automobile and mortgage loans collateralized by the borrower’s primary residence, provided the loan was not obtained while the covered person was a covered person). The proposed amendments would include a new subsection adding “student loans obtained for a covered person’s educational expenses provided the loans were not obtained while the covered person in the firm was a covered person” to the categorical exclusions from independence-impairing lending relationships.
The SEC fact sheet accompanying the proposing release provides an example to illustrate the concerns the proposed amendment is designed to address:
Audit Firm has an audit partner based in Atlanta who continues to pay his student loans taken to attend college before starting his career at Audit Firm. A different audit partner in Atlanta audits the lender that provided the student loan, a large student loan company that originates thousands of student loans. Under the current rules, the student loan of the audit partner who is not part of the audit would still lead to an independence violation for the audit engagement of the lender.
The proposed amendments also would revise existing rules to add de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships. Specifically, the proposal contemplates revising Rule 2-01(c)(1)(ii)(E) to replace the reference to “credit cards” with “consumer loans” and to revise the provision to reference “[a]ny aggregate outstanding consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and any available grace period.”
Portfolio Companies of a Fund
Rule 2-01(f)(6) defines audit client as “the entity whose financial statements or other information is being audited, reviewed, or attested and any affiliates of the audit client ... .” Rule 201(f)(4) defines affiliate of the audit client, in relevant part, to include “[a]n entity that has control over the audit client, or over which the audit client has control, or which is under common control with the audit client, including the audit client’s parents and subsidiaries” and “[e]ach entity in the investment company complex when the audit client is an entity that is part of an investment company complex.” Rule 2-01(f)(14) defines an investment company complex (ICC) to include, in relevant part, “[a]ny entity controlled by or controlling an investment adviser or sponsor ... or any entity under common control with an investment adviser or sponsor ... if the entity: (i) Is an investment adviser or sponsor; or (ii) Is engaged in the business of providing administrative, custodian, underwriting, or transfer agent services to any investment company, investment adviser, or sponsor.” As a result, entities under common control with the audit client (referred to as sister entities) are considered affiliates and fall within the definition of “audit client.” Additionally, each entity in an ICC is considered an affiliate when the audit client is part of the ICC. Consequently, in complex organizational structures, such as large ICCs, the requirement to identify and monitor for potential independence-impairing relationships and services currently applies to affiliated entities, including sister entities, regardless of whether the sister entities are material to the controlling entity.
The proposed amendments would amend the definitions of “affiliate of the audit client” and “investment company complex” to include materiality qualifiers in the respective common control provisions and to distinguish how the definition applies when an accountant is auditing a portfolio company, an investment company or an investment adviser or sponsor. The proposing release notes that these proposed amendments are motivated in part by the concern that existing rules may constrain an audit client’s choice in audit firms and thereby affect audit quality. This concern has become more acute as the asset management industry has grown, investments have become more global and the international audit services industry has consolidated and become more specialized.
The SEC fact sheet provides an example to illustrate the concerns the proposed amendment is designed to address:
Assume Company X is a U.S.-based portfolio company of Fund F. Fund F invests in various companies around the globe, perhaps dozens or even hundreds, including Company X. Audit Firm A is the auditor of Company X. Also assume that two of Audit Firm A’s global network affiliates provide the services discussed below to two separate portfolio companies of Fund F. Call them Company Y and Company Z. Further assume that Company Y and Company Z have no relation to each other or to Company X except for the fact that Fund F is invested in each Company. To add practical context, further assume that:
- An Australian affiliate of Audit Firm A provides limited staffing services to a healthcare portfolio company based in Australia – Company Y – for a short-period of time to meet a resource need.
- A Spanish affiliate of Audit Firm A provides payroll services for a lodging (hotel chain) portfolio company based in Spain – Company Z – for a short-period of time.
Image via SEC Press Release at https://www.sec.gov/news/press-release/2019-276
Also assume that Company X has its own separate governance structure that is unrelated to Company Y or Z, and Company Y and Z are not material to Fund F. Under the current auditor independence rules, if Company X registers with the SEC (e.g., by conducting an IPO), Audit Firm A would not be independent of Company X as a result of the services provided to either Company Y or Z. This is the case regardless of whether, as the Staff has observed in similar situations, these limited services at immaterial portfolio companies (Companies Y and Z) have no impact on the entity under audit in any way and do not impact the objectivity and impartiality of the auditor in conducting the audit for Company X.
