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Conformed to Federal Register version SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 210 Release No. 33-10648; 34-86127; FR-85; IA-5255; IC-33511; File No. S7-10- RIN 3235-AM Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: The Securities and Exchange Commission (“Commission”) is adopting amendments to its auditor independence rules to refocus the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period. The amendments focus the analysis on beneficial ownership rather than on both record and 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 exclude from the definition of “audit client,” for a fund under audit, any other funds, that otherwise would be considered affiliates of the audit client under the rules for certain lending relationships. The amendments will more effectively identify debtor-creditor relationships that could impair an auditor’s objectivity and impartiality, as opposed to certain more attenuated relationships that are unlikely to pose such threats, and thus will focus the analysis on those borrowing relationships that are important to investors. DATES: The final rules are effective on October 3, 2019. FOR FURTHER INFORMATION CONTACT: Peggy Kim, Senior Special Counsel, Office
of the Chief Accountant, or Giles T. Cohen, Acting Chief Counsel, at (202) 551-5300; Daniel
Rooney, Assistant Chief Accountant, Chief Accountant’s Office, Division of Investment Management, at (202) 551-6918; or Joel Cavanaugh, Senior Counsel, Investment Company Regulation Office, Division of Investment Management, at (202) 551-6792, U.S. Securities and
(“Rule 2-01 of Regulation S-X”).
I. Introduction The Commission’s auditor independence standard set forth in Rule 2-01 of Regulation S- X requires auditors^1 to be independent of their audit clients both “in fact and in appearance.”^2 Rule 2-01(b) provides that the Commission will not recognize an accountant as independent with respect to an audit client if the accountant is not (or if a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not) capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.^3 Furthermore, in determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between an accountant and the audit client.^4 Rule 2-01(c) sets forth a nonexclusive list of circumstances that the Commission considers to be inconsistent with the independence standard in Rule 2-01(b), including certain direct financial relationships between an accountant and audit client and other circumstances where the accountant has a financial interest in the audit client.^5 In particular, the existing
(^1) Rule 2-01 refers to “accountants” rather than “auditors.” We use these terms interchangeably in this Release. (^2) See Preliminary Note 1 to Rule 2-01 and Rule 2-01(b) of Regulation S-X. See also United States v. Arthur Young & Co., 465 U.S. 805, 819 n.15 (1984) (“It is therefore not enough that financial statements beaccurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as anindependent professional.”).
(^3) See Rule 2-01(b) of Regulation S-X. (^4) See id. (^5) See Rule 2-01(c) of Regulation S-X; see also Revision of the Commission’s Auditor Independence Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)] (“2000 AdoptingRelease”) available at https://www.sec.gov/rules/final/33-7919.htm, at 65 FR 76009 (“The amendments [to Rule 2-01 adopted in 2000] identify certain relationships that render an accountant not independent of anaudit client under the standard in Rule 2-01(b). The relationships addressed include, among others, financial, employment, and business relationships between auditors and audit clients... .”).
restriction on debtor-creditor relationships in Rule 2-01(c)(1)(ii)(A) (the “Loan Provision”) generally provides that an accountant is not independent when (a) the accounting firm, (b) any covered person^6 in the accounting firm ( e.g. , the audit engagement team and those in the chain of command), or (c) any of the covered person’s immediate family members has any loan (including any margin loan) to or from (x) an audit client, or (y) an audit client’s officers, directors, or (z) record or beneficial owners of more than 10 percent of the audit client’s equity securities.^7 Simply because a lender to an auditor holds 10 percent or less of an audit client’s equity securities does not, in itself, establish that the auditor is independent under Rule 2-01 of Regulation S-X. The general standard under Rule 2-01(b) and the remainder of Rule 2-01(c) still apply to auditors and their audit clients regardless of the applicability of the Loan Provision. In the below illustration, pursuant to the Loan Provision, a lending relationship between any entity in the left hand column and any entity in the right-hand column impairs independence, unless an exception applies_._ Figure 1. Loan Provision Relationships
(^6) See Rule 2-01(f)(11) of Regulation S-X (defining the term “covered person”). (^7) See 2000 Adopting Release, supra footnote 5 at 65 FR 76035.
