Proposed Change to SEC Independence Rule Posted in Federal Register

The proposed changes to the Securities and Exchange Commission's (SEC's) loan rule were published in the Federal Register today.  The comment period ends on July 9th. This follows the May 2nd announcement by the SEC that it was proposing several revisions to the loan rule under Regulation S-X, Rule 2-01, Qualifications of Accountants, which provides the boundaries for independence that CPA firms should observe in performing audits of public companies and other SEC registrants.


On June 20, 2016 the SEC Division of Investment Management issued a “no action” letter (NAL) to Fidelity Management & Research Co et al. (Fidelity) on an independence issue involving loans between certain shareholders of Fidelity affiliates (namely, record or beneficial owners of more than 10 percent of a Fidelity affiliate's equity securities) and its auditor.  Responding to Fidelity’s request, the NAL indicated that the SEC would not take enforcement action against the company and its affiliates for the auditor’s noncompliance with their rule, which prohibits the auditor from having a loan with a greater than 10 percent shareholder of  Fidelity or its affiliated entities. The SEC Staff agreed to not pursue action against the company, subject to the conditions noted in the letter, for a period of eighteen (18) months. The NAL noted that the Division of Investment Management consulted with the SEC’s Office of the Chief Accountant and Division of Corporate Finance in developing its analysis. On September 22, 2017, the SEC extended its no-action relief and prior to that, the SEC added the loan rule to its regulatory agenda.

A High Level Summary of the Proposed Changes

In summary, the changes would limit application of the rule's scope with respect to owners to those who are beneficial owners of an audit client's equity securitiesknown through reasonable inquiry, where the owner has significant influence over the client. (Note: Audit Client, as used in the SEC independence rules includes all affiliates of the audit client.) 

In addition, when applying the rule to an audit client that is a fund within an investment company complex (see Rue 2-01(f)(14)), the term audit client (Rule 2-01(f)(6)) excludes any other fund that otherwise would be considered an affiliate of the audit client (see Rule 2-01(f)(4)).

The SEC's Rationale for the Changes - Excerpts from the Release

The rule applies broadly to audits of all types of clients but was particularly challenging to apply in the mutual fund industry. The SEC provided extensive and thoughtful discussion as to why they believe it is appropriate to amend the loan provision, including the following (which I've categorized and excerpted from the Release): 

Owner of record

Regarding the existing rule: As a proxy for identifying a “special and influential role,” the Commission adopted a bright-line test for loans to or from a record or beneficial owner of more than 10 percent of an audit client’s equity securities. In addition, the term “affiliate of the audit client” includes each entity in an investment company complex (“ICC”) of which the audit client(s) may be only a very small part. Accordingly, in the ICC context, an accounting firm is considered not independent under the Loan Provision if it has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of any entity within the ICC, regardless of which entities in the ICC are audited by the accounting firm.

One challenge associated with the extant Loan Provision is that it applies to both “record” and “beneficial” owners of the audit client’s equity securities. However, publicly traded shares, as well as certain fund shares, often are registered in the name of a relatively small number of financial intermediaries as “record” owners for the benefit of their clients or customers. Certain of these financial intermediaries may also be lenders to public accounting firms or be affiliated with financial institutions that may be lenders to public accounting firms. As a result, audit clients may have financial intermediaries that own, on a “record” basis, more than 10 percent of the issuer’s shares and are also lenders to public accounting firms, covered persons of accounting firms, and their immediate family members, or are affiliated with companies that are lenders to public accounting firms. However, these financial intermediaries are not “beneficial” owners and may not have control over whether they are “record” owners of more than 10 percent of the issuer’s shares. In addition, open-end funds, such as mutual funds, may face significant challenges, because the record ownership percentages of open-end funds may fluctuate greatly within a given period for reasons completely out of the control or knowledge of a lender who is also a fund shareholder of record...However, regardless of their diligence in monitoring compliance, the financial intermediary, the fund, or the auditor may not know that the 10 percent threshold had been exceeded until after the fact.

Firm lending relationships

The current market conditions that have enabled these accounting firms’ financing methods appear to have resulted in various scenarios in which the Loan Provision deems an accounting firm’s independence to be impaired. Nevertheless, the relevant facts and circumstances regarding the relationships between the auditor and theaudit client suggest that in most cases the auditor’s objectivity and impartiality do not appear to be affected.

Moreover, searching for, identifying, and assessing noncompliance or potential noncompliance with the Loan Provision and reporting these instances to audit committees can generate significant costs for entities and their advisers and auditors, which costs are ultimately borne by shareholders. In addition, the compliance challenges associated with the Loan Provision can have broader disruptive effects, particularly in the fund industry.

Comment Period

The comment period ends 60 days after the release is published in the Federal Register (July 9th).

Importantly, the SEC is soliciting comments not only on the proposed changes to the loan provision, but also more widely to other provisions in Rule 2-01 that commenters feel would be appropriate. This is an excellent opportunity for the profession to comment on rules (or elements of the rules) that, similar to this loan provision, create onerous and significant burdens on clients and auditors without commensurate benefit to financial statement users as there is no impact on independence.