Summary

On May 2, 2018, the SEC issued proposed amendments to its auditor independence rules concerning the independence of an audit firm that has a lending relationship with certain shareholders of an audit client. The proposed amendments seek to address the significant compliance challenges presented by the application of the so-called “Loan Provision” in the mutual fund context and certain circumstances in which, as a practical matter, an auditor’s objectivity and impartiality are not impaired despite technical non-compliance with the Loan Provision. Currently, the Loan Provision generally provides that an audit firm is not independent if one of its lenders has record or beneficial ownership of more than 10% of the voting securities of a fund audit client.

The proposed amendments would:

• focus the independence analysis solely on beneficial ownership rather than on both record and beneficial ownership;

• replace the existing 10% bright-line shareholder ownership test with a “significant influence” test;

• apply a “known through reasonable inquiry” standard to the identification of beneficial owners of an audit client’s equity securities; and

• amend the definition of “audit client” for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client.

Background: The Loan Provision

Rule 2-01 of Regulation S-X requires auditors to be independent of their audit clients both “in fact and in appearance.” Rule 2-01(c) sets forth a non-exclusive list of circumstances that are considered inconsistent with the auditor independence standard, including the so-called Loan Provision—a restriction on certain debtor-creditor relationships. The Loan Provision 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 any margin loan) to or from “record or beneficial owners of more than ten percent of the audit client’s equity securities.” An “audit client,” in turn, is defined to include any affiliate of the audit client and, when the audit client is an entity within an “investment company complex” (ICC), it also includes every entity within the ICC, regardless of whether the auditor actually provides audit services to those other entities. In sum, if an auditor is not independent under the Loan Provision with respect to only one fund in an ICC, no fund or other entity in the ICC can engage or retain that firm as an independent auditor. ¹

SEC Staff No-Action Relief

On June 20, 2016, the staff of the SEC’s Division of Investment Management issued a no-action letter to Fidelity Management & Research Company (the Fidelity No-Action Letter),² temporarily addressing some of the issues that have arisen under the Loan Provision. In the Fidelity No-Action Letter, the SEC staff indicated that it would not recommend enforcement action if a registered fund or other entity in the fund’s ICC employs an audit firm that has a relationship with certain lending financial institutions that might cause the audit firm not to be in compliance with the Loan Provision. The SEC staff conditioned its no-action assurances to Fidelity on certain requirements that were intended to ensure that, notwithstanding the audit firm’s technical non-compliance with the Loan Provision, the firm remains objective and impartial with respect to the issues encompassed within its engagement. The relief set forth in the Fidelity No-Action Letter was to expire 18 months from the issuance date; on September 22, 2017, the SEC staff extended the no-action relief indefinitely and indicated that such relief would be “withdrawn upon the effectiveness of any amendments to the Loan Provision designed to address the concerns expressed in the [Fidelity No-Action Letter].” ³

Proposed Amendments

Recognizing that the Loan Provision “may not be functioning as it was intended” and “presents significant practical challenges” ⁴ with “broader disruptive effects, particularly for funds,”⁵ the SEC proposed amendments to the Loan Provision that are intended to “effectively identify those debtor-creditor relationships that could impair an auditor’s objectivity and impartiality” and exclude “certain extended relationships” that pose no such risk. In so doing, the SEC also acknowledged that the Fidelity No-Action Letter “did not resolve all compliance uncertainty, was limited in scope and provided staff-level relief to the requestor based on the specific facts and circumstances in the request, and did not amend the underlying rule.”

Beneficial Ownership-Focused

•The Loan Provision would 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% Bright-Line Test

• The Loan Provision’s bright-line 10% test would be replaced with a “significant influence” test similar to that referenced in other parts of the auditor independence rules. According to the SEC’s proposing release, “an audit firm, together with its audit client, would be required to 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.” In the fund context specifically, those policies would include “the fund’s investment policies and day-to-day portfolio management processes, including those governing the selection, purchase and sale, and valuation of investments, and the distribution of income and capital gains” (collectively defined in the proposing release as “portfolio management processes”). In the proposing release the SEC suggests that an audit firm could assess whether significant influence over the fund’s portfolio management processes exists “based on an initial evaluation of the fund’s governance structure and governing documents, the manner in which its shares are held or distributed, and any contractual arrangements, among other relevant factors.”

• The proposing release also advises that it is “appropriate to consider the nature of the services provided by the fund’s investment adviser(s) pursuant to the terms of an advisory contract” as part of the significant influence analysis. If the adviser has significant discretion over the fund’s portfolio management processes— as is typically the case—and the shareholder does not have the ability to influence those processes, “significant influence generally would not exist.” The proposing release adds that the ability to vote on approving the advisory contract or a fund’s fundamental policies on a pro rata basis with all fund shareholders “generally should not lead to the determination that a shareholder has significant influence.”⁶

• The significant influence test is based on the “totality of the facts and circumstances,” and although it would include a consideration of the lender’s beneficial ownership level in an audit client’s equity securities, a specific percentage ownership would not be dispositive as to independence. ⁷

Rebuttable Presumption at 20% Beneficial Ownership

• Consistent with existing accounting standards, however, a lender beneficially owning 20% or more of an audit client’s voting securities is presumed to have the ability to exercise significant influence, “absent predominant evidence to the contrary.” Conversely, “if the ownership percentage were less than 20%, there would be a rebuttable presumption that the lender does not have significant influence over the audit client, unless it could be demonstrated that the lender has the ability to exert significant influence over the audit client.”

