[Federal Register Volume 85, Number 10 (Wednesday, January 15, 2020)]
[Proposed Rules]
[Pages 2332-2354]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-28476]



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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 210

[Release No. 33-10738; 34-87864; FR-86; IA-5422; IC-33737; File No. S7-
26-19]
RIN 3235-AM63


Amendments to Rule 2-01, Qualifications of Accountants

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: We are proposing amendments to update certain auditor 
independence requirements as a result of recent feedback received from 
the public and our experience administering these requirements since 
their initial adoption nearly two decades ago. The proposed amendments 
would more effectively focus the independence analysis on those 
relationships or services that are more likely to pose threats to an 
auditor's objectivity and impartiality.

DATES: Comments should be received on or before March 16, 2020.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an email to [email protected]. Please include 
File Number S7-26-19 on the subject line.

Paper Comments

     Send paper comments to Vanessa A. Countryman, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090.

All submissions should refer to File Number S7-26-19. This file number 
should be included on the subject line if email is used. To help us 
process and review your comments more efficiently, please use only one 
method of submission. The Commission will post all comments on the 
Commission's website (http://www.sec.gov/rules/proposed.shtml). 
Comments also are available for website viewing and printing in the 
Commission's Public Reference Room, 100 F Street NE, Washington, DC 
20549, on official business days between the hours of 10:00 a.m. and 
3:00 p.m. All comments received will be posted without change. Persons 
submitting comments are cautioned that we do not redact or edit 
personal identifying information from comment submissions. You should 
submit only information that you wish to make publicly available.
    We or the SEC staff (the ``staff'') may add studies, memoranda or 
other substantive items to the comment file during this rulemaking. A 
notification of the inclusion in the comment file of any such materials 
will be made available on our website. To ensure direct electronic 
receipt of such notifications, sign up through the ``Stay Connected'' 
option at www.sec.gov to receive notification by email.

FOR FURTHER INFORMATION CONTACT: Duc Dang, Senior Special Counsel, or 
Giles T. Cohen, Acting Chief Counsel, Office of the Chief Accountant, 
at (202) 551-5300; Alexis Cunningham, Assistant Chief Accountant, or 
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 proposing amendments to 17 CFR 210. 
2-01 (``Rule 2-01'') of 17 CFR 210.01 et seq. (``Regulation S-X).\1\
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    \1\ Hereinafter, all references to Rule 2-01 and any paragraphs 
included within the rule are referring to Rule 2-01 of Regulation S-
X.
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Table of Contents

I. Introduction
II. Proposed Amendments
    A. Proposed Amendments to Definitions
    1. Proposed Amendments to Affiliate of the Audit Client and the 
Investment Company Complex
    2. Proposed Amendment to Audit and Professional Engagement 
Period
    B. Proposed Amendments to Loans or Debtor-Creditor Relationships
    1. Proposed Amendment to Except Student Loans
    2. Proposed Amendment to Clarify the Reference to ``a Mortgage 
Loan''
    3. Proposed Amendment to Revise the Credit Card Rule to Refer to 
``Consumer Loans''
    C. Proposed Amendment to the Business Relationships Rule
    1. Proposed Amendment to the Reference to ``Substantial 
Stockholder''
    2. Additional Guidance on the Reference to ``Audit Client'' when 
Referring to Persons Associated with the Audit Client in a Decision-
Making Capacity, including the Beneficial Owner with Significant 
Influence
    D. Proposed Amendments for Inadvertent Violations for Mergers 
and Acquisitions
    E. Proposed Amendments for Miscellaneous Updates
    1. Proposed Amendments to Update the Reference to Concurring 
Partner Within Rule 2-01
    2. Proposed Amendment to Preliminary Note to Rule 2-01
    3. Proposed Amendment to Delete Outdated Transition and 
Grandfathering Provision
III. Economic Analysis
    A. Introduction
    B. Baseline and Affected Parties
    C. Potential Costs and Benefits
    1. Overall Potential Benefits and Costs
    2. Benefits and Costs of Specific Proposed Amendments
    D. Effects on Efficiency, Competition and Capital Formation
    E. Alternatives
    F. Request for Comment
IV. Paperwork Reduction Act
V. Initial Regulatory Flexibility Act Analysis
    A. Reasons for and Objectives of the Proposed Action
    B. Legal Basis
    C. Small Entities Subject to the Proposed Rules
    D. Projected Reporting, Recordkeeping and Other Compliance 
Requirements
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. Solicitation of Comment
VI. Small Business Regulatory Enforcement Fairness Act
VII. Statutory Basis

