[Federal Register Volume 84, Number 129 (Friday, July 5, 2019)]
[Rules and Regulations]
[Pages 32040-32060]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-13429]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 210
[Release No. 33-10648; 34-86127; FR-85; IA-5255; IC-33511; File No. S7-
10-18]
RIN 3235-AM01
Auditor Independence With Respect to Certain Loans or Debtor-
Creditor Relationships
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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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 Exchange Commission, 100 F Street NE,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: We are adopting amendments to 17 CFR 210.2-
01 (``Rule 2-01 of Regulation S-X'').
Table of Contents
I. Introduction
II. Final Amendments
A. Overview of the Final Amendments
B. Focus the Analysis on Beneficial Ownership
1. Proposed Amendments
2. Comments
3. Final Amendments
C. Significant Influence Test
1. Proposed Amendments
2. Comments
3. Final Amendments
D. Reasonable Inquiry Compliance Threshold
1. Proposed Amendments
2. Comments
3. Final Amendments
E. Excluding Other Funds That Would Be Considered Affiliates of
the Audit Client
1. Proposed Amendments
2. Comments
3. Final Amendments
F. Other Comments
1. Materiality Qualifier
2. Other Potential Changes to the Auditor Independence Rules
III. Other Matters
IV. Paperwork Reduction Act
V. Economic Analysis
A. General Economic Considerations
B. Baseline
C. Anticipated Benefits and Costs
1. Anticipated Benefits
2. Anticipated Costs and Potential Unintended Consequences
D. Effects on Efficiency, Competition, and Capital Formation
E. Alternatives
VI. Final Regulatory Flexibility Analysis
A. Need for the Amendments
B. Significant Issues Raised by Public Comment
C. Small Entities Subject to the Final Rules
D. Projected Reporting, Recordkeeping and Other Compliance
Requirements
E. Agency Action To Minimize Effect on Small Entities
VII. Codification Update
VIII. Statutory Basis
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
[[Page 32041]]
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\
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\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 be accurate; 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 an independent
professional.'').
\3\ See Rule 2-01(b) of Regulation S-X.
\4\ See id.
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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 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.
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\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 Adopting
Release'') 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 an audit 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 . . . .'').
\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.
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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.
[GRAPHIC] [TIFF OMITTED] TR05JY19.000
When the Commission proposed the Loan Provision in 2000, it noted
that a debtor-creditor relationship between an auditor and its audit
client reasonably could be viewed as ``creating a self-interest that
competes with the auditor's obligation to serve only investors'
interests.'' \8\ The Commission's concern about a competing self-
interest extended beyond loans directly between the auditor and its
audit client to loans between the auditor and those shareholders of the
audit client who have a ``special and influential role'' with the audit
client.\9\ 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.\10\
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\8\ See Proposed Rule: Revision of the Commission's Auditor
Independence Requirements, Release No. 33-7870 (June 30, 2000) [65
FR 43148 (July 12, 2000)] (``2000 Proposing Release''), available at
https://www.sec.gov/rules/proposed/34-42994.htm, at 65 FR 43161.
\9\ See 2000 Adopting Release, supra footnote 5, at 65 FR 76035.
\10\ The Commission proposed that the Loan Provision include a
five-percent equity ownership threshold, but raised the threshold to
10 percent when it adopted the Loan Provision. See 2000 Adopting
Release, supra footnote 5, at 65 FR 76035. As the basis for its use
of a 10 percent threshold, the Commission pointed to similar 10
percent ownership thresholds elsewhere in the federal securities
laws, including 17 CFR 210.1-02(r) (Rule 1-02(r) of Regulation S-X)
(defining ``principal holder of equity securities''), Rule 1-02(s)
of Regulation S-X (defining ``promoter''), and Section 16 of the
Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.] (the
``Exchange Act'') (requiring reporting to the Commission of
beneficial ownership information by directors, officers, and
beneficial owners of more than 10 percent of any class of equity
securities of an issuer). Id.
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Under Rule 2-01(f)(6) of Regulation S-X, the term ``audit client''
is defined to include any affiliate of the entity whose financial
statements are being
[[Page 32042]]
audited.\11\ Rule 2-01(f)(4) provides that ``affiliates of the audit
client'' include entities that control, are controlled by, or are under
common control with the audit client.\12\ As a result, generally, an
accounting firm is 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 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.
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\11\ See Rule 2-01(f)(6) of Regulation S-X.
\12\ See Rule 2-01(f)(4) of Regulation S-X, in which an
``affiliate of the audit client'' includes the following: (1) An
entity that has control over the audit client, or over which the
audit client has control, or which is under common control with the
audit client, including the audit client's parents and subsidiaries;
(2) An entity over which the audit client has significant influence,
unless the entity is not material to the audit client; (3) An entity
that has significant influence over the audit client, unless the
audit client is not material to the entity; and (4) Each entity in
the investment company complex when the audit client is an entity
that is part of an investment company complex.
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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.
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\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 investment adviser 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) Is engaged 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 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.S. 80a-3(c) that has
an investment adviser or sponsor included in the definition by
either paragraph (f)(14)(i)(A) or (B).
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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 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\
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\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 FR 20756.
\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 an investment 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 Section 1a(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).
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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.
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\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
record owners, on behalf of contract holders, of certain investment
companies' equity securities.
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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, notwithstanding that the relevant
facts and circumstances regarding the relationships between the auditor
and the audit client suggest that in most cases the auditor's
objectivity and impartiality do not appear to be affected as a
practical matter. Nevertheless, auditors and audit committees \17\ may
feel obligated to devote substantial resources to evaluating potential
instances of non-compliance with the existing Loan Provision, which
could distract auditors' and audit committees' attention from matters
that may be more likely to bear on the auditor's objectivity and
impartiality.\18\ Audit committees' receipt of a high volume of
communications of such relationships could dilute the impact of
communications that identify issues that may actually raise concerns
about an auditor's independence.
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\17\ The audit committees of issuers, including registered
investment companies, may also be focused on this issue because,
under the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley Act''), audit
committees are responsible for the selection, compensation, and
oversight of such issuers' independent auditors. See 17 CFR 240.10A-
3 (Rule 10A-3 under the Exchange Act). In this Release, we use the
term ``audit committee,'' when referring to funds, generally to
refer to audit committees established by a fund's board of directors
or trustees or, where no formal audit committee exists (e.g., for
certain private funds), those responsible for the governance of the
fund. In the absence of an audit committee, the entire board of
directors will be considered to be the audit committee. See, e.g.,
Standards Relating to Listed Company Audit Committees, Release No.
33-8220 (Apr. 3, 2003) [68 FR 18788 (Apr. 16, 2003)].
\18\ For audits conducted pursuant to the standards of the
Public Company Accounting Oversight Board (``PCAOB''), auditors are
required to communicate any relationships, including lending
relationships, with the audit client that may reasonably be thought
to bear on independence to the audit committee at least annually.
See, e.g., PCAOB Rule 3526 (requiring a registered public accounting
firm, at least annually with respect to each of its audit clients,
to: (1) Describe, in writing, to the audit committee of the audit
client, all relationships between the registered public accounting
firm or any affiliates of the firm and the audit client or persons
in financial reporting oversight roles at the audit client that, as
of the date of the communication, may reasonably be thought to bear
on independence; (2) discuss with the audit committee of the audit
client the potential effects of the relationships described in
subsection (b)(1) on the independence of the registered public
accounting firm; (3) affirm to the audit committee of the audit
client, in writing, that, as of the date of the communication, the
registered public accounting firm is independent in compliance with
Rule 3520; and (4) document the substance of its discussion with the
audit committee of the audit client).
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Similarly, numerous violations of the independence rules that no
reasonable investor would view as implicating an auditor's objectivity
and impartiality could desensitize market participants to other, more
significant violations of the independence rules. Respect for the
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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 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.
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\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 (Rule 206(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 pooled investment 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's inability, 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.
\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).
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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 to receive inquiries from
registrants and accounting firms regarding the application of the Loan
Provision, clarification of the Fidelity No-Action Letter, and requests
for consultation regarding issues not covered in the Fidelity No-Action
Letter.
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\22\ See No-Action Letter from the Division of Investment
Management to Fidelity Management & Research Company (June 20, 2016)
(``June 20, 2016 Letter''), available at https://www.sec.gov/divisions/investment/noaction/2016/fidelity-management-research-company-062016.htm. The June 20, 2016 Letter provided temporary no-
action relief and was to expire 18 months from 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 to address 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 the effective 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 Audit Firm 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 has a lending
relationship with an Audit Firm holds more than 10 percent of the
shares of a Fidelity Fund in separate accounts that it maintains on
behalf of its insurance contract holders;'' and (iii) ``An
institution that has a lending relationship with an Audit Firm and
acts as an authorized participant or market maker to a Fidelity ETF
and holds of record or beneficially more than 10 percent of the
shares of a Fidelity ETF.''
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In order to address the compliance challenges discussed above, on
May 2, 2018, the Commission proposed 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.\24\ The
proposed amendments to the Loan Provision were intended to 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 present threats to
objectivity or impartiality. To achieve this objective, the proposed
amendments to the Loan Provision would have: (1) Focused the analysis
solely on beneficial ownership rather than on both record and
beneficial ownership; (2) replaced the existing 10 percent bright-line
shareholder ownership test with a ``significant influence'' test; (3)
added a ``known through reasonable inquiry'' standard with respect to
identifying beneficial owners of the audit client's equity securities;
and (4) amended the definition of ``audit client'' for a fund under
audit to exclude funds that otherwise would be considered affiliates of
the audit client. The Commission also requested comment on certain
other potential amendments to its auditor independence rules.
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\24\ See generally Proposing Release.
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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.
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\25\ The comment letters received in response to the Proposing
Release are available at https://www.sec.gov/comments/s7-10-18/s71018.htm.
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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
[[Page 32044]]
operating companies and registered broker-dealers.
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\26\ See Rule 2-01(b) of Regulation S-X.
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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 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 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.
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\27\ See infra footnote 28.
[GRAPHIC] [TIFF OMITTED] TR05JY19.001
For example, 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, regardless of their diligence in monitoring
compliance. Specifically, as a result of underlying customer activity
in an omnibus account (such as when beneficial owners purchase or
redeem their shares in an open-end fund) or as a result of the activity
of other record or beneficial owners, the record ownership of a lender
that is a financial intermediary holding fund shares for customers may
exceed, or conversely fall below, the 10 percent threshold within a
given period without any
[[Page 32045]]
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.
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\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 to customers, 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 the fund 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 as record 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 firms that 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 more
than 10 percent of an ETF.
An open-end fund, or open-end company, is a management company
that is offering for sale or has outstanding 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. See Section 5 of the Investment Company Act [15 U.S.C. 80a-
5]. ETFs registered with the Commission are organized either as
open-end management companies or unit investment trusts. See Section
4 of the Investment Company Act [15 U.S.C. 80a-4] (defining the
terms ``management company'' and ``unit investment trust'').
References to ``funds'' in this Release include ETFs, unless
specifically noted.
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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 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\
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\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.
\30\ See Proposing Release at 20760.
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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 clarification of the definition of
``beneficial owner'' and expressed support for defining ``beneficial
owner'' to refer to those owners with an economic interest in the
relevant securities.\34\ A number of commenters requested that the
Commission reiterate the guidance set forth in footnote 22 of the
Proposing Release,\35\ describing the entities that are excluded from
the scope of the Loan Provision (e.g., entities that are under common
control with or controlled by the beneficial owner are excluded from
the scope).\36\
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\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 July 5, 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 from MFS 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 (``Grant Thornton''); 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 Investment Company 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''); Letter from 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 from
American 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
Markets Association, 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'').
\34\ See, e.g., Deloitte, PwC, KPMG, CAQ, Grant Thornton, ICI/
IDC, and Invesco.
\35\ See footnote 22 of the Proposing Release: ``We note that
the Loan Provision can be implicated by lending relationships
between an auditing firm and those that control the record or
beneficial owner of more than 10 percent of the shares of an audit
client (i.e., entities that are under common control with or
controlled by the record or beneficial owner are not as such
implicated by the Loan Provision)'' (emphasis added). See also
footnote 5 of the Fidelity No-Action Letter.
\36\ See, e.g., Deloitte, PwC, KPMG, Grant Thornton, ICI/IDC,
Invesco, MFS Funds, T. Rowe Price, SIFMA, and Federated.
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A few commenters agreed that the proposed amendment would ease
compliance burdens,\37\ and two commenters stated that the proposed
amendment did not raise other auditor independence concerns.\38\ Two
commenters expressed the view that, even if the Commission amended the
Loan Provision to provide for evaluation of beneficial ownership alone,
the other proposed amendments would still be necessary and
appropriate.\39\
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\37\ See, e.g., KPMG, Crowe, CAQ, and EY.
\38\ See KPMG and EY.
\39\ See KPMG and EY.
