Rule 2-01 of Regulation S-X currently requires auditors to be independent of their audit clients both “in fact and in appearance.” Rule 2-01(c) sets forth a nonexclusive list of circumstances that are considered inconsistent with the auditor independence standard. Among these is the so-called “Loan Provision,” which generally provides that an auditor is not independent when the audit firm, any “covered person” in the firm or any of the covered person’s immediate family members has a loan (including a margin loan) to or from record or beneficial owners of 10 percent or more of an audit client’s equity securities. For this purpose, “audit client” is defined to include any affiliate of the audit client and, with respect to a registered investment company, any other entity in the same investment company complex—regardless of whether the auditor actually provides audit services to those other entities. Accordingly, if an auditor is not independent under the Loan Provision with respect to one registered fund, the auditor is technically prohibited from serving as an independent auditor to any fund or entity in the same complex.

On June 18, 2019, the SEC adopted amendments to Rule 2-01 of Regulation S-X to address the significant compliance challenges presented by the application of the Loan Provision in the investment company context in certain circumstances in which, as a practical matter, an auditor’s objectivity and impartiality are not impaired despite technical noncompliance with the Loan Provision.

The SEC adopted the amendments largely as proposed, with a few exceptions.

• Beneficial Ownership-Focus. As amended, the Loan Provision will apply only to beneficial owners of the audit client’s equity securities and not holders of record.
• “Significant Influence” Test Applying Qualitative Factors to Replace the 10 Percent Bright-Line Test. The Loan Provision’s 10 percent test will be replaced with a “significant influence” test similar to that referenced in other parts of the auditor independence rules, including ASC Topic 353. Under this test, the audit firm and audit client must assess whether a lender that is also a beneficial owner of the audit client’s equity securities has the ability “to exert significant influence over the audit client’s operating and financial policies,” including investment policies and portfolio management processes. According to guidance set forth in the adopting release, a fund shareholder would typically not have this ability if the fund’s adviser has significant discretion over the fund’s portfolio management process, which is typically the case.
• Rebuttable Presumption at 20 Percent Beneficial Ownership.Consistent with existing accounting standards, a lender beneficially owning 20 percent or more of an audit client’s voting securities will be presumed to have the ability to exercise significant influence, absent predominant evidence to the contrary. Conversely, if the ownership percentage is less than 20 percent, there will be a rebuttable presumption against significant influence.
• Application of a “Known Through Reasonable Inquiry” Standard to Identification of Beneficial Owners of an Audit Client’s Equity Securities. The amendments include a “known through reasonable inquiry” standard, whereby an audit firm, in coordination with its audit client, would be required to analyze beneficial owners of the audit client’s securities that are known through reasonable inquiry.
• Definitions of “Fund” and “Audit Client.” For purposes of the Loan Provision, the amendments define “fund” as excluding commodity pools and define “audit client” as excluding foreign funds and other funds that would be considered an affiliate of the audit client.

Prior to the adoption of the amendments described above, the staff of the SEC’s Division of Investment Management provided conditional no-action relief from the Loan Provision, which temporarily covered many of the issues addressed by the amendments. Upon effectiveness of the amendments, this no-action relief will be withdrawn.

The amendments will become effective on October 3, 2019.

Read the SEC’s adopting release