I. Introduction

    The Commission has long recognized that an audit by an objective, 
impartial, and skilled professional contributes to both investor 
protection and investor confidence.\2\ If investors do not perceive 
that the auditor is independent from the audit client, they will derive 
less confidence from the auditor's report and the audited financial 
statements. As such, the Commission's auditor independence rule, as set 
forth in Rule 2-01, requires auditors \3\ to be independent of their 
audit clients both ``in fact and in appearance.'' \4\
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    \2\ See Revision of the Commission's Auditor Independence 
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec. 
5, 2000)] (``2000 Adopting Release'').
    \3\ We use the terms ``accountants'' and ``auditors'' 
interchangeably in this release.
    \4\ See Preliminary Note 1 to Rule 2-01 and Rule 2-01(b). 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.'').
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    In 2000, the Commission adopted a comprehensive framework of rules 
governing auditor independence, laying out governing principles and 
describing certain specific financial, employment, business, and non-
audit service relationships that would cause an auditor not to be 
independent of its audit client. The 2000 amendments set forth the 
standard for analysis to determine whether an auditor is

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independent. Under this analysis, pursuant to Rule 2-01(b), the 
``Commission will not recognize an accountant as independent, with 
respect to an audit client, if the accountant is not, or 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.'' Rule 2-01(b) further states that the 
``Commission will consider all relevant circumstances, including all 
relationships between the accountant and the audit client,'' in 
determining whether an auditor is independent. Rule 2-01(c) then sets 
forth a nonexclusive list of particular circumstances that the 
Commission considers to be inconsistent with the independence standard 
in Rule 2-01(b), including certain financial, employment, business, and 
non-audit service relationships between an accountant and its audit 
client.\5\
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    \5\ See Rule 2-01(c); see also 2000 Adopting Release, 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, and relationships where 
auditors provide certain non-audit services between auditors and 
audit clients . . .'').
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    Except for revisions made in connection with amendments required by 
the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley Act'') \6\ and the 
recent amendments related to certain debtor-creditor relationships,\7\ 
many of the provisions from the 2000 Adopting Release have remained 
unchanged since adoption. We seek to maintain the relevance of our 
auditor independence requirements, and evaluate their effectiveness in 
light of current market conditions and industry practices. As such, in 
connection with the recent proposal to address certain debtor-creditor 
relationships, we also solicited comment on other potential updates to 
the auditor independence rules.\8\ After considering the feedback 
received from the public and our experience administering these rules 
since their initial adoption nearly two decades ago, we are proposing 
additional amendments to our auditor independence rules to more 
effectively focus the independence analysis on those relationships or 
services that we believe are most likely to threaten an auditor's 
objectivity and impartiality.
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    \6\ Strengthening the Commission's Requirements Regarding 
Auditor Independence, Release No. 33-8183 (Jan. 28, 2003) [68 FR 
6005 (Feb. 5, 2003)].
    \7\ Auditor Independence With Respect to Certain Loans or 
Debtor-Creditor Relationships, Release 33-10648 (June 18, 2019) [84 
FR 32040 (July 5, 2019)] (``Loan Provision Adopting Release''). In 
this release, references to the ``Loan Provision'' are referring to 
Rule 2-01(c)(1)(ii)(A).
    \8\ See Auditor Independence with Respect to Certain Loans or 
Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018) 
[83 FR 20753 (May 8, 2018)] (``Loan Provision Proposing Release''). 
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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    We welcome feedback and encourage interested parties to submit 
comments on any or all aspects of the proposed rule amendments. When 
commenting, it would be most helpful if you include the reasoning 
behind your position or recommendation.