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3. Final Amendments
After considering the comments received, and consistent with the
proposal, we are adopting amendments that focus the analysis on
beneficial ownership rather than on both record and beneficial
ownership. We continue to believe that tailoring the Loan Provision to
focus 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.
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
[[Page 32046]]
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 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.
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\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
altering these standards.
\41\ See 2000 Adopting Release, supra footnote 5.
\42\ See supra footnote 35.
\43\ See supra Section II.C.
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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 Commission's auditor
independence rules.\44\ Specifically, the proposed amendment would
provide, in part, that an accountant would not be independent when the
accounting firm, any covered person in the firm, or any of his or her
immediate family members has 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.\45\ Although not specifically defined,
the term ``significant influence'' appears in other parts of Rule 2-01
of Regulation S-X,\46\ and the Proposing Release noted that use of the
term ``significant influence'' in the proposed amendment was intended
to refer to the principles in the Financial Accounting Standards
Board's (``FASB's'') ASC Topic 323, Investments--Equity Method and
Joint Ventures.\47\
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\44\ See Rule 2-01(c)(1)(i)(E)(1)(i) and (ii), (c)(1)(i)(E)(2)
and (3), and (f)(4)(ii) and (iii) of Regulation S-X.
\45\ See proposed Rule 2-01(c)(1)(ii)(A) (replacing the phrase
``record or beneficial owners of more than ten percent of the audit
client's equity securities'' with ``beneficial owners (known through
reasonable inquiry) of the audit client's equity securities, where
such beneficial owner has significant influence over the audit
client''). Under the proposed amendments, the rule would continue to
have exceptions for four types of loans: (1) Automobile loans and
leases collateralized by the automobile; (2) loans fully
collateralized by the cash surrender value of an insurance policy;
(3) loans fully collateralized by cash deposits at the same
financial institution; and (4) 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. We
discuss the proposed ``known through reasonable inquiry'' standard
below. See infra Section II.D.
\46\ See Rule 2-01(c)(1)(i)(E) (``investments in audit
clients'') and Rule 2-01(f)(4) of Regulation S-X (``affiliate of the
audit client'' definition).
\47\ See Proposing Release at section II.C; ASC 323
Investments--Equity Method and Joint Ventures (``ASC 323''). See
also 2000 Adopting Release, supra footnote 5, at 65 FR 76034, note
284 (referring to Accounting Principles Board Opinion No. 18, ``The
Equity Method of Accounting for Investments in Common Stock'' (Mar.
1971), which was codified at ASC 323).
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2. Comments
(a) Significant Influence Test
Most commenters supported the proposed amendment to replace the 10
percent bright-line shareholder ownership test with a significant
influence test.\48\ Generally, these commenters agreed that significant
influence is a more appropriate framework to identify those lending
relationships that impair an accountant's objectivity and
impartiality.\49\ A few commenters supported codifying the significant
influence test found in ASC 323 (or specific elements of that test) in
our rules to promote consistent application,\50\ but one commenter did
not support codification in our rules so as to avoid confusion in the
future if changes are made to ASC 323.\51\ A few commenters requested
that we affirm that the Commission's auditor independence standards
involve a shared responsibility of the audit client and the
auditor.\52\ One commenter did not support replacing the 10 percent
bright-line test with a significant influence test in part because the
commenter questioned the quality of the equity method of accounting in
general.\53\
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\48\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, NYSCPA,
PBTK, MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity,
NYC Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, First Data, FEI, AICPA,
AIC, SIFMA, Invesco, and Federated.
\49\ See, e.g., Deloitte, PwC, KPMG, CAQ, NYSCPA, Grant
Thornton, BDO, EY, ICI/IDC, Fidelity, RSM, FEI, AICPA, and Invesco.
\50\ See, e.g., KPMG, NYSCPA, and Grant Thornton.
\51\ See EY.
\52\ See e.g., Deloitte, CAQ, and Crowe.
\53\ See CII.
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(b) ASC 323
Many commenters agreed that the framework in ASC 323 is generally
appropriate for assessing significant influence.\54\ Several
commenters, however, asserted that the concepts in ASC 323 may not be
useful to apply to funds or may not be routinely applied in the fund
context.\55\ Two commenters asserted that ASC 323 is not an appropriate
framework for the ``significant influence'' test, and instead proposed
a decision framework with a ``singular focus on the beneficial owner's
ability to exert significant influence over the audit client's
operating and financial policies,'' based on the totality of the facts
and circumstances.\56\ A number of commenters requested that the
Commission reiterate the fund guidance
[[Page 32047]]
from the Proposing Release,\57\ which clarified that in the fund
context, the operating and financial policies relevant to the
significant influence test would include the fund's portfolio
management processes. A few commenters recommended that the Commission
provide additional guidance regarding the application of the
significant influence test in the fund context (e.g., mutual funds,
preferred stockholders in closed-end funds, and exchange-traded
funds).\58\
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\54\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, NYSCPA, Grant
Thornton, BDO, EY, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA,
Federated, RSM, and FEI.
\55\ See, e.g., PwC, KPMG, Crowe, CAQ, EY, and Grant Thornton.
\56\ See KPMG and Invesco.
\57\ See, e.g., Deloitte, Crowe, CAQ, ICI/IDC, MFS Funds, T.
Rowe Price, SIFMA, Federated, Fidelity, and Invesco. See also the
discussion of fund guidance in the Proposing Release at 20761.
\58\ See, e.g., PwC, KPMG, Grant Thornton, ICI/IDC, and EY.
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Several commenters agreed that it would be appropriate to consider
the nature of the services provided by the investment adviser as a
factor in determining whether a beneficial owner has significant
influence.\59\ Several commenters also supported analyzing the concept
of ``portfolio management processes'' as the first step to the
significant influence test for investment companies. These commenters
agreed that, in circumstances in which the advisory contract grants the
investment adviser significant discretion with respect to the fund's
portfolio management processes, it is unlikely that a shareholder will
have significant influence and the factors in ASC 323 would not have to
be further analyzed.\60\ Some commenters recommended that the
Commission confirm that an audit firm need not monitor beneficial
ownership if it initially determines that, based on portfolio
management processes, the audit client cannot be subject to significant
influence and periodically determines that there are no changes to the
fund's governance structure and governing documents.\61\ Two commenters
proposed a framework that focused on the beneficial owner's ability to
exert significant influence over the audit client's operating and
financial policies, based on the totality of the circumstances, and to
avoid the exclusive reliance on the ASC 323 framework in the investment
fund context.\62\
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\59\ See, e.g., Deloitte, Grant Thornton, KPMG, EY, and CAQ.
\60\ See, e.g., Deloitte, ICI/IDC, MFS Funds, T. Rowe Price,
SIFMA, Federated, and Invesco. Deloitte added this as a first step
for limited partnerships and general partners.
\61\ See, e.g., ICI/IDC and T. Rowe Price.
\62\ See KPMG and Invesco.
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(c) Rebuttable Presumption
ASC 323 incorporates a rebuttable presumption of significant
influence once beneficial ownership meets or exceeds 20 percent of an
investee's voting securities.\63\ Two commenters recommended codifying
the rebuttable presumption assessment under the proposed significant
influence test consistent with the accounting standard,\64\ and one
commenter stated that although ASC 323 includes a rebuttable
presumption with respect to 20 percent ownership, it is merely a guide
and may be raised or lowered depending on the facts and
circumstances.\65\ A few commenters did not support applying the 20
percent rebuttable presumption to funds, but rather supported an
analysis of the rights of fund owners under the fund's governance
provisions.\66\ Two commenters viewed the 20 percent rebuttable
presumption as substituting a new 20 percent bright-line test for the
existing 10 percent bright-line test, in the absence of the fund
guidance set forth in the Proposing Release.\67\ One commenter was
concerned that the 20 percent rebuttable presumption could potentially
conflict with the analysis of ``control'' under the federal securities
laws by introducing a new standard that could increase compliance
costs.\68\
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\63\ Conversely, ASC 323 also incorporates a rebuttable
presumption of no significant influence if beneficial ownership is
less than twenty percent of investee's voting securities.
\64\ See FEI and Grant Thornton.
\65\ See NYSCPA.
\66\ See, e.g., ICI/IDC, T. Rowe Price, Invesco, KPMG, EY, and
Fidelity.
\67\ See Fidelity and Invesco.
\68\ See NYC Bar.
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(d) Participation on an Advisory Committee
The Proposing Release noted that if a shareholder in a private
fund, for example, has a side letter agreement outside of the standard
partnership agreement that allows for participation in portfolio
management processes (including participation on a fund advisory
committee), then the shareholder would likely have significant
influence.\69\ A few commenters asserted that although participation on
an advisory committee should be one factor in assessing significant
influence, this factor alone is not likely to indicate significant
influence.\70\ Two commenters noted that the responsibilities of an
advisory committee can vary.\71\ One of these commenters noted that,
when the board or advisory committee has substantive oversight
responsibility or decision-making capacity over operating and financial
policies significant to the fund, the commenter would likely view a
shareholder on the board or advisory committee as having significant
influence. In the absence of those characteristics, the commenter
indicated that it would likely not consider a member of the board or
advisory committee to have significant influence.\72\ The other
commenter stated that the purpose of an advisory committee generally is
to provide suggestions to the investment adviser or general partner,
and that advisory committees typically do not oversee the investment
adviser or general partner and do not participate in the portfolio
management process.\73\
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\69\ See Proposing Release, at 83 FR 20761.
\70\ See, e.g., Deloitte, KPMG, and CAQ.
\71\ See Deloitte and PwC.
\72\ See PwC.
\73\ See Deloitte.
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Two commenters asserted that the right to remove a general partner
or adviser was unlikely to indicate significant influence.\74\ Another
commenter supported drawing a distinction between rights that provide a
shareholder with an ability to actively participate in fund investment
decisions (e.g., approval or veto rights over a new fund investment),
which would indicate significant influence, and rights that allow a
shareholder to address inappropriate behavior on the part of the
investment adviser (e.g., a right to remove an adviser for cause or the
right to approve material changes to the fund governance documents),
which would not indicate significant influence.\75\
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\74\ See Deloitte and PwC.
\75\ See EY.
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(e) Authorized Participants
Authorized participants (``APs'') for ETFs deposit or receive
basket assets in exchange for creation units of the fund. The Proposing
Release noted that the deposit or receipt of basket assets by an AP
that is also a lender to the auditor alone would not constitute
significant influence over an ETF audit client. Several commenters
agreed that the deposit or receipt of basket assets by an authorized
participant that is also a lender to the auditor would not alone
constitute significant influence over an ETF audit client.\76\ A few
commenters stated that market makers also should not be considered to
have significant influence over an ETF audit client since their
objective is not to influence the fund or the portfolio management
process, but to provide liquidity to ETFs.\77\ One commenter
recommended that the Commission clarify that market makers typically
would not be
[[Page 32048]]
considered to have significant influence for purposes of the Loan
Provision.\78\
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\76\ See, e.g., Deloitte, KPMG, EY, PwC, ICI/IDC, MFS Funds, T.
Rowe Price, SIFMA, and Federated.
\77\ See, e.g., Deloitte, EY, and PwC.
\78\ See Deloitte.
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(f) Evaluation of Compliance With the Loan Provision
The Proposing Release indicated that, if the auditor determines
that significant influence does not exist based on the facts and
circumstances at the time of the auditor's initial evaluation,\79\ the
auditor should monitor the Loan Provision on an ongoing basis, which
could be done, for example, by reevaluating its determination when
there is a material change in the fund's governance structure and
governing documents, publicly available information about beneficial
owners, or other information that may implicate the ability of a
beneficial owner to exert significant influence of which the audit
client or auditor becomes aware. Several commenters agreed with this
proposal.\80\ A few commenters indicated that communications with
shareholders or documentation regarding investor rights could be
examples of other information implicating significant influence of
which the audit client or auditor becomes aware.\81\
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\79\ For funds, the auditor's initial determination would be
based on an evaluation of a fund's governance structure and
governing documents, the manner in which its shares are held or
distributed, and any contractual arrangements, among any other
relevant factors.
\80\ See, e.g., Deloitte, PwC, Crowe, CAQ, Grant Thornton, and
EY.
\81\ See e.g., PwC, Crowe, and CAQ.
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The Proposing Release also requested comment on whether the
Commission should permit the Loan Provision or other financial
relationships to be addressed at specific dates during the audit and
professional engagement period, or the beginnings or ends of specific
periods, or under specified circumstances. Rule 2-01(c)(1) of
Regulation S-X provides that an accountant is not independent if the
accountant has an independence-impairing relationship specified in the
rule at any point during the audit and professional engagement period.
Certain existing disclosure requirements require information about
beneficial owners as of a specified date.\82\ Several commenters
expressed the view that specific dates were not needed to assess
compliance with the Loan Provision, and that the frequency and timing
of the evaluation should be developed based on the particular facts and
circumstances relevant to the audited entity.\83\
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\82\ See, e.g., Item 18 of Form N-1A and Item 19 of Form N-2.
