Revised SEC Independence Rules: Affiliate of the Audit Client and Investment Company Complex

The latest issue of Audit Conduct News highlights significant changes to the Securities and Exchange Commission's (SEC's) Rule 2-01, Qualification of Accountants released on October 16, 2020.

The first of two articles covering the revisions addresses changes to two key definitions: Affiliate of the Audit Client and Investment Company Complex.

Note: A formatted PDF version appears below.

Revised SEC Independence Rules:

Affiliate of the Audit Client and Investment Company Complex

By: Cathy Allen

11/17/20

Last December, the Securities and Exchange Commission (SEC) proposed revisions to Rule 2-01, Qualifications of Accountants with the stated goal of focusing audit firms’ independence analyses on relationships or services that are more likely to pose threats to an auditor’s objectivity and impartiality. In summary, those changes would:

• amend key terms, affiliate of the audit client, investment company complex, and audit and professional engagement period,  

• add certain student and de minimis consumer loans as additional exemptions to the loan rule,

• narrow application of the business relationships rule, and

• introduce a framework for addressing prohibited business and service relationships resulting from corporate mergers and acquisitions.

The comment period closed on March 16, 2020, and on October 16, 2020, the SEC issued a final rule (“Final Release”). The SEC adopted changes largely as proposed but also made a few meaningful and significant, additional changes based on the comments. This article, the first of two, highlights the more significant amendments to two important definitions in the Final Release: Affiliate of the Audit Client (“Affiliate”) and Investment Company Complex (“ICC”).

Affiliate and ICC Definitions

An auditor must be independent not only of its audit client but also the audit client’s affiliates.

"Audit Client" Definition

Affiliate includes entities in an ICC, which are entities in the investment company (fund) industry like mutual funds, investment advisers and sponsors, custodial firms, and underwriters. These two definitions determine the universe of entities to which the auditor must maintain independence, therefore, in addition to the audited entity.

Companies Under Common Control  

Changes to both definitions focus on identifying the companies that are under common control with the audit client, i.e., “sister companies,” as affiliates subject to independence requirements. The current Affiliate definition includes all entities under common control with an audit client regardless of whether the company is individually material to the controlling entity:

"Affiliate of the Audit Client"

Likewise, the definition of ICC includes all sister companies under common control with the audit client.  

Proposed Changes

The SEC believes that an auditor’s prohibited services or relationships with its client’s immaterial sister company typically do not threaten the auditor’s objectivity and proposed adding a materiality qualifier to this aspect of the Affiliate definition so that a sister company would only be an Affiliate if the sister company was material to the controlling entity.

The SEC also proposed:

• making a similar change to the ICC definition subject to certain exceptions discussed below;

• clarifying that the term investment company includes unregistered (private) funds and other investment companies excluded by Section 3(c) of the Investment Company Act of 1940;

• that the general standard of auditor independence in Rule 2-01(b) (“general standard”) would still apply, meaning that an auditor should consider the nature, extent, relative importance and other aspects of services or relationships between the auditor, the controlling entity, and immaterial (non-affiliate) sister companies;        

• clarifying that for an ICC, the analysis should start at the affiliate’s relationship with the entity under audit as opposed to the audit client (because audit client includes all Affiliates, starting the analysis at the audit client can add numerous affiliates to the ICC);  

• clarifying that auditors of an investment company (“Fund”), or a(n) investment adviser or sponsor (“Adviser or Sponsor”) should look solely to the ICC definition in revised Rule 2-01(f)(14) to identify Affiliates.

• clarifying that auditors of a portfolio company should look to revised Rule 2-01(f)(4)(i), which applies to operating companies, not to Rule 2-01(f)(14), which applies to entities described in the ICC definition; and

• clarifying that the auditor should analyze independence under each of these respective rules relating to the entity under audit.

Final Amendments

As noted, the SEC adopted the proposed changes to the rules, with some modifications, which are explained next.

From Materiality Qualifier to Dual Materiality Threshold

The most significant additional change to these definitions (since the December 2019 proposal) was the SEC’s agreement to expand the materiality qualifier to a “dual materiality threshold” to identify sister companies as affiliates. The dual materiality threshold means that an auditor should identify an affiliate relationship only if both the audit client (specifically, the entity under audit, explained further below) and the sister company are each material to the entity controlling them. Several commenters successfully argued that services provided to an audit client’s sister company do not typically threaten independence when the firm’s audit client is immaterial to the controlling entity. This approach is also consistent with how the American Institute of Certified Public Accountants (AICPA) and the International Ethics Standards Board for Accountants (IESBA) Codes identify sister companies as affiliates, which the SEC cited as a benefit.