II. Proposed Amendments

A. Proposed Amendments to Definitions

1. Proposed Amendments to Affiliate of the Audit Client and the 
Investment Company Complex
    ``Rule 2-01 is designed to ensure that auditors are qualified and 
independent of their audit clients both in fact and in appearance.'' 
\9\ The term ``audit client'' \10\ is defined as ``the entity whose 
financial statements or other information is being audited, reviewed or 
attested'' \11\ and any ``affiliates of the audit client.'' \12\ The 
definition of ``affiliate of the audit client'' includes, in part, 
``[a]n 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'' 
and ``[e]ach entity in the investment company complex when the audit 
client is an entity that is part of an investment company complex.'' 
\13\ Rule 2-01(f)(14) defines an investment company complex (``ICC'') 
to include, in part, ``[a]ny entity controlled by or controlling an 
investment adviser or sponsor . . . or any entity under common control 
with an investment adviser or sponsor . . . if the entity: (1) Is an 
investment adviser or sponsor; or (2) Is engaged in the business of 
providing administrative, custodian, underwriting, or transfer agent 
services to any investment company, investment adviser, or sponsor.''
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    \9\ Preliminary note 1 to Rule 2-01.
    \10\ Rule 2-01(f)(6).
    \11\ For the purposes of our discussion in this release, we 
refer to this part of the definition as the ``entity under audit.''
    \12\ See Rule 2-01(f)(6). For the purpose of Rule 2-01(c)(1)(i), 
entities covered by Rule 2-01(f)(4)(ii) or (iii) are not considered 
affiliates of the audit client.
    \13\ Rule 2-01(f)(4)(i) and (iv).
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    As noted above, the first paragraph of the definition of affiliate 
of the audit client includes ``an entity that has control over the 
audit client . . . or which is under common control with the audit 
client, including the audit client's parents and subsidiaries'' \14\ 
(emphasis added). As such, entities under common control with the audit 
client (``sister entities'') are considered affiliates and fall within 
the definition of the ``audit client'' set forth in Rule 2-01(f)(6). 
Additionally, pursuant to Rule 2-01(f)(4)(iv), each entity in an ICC is 
considered an affiliate when the audit client is part of the ICC. 
Consequently, in complex organizational structures, such as large ICCs, 
the requirement to identify and monitor for potential independence-
impairing relationships and services currently applies to affiliated 
entities, including sister entities, regardless of whether the sister 
entities are material to the controlling entity.
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    \14\ Rule 2-01(f)(4)(i).
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    In our experience administering the independence rules, we have 
observed some challenges in the practical application of the ``common 
control'' component of the definition of affiliate of the audit client. 
We also have observed a number of situations where a prohibited service 
or relationship with a sister entity did not result in a corresponding 
threat to an auditor's objectivity and impartiality. Additionally, 
several commenters have suggested that we revisit the scope of the 
current application of the independence rules to entities under 
``common control.'' \15\ In the private equity and investment company 
context, where there potentially is a significant volume of 
acquisitions and dispositions of unrelated portfolio companies,\16\ the 
definition of affiliate of the audit client may result in an expansive 
and constantly changing list of entities that are considered to be 
affiliates of the audit client. Such changes in portfolio companies can 
create compliance challenges for audit firms performing independence 
analyses by requiring them to monitor their various relationships and 
services with affiliates of the audit client, even if many of those 
relationships and services likely would not threaten the auditor's 
objectivity and impartiality.
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    \15\ See e.g., letters from PricewaterhouseCoopers LLP (June 29, 
2018) (``PwC''), Center for Audit Quality (July 3, 2018) (``CAQ''), 
BDO USA, LLP (July 9, 2018) (``BDO''), Ernst & Young LLP (July 9, 
2018) (``EY''), American Institute of Certified Public Accountants 
(July 9, 2018) (``AICPA''), and American Investment Council (July 9, 
2018) (``AIC'').
    \16\ In this release, we are using the term ``portfolio 
company'' to refer to an operating company that has among its 
investors, investment companies or unregistered funds in private 
equity structures.
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    Furthermore, individual portfolio companies are often audited by 
different auditors, even when they are within the

