SEC finalizes change to auditor independence rules

The rules are responsive to an issue raised by investment managers, especially Fidelity, which pointed out to the SEC that independence rules were so restrictive, it could not identify an audit firm qualified to audit its financial statements. The SEC amended the rules to reign in the restrictions that had become a little too far reaching in the modern marketplace.

The issue focuses on the “loan provision” in the SEC’s auditor independence rules, which generally prohibits auditors from having lending relationships with shareholders of audit clients. More specifically, the SEC’s Rule 2-01 said auditors are not considered independent of their clients if the firm, any auditors on the engagement team and those in its line of command, or any of their immediate family members had a loan with the client, the client’s officers and directors, or any owners of more than 10 percent of the client’s equity securities.

As audit firms and those in financial services have consolidated and grown over the years, it has become difficult for large entities like Fidelity to engage an independent audit firm under that test. Or in the SEC’s words: “In recent years, the Commission has become aware that, in certain circumstances, the existing Loan Provision may not have been functioning as it was intended. The Commission has become aware of circumstances where the existing rules capture relationships that otherwise do not bear on the impartiality or objectivity of the auditor.”

That prompted the SEC to grant temporary relief in the form of no-action letters while it searched for a way to amend the rule. The new rule focuses the analysis not on both owners of record and beneficial owners, but solely on beneficial owners, or those who actually get benefits of ownership. It also replaces a bright-line 10 percent shareholder ownership test with a “significant influence” test, which suggests some room for judgment.

The new rule focuses on beneficial owners who can be “known through reasonable inquiry” rather than all beneficial owners. It also narrows the scope of funds that would be considered affiliates of the audit client.

“The amendments are intended to more effectively identify debtor-creditor relationships that could impair an auditor’s objectivity and impartiality, as opposed to certain more attenuated relationships that are unlikely to pose such threats,” the SEC says in a fact sheet summarizing the new language.

The new rules become effective 90 days after they are published in the Federal Register.