Loan (including margin loan)
Audit Firm
Audit Firm Covered Person’s Immediate Family Members
Audit Firm Covered Person
Audit Client Officers & Directors
Audit Client (including all affiliates) Record or Beneficial Owners of >10% of Audit Client’s Equity Securities
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 the equity securities of either (a) the firm’s audit client; or (b) any entity that is a controlling parent company of the audit client, a controlled subsidiary of the audit client, or an entity under common control with the audit client. In addition, the term “affiliate of the audit client” includes each entity in an investment company complex (“ICC”) of which the audit client is a part.^13 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. The Commission has become aware that, in certain circumstances, the existing Loan Provision may not be functioning as it was intended. Registered investment companies, other pooled investment vehicles, and registered investment advisers have expressed concerns about the Loan Provision in both public disclosures and, together with their auditors, in extensive consultations with Commission staff.^14 It has become clear that there are certain fact patterns in which an auditor’s objectivity and impartiality are not impaired despite a failure to comply with
An entity that has significant influence over the audit client, unless the audit client is not material to theentity; and (4) Each entity in the investment company complex when the audit client is an entity that is part of an investment company complex. (^13) See id. “Investment company complex” in Rule 2-01(f)(14) of Regulation S-X includes: (1) An investment company and its investment adviser or sponsor; (2) Any entity controlled by or controlling an investmentadviser or sponsor in paragraph (f)(14)(i)(A), or any entity under common control with an investment adviser or sponsor in paragraph (f)(14)(i)(A) if the entity: (i) Is an investment adviser or sponsor; or (ii) Isengaged in the business of providing administrative, custodian, underwriting, or transfer agent services to any investment company, investment adviser, or sponsor; and (3) Any investment company or entity thatwould be an investment company but for the exclusions provided by section 3(c) of the Investment Company Act of 1940 (15 U.S.S. 80a-3(c) that has an investment adviser or sponsor included in thedefinition by either paragraph (f)(14)(i)(A) or (B).
(^14) See Section I.B. of Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018) [83 FR 20753 (May 8, 2018)] (“Proposing Release”), at 83 FR20756.
the requirements of the Loan Provision. These fact patterns have arisen most frequently with respect to funds, although as noted in the Proposing Release, non-fund issuers also have faced challenges associated with the Loan Provision.^15 The Commission understands that accounting firms use loans to help finance their core business operations. Accounting firms frequently obtain financing to pay for their labor and out- of-pocket expenses before they receive payments from audit clients for those services. Accounting firms also use financing to fund current operations and provide capital to fund ongoing investments in their audit methodologies and technology. Accounting firms borrow from commercial banks or through private placement debt issuances, typically purchased by large financial institutions, both of which give rise to debtor-creditor relationships.^16 For creditor diversification purposes, credit facilities provided or arranged by commercial banks are often syndicated among multiple financial institutions, thereby expanding the number of lenders to an accounting firm. As a result, accounting firms typically have a wide array of borrowing arrangements. These arrangements facilitate firms’ provision of audit services to investors and other market participants, but also multiply the number of lenders that may be record or beneficial owners of securities in audit clients and that must be analyzed under the Loan Provision.
(^15) See footnote 20 of the Proposing Release. As discussed below, our amendments to Rule 2-01 will define “fund” as it relates to the Loan Provision as: (i) an investment company or an entity that would be aninvestment company but for the exclusions provided by Section 3(c) (15 U.S.C. 80a-3(c)) of the Investment Company Act of 1940 (the “Investment Company Act”); or (ii) a commodity pool as defined in Section1a(10) of the U.S. Commodity Exchange Act, as amended (“CEA”) that is not an investment company or does not rely on Section 3 of the Investment Company Act. See Rule 2-01(c)(1)(ii)(A)( 2 )( ii ). (^16) The Commission further understands that insurance companies may purchase accounting firms’ private placement notes. Insurance companies may also act as sponsors of insurance products and may be recordowners, on behalf of contract holders, of certain investment companies’ equity securities.