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same ICC or private equity structure. Where the portfolio companies are 
otherwise unrelated, multiple audit firms may need to be independent of 
each of the entities currently deemed affiliates of the audit client. 
As a result, the shared responsibility of the audit client and 
respective audit firm to monitor the relationships and services against 
this often expansive and constantly changing list of affiliates as part 
of their independence analysis throughout the audit and professional 
engagement period could result in substantial compliance costs. Such 
compliance costs from independence monitoring arise even where the 
relationships being monitored are not likely to threaten the auditor's 
objectivity and impartiality, as discussed further below.
    In addition to impacting monitoring and compliance efforts, the 
current application of the common control prong in Rule 2-01(f)(4)(i) 
to an auditor's relationships and services with sister entities also 
may have competitive effects on the market for audit and non-audit 
services. Where a potential audit client is in the market for an 
auditor, the number of qualified audit firms may be reduced because 
certain audit firms may have relationships with or provide services to 
sister entities that are impermissible under the current auditor 
independence rules regardless of the impact to the objectivity or 
impartiality of the audit firm. This potential reduction in the number 
of qualified audit firms may constrain the audit client's choice as to 
its preferred auditor and thereby also may have an impact on audit 
quality. For example, those responsible for selecting an auditor may 
believe a certain audit firm is the best fit from an audit quality 
perspective to audit one of the portfolio companies, but the audit firm 
would not be considered independent if it is providing a prohibited 
service to a sister entity, even where such sister entity is not 
material to the controlling entity.
    To address these challenges and more effectively focus the 
definition of affiliate of the audit client on those relationships and 
services that are most likely to threaten auditor objectivity and 
impartiality, we propose amending both paragraphs (f)(4) (i.e., the 
affiliate of the audit client definition) and (f)(14) (i.e., the ICC 
definition) of Rule 2-01 to include materiality qualifiers in the 
respective common control provisions and to distinguish how the 
definition applies when an accountant is auditing a portfolio company, 
an investment company, or an investment adviser or sponsor.
    Although the proposed amendments in this section will impact an 
auditor's analysis under Rule 2-01(c) by changing the population of 
entities that are included in the definition of audit client, the 
proposed amendments do not alter the application of the general 
standard in Rule 2-01(b). Because the Commission is not able to 
ascertain all the permutations of relationships or services that would 
impair an auditor's objectivity and impartiality, the Commission 
focused ``the legal standard [in Rule 2-01(b)] by including the 
explicit reference to `all relevant facts and circumstances.' '' \17\ 
As noted in the 2000 Adopting Release, ``[c]ircumstances that are not 
specifically set forth in our rule are measured by the general standard 
set forth in Rule 2-01(b).'' As such, notwithstanding the potential 
exclusion from the term audit client of entities that are currently 
considered affiliates of the audit client but would no longer be deemed 
affiliates under the proposed amendments, relationships and services 
between an auditor and such entities are still subject to the general 
standard. For example, the audit firm, or those charged with governance 
of the entity under audit, may identify independence concerns in fact 
or in appearance, individually or in the aggregate, upon considering 
the nature, extent, relative importance and other aspects of the 
services or relationships between the auditor, the controlling entity, 
