On June 18, 2019, the Securities and Exchange Commission (“SEC”) adopted final amendments to Rule 2-01(c)(1)(ii)(A) of Regulation S-X (the “Loan Rule”) to clarify the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with shareholders of an audit client (the “SEC Release” or “Release”). The Loan Rule currently provides that an audit firm is not independent if the firm, any covered person in the firm or any of their immediate family members have a loan to or from an audit client or the record or beneficial owners of more than 10 percent of the audit client’s equity securities (“10 Percent Bright-Line Test”). The final amendments to the Loan Rule:
- focus the Loan Rule analysis solely on beneficial ownership rather than on both record and beneficial ownership;
- replace the existing 10 Percent Bright-Line Test with a “significant influence” test;
- add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities; and
- amend the definition of “audit client” for a fund under audit to exclude funds that would otherwise be considered affiliates of the audit client.
The existing Loan Rule provides that an accountant is not independent when (a) the accounting firm, (b) any covered person in the accounting firm, which includes the audit engagement team and management personnel, or (c) any of the covered person’s immediate family members has any loan to or from (i) an audit client, (ii) an audit client’s officers or directors, or (iii) record or beneficial owners of more than 10 percent of the audit client’s equity securities. In 2016, the staff of the SEC Division of Investment Management (the “Division”) raised concerns that certain lending relationships among fund shareholders and audit firms could impair auditor independence. In response, the staff provided temporary relief to the fund industry relating to the Loan Rule through a no-action letter issued to Fidelity Management and Research Company (“Fidelity”) (the “Fidelity Letter”). Although originally set to expire 18 months from the date of its issuance, the Division extended the no-action relief until the SEC amended the Loan Rule to address concerns expressed in the no-action letter.
The Fidelity Letter pointed out that shares of its funds and affiliated accounts (each, a “Fidelity Fund”) may be held by a wide variety of institutions, some of which may be lenders to its auditors, who may also hold of record or beneficially more than 10% of a Fidelity Fund’s equity securities. Accordingly, Fidelity asserted that under the existing Loan Rule, a Fidelity Fund’s audit firm could be deemed not to be independent if it or its personnel were in a lending relationship with the shareholder. The SEC granted no-action relief to Fidelity so long as, among other things:
- the auditor complies with the Public Company Accounting Oversight Board Rules 3526(b)(1) and (2), which together require the auditor to provide to its clients a written description of any relationships bearing on its independence, a discussion of the potential effects of the relationships on its independence and an affirmation of its independence as of the date of the communication; and
- an affirmation that the audit firm has concluded that, notwithstanding non-compliance with the Loan Rule, it is objective and impartial with respect to issues encompassed within its engagement.
The final amendments provide further relief to audit firms and funds through several changes to the existing Loan Rule. Among them, the amendments (i) focus the analysis of loan relationships on beneficial, rather than record, ownership; (ii) impose a “significant influence” test for determining impairment of an audit firm’s independence in lieu of the previous 10 Percent Bright-Line Test; (iii) add a “known through reasonable inquiry” standard to the identification of beneficial owners; and (iv) exclude from the definition of “audit client” any other fund that would otherwise be considered an affiliate of the audit client.
The SEC Release provides additional guidance and clarification on applying these changes to the determination of auditor independence under the Loan Rule.
Analysis on Beneficial Ownership
Under the final Loan Rule, and in contrast to the Fidelity Letter, financial intermediaries holding shares as record owners with limited authority to make or direct voting or investment decisions on behalf of the underlying shareholders of the audit clients are not considered beneficial owners. If the financial intermediary takes additional steps to remove its discretion over the voting or disposition of shares, the financial intermediary generally will not be considered a beneficial owner, which is consistent with the Fidelity Letter.
Furthermore, entities under common control with or controlled by the beneficial owner of the audit client’s equity securities when such beneficial owner has significant influence over the audit client are excluded from the scope of the Loan Rule.
Significant Influence Test
As noted above, the final Loan Rule replaces the 10% Bright-Line Test with a “significant influence” test for purposes of determining whether a beneficial owner or loan relationship may impair the auditor’s independence. The SEC believes that the framework in Financial Accounting Standards Board’s ASC Topic 323, Investments – Equity Method and Joint Ventures (“ASC 323”), is appropriate for purposes of applying this test and provided guidance in the SEC Release with respect to applying it in the fund context. For example, auditors could initially analyze whether a beneficial owner has significant influence on a fund’s portfolio management processes based on an evaluation of the fund’s governance structure and relevant governing documents, contractual arrangements, distribution arrangements, etc.