\83\ See, e.g., Deloitte, PwC, Crowe, CAQ, Grant Thornton, BDO,
EY, and RSM.
---------------------------------------------------------------------------
A few commenters supported including specific dates or periods,
such as:
The onset of the engagement period and the balance sheet
date for each audit; \84\
---------------------------------------------------------------------------
\84\ See KPMG.
---------------------------------------------------------------------------
At the planning and reporting stages of the audit and
potentially significant or material events; \85\ or
---------------------------------------------------------------------------
\85\ See FEI.
---------------------------------------------------------------------------
The beginning of the engagement, prior to accepting a new
engagement, and when the governance structure (including any
contractual relationships) of the audit client changes.\86\
---------------------------------------------------------------------------
\86\ See Invesco.
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(g) Alternatives to the Significant Influence Test
Two commenters proposed alternatives to the significant influence
test: (1) Focusing on material direct financial interests,\87\ and (2)
focusing the analysis on beneficial ownership, but maintaining the
existing 10 percent bright-line shareholder ownership test.\88\ The
commenter that recommended maintaining the existing 10 percent bright-
line ownership test but applying it to beneficial owners argued that
this alternative approach would be simpler and easier to understand
than the proposed significant influence test.\89\ This commenter also
asserted that the alternative approach would address most of the issues
raised in the Fidelity No-Action Letter and avoid replacing the 10
percent bright-line test with a significant influence test that
incorporates a 20% rebuttable presumption.\90\
---------------------------------------------------------------------------
\87\ See Invesco.
\88\ See CII. A separate commenter suggested that auditors
should resign or the engagement partner be replaced in circumstances
involving both significant influence and related party transactions,
but did not provide further explanation. See Letter from Elisabeth
Rossen, dated June 3, 2018 (``Rossen'').
\89\ See CII.
\90\ See id.
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One commenter stated that alternatives to the significant influence
test are not needed.\91\ The Proposing Release also requested comment
on whether the modifier ``significant'' should be removed, such that
the test would hinge on whether a lender shareholder has influence over
an audit client. Two commenters opposed the removal of the modifier
``significant'' from the significant influence test, arguing that it
would not achieve the objective of more effectively identifying those
lending relationships that impair objectivity and impartiality.\92\
Another commenter did not support an alternative test based on mere
``influence,'' describing significant influence as being able to alter
management's decision-making process, whereas mere ``influence'' could
be disregarded by management.\93\
---------------------------------------------------------------------------
\91\ See Grant Thornton.
\92\ See KPMG and EY.
\93\ See NYSCPA.
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3. Final Amendments
After carefully considering the comments received, and consistent
with the proposal, we are adopting amendments 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
Commission's auditor independence rules and based on the concepts
applied in ASC 323. We are not adopting an alternative framework, as
suggested by two commenters,\94\ that focuses on the beneficial owner's
ability to exert significant influence over the audit client's
operating and financial policies, based on the totality of the facts
and circumstances, rather than the concepts applied in ASC 323. We
continue to believe that given its use in other parts of the
Commission's independence rules,\95\ the concept of ``significant
influence'' is one with which audit firms and their clients are already
required to be familiar and would effectively identify those debtor-
creditor relationships that could impair an auditor's objectivity and
impartiality. In this regard, introducing a separate significant
influence determination for these purposes would introduce additional
complexity to the auditor independence rules without, in our view,
necessarily resulting in more accurate assessments of auditor
independence.
---------------------------------------------------------------------------
\94\ See Invesco and KPMG.
\95\ See supra footnote 44.
---------------------------------------------------------------------------
While the term ``significant influence'' in the final amendment
refers to the principles in ASC 323, we agree with the commenter who
stated that the specific considerations described in the significant
influence test in ASC 323 should not be codified in our rules so as to
avoid confusion in the future if changes are made to ASC 323.\96\ For
similar reasons, we are not codifying ASC 323's 20 percent rebuttable
presumption in our rules.
---------------------------------------------------------------------------
\96\ See EY.
---------------------------------------------------------------------------
While audit firms and audit committees of operating companies
already should be familiar with application of the ``significant
influence'' concept, we appreciate that this concept is not as
routinely applied
[[Page 32049]]
by funds for financial reporting purposes. Therefore, in response to
comments requesting that the Commission reiterate the fund guidance
from the Proposing Release \97\ and comments recommending additional
guidance regarding the application of the significant influence test in
the fund context,\98\ we are reiterating the fund guidance in the
Proposing Release, with further clarification about the application in
this context of the rebuttable presumption and other fund specific
issues. In the fund context, we believe that the operating and
financial policies relevant to the significant influence test would
include the fund's investment policies and day-to-day portfolio
management processes, including those governing the selection, purchase
and sale, and valuation of investments, and the distribution of income
and capital gains (collectively ``portfolio management processes''). An
audit firm could analyze, in its initial assessment under the rule,
whether significant influence over the fund's portfolio management
processes exists based on an evaluation of the fund's governance
structure and governing documents, the manner in which its shares are
held or distributed, and any contractual arrangements, among any other
relevant factors.
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\97\ See supra footnote 57.
\98\ See supra footnote 58.
---------------------------------------------------------------------------
We believe that it would be appropriate to consider the nature of
the services provided by the fund's investment adviser(s) pursuant to
the terms of an advisory contract with the fund as part of this
analysis. In circumstances where the terms of the advisory agreement
grant the adviser significant discretion with respect to the fund's
portfolio management processes and the shareholder does not have the
ability to influence those portfolio management processes, significant
influence generally would not exist and the evaluation of significant
influence would be complete unless there is a material change in the
fund's governance structure and governing documents (as discussed
below). This should be the case even if the shareholder holds 20
percent or more of a fund's equity securities, which would otherwise
trigger the rebuttable presumption under application of the concepts
described in ASC 323.
The ability to vote on the approval of a fund's advisory contract
or a fund's fundamental policies on a pro rata basis with all holders
of the fund alone generally should not lead to the determination that a
shareholder has significant influence. Similarly, the ability to remove
or terminate a fund's advisory contract alone generally should not lead
to a determination that a shareholder has significant influence.
As the Commission observed in the Proposing Release, if a
shareholder in a private fund, for example, has a side letter agreement
outside of the standard partnership agreement that allows for
participation in portfolio management processes (including
participation on a fund advisory committee), then the shareholder would
likely have significant influence. In response to commenters noting
that the responsibilities of an advisory committee can vary,\99\ we are
further clarifying that a shareholder in a private fund that
participates on a fund advisory committee would likely have significant
influence if that committee involves substantive oversight
responsibility or decision-making capacity over operating and financial
policies significant to the fund.
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\99\ See Deloitte and PwC.
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In addition, we believe that the deposit or receipt of basket
assets by an AP that is also a lender to the auditor would not alone
constitute significant influence over an ETF audit client. Similarly,
in circumstances where a market maker is a lender to the auditor, the
deposit or receipt of basket assets by a market maker (acting through
an AP) would not alone constitute significant influence over such an
ETF audit client.
Holders of a closed-end fund's preferred stock have certain rights
that may be relevant to a significant influence analysis.\100\ The
determination of whether preferred stockholders have significant
influence over the fund would be based on an evaluation of the relevant
facts and circumstances.
---------------------------------------------------------------------------
\100\ See section 18(a)(2)(C) of the Investment Company Act. See
also ICI/IDC.
---------------------------------------------------------------------------
Further to the guidance set forth above, we wish to emphasize that
auditor independence is a shared responsibility between the audit firm
and audit client.\101\ The reliability of the process for identifying
beneficial owners will be enhanced when both auditors and audit clients
take responsibility for promoting the accuracy of information required
to assess the auditor's independence.
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\101\ See Commission Final Rule, Revision of the Commission's
Auditor Independence Requirements, Release No. 33-7919 (Nov. 21,
2000) (``[Issuers and other registrants] have the legal
responsibility to file the financial information with the
Commission, as a condition to accessing the public securities
markets, and it is their filings that are legally deficient if
auditors who are not independent certify their financial
statements''). Moreover, many Commission regulations require
entities to file or furnish financial statements that have been
audited by an independent auditor. For example, Items 25 and 26 of
Schedule A to the Securities Act [15 U.S.C. 77aa(25) and (26)] and
Section 17(e) of the Exchange Act [15 U.S.C. 78q] expressly require
that financial statements be certified by independent public or
certified accountants. In addition, Sections 12(b)(1)(J) and (K) and
13(a)(2) of the Exchange Act [15 U.S.C. 78l and 78m], Sections
8(b)(5) and 30(e) and (g) of the Investment Company Act [15 U.S.C.
80a-8 and 80a-29], and Section 203(c)(1)(D) of the Investment
Advisers Act [15 U.S.C. 80b-3(c)(1)] authorize the Commission to
require the filing of financial statements that have been audited by
independent accountants. Title 17 CFR 240.17a-5(f)(1) (Paragraph
(f)(1) of Rule 17a-5 under the Exchange Act) requires that for
audits under paragraph (d) of Rule 17a-5 of broker-dealers
registered with the Commission, an independent public accountant
must be independent in accordance with Rule 2-01 of Regulation S-X.
See also id. (discussing Rule 206(4)-2 under the Investment Advisers
Act).
---------------------------------------------------------------------------
If the auditor determines that significant influence over the
fund's management processes does not exist at the time of the initial
application of the rule, the auditor should monitor the Loan Provision
on an ongoing basis.\102\ We continue to believe, as expressly
supported by several commenters,\103\ that the auditor could satisfy
this obligation to monitor its independence on an ongoing basis by
reevaluating its determination in response to a material change in the
fund's governance structure and governing documents, Commission filings
about beneficial owners,\104\ or other information which may implicate
the ability of a beneficial owner to exert significant influence of
which the audit client or auditor becomes aware. Outside of the fund
context, audit firms and their audit clients should continue to monitor
the auditor's independence on an ongoing basis by using their existing
processes for determining whether significant influence exists
consistent with the principles of ASC 323. In this regard, we agree
with those commenters \105\ who indicated that the frequency and timing
of the significant influence evaluation should be based on the
particular facts and circumstances relevant to the audited entity,
consistent with the requirement that the auditor be independent
throughout the audit and professional engagement period. Accordingly,
we have not included specific dates, periods or circumstances upon
which the significant influence evaluation should occur.
---------------------------------------------------------------------------
\102\ See Proposing Release at 20761.
\103\ See, e.g., Deloitte, PwC, Crowe, CAQ, Grant Thornton, and
EY.
\104\ This language is a slight change from the guidance
provided in the Proposing Release, which referenced ``publicly
available information about beneficial owners.'' See Proposing
Release at 20765. We believe reference to Commission filings is more
precise and will clarify the scope of monitoring that is discussed
above.
\105\ See KPMG, FEI, and Invesco.
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[[Page 32050]]
Finally, although we carefully considered the comments regarding
alternatives to the significant influence test, we have not been
persuaded to retain the existing 10 percent bright-line shareholder
ownership test. We believe that in situations where the lender is
unable to influence the audit client through its holdings, the lender's
ownership of an audit client's equity securities alone would not
threaten an audit firm's objectivity and impartiality. In these
situations, we continue to believe that the significant influence test
would more effectively determine which shareholders have ``a special
and influential role with the issuer'' by focusing on a shareholder's
ability to influence the policies and management of an audit client.
We disagree with the commenter who expressed support for retaining
a 10 percent bright-line test based on beneficial ownership.\106\ We
continue to believe that a test based on significant influence, rather
than one based on numerical bright lines, will better address the
compliance challenges associated with the Loan Provision while also
more effectively identifying debtor-creditor relationships that could
impair an auditor's objectivity and impartiality. One potential benefit
of the final amendments is that the significant influence test could
potentially identify risks to auditor independence that might not have
been identified under the existing 10 percent bright-line test. For
example, a beneficial owner that holds slightly less than 10 percent of
an audit client's equity securities is likely to have similar
incentives and ability to influence the auditor's report than a
beneficial owner that holds slightly more than 10 percent of the same
audit client's equity securities. The existing 10 percent threshold in
the Loan Provision would differentially classify these two hypothetical
situations, despite their similarity. Under the final amendments, an
audit firm, where it is evaluating beneficial owners for significant
influence, would evaluate both beneficial owners to determine if they
have significant influence, thus providing a consistent analysis under
the Loan Provision for these economically similar fact patterns.
Regarding the alternative of focusing on material direct financial
interests, we discuss our reasons for not adopting a materiality
qualifier below.\107\
---------------------------------------------------------------------------
\106\ See CII.
\107\ See infra Section II.F.1.