Replace Audit Client with Entity Under Audit

The final rules replace audit client with the term entity under audit in Rule 2-01(f)(4)(i)-(ii) to focus the analysis on the entity under audit rather than the audit client, which by definition includes all of the audit client’s affiliates. The SEC believes the change is necessary to avoid negating the impact of using the dual materiality threshold. The SEC does not intend to make similar changes to other parts of Rule 2-01, including 2-01(f)(4)(iii)-(iv) and changes do not signify a change from the SEC’s previous application of these provisions.  

Clarifying the Application of the Definitions

As proposed, the Final Release directs auditors of a Fund, Adviser or Sponsor to look solely to the revised ICC definition to identify affiliates. The auditor of a portfolio company in a private equity structure should look to Affiliate definition, which applies to operating companies. If a structure includes both portfolio companies and Funds, Adviser or Sponsor, the auditor should apply the definition depending on the types of entities the firm provides audit services to.  

Determining Materiality

The SEC declined to provide specific guidance on materiality in response to commenters’ requests but did note that auditors should continue to apply approaches based on current rules. The Final Release added that in some cases, it may be reasonable to use assets under management and that assessments of materiality should be attentive to the:

• nature of the relationship,

• entity’s organizational and governance structure,

• certain business and financial relationships, and

• other relevant qualitative factors.

Monitoring Obligations

The SEC stated that auditors and their clients (management and the audit committee) share responsibility for maintaining the auditor’s independence. This duty includes monitoring affiliates and obtaining information (including accurate organizational and financial information) to assess materiality of possible affiliates. Once materiality is initially established, auditors should work with the client to ensure they are notified of changes that may impact the client’s affiliate relationships (for example, a pending acquisition or registration statement with the SEC) in a timely manner. The auditor should make reasonable inquiries for this information and promptly update its assessment when learning of an SEC filing, transaction, or other relevant information. If changes to the materiality of the entity under audit or a sister company to the controlling entity cause an independence violation, the SEC encouraged auditors and their clients to consult with the SEC Office of the Chief Accountant.

Reacting to concerns that information needed to evaluate materiality can be difficult to obtain, the SEC believes its dual materiality threshold should alleviate those concerns since the auditor will not need to assess materiality of the sister company to the controlling entity when the entity under audit is not material to the controlling entity.  

Note: The Final Release clarifies that auditors lacking the requisite information to determine whether a sister company is material to the controlling entity should conclude that such sister company is an Affiliate.

SEC General Standard (Rule 2-01(b))

The SEC neither proposed nor adopted changes to the general standard (Rule 2-01(b)). However, in discussing these changes, the Final Release stated that auditors should consider relationships and services affected by the proposed revisions to the Affiliate definition, both individually and in the aggregate, under the general standard (see below).

"General Standard"

Further, the preliminary note to Rule 2-01 describes four fundamental principles the SEC looks to in evaluating facts and circumstances (see below).

Preliminary Note to Rule 2-01

Among other things, the nature, extent, or relative importance of the service or relationship may threaten an auditor’s independence. For example, a firm may perform numerous services for, or have several business relationships with a non-affiliate sister company; the firm should have sufficient information to evaluate those services and relationship with the non-affiliate to determine whether independence is impacted under the general standard.  

Definition of Investment Company

As proposed, the Final Release amends the term investment company to include unregistered (private) funds and other investment companies excluded by Section 3(c) of the Investment Company Act of 1940.

Investment Advisers and Sponsors

The SEC continues to believe that due to the strength of the relationship between a Fund and its Adviser or Sponsor, a Fund that shares the same Adviser or Sponsor as the entity under audit should be included in the ICC regardless of materiality.  

Portfolio Companies Controlled by Sister Investment Companies

Responding to several comments, the SEC explained how the amended ICC definition applies to a portfolio company controlled by a sister Fund (affiliate) of a Fund under audit (see below). Under the amended definition, the auditor should apply the dual materiality threshold to any sister companies controlled by the same Adviser or Sponsor unless the portfolio company provides administrative, custodial, underwriting, or transfer agent services to any entity identified in 2-01(f)(14)(i)(A) or (B), in which case materiality is not considered.

Example 5: SEC Final Release

Note: The amended definition does not change the application of the ICC definition when a Fund under audit controls the portfolio company (in which case materiality should not be considered).

Effective Date and Transition

The effective date of these and other amendments to Rule 2-01 will be 180 days after their publication in the Federal Register. Once publication occurs, auditors may apply the rules early if the firm applies the amended rules in their entirety. Auditors should comply with the amended rules on a prospective basis, beginning on the rule’s effective date or the date the firm elects early compliance. Auditors may not retroactively apply the final amendments to relationships and services that existed before the effective date (or the early compliance date if selected).