On June 18, 2019 the Securities and Exchange Commission (SEC) issued a final rule, Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships, which amends the SEC’s independence rules when an auditor has a lending relationship with certain shareholders of an audit client (including the client’s affiliates) during the audit or professional engagement period (the Loan Provision).
The SEC received 31 comment letters, mostly in support of the SEC’s proposed changes to the Loan Provision.
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 prohibited 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, added the Loan Provision to its regulatory agenda.
Summary of Proposed Changes
In May 2018, the SEC proposed changes to the Loan Provision, which would narrow the rule's scope with respect to owners of more than 10 percent of an audit client's equity securities to those who are beneficial owners, known through reasonable inquiry, where the owner has significant influence over the client. In addition, when applying the rule to an audit client that is a fund within an investment company complex or “ICC” (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)).
Summary of Adopted Changes
The final amendments to the Loan Provision were generally consistent with the proposed revisions, except that the SEC clarified the definitions of "fund" and “audit client” for purposes of this rule (discussed below).
The final rules release states that the Loan Provision applies broadly to audits of all types of clients and was particularly challenging to apply in the mutual fund industry. However, the SEC noted that non-fund issuers have also faced challenges applying the Loan Provision and therefore, the final amendments apply to entities beyond the mutual fund industry, including operating companies and registered broker-dealers.
The final rule expands the definition of “fund” for purposes of the Loan Provision to include commodity pools and also excludes foreign funds from the definition of “audit client”. According to the release, a foreign fund that is part of an ICC would be covered by the exclusion for funds other than the fund under audit.
Final Rules Text - Loan Provision
The text of the final rule follows:
§ 210.2-01 Qualifications of accountants.
(A) Loans/debtor-creditor relationship.
(1) Any loan (including any margin loan) to or from an audit client, or an audit client’s
officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client, except for the following loans obtained from a financial institution under its normal lending procedures, terms, and requirements:
(i) Automobile loans and leases collateralized by the automobile;
(ii) Loans fully collateralized by the cash surrender value of an insurance policy;
(iii) Loans fully collateralized by cash deposits at the same financial institution; and
(iv) A mortgage loan collateralized by the borrower’s primary residence provided the loan was not obtained while the covered person in the firm was a covered person.
(2) For purposes of paragraph (c)(1)(ii)(A) of this section:
(i) The term audit client for a fund under audit excludes any other fund that otherwise would be considered an affiliate of the audit client;
(ii) The term fund means: an investment company or an entity that would be an investment company but for the exclusions provided by Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)); or a commodity pool as defined in Section 1a(10) of the U.S. Commodity Exchange Act, as amended [(7 U.S.C. 1-1a(10)], that is not included in paragraph (c)(2)(ii)(a) of this section.
Additional changes to independence rules possible
The release also indicated that the Chairman has directed the staff to formulate recommendations to the Commission for possible additional changes to the independence rules, comments on which were solicited in the proposed revisions to the Loan Provision.
The amendments become effective October 3, 2019.