---------------------------------------------------------------------------
One commenter raised concerns that the 20 percent rebuttable
presumption included in the significant influence analysis would
introduce a new standard and require performing multiple layers of
overlapping and potentially conflicting analysis.\108\ The commenter
cited to the definition of ``affiliate of the audit client'' set forth
in Rule 2-01(f)(4) of Regulation S-X to suggest that the reference to
``control'' under that definition could overlap with the application of
the significant influence test.\109\ However, the concept of
``significance influence'' in ASC 323 is distinct from any reference to
``control'' in Rule 2-01(f)(4) or elsewhere under the federal
securities laws. Specifically, the determination of whether an entity
has control of another entity is distinct from whether an entity has
significant influence over the audit client. For this reason, we do not
believe the concept of ``significant influence'' in ASC 323 overlaps
with other definitions. Moreover, the concept of ``significant
influence,'' which includes the 20 percent rebuttable presumption, is
not a new standard but has been part of the Commission's auditor
independence rules since 2000 and part of the accounting standards
since 1971.\110\
---------------------------------------------------------------------------
\108\ See NYC Bar.
\109\ See id.
\110\ See Accounting Principles Board (APB) Opinion No. 18
(March 1971).
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D. Reasonable Inquiry Compliance Threshold
1. Proposed Amendments
As noted in the Proposing Release, another challenge in the
application of the current Loan Provision involves the difficulty in
accessing information about the ownership percentage of an audit client
for purposes of the current 10 percent bright-line test. The proposed
amendments to the Loan Provision would have addressed concerns about
accessibility to records or other information about beneficial
ownership by adding a ``known through reasonable inquiry'' standard
with respect to the identification of such owners. Under this proposed
amendment, an audit firm, in coordination with its audit client, would
be required to assess beneficial owners of the audit client's equity
securities who are known through reasonable inquiry. The Proposing
Release noted that if an auditor does not know after reasonable inquiry
that one of its lenders is also a beneficial owner of the audit
client's equity securities, including because that lender invests in
the audit client indirectly through one or more financial
intermediaries, the auditor's objectivity and impartiality is unlikely
to be impacted by its debtor-creditor relationship with the lender. The
Proposing Release also noted that this ``known through reasonable
inquiry'' standard is generally consistent with regulations
implementing the Investment Company Act, the Securities Act, and the
Exchange Act,\111\ and therefore is a concept that already should be
familiar to those charged with compliance with the Loan Provision.
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\111\ See, e.g., 17 CFR 240.3b-4 (Rule 3b-4 under the Exchange
Act [15 U.S.C. 78a et seq.]) (stating, with respect to the
definition of foreign private issuer, that if, after reasonable
inquiry, you are unable to obtain information about the amount of
shares represented by accounts of customers resident in the United
States, you may assume, for purposes of this definition, that the
customers are residents of the jurisdiction in which the nominee has
its principal place of business.); 17 CFR 230.144(g) (Rule 144(g)
under the Securities Act) (noting that the term brokers'
transactions in section 4(4) of the Securities Act shall be deemed
to include transactions by a broker in which such broker after
reasonable inquiry is not aware of circumstances indicating that the
person for whose account the securities are sold is an underwriter
with respect to the securities or that the transaction is a part of
a distribution of securities of the issuer); 17 CFR 230.502(d) (Rule
502(d) under the Securities Act) (stating, with respect to limits on
resales under Regulation D, that the issuer shall exercise
reasonable care to assure that the purchasers of the securities are
not underwriters within the meaning of section 2(a)(11) of the
Securities Act, which reasonable care may be demonstrated by
reasonable inquiry to determine if the purchaser is acquiring the
securities for himself or for other persons). Registered investment
companies also are subject to a similar requirement to disclose
certain known beneficial owners. See Item 18 of Form N-1A (``State
the name, address, and percentage of ownership of each person who
owns of record or is known by the Fund to own beneficially 5% or
more of any Class of the Fund's outstanding equity securities.'');
and Item 19 of Form N-2 (``State the name, address, and percentage
of ownership of each person who owns of record or is known by the
Registrant to own of record or beneficially five percent or more of
any class of the Registrant's outstanding equity securities.'').
---------------------------------------------------------------------------
2. Comments
Commenters generally expressed support for the proposed amendment
to add a ``known through reasonable inquiry'' standard with respect to
identifying beneficial owners of the audit client's equity
securities.\112\ A number of these commenters agreed that the proposed
amendment would address compliance challenges and further agreed that
if an auditor does not know after reasonable inquiry that one of its
lenders is also a beneficial owner of the audit client's equity
securities, the auditor's objectivity and impartiality is unlikely to
be impacted by its debtor-creditor relationship with the lender.\113\
---------------------------------------------------------------------------
\112\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, NYSCPA,
PBTK, MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity,
NYC Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, FEI, AICPA, AIC, SIFMA,
Invesco, and Federated.
\113\ See, e.g., Deloitte, PwC, KPMG, CAQ, Grant Thornton, MFDF,
BDO, RSM, FEI, and AICPA.
---------------------------------------------------------------------------
Other commenters requested guidance on what constituted
``reasonable
[[Page 32051]]
inquiry,'' \114\ such as whether reviewing publicly available
information or information readily available to the issuer would be
sufficient for this purpose. Several commenters requested substituting
the proposed ``known through reasonable inquiry'' standard with a
``known'' standard,\115\ while two commenters viewed both the ``known''
and ``known through reasonable inquiry'' standards to be similar.\116\
---------------------------------------------------------------------------
\114\ See, e.g., KPMG, CAQ, Grant Thornton, BDO, EY, ICI/IDC,
MFS Funds, RSM, T. Rowe Price, FEI, SIFMA, and Federated.
\115\ See, e.g., ICI/IDC, MFS Funds, T. Rowe Price, SIFMA,
Invesco, and Federated.
\116\ See EY and FEI.
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3. Final Amendments
After considering the comments received, we are adopting the
amendment to add a ``known through reasonable inquiry'' standard with
respect to identifying beneficial owners of the audit client's equity
securities as proposed. In response to commenters, we believe auditors
and their audit clients could conduct the reasonable inquiry analysis
by looking to the audit client's governance structure and governing
documents, Commission filings about beneficial owners, or other
information prepared by the audit client which may relate to the
identification of a beneficial owner.\117\
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\117\ See also supra Section II.C.
---------------------------------------------------------------------------
In addition, we have determined not to substitute a ``known through
reasonable inquiry'' standard with a ``known'' standard because we
believe an inquiry by the auditor and the audit client in conjunction
with the consideration of the audit client's governance structure,
governing documents, Commission filings, or other information prepared
by the audit client, would be a practical approach that would not
impose an undue burden in identifying and evaluating beneficial owners
of the audit client's equity securities.
E. Excluding Other Funds That Would Be Considered Affiliates of the
Audit Client
As discussed in the Proposing Release, the current definition of
``audit client'' in Rule 2-01 of Regulation S-X includes all
``affiliates of the audit client,'' which broadly encompasses, among
others, each entity in an ICC of which the audit client is a part. In
the fund context, this expansive definition of ``audit client'' could
result in an audit firm being deemed not to be independent as to a
broad range of entities, even where an auditor does not audit that
entity.\118\ Yet, in the investment management context, investors in a
fund typically do not possess the ability to influence the policies or
management of another fund in the same fund complex. Although an
investor in one fund in a series company can vote on matters put to
shareholders of the company as a whole, rather than only to
shareholders of one particular series, even an investor with a
substantial investment in one series would be unlikely to have a
controlling percentage of voting power of the company as a whole.
---------------------------------------------------------------------------
\118\ For example, under the current Loan Provision, an audit
firm (``Audit Firm B'') could be deemed not to be independent as to
an audit client under the following facts: Audit Firm A audits an
investment company (``Fund A'') for purposes of the Custody Rule. A
global bank (``Bank'') has a greater than 10 percent interest in
Fund A. Bank is a lender to a separate Audit Firm B, but has no
lending relationship with Audit Firm A. Audit Firm B audits another
investment company (``Fund B'') that is part of the same ICC as Fund
A because it is advised by the same registered investment adviser as
Fund A. Under these facts, Audit Firm B would not be independent
under the existing Loan Provision because the entire ICC would be
tainted as a result of Bank's investment relationship with Fund A.
---------------------------------------------------------------------------
Moreover, as noted in the Proposing Release, for the purposes of
the Loan Provision, the inclusion of certain entities in the ICC as a
result of the definition of ``audit client'' is in tension with the
Commission's original goal to facilitate compliance with the Loan
Provision without decreasing its effectiveness.\119\ Indeed, auditors
often have little transparency into the investors of other funds in an
ICC (unless they also audit those funds), and therefore, are likely to
have little ability to collect such beneficial ownership information.
---------------------------------------------------------------------------
\119\ See Proposing Release at 20762. See also 2000 Adopting
Release, supra footnote 5, at 76035 (The Commission, in adopting an
ownership threshold of 10 percent, rather than the five percent
proposed, stated that ``[w]e have made this change because we
believe that doing so will not make the rule significantly less
effective, and may significantly increase the ease with which one
can obtain the information necessary to assure compliance with this
rule.'').
---------------------------------------------------------------------------
1. Proposed Amendments
In order to address these compliance challenges, the proposed
rules, for purposes of the Loan Provision, would have excluded from the
definition of audit client, for a fund under audit, any other fund that
otherwise would be considered an affiliate of the audit client.\120\
Thus, for example, if an auditor were auditing Fund ABC, a series in
Trust XYZ, the audit client for purposes of the Loan Provision would
exclude all other series in Trust XYZ and any other fund that otherwise
would be considered an affiliate of the audit client. The proposed
amendment would have, without implicating an auditor's objectivity and
impartiality, addressed the compliance challenges associated with the
application of the Loan Provision where the audit client is part of an
ICC, such as when an accountant is an auditor of only one fund within
an ICC, and the auditor must be independent of every other fund (and
other entity) within the ICC, regardless of whether the auditor audits
that fund.
---------------------------------------------------------------------------
\120\ See proposed Rule 2-01(c)(1)(ii)(A)(2) of Regulation S-X
which provided that for purposes of paragraph (c)(1)(ii)(A), the
term audit client for a fund under audit excludes any other fund
that otherwise would be considered an affiliate of the audit client.
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)).
---------------------------------------------------------------------------
2. Comments
Many commenters supported the proposal to amend the definition of
``audit client'' for a fund under audit to exclude funds that otherwise
would be considered affiliates of the audit client.\121\ Several of
these commenters also agreed that the proposed amendment would address
some of the compliance challenges associated with the Loan Provision
while still effectively identifying lending relationships that may
impair independence.\122\ Two commenters, however, asserted that
affiliates of an audit client should not be categorically excluded from
the definition of ``audit client'' when evaluating significant
influence.\123\ Many commenters supported expanding the proposed
amendment to exclude other non-fund affiliates in an investment company
complex or private fund complex (e.g., investment advisers, broker-
dealers, and service providers, such as custodians, administrators, and
transfer agents),\124\ while other
[[Page 32052]]
commenters supported broadening the proposed exclusion to all audit
clients, not just fund affiliates.\125\ Several commenters recommended
we address downstream affiliates of excluded funds, such as portfolio
companies of the excluded funds.\126\ These commenters generally argued
that downstream affiliates of excluded funds that are not audit clients
do not pose a threat to auditor independence since these affiliates,
and investors in these affiliates, do not have the ability to exert
significant influence over the entity under audit.\127\
---------------------------------------------------------------------------
\121\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, PBTK,
MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity, NYC
Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, First Data, FEI, AICPA, AIC,
SIFMA, Invesco, and Federated.
\122\ See, e.g., KPMG, BDO, EY, and FEI.
\123\ See KPMG and NYSCPA. One of these commenters stated that
affiliates of the audit client should be excluded from the
definition of ``audit client'' for the purposes of the Loan
Provision, and also described scenarios where it believes it is
possible that an investor's significant influence over an entity can
affect other affiliates of that entity. For example, the commenter
described a scenario where the policies for the portfolio management
of the fund under audit span a wider group of funds. Under this
scenario, an investor may have significant influence in a large fund
in the complex that could result in effective influence over a
sister fund, where both funds are managed by the same team under the
same policies. See KPMG.
\124\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, MFS Funds,
BDO, EY, Fidelity, ICI/IDC, RSM, T. Rowe Price, AICPA, AIC, SIFMA,
Invesco, and Federated.
\125\ See, e.g., Deloitte, PwC, KPMG, CAQ, Grant Thornton, BDO,
EY, NYC Bar, RSM, First Data, FEI, and AICPA.
\126\ See, e.g., Crowe, CAQ, Grant Thornton, RSM, EY, and AICPA.
Crowe supported excluding downstream entities unless they had
significant influence over an entity being audited.
\127\ See, e.g., Crowe, CAQ, and RSM.
