The U.S. Securities and Exchange Commission on June 18, 2019 adopted amendments to Rule 2‑01(c)(1)(ii)(A) under Regulation S-X – the so-called “Loan Provision” (Final Rule). The Final Rule will become effective on October 3, 2019. Generally, the Loan Provision, as currently in force, provides that an audit firm will not be considered independent from an audit client under Regulation S-X if the audit firm (or certain of its personnel) has a lending relationship with a person that owns, beneficially or of record, more than 10% of the equity securities of the audit client. While the Loan Provision applies broadly to many different types of entities, compliance has posed particular challenges in the case of registered investment companies and other “funds” due to the manner in which their securities are sold and held through financial intermediaries.
As background, the SEC originally proposed amendments to the Loan Provision on May 2, 2018 (Proposal) and has adopted the amendments largely as proposed. Consistent with the Proposal, the Final Rule significantly narrows the universe of lending relationships that implicate the Loan Provision and reduces the compliance burden for audit firms and their audit clients. The Final Rule also addresses significant concerns over audit firms’ ability to comply with the Loan Provision with respect to registered investment companies and other funds. These concerns were initially publicized in 2016 and temporarily addressed in a no-action letter issued that year by the SEC’s Division of Investment Management (No Action Letter)5.
The Final Rule introduces four amendments to the Loan Provision. Specifically, the amendments:
- Focus exclusively on beneficial ownership of an audit client’s equity securities;
- Replace the 10% equity ownership threshold with a more qualitative “significant influence” test;
- Establish a “known through reasonable inquiry” standard for purposes of an audit firm’s responsibility to identify an audit client’s beneficial owners of shares; and
- Reduce the scope of entities deemed to be affiliates of an audit client that is a registered investment company or other pooled investment vehicle.6
A marked comparison reflecting the changes to the Loan Provision is presented in the Appendix.
The Final Rule
In the Adopting Release, the SEC acknowledged that, in the case of registered investment companies, other pooled investment vehicles, and registered investment advisers, application of the existing Loan Provision: was out of step with its original purpose of identifying relationships likely to compromise an audit firm’s independence; presented “significant practical challenges,” both for audit firms and the audit committees of their audit clients; could serve to “distract auditors’ and audit committees’ attention from matters that might be more likely to bear on the auditor’s objectivity and impartiality"; and may generate “significant costs” for entities, which are ultimately borne by shareholders.
Citing the original proposing and adopting releases for the Loan Provision, the Adopting Release explains that the rule was designed to prohibit lending relationships that “reasonably could be viewed as creating a self-interest that competes with the auditor’s obligation to serve only investors’ interests,” and that such concerns extended only to those shareholders of an audit client that have “'a special and influential role' with the audit client.” The Adopting Release cautions that violations of the auditor independence rules that “no reasonable investor” would view as compromising an audit firm’s independence could ultimately lead to the desensitization of market participants to more serious violations. According to the Adopting Release, the Loan Provision’s original purpose is therefore better served by limiting violations to cases where an auditor’s independence is actually impaired “in fact or in appearance.” The Final Rule’s four amendments are thus intended to more closely align the Loan Provision with its original aims and reduce the focus on fact patterns that do not impair an audit firm’s objectivity and impartiality.
The existing Loan Provision posed particular challenges for registered investment companies, in part because it applied both to “record” and “beneficial” owners of an audit client’s equity securities. The SEC recognized in the Adopting Release that shares of registered investment companies are commonly held by financial intermediaries in omnibus accounts on behalf of their clients, with the financial intermediaries serving as “record” owners of the shares. As a result of those arrangements, many intermediaries were implicated by the Loan Provision despite serving a merely custodial function with respect to fund shares. In the Adopting Release, the SEC acknowledged that those intermediaries might be unable (or lack economic incentive) to exercise voting control over shares or to otherwise be in a position to influence their issuer. The Final Rule limits the Loan Provision’s scope to beneficial ownership of an audit client’s equity securities (and those of the audit client’s non-fund affiliates) and does not extend to mere record holders of those securities. The SEC expressed the view that focusing solely on beneficial ownership will more effectively capture those relationships that implicate the Loan Provision’s objectives.
The Adopting Release also clarifies that, for purposes of the Loan Provision, the term “beneficial owner” does not include financial intermediaries that are record holders with “limited authority” to exercise voting control or make investment decisions on behalf of underlying shareholders.7 This change is expected to drastically reduce the number of broker-dealers, custodians, and other financial intermediaries that are implicated by the Loan Provision solely as a result of their holding shares on behalf of their clients.
Significant Influence Test
The Final Rule replaces the Loan Provision’s existing quantitative, bright-line equity ownership test (10% Test) with a qualitative “significant influence test.” The existing 10% Test would prohibit a lending relationship between an auditor and any entity that held more than 10% (beneficially and/or of record) of an audit client’s shares. Thus, routine fluctuations in investment activity by an intermediary’s clients could cause the intermediary to exceed the 10% Test, despite the absence of meaningful changes in the intermediary’s relationship with an audit client. Further, the 10% Test has imposed significant operational burdens on audit firms and funds due to ongoing monitoring of ownership levels. In the Adopting Release, the SEC characterized the Loan Provision’s existing 10% beneficial or record ownership test as potentially being both under- and over-inclusive for purposes of identifying shareholders that have a “special and influential role” with an audit client. In its place, the Final Rule adopts a facts-and-circumstances-based test to determine whether a shareholder has the ability to exercise “significant influence” over an issuer.