The nature of the services provided by the fund’s investment adviser pursuant to the terms of an advisory contract with the fund would also be an appropriate part of this analysis. According to the SEC Release, when the terms of the advisory agreement grant the adviser significant discretion with respect to the fund’s portfolio management processes and the shareholder does not have the ability to influence those portfolio management processes, significant influence generally would not exist. Unless there is a material change in the fund’s governance structure and governing documents, the SEC Release states that the evaluation of significant influence would be complete here even if the shareholder holds 20 percent or more of a fund’s equity securities, otherwise triggering the rebuttable presumption of significant influence under the framework of ASC 323.
For exchange-traded funds (“ETFs”), the deposit or receipt of basket assets by an authorized participant (“AP”) that is also a lender to the auditor would not, by itself, constitute significant influence over an ETF audit client. In addition, where a market maker is a lender to the auditor, the deposit or receipt of basket assets by a market maker, acting through an AP, would not alone constitute significant influence over the ETF audit client.
The SEC did not provide requirements regarding the frequency and timing of the significant influence evaluation. Instead, the SEC indicated that frequency and timing should be based on the particular facts and circumstances relevant to the audited entity, while being consistent with the requirement that the auditor be independent throughout the audit and professional engagement period. As a best practice, the SEC notes that audit firms and their audit clients should consider regularly monitoring the auditor’s independence using processes consistent with the principles of ASC 323.
Reasonable Inquiry Compliance Threshold
Another deficiency with the prior rule was the identification of beneficial owners. Shareholders in funds come and go and the process of identifying them can be complex and time consuming. For that reason, the SEC adopted a “known through reasonable inquiry” test. According to the SEC Release, auditors and their audit clients should conduct the reasonable inquiry analysis by referencing the audit client’s governance structure and governing documents, SEC filings about beneficial owners or other information prepared by the audit client that may relate to the identification of a beneficial owner.
Affiliate of the Audit Client Definition
In addition to excluding any other fund that otherwise would be considered an affiliate of the audit client, the definition of “fund” in the final Loan Rule would exclude entities that would be included in the audit client definition solely by virtue of their association with such an excluded fund, as these entities typically have no influence over fund matters. The definition has expanded to provide that a commodity pool that is not an investment company or does not rely on Section 3 of the Investment Company Act of 1940 is not considered a fund for purposes of the Loan Rule. A foreign fund that is part of an investment company complex would also be excluded under the Loan Rule.
The final amendments relating to the Loan Rule will be effective 90 days after the date of publication in the federal register and will not impose any new reporting, recordkeeping, or shareholder disclosure requirements.
Practice Points and Tips
The final amendments to the Loan Rule are welcome improvements to the industry by streamlining the compliance process surrounding the analysis of auditor independence vis-à-vis fund shareholders where an auditor may have a debtor-creditor relationship. The process of searching for, identifying and assessing compliance with the Loan Rule and reporting these instances to audit committees generates significant costs which, as the SEC recognized in its Release, are ultimately borne by shareholders. Additionally, these compliance challenges can have broad disruptive effects for funds. According to the SEC, non-compliance with the Loan Rule, in some cases, could result in affected funds not being able to offer or sell shares, investors not being able to rely on affected financial statements, or funds having to incur the costs of re-audits.
Fund audit committees should consider discussing the final Loan Rule requirements and their implications with their auditors. Audit committees may also consider and discuss with management and their auditors the development of written policies and procedures for the “significant influence” test and the “known through reasonable inquiry” compliance threshold. The auditor’s compliance with the Loan Rule is an important factor in the audit committee’s evaluation of the auditor’s independence. Therefore, it would be prudent for audit committees to consider with their auditors the appropriate committee reporting framework and schedule for purposes of compliance with the Loan Rule.
For more information on the Loan Rule, please see our previous alerts, Funds Receive Auditor Independence Relief From SEC and SEC Extends No-Action Relief Under The Loan Rule, or reach out to your contact within the Investment Management Group.