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Several other commenters also suggested excluding from the
definition of ``audit client'' other pooled investment vehicles in an
investment company complex that may be deemed to be an affiliate of the
audit client, including pooled products that are not investment
companies and do not rely on Section 3(c) of the Investment Company Act
(e.g., commodity pools), as well as certain foreign funds.\128\ These
commenters were concerned that these types of pooled investment
vehicles could be deemed to be ``affiliates of the audit client,'' even
though a lender likely would not have the ability to influence these
other funds in the fund complex.\129\ Another commenter stated that
investment advisers that are part of an ICC of which an audit client is
a part may conduct business that is unrelated to serving as the
investment adviser to registered investment companies.\130\ A number of
commenters also specifically discussed excluding certain entities in
the typical private equity fund structure from the definition of audit
client, including other funds advised by the private equity sponsor
when the private equity sponsor is the audit client.\131\ We also
received other comments on the ``affiliate of the audit client''
definition, which would impact other provisions of the auditor
independence rules and are discussed below.\132\
---------------------------------------------------------------------------
\128\ See, e.g., ICI/IDC, MFS Funds, T. Rowe Price, SIFMA,
Federated, and Invesco. As discussed below, for purposes of Rule 2-
01, a ``commodity pool'' would be a commodity pool as defined in
Section 1a(10) of the CEA that is not an investment company and does
not rely on Section 3(c) of the Investment Company Act. See, e.g.,
Reporting by Investment Advisers to Private Funds and Certain
Commodity Pool Operations and Commodity Trading Advisors on Form PF,
Investment Company Act Release No. 3308 (Oct. 31, 2011) [76 FR 71128
(Nov. 16, 2011)]. We use the term ``foreign fund'' in this release
to refer to an ``investment company'' as defined in Section
3(a)(1)(A) of the Investment Company Act that is organized outside
the U.S. and that does not offer or sell its securities in the U.S.
in connection with a public offering. See Section 7(d) of the
Investment Company Act (prohibiting a foreign fund from using the
U.S. mails or any means or instrumentality of interstate commerce to
offer or sell its securities in connection with a public offering
unless the Commission issues an order permitting the foreign fund to
register under the Act). A foreign fund may conduct a private U.S.
offering in the United States without violating Section 7(d) of the
Act only if the foreign fund conducts its activities with respect to
U.S. investors in compliance with either section 3(c)(1) or 3(c)(7)
of the Act (or some other available exemption or exclusion). See
Exemptions for Advisers to Venture Capital Funds, Private Fund
Advisers With Less Than $150 Million in Assets Under Management, and
Foreign Private Advisers, Investment Advisers Act Release No. 3222
(June 22, 2011) [76 FR 39646 (July 6, 2011)].
\129\ See ICI/IDC.
\130\ See Invesco.
\131\ See, e.g., AIC, EY, RSM, CCMC, Deloitte, CAQ, and
Grundfest.
\132\ See infra Section II.F.2.
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3. Final Amendments
We are adopting, as proposed, the amendment to the Loan Provision
to exclude from the definition of audit client, for a fund under audit,
any other fund (e.g., ``sister fund'') that otherwise would be
considered an affiliate of the audit client. Commenters generally
supported this exclusion. However, in response to commenters that urged
us to exclude commodity pools that are part of an ICC, we have expanded
the definition of ``fund'' in the final amendments to provide that a
commodity pool that is not an investment company or does not rely on
Section 3 of the Investment Company Act also is not considered a fund
for purposes of the Loan Provision.\133\ A foreign fund that is part of
an ICC would be covered by the exclusion for funds other than the fund
under audit.
---------------------------------------------------------------------------
\133\ A commodity pool that is an investment company or that
relies on Section 3 of the Investment Company Act would already be
covered by the fund exclusion.
---------------------------------------------------------------------------
We agree that investors in a fund typically do not possess the
ability to influence the policies or management of other ``sister''
funds and that this does not depend on whether the funds are investment
companies or other types of pooled investment vehicles. We also believe
that expanding the definition of ``fund'' to encompass commodity pools
is consistent with our intent to exclude for a fund under audit any
other funds that otherwise would be considered an affiliate of the
audit client.
Commenters also urged that we exclude any downstream affiliates of
excluded funds. We do not believe it is necessary to expressly carve
these entities out of the audit client definition. However, to avoid
any confusion, we are clarifying that, for purposes of the Loan
Provision, the exclusion of sister funds from the audit client
definition also excludes entities that would otherwise be included in
the audit client definition solely by virtue of their association with
an excluded sister fund. This clarification should remove any questions
about whether entities in which a sister fund invests (and that have an
even more attenuated relationship to a fund audit client) could
themselves be treated as an audit client for purposes of the Loan
Provision. We agree with commenters that these types of affiliates do
not have the ability to exert significant influence over the entity
under audit in these circumstances and, therefore, should not be
treated as an audit client.
F. Other Comments
In the Proposing Release, the Commission also requested comment on
other matters that might have an effect on the proposed amendments or
the Loan Provision and any suggestions for additional changes to other
parts of Rule 2-01 of Regulation S-X.
1. Materiality Qualifier
The Proposing Release did not include a materiality qualifier for
the Loan Provision but requested comment on whether one should be
included. Although a number of commenters expressed support for a
materiality qualifier,\134\ there were diverse recommendations about
how it should be applied. A number of commenters expressed support for
assessing the materiality of the loan to the auditor or covered
person,\135\ while other commenters supported assessing the materiality
of the lender's investment in the audit client.\136\ Several commenters
held the view that if their recommendation to exclude all affiliates of
the entity under audit was adopted, then a materiality qualifier would
not be necessary.\137\
---------------------------------------------------------------------------
\134\ See, e.g., Deloitte, PwC, KPMG, Crowe, CAQ, PTBK, Grant
Thornton, BDO, EY, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA,
Federated, CCMC, RSM, First Data, FEI, AICPA, and Invesco.
\135\ See, e.g., Deloitte, PwC, KPMG, CAQ, BDO, EY, ICI/IDC, MFS
Funds, T. Rowe Price, SIFMA, Federated, RSM, First Data, and
Invesco.
\136\ See, e.g., PwC, Crowe, CAQ, PTBK, Grant Thornton, BDO, EY,
CCMC, RSM, First Data, and FEI.
\137\ See, e.g., KPMG, Crowe, CAQ, EY, Grant Thornton, RSM, and
AICPA.
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After carefully considering the comments, we believe that the final
amendments appropriately address the compliance challenges raised by
the existing Loan Provision while
[[Page 32053]]
refocusing the rule on the qualitative nature of those lending
relationships auditors may have with lenders that ``hav[e] a special
and influential role with the audit client.'' Accordingly, we have
retained the significant influence test, as proposed, rather than
having the analysis turn on whether a specific loan may be material to
the lender or audit firm. We also believe that given the size of the
financial institutions, in terms of revenue or other quantitative
measures, and the audit firms that have lending relationships with
them, a materiality qualifier would result in scoping out from the Loan
Provision a broad range of lending relationships and would not
sufficiently address the threat to auditor independence, in fact or
appearance, posed by at least some of these lending relationships.
Furthermore, when determining whether an accountant is capable of
exercising objective and impartial judgment, the auditor and audit
client should consider all relevant circumstances between an accountant
and the audit client,\138\ which would include any qualitative and
quantitative factors. Moreover, adding a materiality qualifier could
cause the auditor independence inquiry to be affected by fluctuating
market conditions, rather than an assessment that is market
neutral.\139\
---------------------------------------------------------------------------
\138\ See Rule 2-01(b) of Regulation S-X.
\139\ For example, fluctuating market conditions could cause
changes in the value of the assets securing a loan, thereby leading
to different determinations at different times of the materiality of
a lending relationship.
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2. Other Potential Changes to the Auditor Independence Rules
The final amendments are intended to address the significant
practical challenges associated with the existing Loan Provision. The
Proposing Release also solicited comment on other changes to the Loan
Provision and to the other auditor independence rules. Generally, these
comments can be categorized as follows: (1) Relating to the Loan
Provision, but not the significant compliance challenges that need to
be immediately addressed (e.g., other types of loans that commenters
suggested should be excluded from the Loan Provision, such as student
loans); (2) broadly impacting provisions of the auditor independence
rules, including the Loan Provision (e.g., comments relating to the
``covered person'' and ``affiliate of the audit client'' definitions);
or (3) broadly impacting provisions of the auditor independence rules
other than the Loan Provision (e.g., suggestions to narrow the look-
back period for domestic initial public offerings so that the period is
similar to that for foreign private issuers). In response to these
comments and the need for more information gathering as to how best to
address these categories of comments, the Chairman has directed the
staff to formulate recommendations to the Commission for possible
additional changes to the auditor independence rules in a future
rulemaking.
III. Other Matters
If any of the provisions of these amendments, or the application of
these provisions to any person or circumstance, is held to be invalid,
such invalidity shall not affect other provisions or application of
such provisions to other persons or circumstances that can be given
effect without the invalid provision or application.
Pursuant to the Congressional Review Act,\140\ the Office of
Information and Regulatory Affairs has designated these amendments as
not a ``major rule,'' as defined by 5 U.S.C. 804(2).
---------------------------------------------------------------------------
\140\ 5 U.S.C. 801 et seq.
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IV. Paperwork Reduction Act
The final amendments do not impose any new ``collections of
information'' within the meaning of the Paperwork Reduction Act of 1995
(``PRA''),\141\ nor do they create any new filing, reporting,
recordkeeping, or disclosure requirements. Accordingly, we are not
submitting the final amendments to the Office of Management and Budget
for review in accordance with the PRA.\142\ We did not receive any
comments about our conclusion that there are no collections of
information.
---------------------------------------------------------------------------
\141\ 44 U.S.C. 3501 et seq.
\142\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------
V. Economic Analysis
As discussed above, the Commission is adopting amendments to the
Loan Provision in Rule 2-01 of Regulation S-X to focus the analysis on
beneficial ownership rather than both record and beneficial ownership;
replace the existing 10 percent bright-line shareholder ownership test
with a ``significant influence'' test; \143\ 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 Loan Provision.
---------------------------------------------------------------------------
\143\ See Section II.C for a discussion of the concept of
``significant influence.''
---------------------------------------------------------------------------
Under the existing rules, the 10 percent bright-line shareholder
ownership test does not recognize an accountant as independent if the
accounting firm, any covered person in the firm, or any of his or her
immediate family members has certain loans to or from an audit client
or an audit client's officers, directors, or record or beneficial
owners of more than 10 percent of the audit client's equity securities.
In addition, under the existing rules, ``audit client'' is defined
broadly to include any affiliate of the entity whose financial
statements are being audited, which, for funds, would include each
entity in an ICC of which the audit client is a part. As discussed
above, Commission staff has engaged in extensive consultations with
audit firms, funds, and operating companies regarding the application
of the Loan Provision. These consultations revealed that a number of
entities face significant practical challenges to comply with the Loan
Provision. These discussions also revealed that in certain scenarios,
in which the Loan Provision was implicated, the auditor's objectivity
and impartiality in performing the required audit and interim reviews
were not impaired.
We are mindful of the benefits obtained from and the costs imposed
by our rules and amendments.\144\ The following economic analysis seeks
to identify and consider the likely benefits and costs that will result
from the final amendments, including their effects on efficiency,
competition, and capital formation. The discussion below elaborates on
the likely economic effects of the final amendments.
---------------------------------------------------------------------------
\144\ Section 2(b) of the Securities Act [15 U.S.C. 77b(b)],
Section 3(f) of the Exchange Act [17 U.S.C. 78c(f)], Section 2(c) of
the Investment Company Act [15 U.S.C. 80a-2(c)], and Section 202(c)
of the Investment Advisers Act [15 U.S.C. 80b-2(c)] require the
Commission, when engaging in rulemaking where it is required to
consider or determine whether an action is necessary or appropriate
in the public interest, to consider, in addition to the protection
of investors, whether the action will promote efficiency,
competition and capital formation. Additionally, Section 23(a)(2) of
the Exchange Act [15 U.S.C. 78w(a)(2)] requires the Commission, when
adopting rules under the Exchange Act, to consider, among other
things, the impact that any new rule would have on competition and
not to adopt any rule that would impose a burden on competition that
is not necessary or appropriate in furtherance of the Exchange Act.
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A. General Economic Considerations
In order for the reported information to be useful to investors, it
needs to be relevant and reliable. The independent audit of such
information by impartial skilled professionals (i.e., auditors) is
intended to enhance the reliability of
[[Page 32054]]
financial reports.\145\ Conflicts of interest between companies or
funds and their auditors may impair the objectivity and impartiality of
the auditors in certifying the audit client's reported performance,
thus lowering the credibility and usefulness of these disclosures to
investors. Academic literature discusses and documents the importance
of the role of auditors as an external governance mechanism for the
firm.\146\ These studies generally find that better audit quality
improves financial reporting by increasing the credibility of the
financial reports.
---------------------------------------------------------------------------
\145\ See M. Defond & J. Zhang, A Review of Archival Auditing
Research, 58 J. Acct. & Econ. 275-326 (2014).