participants to other, more significant violations of the independence rules. Respect for the seriousness of these obligations, and attention to any breach or potential breach of these obligations, is better fostered through limiting violations to those instances in which the auditor’s independence would be impaired in fact or in appearance. Moreover, searching for, identifying, and assessing non-compliance or potential non- compliance with the Loan Provision and reporting these instances to audit committees also may generate significant costs for entities and their advisers and auditors, which are ultimately borne by shareholders. These costs are unlikely to have corresponding benefits to the extent that the Loan Provision’s breadth identifies and requires analysis of circumstances that are unlikely to bear on the auditor’s independence. In addition, the compliance challenges associated with the Loan Provision can have broader disruptive effects, particularly for funds.^19 For example, in order for a registered open- end fund to make a continuous offering of its securities, it must maintain a current prospectus by periodically filing post-effective amendments to its registration statement that contain updated financial information audited by an independent public accountant in accordance with Regulation S-X_._^20 In addition, the federal securities laws require that investment companies registered under the Investment Company Act transmit annually to shareholders and file with the
(^19) Registered investment advisers that have custody of client funds or securities also face compliance challenges from the Loan Provision. These advisers generally are required by 17 CFR 275.206(4)-2 (Rule206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (the “Investment Advisers Act”)) to obtain a surprise examination conducted by an independent public accountant or, for pooledinvestment vehicles, may be deemed to comply with the requirement by distributing financial statements audited by an independent public accountant to the pooled investment vehicle’s investors. An auditor’sinability, or potential inability, to comply with the Loan Provision raises questions concerning an adviser’s ability to satisfy the requirements of the Custody Rule. (^20) See generally Section 10(a)(3) of the Securities Act of 1933 (the “Securities Act”) [15 U.S.C. 77a et seq. ] and Item 27 of Form N-1A.
Commission financial statements audited by an independent registered public accounting firm.^21 Accordingly, non-compliance with the auditor independence rules in some cases could result in affected funds not being able to offer or sell shares, investors not being able to rely on affected financial statements, or funds (and, indirectly, but importantly, their investors) having to incur the costs of re-audits. In order to provide time for the Commission to address these challenges, and recognizing that funds and their advisers were most acutely affected by the Loan Provision, the Commission staff issued a no-action letter to Fidelity Management & Research Company in 2016 regarding the application of the Loan Provision (“Fidelity No-Action Letter”).^22 In the Fidelity No-Action Letter, the staff stated that it would not recommend enforcement action to the Commission, even though certain Fidelity entities identified in the letter used audit firms that were not in compliance with the Loan Provision, subject to certain conditions specified in the letter ( e.g. , that notwithstanding such non-compliance, the audit firm had concluded that it is objective and impartial with respect to the issues encompassed within the engagement).^23 Staff has continued
(^21) 15 U.S.C. 80a-1 et seq. See 17 CFR 270.30e-1 and 17 CFR 270.30b2-1 (Rules 30e-1 and 30b2-1 under the Investment Company Act). (^22) See No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (June 20, 2016) (“June 20, 2016 Letter”), https://www.sec.gov/divisions/investment/noaction/2016/fidelity-management-research-company- available at 062016.htm. The June 20, 2016 Letter provided temporary no-action relief and was to expire 18 monthsfrom the issuance date. On September 22, 2017, the staff extended the June 20, 2016 Letter until the effective date of any amendments to the Loan Provision adopted by the Commission that are designed toaddress the concerns expressed in the June 20, 2016 Letter. See No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (Sept. 22, 2017) (“September 22,2017 Letter”), available at https://www.sec.gov/divisions/investment/noaction/2017/fidelity-management- research-092217-regsx-rule-2-01.htm. The Fidelity No-Action Letter therefore will be withdrawn on theeffective date of the amendments we are adopting in this release.
(^23) The June 20, 2016 Letter described the following circumstances, each of which could have potential implications under the Loan Provision: (i) “An institution that has a lending relationship with an AuditFirm holds of record, for the benefit of its clients or customers (for example, as an omnibus account holder or custodian), more than 10 percent of the shares of a Fidelity Entity;” (ii) “An insurance company that hasa lending relationship with an Audit Firm holds more than 10 percent of the shares of a Fidelity Fund in
In developing the final amendments, we considered the thirty-one comment letters received in response to the Proposing Release.^25 Most commenters expressed general support for the proposed amendments, and only a few commenters did not.
II. Final Amendments A. Overview of the Final Amendments We are adopting amendments to Rule 2-01 of Regulation S-X that we believe would more effectively identify those debtor-creditor relationships that could impair an auditor’s objectivity and impartiality, yet would not include certain attenuated relationships that are unlikely to present threats to objectivity or impartiality.^26 Because compliance challenges associated with applying the Loan Provision have arisen with entities other than funds, and given that we did not receive comments objecting to our proposal to apply these amendments broadly, the final amendments will apply to entities beyond the investment management industry, including operating companies and registered broker-dealers. We are adopting the amendments generally as proposed with a few additional changes. As was proposed, we are focusing the analysis on beneficial ownership rather than on both record and beneficial ownership. Also, as proposed, we are replacing the existing 10 percent bright-line shareholder ownership test with a “significant influence” test and adding a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities. In addition, we are excluding from the definition of “audit client,” for a fund under audit, any other funds that otherwise would be considered affiliates of the audit
(^25) The comment letters received in response to the Proposing Release are available at https://www.sec.gov/comments/s7-10-18/s71018.htm. (^26) See Rule 2-01(b) of Regulation S-X.
client under the Loan Provision. In a change from the proposal and in response to comments, the final amendments define “fund” for these purposes to also exclude commodity pools and we clarify that foreign funds (as described below) are excluded for purposes of the definition of audit client. Finally, the Chairman has directed the staff to formulate recommendations to the Commission for possible additional changes to the auditor independence rules, as discussed further below.
