SEC proposes change to auditor independence rules

The Securities and Exchange Commission is looking to dial back strict requirements on auditors that have made it difficult for Big 4 firms to assert their independence on certain big engagements.

The SEC is seeking feedback to a tweak of its auditor independence rules under Rule 2-01 of Regulation S-X, which defines the form and content of public company financial statements, including qualifications for auditors to provide an independent audit opinion. The amendments focus on the “loan provision” language in the rules, which address any ties an audit firm might have to an audit client via certain lending relationships.

The loan provision under Rule 2-01 says auditors generally are not independent if the firm, any auditors on the engagement team and those in the chain of command, or any immediate family members of those auditors or audit leaders has a loan with the audit client, the client’s officers and directors, or any “record or beneficial owners” of more than 10 percent of the client’s equity securities.

Given the vast reach of certain financial institutions—especially investment company complexes that include mutual funds, their advisers, and any other entity under common control—it has become difficult for Big 4 firms to identify all of the potential relationships that might fall under the loan provision umbrella. Fidelity discovered as much when it wrote to the SEC in 2016 to explain its predicament.

Fidelity learned its audit firm had an independence problem under the loan provision, and Fidelity’s analysis determined it would likely have the same problem with any other of the limited number of Big 4 firms with the expertise and bandwidth necessary to perform its financial statement audit.

The SEC notes in its proposing release that other big names in financial services like Goldman Sachs and Invesco explained similar concerns in public filings in 2016. The problem has also surfaced with issuers other than funds, the SEC says, although not to the same extent. The SEC has also had “extensive consultants” with firms and their auditors on the issue.

In a “no action” letter, Fidelity asked the SEC to withhold enforcement action while legal experts determined how to address the problem. The SEC granted the no action request with an expiration date and then extended it indefinitely while the staff worked on a revision to the independence rules.

“The Commission is taking a sensible, thoughtful approach to addressing an area of the independence ruleset that has shown some practical challenges over recent years. They’re really looking for a way to fine tune the rules.”
Michael Scanlon, Partner, Gibson, Dunn & Crutcher

The SEC says it acknowledges firms have a wide variety of financing activities that lead to lending relationships, the complexity of which mushrooms under current market conditions. The independence analysis under strict interpretation of the current bright-line rules leads to unwieldy analysis and communication activity that does not necessarily get to the heart of whether in fact an auditor is independent or not on a given engagement, the SEC says.

The proposal seeks to address the problem by eliminating the bright lines in the current rule, giving audit firms some room to exercise judgment about whether certain lending relationships would impinge on the firm’s ability to deliver an impartial audit opinion. The amendments would make some surgical edits to the current language intended to refocus the analysis, the SEC says. The amendments would:

Focus the analysis solely on beneficial ownership;

Replace the existing 10 percent bright-line shareholder ownership 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 from the provision funds that otherwise would be considered “affiliates of the audit client.”

The difference between record ownership or beneficial ownership hinges on economic interest, says Dan Goelzer, a partner at law firm Baker McKenzie. “The beneficial owner means I have the economic benefits of owning shares,” he says. Where a large financial institution is simply holding shares as a service to its customers, the proposed new independence language would not raise a concern.

“The Commission is taking a sensible, thoughtful approach to addressing an area of the independence ruleset that has shown some practical challenges over recent years,” says Michael Scanlon, a partner at law firm Gibson, Dunn & Crutcher. He’s not expecting the changes to generate any controversy. “They’re really looking for a way to fine tune the rules.”

In Scanlon’s view, the SEC took care to assure the changes would not raise any concerns regarding investor protection. “The focus is on not impacting the auditor’s real objectivity or impartiality,” says Scanlon.

“Investment companies are saying this is not fair,” says Lewis Ferguson, an attorney and former member of the Public Company Accounting Oversight Board, which indicated recently it is also examining auditor independence rules. “The bank itself may not be the owner of a fund. It may merely hold legal title to shares, which are held by many, many individual investors. And ownership can change dramatically over the course of a measurement period as people go in and out of funds. The SEC is saying this is not what the independence rules are meant to deal with.”

Audit firms will have to exercise some judgment under the proposed new language about where a particular lending relationship might involve “significant influence” that could impair independence. “This kind of reflects modern day reality,” says Nancy Reimer, a partner at law firm LeClairRyan. “Instead of looking at bright-line tests, this is a more practical approach. It will let audit firms and audit committees look at the reality of a situation.”

Scanlon doesn’t expect the standard as proposed to produce any significant change in the audit firm’s analysis or exercise of judgment with respect to independence. “Audit committees are already laser focused on independence issues,” he says. “Audit committees are already asking deep and probing questions about independence issues.”