and such sister entities that are not material to the controlling 
entity.
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    \17\ 2000 Adopting Release at 65 FR 76031.
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a. Proposed Amendments for Common Control and the Affiliate of the 
Audit Client
    We are proposing to amend Rule 2-01(f)(4)(i) to include a 
materiality requirement with respect to operating companies under 
common control.\18\ With respect to the application of the affiliate of 
the audit client definition to operating companies, including portfolio 
companies, we propose amending Rule 2-01(f)(4)(i) to focus the 
independence analysis on sister entities that are material to the 
controlling entity. Specifically, proposed Rule 2-01(f)(4)(i)(B) would 
qualify the definition with ``unless the entity is not material to the 
controlling entity.''
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    \18\ Proposed Rule 2-01(f)(4)(i)(B). In the 2000 Adopting 
Release, the Commission stated that ``entities, if not part of an 
[ICC], will be considered affiliates of the audit client if they 
satisfy the criteria of one of the three paragraphs of Rule 2-
01(f)(4).'' 2000 Adopting Release at 65 FR 76059. The proposed 
amendments do not alter the scope of application for the affiliate 
of the audit client definition. For the purpose of this release, we 
use the term ``operating company'' to refer to entities that are not 
investment companies, investment advisers, or sponsors.
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    To demonstrate the application of proposed Rule 2-01(f)(4)(i)(B) to 
operating companies, consider the following organizational structure: A 
parent company (Parent Company A) has control over three operating 
companies, including Operating Company B. If an accountant is serving 
as Operating Company B's auditor, it would need to consider whether 
either of the other two sister entities are material to Parent Company 
A to determine whether one or both of the sister entities are 
affiliates of the audit client.
    As noted below, we believe it is appropriate to identify the 
affiliates of the audit client for a portfolio company under audit 
under proposed Rule 2-01(f)(4)(i) rather than under proposed Rule 2-
01(f)(14). Portfolio companies are a type of operating company and, 
also as discussed below, often the portfolio companies are unrelated 
even though they are controlled by the same entity in the private 
equity structure or ICC.
    To demonstrate the application of the proposed Rule 2-01(f)(4)(i) 
to portfolio companies, consider the situation where the accountant is 
serving as the auditor for Portfolio Company C, which is controlled by 
Unregistered Fund D. Even though Portfolio Company C is controlled by 
an entity within proposed Rule 2-01(f)(14) (discussed further below), 
Portfolio Company C's auditor would still look to proposed Rule 2-
01(f)(4)(i)(A) through (D) and not proposed paragraph (f)(14) to 
determine which entities are affiliates of Portfolio Company C. That is 
because the portfolio company is the entity under audit and, as such, 
it does not fall within the definition of ICC set forth in proposed 
Rule 2-01(f)(14).
    Based on the SEC staff's consultation experience, audit firms 
providing services to or having relationships with sister entities not 
material to the controlling entity do not typically present issues with 
respect to the audit firm's objectivity or impartiality. As such, we 
believe it is appropriate to exclude sister entities that are not 
material to the controlling entity from being considered affiliates of 
the audit client because an auditor's relationships and services with 
such entities do not typically pose a threat to the auditor's 
objectivity and impartiality.
    We recognize that adding an evaluation of materiality as proposed 
may result in additional work to be done by audit firms with ongoing 
monitoring responsibilities for the purposes of compliance with the