B. Focus the Analysis on Beneficial Ownership Where a lender to an auditor holds more than 10 percent of the equity securities of that auditor’s audit client either as a beneficial owner or as a record owner, current rules dictate that the auditor is not independent of the audit client. As noted in the Proposing Release, one challenge associated with the 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^27 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 (see Figure 2 below for illustration). However, these financial
(^27) See infra footnote 28.
within a given period without any affirmative action on the part of the financial intermediary.^28 In this scenario, the financial intermediary’s holdings might constitute less than 10 percent of a mutual fund and, as a result of subsequent redemptions by beneficial owners through other non- affiliated financial intermediaries, the same investment could then constitute more than 10 percent of the mutual fund. However, regardless of their diligence in monitoring compliance, the financial intermediary, the fund, and the auditor may not know that the 10 percent threshold had been exceeded until after the fact.
1. Proposed Amendments Under the proposed amendments, the Loan Provision would apply only to beneficial owners of the audit client’s equity securities and not to those who merely hold the audit client’s equity securities as a holder of record on behalf of their beneficial owners.^29 The Proposing Release noted that tailoring the Loan Provision to focus on the beneficial ownership of the audit
(^28) Financial intermediaries such as broker-dealers, banks, trusts, insurance companies, and retirement plan third-party administrators perform the recordkeeping of open-end fund positions and provide services tocustomers, including beneficial owners and other intermediaries and, in most cases, aggregate their customer records into a single or a few “omnibus” accounts registered in the intermediary’s name on thefund transfer agent’s recordkeeping system. Shares of other types of registered investment companies, such as closed-end funds, also are frequently held by broker-dealers and other financial intermediaries asrecord owners on behalf of their customers, who are not required and may be unwilling to provide, information about the underlying beneficial owners to accounting firms, and particularly accounting firmsthat do not audit the fund. In addition, a financial intermediary may act as an authorized participant or market maker to an exchange-traded fund (“ETF”) and be the holder of record or beneficial owner of morethan 10 percent of an ETF. An open-end fund, or open-end company, is a management company that is offering for sale or hasoutstanding any redeemable securities of which it is the issuer. A closed-end fund, or closed-end company, is any management company other than an open-end company.Act [15 U.S.C. 80a-5]. ETFs registered with the Commission are organized either as open-end See Section 5 of the Investment Company management companies or unit investment trusts.U.S.C. 80a-4] (defining the terms “management company” and “unit investment trust”). References to See Section 4 of the Investment Company Act [ “funds” in this Release include ETFs, unless specifically noted. (^29) An equity holder who acquired such ownership by buying a certificated share would be both a record owner and a beneficial owner and thus would continue to be analyzed under the Loan Provision.
