There have been significant changes in the capital markets and those who participate in them since the initial implementation of the auditor independence framework in 2000 and its revision in 2003. Since that time, the SEC has continued to learn about the application of the independence rule set and the efficiency and effectiveness of our independence requirements as market conditions and industry practices have changed. The proposed amendments focus primarily on fact patterns presented to the SEC through consultations that involve a relationship with, or services provided to, an entity that has little or no relationship with the entity under audit and no relationship to the team conducting the audit. In these scenarios, the SEC has regularly observed that the audit firm is objective and impartial and does not object to their continuing the audit relationship with the audit client.

The proposed amendments apply to Rule 2-01 and are designed to respond to those changes, reflect the SEC’s experience administering the independence requirement, and incorporate consideration of the recent and longer term feedback from the public. The following examples illustrate some of the concerns with the current rules that the proposed amendments would address:

Example 1 – Student Loans

An Audit Firm has an audit partner based in Atlanta who continues to pay his student loans taken to attend college before starting his career at Audit Firm. A different audit partner in Atlanta audits the lender that provided the student loan (which is a large student loan company that originates thousands of student loans). According to the current rules, the student loan of the audit partner who is not part of the audit would still lead to an independence violation for the audit engagement of the lender.

Example 2 – Portfolio Companies

Company X is a U.S.-based portfolio company of Fund F. Fund F invests in dozens or even hundreds of various companies around the globe, including Company X. Audit Firm A is the auditor of Company X. Two of Audit Firm A’s global network affiliates provide the services discussed below to two separate portfolio companies of Fund F, Company Y and Company Z. Company Y and Company Z have no relation to each other or to Company X except for the fact that Fund F is invested in each Company. To add practical context, an Australian affiliate of Audit Firm A provides limited staffing services to a healthcare portfolio company based in Australia (Company Y) for a short-period of time to meet a resource need. In addition, a Spanish affiliate of Audit Firm A provides payroll services for a hotel chain portfolio company based in Spain (Company Z) for a short-period of time. Company X has its own separate governance structure that is unrelated to Company Y or Z. Company Y and Z are also not material to Fund F.

Under the current auditor independence rules, if Company X registers with the SEC, Audit Firm A would not be independent of Company X as a result of the services provided to either Company Y or Z. This is the case regardless of whether these limited services at immaterial portfolio companies (Companies Y and Z) have no impact on the entity under audit in any way and do not impact the objectivity and impartiality of the auditor in conducting the audit for Company X. The proposed amendments to the auditor independence rules would avoid require Company X, under such circumstances, to (i) replace Audit Firm A with another audit firm, (ii) wait up to three years after the termination of services provided to Companies Y or Z to register with the SEC, or (iii) make a determination, likely in consultation with SEC staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality. The issue of the independence rule set affecting auditor choice is brought home by this example. In some situations, the existing audit firm cannot be practically replaced because all other qualified audit firms have provided services or established other relationships with portfolio companies of Fund F, which would then trigger a breach of the SEC’s independence rule. These issues have increased significantly as the asset management industry has grown, investments have become more global, and the global audit services ecosystem has consolidated and become more specialized.

Proposed Amendments to Rule 2-01

If adopted, the proposed changes would:

• Amend the definitions of affiliate of the audit client (in Rule 2-01(f)(4)) and Investment Company Complex (in Rule 2-01(f)(14)) to address certain affiliate relationships, including entities under common control
• Amend the definition of the audit and professional engagement period (specifically Rule 2-01(f)(5)(iii)) to shorten the look-back period for domestic first time filers in assessing compliance with the independence requirements
• Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships
• Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationship rule with the concept of beneficial owners with significant influence
• Replace the outdated transition and grandfathering provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of merger and acquisition transactions

Other miscellaneous updates have also been proposed. The SEC seeks public comment on these proposed changes. The public comment period will be open for 60 days after publication in the Federal Register. You can submit comments using the form available on the SEC’s website or by e-mailing rule-comments@sec.gov with the proposed rules’ reference number in the subject line. You can also use the Federal Rulemaking Portal to submit comments or send your comments by mail to Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. In all cases, be sure to reference File Number S7-26-19.

Sources:

SEC Proposes to Codify Certain Consultations and Modernize Auditor Independence Rules (www.sec.gov)

Ame ndme nts to Rule 2-01, Qualifications of Accountants (www.sec.gov)