The Adopting Release states that the Final Rule’s “significant influence” test is intended to correspond with the Financial Accounting Standards Board’s Accounting Standards Codification Topic 323 (ASC 323),8 which is currently referenced in other sections of the SEC’s auditor independence rules and, accordingly, will be familiar to audit firms. Under ASC 323, share ownership is only one of a number of factors that may indicate “significant influence.” Further, the Adopting Release states that, consistent with ASC 323, a shareholder’s ownership of less than 20% of an issuer’s voting securities would give rise to a rebuttable presumption that the shareholder does not have the ability to exercise significant influence over that issuer.9
In the fund context, the Adopting Release indicates that indicia of influence would include influence over a fund’s investment policies or its day-to-day portfolio management processes. The SEC identified decisions relating to the selection and valuation of investments, as well as the distribution of income and capital gains, as examples of day-to-day portfolio management processes. In cases where an investment adviser has significant discretion over a fund’s portfolio management process under the terms of an advisory agreement, the Adopting Release indicates that a shareholder that does not possess the ability to influence the investment adviser generally would not be deemed to have significant influence over the fund.10 The Adopting Release states that an audit firm could analyze significant influence by considering factors such as: a fund’s governance structure and governing documents; the manner in which fund shares are sold and held through financial intermediaries; and relevant contractual arrangements.11
Known Through Reasonable Inquiry Standard
The SEC notes that auditor independence is a "shared responsibility" between the audit firm and the audit client. The Adopting Release observes that monitoring for compliance with the Loan Provision’s existing quantitative, bright-line equity ownership test has posed significant challenges for auditors and their audit clients, including the need to share and access records or other information concerning share ownership. In addition to adopting the more qualitative significant influence test, the Final Rule addresses these operational challenges by establishing a “known through reasonable inquiry” standard to be applied when identifying the beneficial owners of an audit client’s shares. The Adopting Release acknowledges that, due to the manner in which shares of investment companies are distributed and held, shareholders’ identities may not be readily known to issuers or their audit firms; further, in some instances, banks or broker-dealers holding those shares on behalf of customers may be prohibited from disclosing beneficial owners’ identities. In addition, the SEC observed that if, following reasonable inquiry and in coordination with an audit client, an audit firm is not aware that an entity with which it has a lending relationship beneficially owns shares of the audit client, it is unlikely that such a relationship would impact the audit firm’s objectivity and impartiality.
While the Adopting Release does not provide specific guidance as to what would constitute a “reasonable inquiry” in this context, it reiterates the observation in the Proposing Release that such a standard is “generally consistent with regulations implementing” the Investment Company Act of 1940, the Securities Act of 1933 and the Securities Exchange Act of 1934, and should, therefore, be familiar to issuers. The Adopting Release states that audit firms and their clients could conduct a reasonable inquiry analysis by examining “the audit client’s governance structure and governing documents, Commission filings about beneficial owners, or other information prepared by the audit client which may relate to the identification of a beneficial owner.”12
Exclusion of Funds from Affiliate Definition
The Final Rule no longer requires registered investment companies and other pooled investment vehicles within the same investment company complex to be deemed to be affiliates of one another for purposes of the Loan Provision. As noted above, under the existing Loan Provision, an audit firm’s “audit client” is defined to include affiliates of the audit client, which, for a registered investment company, include all entities within the investment company complex, regardless of whether the audit firm actually provides audit services to those other entities. As a result of this expansive definition, under both the existing Loan Provision and the No-Action Letter, auditors were forced to monitor the ownership of all registered investment companies and private funds advised or sponsored by an audit client’s investment adviser, as well as the ownership of the adviser itself and certain of its affiliates. The Adopting Release notes that fund shareholders generally are not able to exercise influence over the management of other funds in the same fund complex. Therefore, the Final Rule amends the definition of “audit client” as it applies to a “fund” to exclude any other fund that otherwise would be considered an affiliate of the audit client.13
Most notably, this change would eliminate the requirement that an audit firm expend resources assessing the owners of every fund within an investment company complex rather than focusing only on those funds for which it provides audit services. It eliminates situations in which an audit firm would fail to comply with the Loan Provision due to a lender’s ownership of shares of a fund for which the audit firm does not provide audit services.
In a change from the original Proposal, the definition of “fund” in the Final Rule is expanded to include not only an investment company or an issuer that would be an investment company but for the exceptions in Section 3(c) of the 1940 Act, but also a commodity pool as defined in Section 1a(10) of the Commodity Exchange Act, which is not an investment company and does not rely on an exclusion from investment company status in Section 3(c) of the 1940 Act. In addition, the SEC clarified in the Adopting Release that the definition of a “fund” for purposes of the Loan Provision also encompasses “foreign funds.”14
Other Potential Amendments
The Adopting Release states that SEC Chairman Jay Clayton has directed the SEC staff to consider recommendations for possible additional changes to the SEC’s auditor independence rules, including the Loan Provision, in light of comments that were submitted in response to the Proposing Release, some of which addressed unrelated provisions of the auditor independence rules. The Adopting Release notes that those comments related to, among other things, the definitions of the terms “covered person” and “affiliate of the audit client.”
The Final Rule provides relief for investment companies and audit firms that have continued to allocate significant resources to complying with the requirements of the No-Action Letter. In addition, the Final Rule should reduce or eliminate the disproportionate degree of attention that fund audit committees have been required to devote to considering technical violations of the Loan Provision that have no bearing on an auditor’s objectivity and impartiality.