The intent of the proposed amendments to the auditor independence rules is to avoid requiring Company X, under these and similar circumstances, to (1) replace Audit Firm A with another audit firm, (2) wait to register with the SEC for up to three years after termination of the services provided to Company Y and Company Z, or (3) make a determination, likely in consultation with Commission staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality.
Paragraphs (c)(1) through (5) of Rule 2-01 enumerate certain circumstances that, if they occur during the “audit and professional engagement period,” are inconsistent with the general independence standard of Rule 2-01(b). Under the existing rules, the term “audit and professional engagement period” is defined differently for domestic first-time filers and foreign private issuer (FPI) first-time filers. A domestic IPO registration statement must include either two or three years of audited financial statements, and auditors of domestic first-time filers need to be independent in accordance with Rule 2-01 during all audited financial statement periods included in the registration statement. Conversely, the auditor of an FPI engaging in an IPO has to be independent in accordance with Rule 2-01 only during the immediately preceding fiscal year, regardless of how many years of audited financial statements are included in the registration statement.
The proposal would amend the definition such that the one-year look-back provision currently applicable only to FPIs would apply to all first-time filers, domestic and foreign. Accordingly, as proposed, an auditor for a first-time filer that is either a domestic issuer or an FPI would apply Rule 2-01 for the most recently completed fiscal year included in its first filing, provided there has been full compliance with applicable independence standards in all prior periods covered by any registration statement or report filed with the SEC (i.e., relationships and services in prior years that would not be included in the look-back period as a result of the proposed amendments should still be considered under the general independence standard of Rule 2-01(b) and any other applicable independence requirements such as those of the American Institute of Certified Public Accountants).
The proposing release notes that shortening the look-back period could help domestic firms avoid the compliance costs associated with having to switch auditors or delay their IPOs in order to comply with the auditor independence rules. The reduced compliance costs, in turn, could encourage capital formation by mitigating challenges associated with consummating IPOs and otherwise facilitating additional domestic IPOs.
The release outlines — and invites comment on — an alternative approach that would lengthen the look-back period for FPIs to all periods in which the financial statements are being audited or reviewed. The release notes, however, that while this alternative would help level the playing field between domestic and FPI first-time filers, it would increase compliance burdens for FPIs and thus could reduce the incentives for FPIs to list in the United States, thereby impeding capital formation and limiting investment opportunities for U.S. investors.
Rule 2-01(c)(3) prohibits, at any point during the audit and professional engagement period, the accounting firm or any covered person from having “any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors, or substantial stockholders ... .” [Emphasis added.] The proposal would revise this provision by replacing the reference to “substantial stockholders” with a reference to “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.” The proposing release indicates that the Staff believes this change would improve the rule by making it clearer and less complex.
Mergers and Acquisitions
The proposed amendments include revisions to Rule 2-01(e) providing that an auditor’s independence “will not be impaired because an audit client engages in a merger or acquisition that gives rise to a relationship or service that is inconsistent with this rule,” provided that (i) the auditor is in compliance with the applicable independence standards related to the services or relationships when the services or relationships originated and throughout the period in which the applicable independence standards apply, (ii) the lack of independence is corrected as promptly as possible and (iii) the auditor has in place a quality control system that monitors merger and acquisition activity to provide timely notice of such transactions and promptly identifies potential violations before the transaction has occurred. These amendments are intended to address independence violations that arise solely as the result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of such corporate event.
The proposed amendments may help promote consistency in application of the rules by making positions previously available only through consultation with the Staff available to all companies subject to the rules. Additionally, if adopted, the amendments are expected to permit companies to choose from among a wider array of audit firms. Finally, the amendments are designed to focus the independence analysis performed by audit firms, audit committees, Staff and others on those relationships or services that are more likely to pose threats to an auditor’s objectivity and impartiality.