\146\ See e.g., N. Tepalagul & L. Lin, Auditor Independence and
Audit Quality: A Literature Review, 30 J. Acct. Audit. & Fin. 101-
121 (2015); M. Defond & J. Zhang, A Review of Archival Auditing
Research, 58 J. Acct. & Econ. 275-326 (2014); Y. Chen, S. Sadique,
B. Srinidhi, & M. Veeraraghavan, Does High-Quality Auditing Mitigate
or Encourage Private Information Collection?; and R. Ball, S.
Jayaraman & L. Shivakumar, Audited Financial Reporting and Voluntary
Disclosure as Complements: A Test of the Confirmation Hypothesis, J.
Acct. & Econ. 53(1): 136-166 (2012).
---------------------------------------------------------------------------
An accounting firm is not independent under the Loan Provision's
existing bright-line shareholder ownership test if the firm has a
lending relationship with an entity having record or beneficial
ownership of more than 10 percent of the equity securities of either:
(1) The firm's audit client; or (2) any ``affiliate of the audit
client,'' including, but not limited to, 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. The magnitude of a party's investment in a company or fund is
likely to be positively related with any incentive of that party to use
leverage over the auditor with whom the party has a lending
relationship in order to obtain personal gain.
The 10 percent bright-line test in the Loan Provision does not,
however, distinguish between holders of record and beneficial owners
even though beneficial owners are more likely to pose a risk to auditor
independence than record owners given that the financial gain of
beneficial owners is tied to the performance of their investment, and
as such, beneficial owners may have strong incentives to influence the
auditor's report. Record owners, on the other hand, may not benefit
from the performance of securities of which they are record owners, and
as such, they may have low incentives to influence the report of the
auditor. Both the magnitude and the type of ownership in the audit
client, are likely to be relevant factors in determining whether
incentives exist for actions that could impair auditor independence.
Beneficial ownership of a company's or fund's equity securities by a
lender to the company's or fund's auditor is likely to pose a more
significant risk to auditor independence than record ownership of the
company's or fund's securities by the same lender.
The current Loan Provision may in some cases over-identify and in
other cases under-identify threats to auditor independence. The
likelihood that the provision over-identifies threats to auditor
independence will tend to be higher when the lender is not a beneficial
owner of an audit client and does not have incentives to influence the
auditor's report, but has record holdings that exceed the 10 percent
ownership threshold. On the other hand, under-identification of the
threat to auditor independence may occur when the lender is a
beneficial owner--implying the existence of potential incentives to
influence the auditor's report--and the investment is close to, but
does not exceed, the 10 percent ownership threshold.\147\
---------------------------------------------------------------------------
\147\ We are unable to estimate the extent to which the 10
percent ownership threshold may over- or under-identify threats to
independence because, among other reasons, fund ownership data is
not readily available.
---------------------------------------------------------------------------
We are not aware of academic studies that specifically examine the
economic effects of the Loan Provision. The remainder of the economic
analysis in this section presents the baseline against which we perform
our analysis, the anticipated benefits and costs of the final
amendments, potential effects on efficiency, competition and capital
formation, and an analysis of alternatives to the final amendments.
B. Baseline
The final amendments will change the Loan Provision compliance
requirements for the universe of affected registrants. We believe the
main affected parties will be audit clients, audit firms, and
institutions engaging in financing transactions with audit firms and
their partners and employees. Other parties that may be affected are
covered persons and their immediate family members. Indirectly, the
final amendments will affect audit clients' investors.
We are not able to precisely estimate the number of current auditor
engagements that will be immediately affected by the final amendments.
Specifically, precise data on how audit firms finance their operations
and how covered persons arrange their personal financing are not
available to us, and no commenters provided data to enable such an
estimate. As such we are not able to identify pairs of auditors-
institutions (lenders). Moreover, sufficiently detailed and complete
data on fund ownership are not available to us, and no commenters
provided such data, thus limiting our ability to estimate the
prevalence/frequency of instances of significant fund ownership by
institutions that are also lenders to fund auditors.
Although data on fund ownership are not readily available, academic
studies of operating companies have shown that, for a selected sample
of firms, the average blockholder (defined as beneficial owners of five
percent or more of a company's stock) holds about 8.5 percent of a
company's voting stock.\148\ These studies also show that numerous
banks and insurance companies are included in the list of blockholders.
These findings suggest that the prevalence of instances of significant
ownership by institutions that are also lenders to auditors could be
high.
---------------------------------------------------------------------------
\148\ See Y. Dou, O. Hope, W. Thomas & Y. Zou, Blockholder
Heterogeneity and Financial Reporting Quality, working paper (2013).
---------------------------------------------------------------------------
As mentioned above, the final amendments will impact audits for the
universe of affected entities. The baseline analysis below focuses
mainly on the investment management industry because that is where the
most widespread issues with Loan Provision compliance have been
identified to date; however, the final rule will affect entities
outside of this space, which are also subject to the auditor
independence rules.\149\
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\149\ Based on data in the SEC's EDGAR database, during the
period from January 1, 2018 to December 31, 2018, there were a total
of 6,919 entities that filed at least one Form 10-K, 20-F, or 40-F,
or an amendment to one of these forms. This total does not include
investment companies and business development companies.
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As shown in Table 1 below, as of December 2018, there were
approximately 12,577 fund series, with total net assets of $23
trillion, that are covered by Morningstar Direct with identified
accounting firms.\150\ In addition, there were 23 accounting firms
performing audits for these investment companies, though these auditing
services were concentrated among the four largest accounting firms.
Indeed, about 86 percent of the funds were audited by the four largest
accounting firms, corresponding to 98 percent of the aggregate fund
asset value.\151\
---------------------------------------------------------------------------
\150\ These fund statistics are based on information available
from Morningstar Direct, and may not represent the universe of fund
families. The statistics include open-end funds, closed-end funds,
and exchange traded funds.
\151\ According to aggregated information from Forms 2, as of
December 31, 2018, there were 1,862 audit firms registered with the
PCAOB (of which 984 are domestic audit firms, with the remaining 878
audit firms located outside the United States). The concentration in
the provision of audit services for investment companies is
indicative of the overall market as well. According to a report by
Audit Analytics, the four largest accounting firms audit 75% of
accelerated and large accelerated filers. See Who Audits Larger
Public Companies-2018 Edition, available at http://www.auditanalytics.com/blog/who-audits-larger-public-companies-2018-edition.
[[Page 32055]]
Table 1--Audited Fund Series and Their Investment Company Auditors
[As of December 31, 2018]
------------------------------------------------------------------------
------------------------------------------------------------------------
Total Number of Fund Series............................. 12,577
Average Number of Fund Series Per Auditor............... 547
Average Net Assets (in millions) Per Auditor............ 1,023,086
Four Largest Audit Firms:
Total Number of Fund Series......................... 10,876
Average Number of Fund Series Per Auditor........... 2,719
Average Net Assets (in millions) Per Auditor........ 5,757,533
% of Four Audit Firms by Series......................... 86%
% of Four Audit Firms by Net Assets..................... 98%
------------------------------------------------------------------------
The scope of the auditor independence rules, including the Loan
Provision, extends beyond the audit client to encompass affiliates of
the audit client. According to Morningstar Direct, as of December 31,
2018, 543 out of 901 fund families \152\ have more than one fund, 162
have at least 10 funds, 57 have more than 50 funds, and 38 have more
than 100 funds. According to the Investment Company Institute, also as
of December 31, 2018, there were approximately 11,587 open-end funds
and around 5,500 closed-end funds, with many funds belonging to the
same fund family. Given that many fund complexes have several funds,
with some complexes having several hundred funds, if any auditor is
deemed not in compliance with the Loan Provision with respect to one
fund, under the current rule it cannot audit any of the other funds
within the same ICC.
---------------------------------------------------------------------------
\152\ These fund statistics are based on information available
from Morningstar Direct and may not represent the universe of fund
families. The statistics include open-end funds, closed-end funds
and ETFs.
---------------------------------------------------------------------------
In response to compliance challenges, and as discussed above,
Commission staff issued the Fidelity No-Action Letter. The Fidelity No-
Action Letter, however, did not resolve all compliance uncertainty, was
limited in scope, and provided staff-level no-action relief to the
requestor based on the specific facts and circumstances in the request.
Importantly, the Fidelity No-Action Letter did not amend the underlying
rule. Staff has continued to receive inquiries from registrants and
accounting firms regarding the application of the Loan Provision, or
clarification of the Fidelity No-Action Letter, and requests for
consultation regarding issues not covered in the Fidelity No-Action
Letter. As a result of the remaining compliance uncertainty, auditors
and audit committees may spend a significant amount of time and effort
to comply with the Loan Provision.
C. Anticipated Benefits and Costs
1. Anticipated Benefits
Overall, we anticipate monitoring for non-compliance throughout the
reporting period will be less burdensome for registrants under the
final amendments. For example, based on the 10 percent bright-line
test, an auditor may be in compliance at the beginning of the reporting
period. However, the percentage of ownership may change during the
reporting period, which may result in an auditor becoming non-
compliant, even though there may be no threat to the auditor's
objectivity or impartiality. A significant influence framework is
likely to better identify a lack of independence and help avoid such
anomalous outcomes.
There are also potential benefits associated with excluding record
holders from the Loan Provision. Currently, the Loan Provision uses the
magnitude of ownership by an auditor's lender as an indication of the
likelihood of a threat to auditor independence regardless of the nature
of ownership. From an economic standpoint, the nature of ownership also
could determine whether the lender has incentives as well as the
ability to use any leverage (due to the lending relationship) over the
auditor that could affect the objectivity of the auditor. For example,
a lender that is a record owner of the audit client's equity securities
may be less likely to attempt to influence the auditor's report than a
lender that is a beneficial owner of the audit client's equity
securities because, unlike a record holder, a beneficial owner has an
economic interest in the equity securities. By taking into account the
nature as well as the magnitude of ownership, the final amendments will
focus on additional qualitative information to assess the relationship
between the lender and the investee (e.g., a company or fund). Thus, we
believe that, where there may be weak incentives by the lender to
influence the audit, such as when the lender is only a holder of
record, the final amendments will exclude relationships that are not
likely to be a risk to auditor independence. The final amendments will
thus provide benefits to the extent that they alleviate compliance and
related burdens that auditors and audit clients would otherwise incur
to analyze debtor-creditor relationships that are not likely to
threaten an auditor's objectivity and impartiality. Affected
registrants also will be less likely to disqualify auditors in
situations that do not pose a risk to auditor independence, thereby
reducing auditor search costs for these entities.
The potential expansion of the pool of eligible auditors also could
result in better matching between the auditor and the client. For
example, auditors tend to exhibit a degree of specialization in certain
industries.\153\ If fewer auditors are considered to be independent due
to the Loan Provision, then companies may have to select an auditor
without the relevant specialization to perform the audit. Such an
outcome could impact the quality of the audit and, as a consequence,
negatively impact the quality of financial reporting to the detriment
of the users of information contained in audited financial reports.
Because they lack experience in the relevant industry, this outcome
also may lead to less specialized auditors expending more time to
perform the audit service, thereby increasing audit fees for
registrants. We anticipate that the final amendments likely will
positively impact audit quality for scenarios such as the one described
above. Relatedly, if the final amendments expand the pool of eligible
auditors, we expect increased competition among auditors, which could
reduce the cost of audit services to affected companies and, if such
cost savings are passed through to investors, could result in a lower
cost to investors. However, as discussed in Section V.B above, the
audit industry is highly concentrated, and as a consequence, such a
benefit may not be significant.\154\
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\153\ See e.g., N. Dopuch & D. Simunic, Symposium, Competition
in Auditing: An Assessment, Fourth Symposium on Auditing Research, p
401-450 (1982); and R.W. Knechel, V. Naiker & G. Pachecho, Does
Audit Industry Specialization Matter? Evidence from Market Reaction
to Auditor Switches, 26 Audit. J. Prac. & Theory 19-45 (2007).
\154\ The final amendments could result in some crowding-out
effect, as the four largest audit firms may be deemed to be
independent with more clients, potentially crowding out smaller
audit firms. We discuss this effect in more detail in Section V.D
below. However, we believe that better matching between auditors'
specialization and their clients and reduced unnecessary auditor
turnovers could potentially prevent audit quality decline and in the
long run may improve audit quality.
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[[Page 32056]]
Another potential benefit of the final amendments is that the
replacement of the bright-line test with the significant influence test
could potentially identify risks to auditor independence that might not
have been identified under the existing 10 percent bright-line
test.\155\ For example, a beneficial owner that holds slightly less
than 10 percent of an audit client's equity securities is likely to
have similar incentives and ability to influence the auditor's report
than a beneficial owner that holds the same audit client's equity
securities at slightly above the 10 percent threshold. The existing
Loan Provision differentially classifies these two hypothetical
situations, despite their similarity. To the extent that the final
amendments are able to improve identification of potential risks to
auditor independence through the use of qualitative criteria, investors
are likely to benefit from the final amendments. In the example above,
under the final amendments, an audit firm will evaluate both beneficial
owners to determine if they have significant influence, thus providing
a consistent analysis under the Loan Provision for these economically
similar fact patterns.