Application of a “Known Through Reasonable Inquiry” Standard to Identification of Beneficial Owners of an Audit Client’s Equity Securities

• The proposed 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 who are known through reasonable inquiry. If beneficial owners are not identified through reasonable inquiry, the SEC believes it unlikely that the auditor’s objectivity and impartiality would be compromised by a debtor- creditor relationship with the lender.

• In a footnote in the Fidelity No-Action Letter, the SEC staff stated that it expects funds to develop policies and procedures reasonable designed to ensure that they make a reasonable inquiry whenever shareholders vote on the election of trustees/directors, the appointment of an independent auditor or other matters that similarly could influence the objectivity and impartiality of the independent auditor. The proposed amendments do not refer to any required policies or procedures regarding “reasonable inquiry” and, other than noting that the “known through reasonable inquiry” standard would be generally consistent with regulations implementing the Investment Company Act of 1940, the Securities Act of 1933 and the Securities Exchange Act of 1934,⁸ the proposing release did not identify any particular processes that may or should be implemented to satisfy the standard.

Limitation on Definition of “Audit Client”

• To seek to address compliance challenges associated with the expansive definition of “audit client” in the fund context, the proposed amendments would exclude from that definition other funds that would be considered an “affiliate of the audit client” as it relates to the Loan Provision. The proposing release requests comment on the proposed tailoring of the Loan Provision analysis to beneficial ownership, the replacement of the 10% bright-line test with a “significant influence” test, the inclusion of a “known through reasonable inquiry” standard and other elements of the proposed amendments.

Notably, the SEC is seeking comments on other potential changes to the Loan Provision and other provisions in Rule 2-01 that the SEC considered but determined not to propose at this time. These potential changes include adding a “materiality qualifier” to the proposed significant influence test and amending the definition of “covered person”—e.g., removing immediate family members, limiting the scope of audit firm personnel captured by the definition—for purposes of the Loan Provision or elsewhere in the auditor independence rules. In addition, the SEC is seeking comment on potential changes to the operation of the auditor independence rules, including how compliance is evaluated. For instance, the SEC asks if any changes related to the frequency with which, the date as of which or circumstances under which an auditor must assess compliance with the Loan Provision or other provisions of Rule 2-01 of Regulation S-X. Finally, noting that “[t]he existing Loan Provision encompasses lending  arrangements that may change depending upon secondary market purchases of syndicated or other debt,” the SEC asks if such secondary market relationships should be taken into account or excluded from the Loan Provision and whether such relationships raise concerns about auditor independence.

The public comment period on the proposed amendments will be open until July 9, 2018.

The SEC’s proposing release is available at:https://www.sec.gov/rules/proposed/2018/33-10491.pd

_{1 Consequently, under the current rules, an auditor to one fund in the ICC must seek information regarding the record and beneficial owners of all of the other funds (and other entities) in the ICC and such owners’ affiliates. As the proposing release notes, other funds in the ICC that are not being audited by the requesting audit firm are not required to provide this information and may not be willing to do so without first establishing information-sharing protocols, “all of which can require substantial time and expense incurred by auditors and funds.”}

_{2 See No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (June 20, 2016), available at: https://www.sec.gov/divisions/investment/noaction/2016/fidelity-management-research-company-062016.htm}

_{3 See No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (Sept. 22, 2017), available at: https://www.sec.gov/divisions/investment/noaction/2017/fidelity-management-research-092217-regsx-rule-2-01.htm}

_{4For example, the record ownership percentages of open-end funds may fluctuate within a given period for reasons beyond the control or knowledge of a lender who is also a fund shareholder of record.}

_{5 The proposing release notes that non-compliance with the auditor independence rules could result in affected funds not being able to sell shares and funds—and indirectly, shareholders—“having to incur the cost of re-audits,” because, in order for a registered open-end fund to make a continuous offering of its securities, a registered open-end fund must maintain a current prospectus by periodically filing post-effective amendments to its registration statement that contain updated financial information audited by an independent public accountant in accordance with Regulation S-X.}

_{6In contrast, a private fund shareholder with a side letter arrangement, for instance, that allows for participation in portfolio management processes would, according to the proposingrelease, likely have “significant influence.”}

_{7The proposing release notes that although “significant influence” is not specifically defined, the concept “has been part of the [SEC’s] auditor independence rules since 2000 andhas been part of the accounting standards since 1971,” and thus, “is one with which audit firms and their clients are already required to be familiar” and is applicable to funds underexisting auditor independence rules. “Significant influence,” according to the proposing release, could be indicated in several ways, including: (i) board representation;(ii) participating in policy-making processes; (iii) material intra-entity transactions; (iv) interchange of managerial personnel; or (v) technological dependency.}

_{8 The proposing release notes that the “known through reasonable inquiry” standard is generally consistent with existing provisions of the federal securities laws, including Rule 502(d) of Regulation D (reasonable inquiry to determine if a purchaser is acquiring securities for himself or for others) and Item 18 of Form N-1A (identification of each person who owns of record or is known by the fund to own beneficially 5% or more of any class of the fund’s outstanding equity securities). Thus, the proposing release states that “knownthrough reasonable inquiry” is “a concept that already should be familiar to those charged with compliance with the provision.}