client’s equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor’s independence.^30
2. Comments Commenters generally supported the proposed amendment to focus the analysis on beneficial owners,^31 and several of these commenters agreed that tailoring the Loan Provision to focus only on the beneficial ownership of the audit client’s equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor’s independence.^32 One commenter expressed the view that auditors should not have any lending relationship with any shareholders of an audit client.^33 Several commenters requested
(^30) See Proposing Release at 20760. (^31) See, e.g., CII; Letter from Deloitte LLP, dated June 29, 2018 (“Deloitte”); Letter from PricewaterhouseCoopers LLP, dated June 29, 2018 (“PwC”); Letter from KPMG LLP, dated July 3, 2018(“KPMG”); Letter from Crowe LLP, dated July 3, 2018 (“Crowe”); Letter from Center for Audit Quality, dated July 3, 2018 (“CAQ”); Letter from National Association of State Boards of Accountancy, dated July5, 2018 (“NASBA”); Letter from New York State Society of Certified Public Accountants, dated July 6, 2018 (NYSCPA”); Letter from Piercy, Bowler, Taylor & Kern, dated July 6, 2018 (“PBTK”); Letter fromMFS Funds Board Audit Committee, dated July 6, 2018 (“MFS Funds”); Letter from Prof. Joseph A. Grundfest, dated July 9, 2018 (“Grundfest”); Letter from Grant Thornton LLP, dated July 9, 2018 (“GrantThornton”); Letter from Mutual Fund Directors Forum, dated July 9, 2018 (“MFDF”); Letter from BDO USA, LLP, dated July 9, 2018 (“BDO”); Letter from Ernst & Young LLP, dated July 9, 2018 (“EY”);Letter from Fidelity Management Research Company, dated July 9, 2018 (“Fidelity”); Letter from Association of the Bar of the City of New York, dated July 9, 2018 (“NYC Bar”); Letter from InvestmentCompany Institute and Independent Directors Council, dated July 9, 2018 (“ICI/IDC”); Letter from U.S. Chamber of Commerce Center for Capital Markets Competitiveness, dated July 9, 2018 (“CCMC”); Letterfrom RSM US LLP, dated July 9, 2018 (“RSM”); Letter from T. Rowe Price Funds, dated July 9, 2018 (“T. Rowe Price”); Letter from Financial Executives International, dated July 9, 2018 (“FEI”); Letter fromAmerican Institute of Certified Public Accountants, dated July 9, 2018 (“AICPA”); Letter from American Investment Council, dated Jul 9, 2018 (“AIC”); Letter from Securities Industry and Financial MarketsAssociation, dated July 9, 2018 (“SIFMA”); Letter from Invesco Funds, dated July 9, 2018 (“Invesco”); and Letter from Federated Investors, Inc., dated July 10, 2018 (“Federated”). (^32) See, e.g., CII, Deloitte, PwC, CAQ, BDO, EY, RSM, and ICI/IDC. (^33) See Letter from Tinee Carraker, dated May 20, 2018 (“Carraker”).
the beneficial ownership of the audit client’s equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor’s independence. In response to commenters who requested clarification of the term “beneficial owner,” we are providing additional guidance that financial intermediaries, who hold shares as record owners, and who have limited authority to make or direct voting or investment decisions on behalf of the underlying shareholders of the audit clients, are not considered “beneficial owners” for purposes of the Loan Provision.^40 Furthermore, if the financial intermediary undertakes steps to remove its discretion over the voting or disposition of shares, the financial intermediary generally will not be considered to be a beneficial owner for purposes of the Loan Provision. Such steps could include, for example: (1) mirror voting ( i.e. , the intermediary is obligated to vote the shares held by it in the same proportion as the vote of all other shareholders); (2) the financial intermediary holds the shares in an irrevocable voting trust without discretion for the institution to vote the shares; (3) an agreement to pass through the voting rights to an unaffiliated third-party entity; or (4) the intermediary has otherwise relinquished its right to vote such shares.^41 As requested by commenters, we also are reiterating the guidance set forth in the Proposing Release,^42 but with certain conforming changes because the final amendments remove the reference to “record owners” from the Loan Provision and replace the 10 percent bright-line
(^40) By providing this guidance, we are not interpreting 17 CFR 240.13d-3 (Exchange Act Rule 13d-3), applying the existing standards for determining who is a beneficial owner under Rule 13d-3, or alteringthese standards.
(^41) See 2000 Adopting Release, supra footnote 5. (^42) See supra footnote 35.
test with a significant influence test.^43 Accordingly, entities that are under common control with or controlled by the beneficial owner of the audit client’s equity securities when such beneficial owner has significant influence over the audit client, are excluded from the scope of the Loan Provision.
C. Significant Influence Test As discussed in the Proposing Release, the current bright-line 10 percent test may be both over- and under-inclusive as a means of identifying those debtor-creditor relationships that actually impair the auditor’s objectivity and impartiality. For example, the existing Loan Provision may apply even in situations where the lender may be unable to influence the audit client through its holdings (such as with omnibus accounts that hold as record owner more than 10 percent of the equity shares of an audit client). In such circumstances, the lender’s ownership of an audit client’s equity securities alone would not threaten an audit firm’s objectivity and impartiality. Conversely, the existing Loan Provision does not apply if the auditor’s lender owns 10 percent or less of the audit client’s equity securities, despite the fact that such an owner may be able to exert significant influence over the audit client through contractual or other means. A holder of 10 percent or less of an audit client’s equity securities could, for example, have the contractual right to remove or replace a pooled investment vehicle’s investment adviser.
1. Proposed Amendments The Commission proposed to replace the existing 10 percent bright-line test in the Loan Provision with a “significant influence” test similar to that referenced in other parts of the
(^43) See supra Section II.C.