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\155\ This benefit will be limited to the extent that an auditor
whose lending relationships are not implicated by the Loan
Provision's existing 10 percent bright-line ownership test would be
otherwise identified as not meeting the general independence
requirement in Rule 2-01(b) of Regulation S-X.
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Another potential benefit of replacing the bright-line ownership
test with a significant influence test is that fluctuations in the
ownership percentage that do not change the economics of the
relationship between the auditor and the audit client likely will not
result in the auditor being deemed not to be independent. For instance,
there may be instances in which non-compliance with the Loan Provision
may occur during the reporting year, after an auditor is selected by
the registrant or fund. Particularly for companies in the investment
management industry, an auditor may be deemed to comply with the Loan
Provision using the bright-line test when the auditor is hired by the
fund but, due to external factors, such as redemption of investments by
other owners of the fund during the period, the lender's ownership
level may increase and exceed 10 percent. Such outcomes will be less
likely under the final amendments, which take into account multiple
qualitative factors in determining whether the Loan Provision is
implicated during the period. We anticipate that the final amendments
likely will avoid changes in auditors' independence status solely as a
result of small changes in the magnitude of ownership of audit client
securities and thereby mitigate any negative consequences that can
arise from uncertainty about compliance and the associated costs to the
funds or companies and their investors.
Adding a ``known through reasonable inquiry'' standard could
potentially improve the practical application of the Loan Provision,
particularly in the context of funds. As described above, some of the
challenges to compliance with the existing Loan Provision involve the
lack of access to information about the ownership percentage of a fund
that was also an audit client. If an auditor does not know that one of
its lenders is also an investor in an audit client, including because
that lender invests in the audit client indirectly through one or more
financial intermediaries, the auditor's objectivity and impartiality
may be less likely to be impacted by its debtor-creditor relationship
with the lender. The ``known through reasonable inquiry'' standard we
are adopting is generally consistent with regulations implementing the
Investment Company Act, the Securities Act and the Exchange Act,\156\
and therefore is a concept that already should be familiar to those
charged with compliance with the provision. This standard is expected
to reduce the compliance costs for audit firms as they could
significantly reduce their search costs for information and data to
determine beneficial ownership. Given that this will not be a new
standard in the Commission's regulatory regime, we do not expect a
significant adjustment to apply the ``known through reasonable
inquiry'' standard for auditors and their audit clients.
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\156\ See supra footnote 111.
---------------------------------------------------------------------------
Amending the definition of ``audit client'' to exclude any fund not
under audit that otherwise would be considered an ``affiliate of the
audit client'' might potentially lead to a larger pool of eligible
auditors, potentially reducing the costs of switching auditors and
creating better matches between auditors and clients. In addition, the
larger set of potentially eligible auditors could improve matching
between auditor specialization and client needs and may lead to an
increase in competition among auditors. Though the concentrated nature
of the audit industry may not give rise to a significant increase in
competition,\157\ the improved matching between specialized auditors
and their clients should have a positive effect on audit quality. In
contrast to the proposal, the final amendments also exclude commodity
pools from the definition of ``audit client,'' extending these benefits
to a broader set of auditor-client relationships.
---------------------------------------------------------------------------
\157\ See infra Section V.D.
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The final amendments also could have a positive impact on the cost
of audit firms' financing. The final amendments may result in an
expanded set of choices among existing sources of financing. This could
lead to more efficient financing activities for audit firms, thus
potentially lowering the cost of capital for these firms. If financing
costs for audit firms decrease as a result of the final amendments,
then such savings may be passed on to the audit client in the form of
lower audit fees. Investors also may benefit from reduced audit fees if
the savings are passed on to investors. The Commission understands,
however, that audit firms likely already receive market financing
terms. Therefore, this effect may not be significant in practice.
Replacing the 10 percent bright-line test with the significant
influence test also potentially allows more financing channels for the
covered persons in accounting firms and their immediate family
members.\158\ For example, the covered persons may not be able to
borrow money from certain lenders due to potential non-compliance with
the existing Loan Provision. A larger set of financing channels may
potentially lead to lower borrowing costs for covered persons. Lower
borrowing costs may encourage covered persons to make additional
investments.
---------------------------------------------------------------------------
\158\ See Rule 2-01(f)(11) of Regulation S-X.
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2. Anticipated Costs and Potential Unintended Consequences
Using a significant influence test for the Loan Provision may
increase the demands on the time of auditors and audit clients as they
seek to familiarize themselves with the test and gather and assess the
relevant information to apply the test. However, given that the
significant influence test has been part of the Commission's auditor
independence rules since 2000 and has existed in U.S. GAAP since 1971,
we do not expect a significant learning curve in applying the test. We
also do not expect significant compliance costs for auditors to
implement the significant influence test in the context of the Loan
Provision given that they already are required to apply the concept in
other parts of the auditor independence rules. We recognize that funds
do not generally apply a significant influence
[[Page 32057]]
test for financial reporting purposes. As such, despite the fact that
they are required to apply the significant influence test to comply
with the existing Commission independence rules, their overall
familiarity in other contexts may be less and thus the demands on their
time to apply the test may be relatively greater than for operating
companies. However, the Commission is reiterating and providing
expanded guidance about the application of the significant influence
test in the fund context,\159\ which may reduce the attendant costs for
funds.
---------------------------------------------------------------------------
\159\ See supra section II.C.3.
---------------------------------------------------------------------------
The replacement of the bright-line test with the significant
influence test and the adoption of the ``known through reasonable
inquiry'' standard will introduce more judgment in the determination of
compliance with the Loan Provision. As discussed earlier, the
significant influence test contains multiple qualitative elements to be
considered in determining whether an investor has significant influence
over the operating and financial policies of the investee. As a result,
there may be additional transition costs to the extent an auditor and
audit client need to adjust their compliance activities to now focus on
these new elements. The judgment involved in the application of the
significant influence test also could lead to potential risks regarding
auditor independence. In particular, because the significant influence
test relies on qualitative factors that necessarily involve judgment,
there is a risk that the significant influence test could result in
mistakenly classifying a non-independent auditor as independent under
the Loan Provision. However, auditor reputational concerns may impose
some discipline on the application of the significant influence test in
determining compliance with the Loan Provision, thus mitigating this
risk.
D. Effects on Efficiency, Competition, and Capital Formation
The Commission believes that the final amendments are likely to
improve the application of the Loan Provision, enhance efficiency of
implementation, and reduce compliance burdens. The final amendments
also may facilitate capital formation.
The final amendments may expand an audit client's choices by
expanding the number of auditors that meet the auditor independence
rules under the Loan Provision. As discussed earlier, the current
bright-line test may be over-inclusive under certain circumstances. If
more audit firms are eligible to undertake audit engagements without
implicating the Loan Provision, then audit clients will have more
options and, as a result, audit costs may decrease, although given the
highly concentrated nature of the audit industry, this effect may not
be significant. Moreover, the potential expansion of choice among
eligible audit firms and the reduced risk of being required to switch
auditors may lead to better matching between the audit client and the
auditor. Improved matching between auditor specialties and audit
clients could enable auditors to perform auditing services more
efficiently, thus potentially reducing audit fees and increasing audit
quality over the long term. Higher audit quality is linked to better
financial reporting, which could result in a lower cost of capital.
Reduced expenses and higher audit quality may decrease the overall cost
of investing as well as the cost of capital with potential positive
effects on capital formation. However, due to the concentrated nature
of the audit industry, we acknowledge that any such effects may not be
significant.
The replacement of the existing bright-line test with the
significant influence test could more effectively capture those
relationships that may pose a threat to an auditor's objectivity and
impartiality. To the extent that the final amendments do so, the
quality of financial reporting is likely to improve, and the amount of
board attention to independence questions when impartiality is not at
issue is likely to be reduced, thus allowing the board to focus on its
other responsibilities. For example, an operating company's board might
focus on hiring the best management, choosing the most value-enhancing
investment projects, and monitoring management to maximize shareholder
value, and this sharpened focus could potentially benefit shareholders.
Furthermore, we expect that improved identification of threats to
auditor independence would increase investor confidence about the
quality and accuracy of the information reported. Reduced uncertainty
about the quality and accuracy of financial reporting should attract
capital, and thus facilitate capital formation.
Under the final amendments, audit firms would potentially be able
to draw upon a larger set of lenders, which could lead to greater
competition among lending institutions and thus lower borrowing costs
for audit firms. Again, this could result in lower audit fees, lower
fund fees, lower compliance expenses, and help facilitate capital
formation, to the extent that lower borrowing costs for audit firms get
passed on to their audit clients. However, as noted above, this effect
may not be significant given that audit firms likely already receive
market financing terms.
The final amendments also may lead to changes in the competitive
structure of the audit industry. We expect more accounting firms to be
eligible to provide auditing services and be in compliance with auditor
independence under the final amendments. If larger audit firms are more
likely to engage in significant financing transactions and are more
likely not to be in compliance with the existing Loan Provision, then
these firms are more likely to be positively affected by the final
amendments. In particular, these firms may be able to compete for or
retain a larger pool of audit clients. At the same time, the larger
firms' potentially increased ability to compete for audit clients could
potentially crowd out smaller audit firms. However, we estimate that
four audit firms already perform 86 percent of audits in the investment
management industry.\160\ As a result, we do not expect any potential
change in the competitive dynamics among auditors for registered
investment companies to be significant.
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\160\ The market share of the four largest accounting firms in
other industries is significantly high as well. According to the
sample of 6,754 registrants covered by Audit Analytics in 2018, the
four largest accounting firms' mean (median) market share across
industries (based on two digit standard industry code) is 58% (56%).
The upper quartile is as high as 62% with low quartile of the
distribution being 49%.
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E. Alternatives
The existing Loan Provision applies to loans to and from the
auditor by ``record or beneficial owners of more than 10 percent of the
audit client's equity securities.'' As discussed earlier, record owners
are relatively less likely to have incentives to take actions that
would threaten auditor independence than are beneficial owners. An
alternative approach to the final amendments would be to maintain the
10 percent bright-line test, but to distinguish between types of
ownership under the 10 percent bright-line test and tailor the rule
accordingly. For example, record owners could be excluded from the 10
percent bright-line test, to which beneficial owners would remain
subject. The potential benefit of distinguishing between types of
ownership while retaining the 10 percent bright-line test is that
applying a bright-line test would involve less judgment than a
significant influence test. One commenter supported such an
approach.\161\
[[Page 32058]]
Although excluding record holders could partially overcome the over-
inclusiveness of the existing rule, we believe the significant
influence test we are adopting will more effectively detect possible
threats to auditor independence by focusing on the shareholder's
ability to influence the financial and operating policies of an audit
client. For example, merely owning more than 10 percent of an audit
client's equity securities might not necessarily mean a lender to the
auditor has the ability to influence the auditor's report (i.e., the
lender's ownership of the audit client's equity securities may not, in
itself, threaten an audit firm's objectivity and impartiality). The
adopted significant influence test also could identify risks to auditor
independence in situations where a beneficial owner holds slightly
under 10 percent of an audit client's equity and is likely to have
incentives and ability to influence the auditor's report, but the
lending relationship would not have been identified as independence-
impairing under the existing 10 percent bright-line test.
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\161\ See CII.
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A second alternative would be to use the materiality of a stock
holding to the lender in conjunction with the significant influence
test as a proxy for incentives that could threaten auditor
independence. Specifically, the significance of the holding to the
lender could be assessed based on the magnitude of the stock holding to
the lender (i.e., what percentage of the lender's assets are invested
in the audit client's equity securities), after determining whether the
lender has significant influence over the audit client. For example,
two institutions that hold 15 percent of a fund may be committing
materially different amounts of their capital to the specific
investment. The incentives to influence the auditor's report are likely
to be stronger for the lender that commits the relatively larger amount
of capital to a specific investment. As such, the materiality of the
investment to a lender with significant influence could be used as an
indicator of incentives by the lender to attempt to influence the
auditor's report and may better capture those incentives that could
pose a threat to auditor independence. However, given the typical size
of lending institutions, a materiality component might effectively
exclude most, if not all, lending relationships, including those that
pose a threat to an auditor's objectivity and impartiality. In
addition, this alternative could impose additional costs on auditors
and audit clients, as they would need to gather and analyze additional
information to assess their compliance with the Loan Provision.
Another alternative would be to assess the materiality of the
lending relationship between the auditor and the lending institution in
conjunction with the significant influence test. A number of commenters
supported such an approach.\162\ The materiality of the lending
relationship between the lender and the auditor, from both the lender's
and the auditor's points of view, could act as an indicator of the
leverage that the lender may have if it attempts to influence the
auditor's report. However, given the typical size of most impacted
audit firms and lending institutions, a materiality component might
effectively exclude most, if not all, lending relationships, including
those that pose a threat to an auditor's objectivity and impartiality.
In addition, lending relationships could be affected by market
conditions, which might affect the market neutrality of the auditor
independence inquiry. For example, fluctuating market conditions could
cause changes in the value of the assets securing a loan thereby
causing different determinations at different times of the materiality
of a lending relationship.
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\162\ See supra footnote 136.
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VI. Final Regulatory Flexibility Analysis
The Regulatory Flexibility Act (``RFA'') \163\ requires the
Commission, in promulgating rules under section 553 of the
Administrative Procedure Act,\164\ to consider the impact of those
rules on small entities. We have prepared this Final Regulatory
Flexibility Analysis (``FRFA'') in accordance with Section 604 of the
RFA.\165\ This FRFA relates to final amendments to Rule 2-01 of
Regulation S-X. An Initial Regulatory Flexibility Analysis (``IRFA'')
was prepared in accordance with the RFA and was included in the
Proposing Release. The Proposing Release included, and solicited
comment on, the IRFA.
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\163\ 5 U.S.C. 601 et seq.
\164\ 5 U.S.C. 553.
\165\ 5 U.S.C. 604.
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A. Need for the Amendments
As discussed above, the primary reason for, and objective of, the
final amendments is to address certain significant compliance
challenges for audit firms and their audit clients resulting from
application of the Loan Provision that do not otherwise appear to
affect the impartiality or objectivity of the auditor. Specifically,
the final amendments will:
Focus the analysis on 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 Loan Provision.
The need for, and objectives of, the final amendments are discussed
in more detail in Sections I and II above.
B. Significant Issues Raised by Public Comment
In the Proposing Release, we requested comment on the IRFA,
requesting in particular comment on the number of small entities that
would be subject to the proposed amendments to Rule 2-01 of Regulation
S-X, and the existence or nature of the potential impact of the
proposed amendments on small entities discussed in the analysis. In
addition, we requested comments regarding how to quantify the impact of
the proposed amendments and alternatives that would accomplish our
stated objectives while minimizing any significant adverse impact on
small entities. We also requested that commenters describe the nature
of any effects on small entities subject to the proposed amendments to
Rule 2-01 of Regulation S-X and provide empirical data to support the
nature and extent of such effects. Furthermore, we requested comment on
the number of accounting firms with revenue under $20.5 million. We did
not receive comments regarding the impact of our proposal on small
entities.
C. Small Entities Subject to the Final Rules
The final amendments will affect small entities that file
registration statements under the Securities Act, the Exchange Act, and
the Investment Company Act and periodic reports, proxy and information
statements, or other reports under the Exchange Act or the Investment
Company Act, as well as smaller registered investment advisers and
smaller accounting firms. The RFA defines ``small entity'' to mean
``small business,'' ``small organization,'' or ``small governmental
jurisdiction.'' \166\ The Commission's rules define ``small business''
and ``small organization'' for purposes of the Regulatory Flexibility
Act for each of the types of entities
[[Page 32059]]
regulated by the Commission. Title 17 CFR 230.157 \167\ and 17 CFR
240.0-10(a) \168\ define an issuer, other than an investment company,
to be a ``small business'' or ``small organization'' if it had total
assets of $5 million or less on the last day of its most recent fiscal
year. We estimate that, as of December 31, 2018, there are
approximately 1,173 issuers, other than registered investment
companies, that may be subject to the final amendments.\169\ The final
amendments will affect small entities that have a class of securities
that are registered under Section 12 of the Exchange Act or that are
required to file reports under Section 15(d) of the Exchange Act. In
addition, the final amendments will affect small entities that file, or
have filed, a registration statement that has not yet become effective
under the Securities Act and that has not been withdrawn.
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\166\ 5 U.S.C. 601(6).
\167\ Securities Act Rule 157.
\168\ Exchange Act Rule 0-10(a).
\169\ This estimate is based on staff analysis of issuers,
excluding co-registrants, with EDGAR filings on Forms 10-K, 20-F,
and 40-F, or amendments filed during the calendar year of January 1,
2018 to December 31, 2018. The analysis is based on data from XBRL
filings, Compustat, and Ives Group Audit Analytics.
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An investment company is considered to be a ``small business'' for
purposes of the RFA, if it, together with other investment companies in
the same group of related investment companies, has net assets of $50
million or less at the end of the most recent fiscal year.\170\ We
estimate that, as of December 2018, there were 114 investment companies
that would be considered small entities.\171\ We estimate that, as of
December 31, 2018, there were 59 open-end investment companies that
will be subject to the final amendments that may be considered small
entities. This number includes open-end ETFs.\172\
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\170\ 17 CFR 270.0-10(a).
\171\ This estimate is based on staff review of data obtained
from Morningstar Direct as well as data reported on Forms N-CEN, N-
Q, 10-K, and 10-Q filed with the Commission as of June 2018.
\172\ This estimate is derived from an analysis of data obtained
from Morningstar Direct as well as data reported on Form N-SAR filed
with the Commission for the period ending June 30, 2017.
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For purposes of the RFA, an investment adviser is a small entity if
it:
(1) Has assets under management having a total value of less than
$25 million;
(2) did not have total assets of $5 million or more on the last day
of the most recent fiscal year; and
(3) does not control, is not controlled by, and is not under common
control with another investment adviser that has assets under
management of $25 million or more, or any person (other than a natural
person) that had total assets of $5 million or more on the last day of
its most recent fiscal year.\173\ We estimate that there are
approximately 552 investment advisers that will be subject to the final
amendments that may be considered small entities.\174\
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\173\ 17 CFR 275.0-7.
\174\ This estimate is based on Commission-registered investment
adviser responses to Form ADV, Part 1A, Items 5.F and 12.
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For purposes of the RFA, a broker-dealer is considered to be a
``small business'' if its total capital (net worth plus subordinated
liabilities) is less than $500,000 on the date in the prior fiscal year
as of which its audited financial statements were prepared pursuant to
Rule 17a-5(d) under the Exchange Act,\175\ or, if not required to file
such statements, a broker-dealer with total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last day of the
preceding fiscal year (or in the time that it has been in business, if
shorter); and that is not affiliated with any person (other than a
natural person) that is not a small business or small
organization.\176\ As of December 2018, there were approximately 985
small entity broker-dealers that will be subject to the final
amendments.\177\
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\175\ 17 CFR 240.17a-5(d).
\176\ 17 CFR 240.0-10(c).
\177\ This estimate is based on the most recent information
available, as provided in Form X-17A-5 Financial and Operational
Combined Uniform Single Reports filed pursuant to Section 17 of the
Exchange Act and Rule 17a-5 thereunder.
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Our rules do not define ``small business'' or ``small
organization'' for purposes of accounting firms. The Small Business
Administration (SBA) defines ``small business,'' for purposes of
accounting firms, as those with under $20.5 million in annual
revenues.\178\ We have limited data indicating revenues for accounting
firms, and we cannot estimate the number of firms with less than $20.5
million in annual revenue. We also did not receive any data from
commenters that would enable us to make such an estimate.
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\178\ 13 CFR 121.201 and North American Industry Classification
System (NAICS) code 541211. The SBA calculates ``annual receipts''
as all revenue. See 13 CFR 121.104.
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D. Projected Reporting, Recordkeeping and Other Compliance Requirements
The final amendments will not impose any reporting, recordkeeping,
or disclosure requirements. The final amendments will impose new
compliance requirements with respect to the Loan Provision.
Although we are replacing the 10 percent bright-line test with a
``significant influence'' test that requires the application of more
judgment, we believe that the final amendments will not significantly
increase costs for smaller entities, including smaller accounting
firms. The concept of ``significant influence'' already exists in the
auditor independence rules and in U.S. GAAP,\179\ and accounting firms,
issuers and their audit committees are already required to apply the
concept in these contexts and may have developed practices, processes
or controls for complying with these provisions.\180\ We believe that
these entities likely will be able to leverage any existing practices,
processes, or controls to comply with the final amendments. We are also
providing additional guidance in this release to clarify the
application of the significant influence test in the fund context,
which may further facilitate compliance.
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\179\ See ASC 323 and supra footnote 44.
\180\ Although the concept of ``significant influence'' is not
as routinely applied today in the funds context for financial
reporting purposes, nevertheless, the concept of significant
influence is applicable to funds under existing auditor independence
rules.
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We also believe that the ``known through reasonable inquiry''
standard will not significantly increase costs for smaller entities,
including smaller accounting firms. The ``known through reasonable
inquiry'' standard is generally consistent with regulations
implementing the Investment Company Act, the Securities Act, and the
Exchange Act.\181\ Smaller entities, including smaller accounting
firms, should therefore already be familiar with the concept. To
further facilitate compliance, we are also providing additional
guidance in this release to clarify what the ``known through reasonable
inquiry'' standard requires.
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\181\ See supra footnote 111.
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In addition, we believe that the final amendments to exclude record
owners and certain fund affiliates for purposes of the Loan Provision
will reduce costs for smaller entities, including smaller accounting
firms.
Compliance with the final amendments will require the use of
professional skills, including accounting and legal skills. The final
amendments are discussed in detail in Section II above. We discuss the
economic impact, including the estimated costs, of the final amendments
in Section V above.
E. Agency Action To Minimize Effect on Small Entities
The RFA directs us to consider significant alternatives that would
accomplish our stated objectives, while minimizing any significant
adverse impacts on small entities. Accordingly, we considered the
following alternatives:
[[Page 32060]]
Establishing different compliance or reporting
requirements or timetables that take into account the resources
available to small entities;
clarifying, consolidating, or simplifying compliance and
reporting requirements under the amendments for small entities;
using performance rather than design standards; and
exempting small entities from coverage of all or part of
the amendments.
In connection with the amendments to Rule 2-01 of Regulation S-X,
we do not think it feasible or appropriate to establish different
compliance or reporting requirements or timetables for small entities.
The amendments are designed to address compliance challenges for both
large and small issuers and audit firms. With respect to clarification,
consolidation or simplification of compliance and reporting
requirements for small entities, the amendments do not contain any new
reporting requirements. While the amendments create a new compliance
requirement that focuses on ``significant influence'' over the audit
client to better identify those lending relationships that could impair
an auditor's objectivity and impartiality, that standard is more
qualitative in nature and its application will vary according to the
circumstances. This more flexible standard will be applicable to all
issuers, regardless of size.
With respect to using performance rather than design standards, we
note that our amendments establishing a ``significant influence'' test
and adding a ``known through reasonable inquiry'' standard are more
akin to performance standards. Rather than prescribe the specific steps
necessary to apply such standards, the amendments recognize that
``significant influence'' and ``known through reasonable inquiry'' can
be implemented in a variety of ways. We believe that the use of these
standards will accommodate entities of various sizes while potentially
avoiding overly burdensome methods that may be ill-suited or
unnecessary given the entity's particular facts and circumstances.
The amendments are intended to address significant compliance
challenges for audit firms and their clients, including those that are
small entities. In this respect, exempting small entities from the
amendments would increase, rather than decrease, their regulatory
burden relative to larger entities.
VII. Codification Update
The ``Codification of Financial Reporting Policies'' announced in
Financial Reporting Release No. 1 \182\ (April 15, 1982) is updated by
adding at the end of Section 602, under the Financial Reporting Release
Number (FR-85) assigned to this final release, the text in Sections I
and II of this release.
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\182\ 47 FR 21028 (May 17, 1982).
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The Codification is a separate publication of the Commission. It
will not be published in the Code of Federal Regulations.
VIII. Statutory Basis
The amendments described in this release are being adopted under
the authority set forth in Schedule A and Sections 7, 8, 10, and 19 of
the Securities Act, Sections 3, 10A, 12, 13, 14, 17, and 23 of the
Exchange Act, Sections 8, 30, 31, and 38 of the Investment Company Act,
and Sections 203 and 211 of the Investment Advisers Act.
List of Subjects in 17 CFR Parts 210
Accountants, Accounting, Banks, Banking, Employee benefit plans,
Holding companies, Insurance companies, Investment companies, Oil and
gas exploration, Reporting and recordkeeping requirements, Securities,
Utilities.
In accordance with the foregoing, the Commission amends title 17,
chapter II of the Code of Federal Regulations as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF
1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975
0
1. The authority citation for part 210 continues to read as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77aa(25), 77aa(26), 77nn(25), 77nn(26), 78c, 78j-1, 78l, 78m, 78n,
78o(d), 78q, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-20, 80a-29, 80a-30,
80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, and sec. 102(c),
Pub. L. 112-106, 126 Stat. 310 (2012), unless otherwise noted.
0
2. Amend Sec. 210.2-01 by revising paragraph (c)(1)(ii)(A) to read as
follows:
Sec. 210.2-01 Qualifications of accountants.
* * * * *
(c) * * *
(1) * * *
(ii) * * *
(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 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)).
* * * * *
By the Commission.
Dated: June 18, 2019.
Vanessa Countryman,
Acting Secretary.
[FR Doc. 2019-13429 Filed 7-3-19; 8:45 am]
BILLING CODE 8011-01-P