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independence rules. However, the affiliate of the audit client 
definition already has a materiality evaluation, which is familiar to 
auditors and their audit clients. In particular, materiality is applied 
currently in the existing affiliate of the audit client definition in 
Rule 2-01(f)(4)(ii) and (iii).\19\ Also, a materiality evaluation as it 
relates to sister entities is consistent, in part, with the definition 
of ``affiliate'' used by the American Institute of Certified Public 
Accountants (``AICPA'') in its ethics and independence rules, which are 
the independence rules typically applied when domestic companies are 
not subject to SEC and Public Company Accounting Oversight Board 
(``PCAOB'') independence requirements.\20\ Auditors therefore have 
experience in applying a materiality standard when identifying 
affiliates, whether applying the independence rules of the SEC or 
AICPA.
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    \19\ Rule 2-01(f)(4)(ii) includes as an affiliate of the audit 
client ``an entity over which the audit client has significant 
influence, unless the entity is not material to the audit client.'' 
Rule 2-01(f)(4)(iii) includes as an affiliate of the audit client 
``an entity that has significant influence over the audit client, 
unless the audit client is not material to the entity.''
    \20\ See AICPA Professional Code of Conduct available at https://pub.aicpa.org/codeofconduct/ethicsresources/et-cod.pdf. We 
acknowledge that the proposed amendment may not result in the same 
number of sister entities being deemed material to the controlling 
entity under our rules and the AICPA rules. For example, in defining 
control the AICPA uses the accounting standards adopted by the 
Financial Accounting Standards Board, whereas our rules define 
control in Rule 1-02(g) of Regulation S-X. Also, the AICPA affiliate 
definition pertaining to common control deems a sister entity as an 
affiliate if both the entity under audit and the sister entity are 
material to the entity that controls both. The proposed amendment 
only focuses on the materiality of the sister entity to the 
controlling entity because we believe requiring materiality between 
the entity under audit and the controlling entity may exclude, from 
the proposed definition, sister entities whose relationships with or 
services from an auditor would impair the auditor's objectivity and 
impartiality.
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    We note that a determination under the proposed amendments that 
sister entities are not material to the controlling entity, by itself, 
does not conclude the independence analysis under Rule 2-01. This is 
because, as explained above, auditors and audit clients must consider 
``all relevant facts and circumstances'' when assessing independence 
pursuant to the general standard in Rule 2-01(b).
    We believe focusing on sister entities that are material to the 
controlling entity would relieve some of the compliance burden 
associated with making independence determinations, as there should be 
fewer entities considered affiliates. For the relationships and 
services that might nevertheless impact the auditor's independence 
under the general standard in Rule 2-01(b), we would expect those 
relationships and services individually or in the aggregate would be 
easily known by the auditor and the audit client because such services 
and relationships are most likely to threaten an auditor's objectivity 
and impartiality due to the nature, extent, relative importance or 
other aspects of the service or relationship. We also believe the 
proposed amendments could increase choice and competition for audit and 
non-audit services.
Request for Comment
    1. Should we add the materiality requirement, as proposed, so that 
only sister entities that are material to the controlling entity are 
deemed to be an affiliate of the audit client? Alternatively, should we 
retain the current common control provision in the affiliate of the 
audit client definition?
    2. Does the proposed amendment sufficiently focus the common 
control prong of the definition of affiliate of the audit client on 
those relationships and services that are most likely to threaten 
auditor objectivity and impartiality? Should we focus on the 
materiality of sister entities to the controlling entity, as proposed? 
If not, are there other amendments that would better focus on 
relationships and services that are more likely to threaten auditor 
objectivity and impartiality? For example, should we focus on whether 
sister entities are material to the entity under audit, in addition to 
whether they are material to the controlling entity? Should we consider 
aggregating sister entities in the materiality assessment rather than 
the assessment being done on an individual basis? Or is aggregation of 
multiple sister entities sufficiently covered by the general standard 
under Rule 2-01(b)?
    3. Would auditors and audit clients face challenges in applying the 
materiality concept in this context? Would auditors face particular 
challenges assessing materiality in connection with private portfolio 
companies? If so, what are those challenges and how could they be 
addressed?
    4. Would focusing only on sister entities that are material to the 
controlling entity increase the risk that auditors will be performing 
audits when they are not objective and impartial? If so, is the 
overarching consideration of all relevant facts and circumstances, as 
required by Rule 2-01(b), sufficient to mitigate this risk? Would 
focusing on sister entities that are material to the controlling entity 
increase the risk of appearance issues?
    5. Are there other types of affiliates that should be excluded from 
the definition because the services and relationships with such 
entities rarely threaten an auditor's objectivity and impartiality?
b. Proposed Amendments to the Investment Company Complex
    We are also proposing to clarify that with respect to an entity 
under audit that is an investment company or an investment adviser or 
sponsor, the auditor and the audit client should look solely to 
proposed Rule 2-01(f)(14) (i.e., the ICC definition) to identify 
affiliates of the audit client.\21\ The proposed amendments would 
explicitly direct auditors of an investment company or an investment 
adviser or sponsor to include all entities within the proposed ICC 
definition as affiliates of the audit client instead of conducting an 
analysis based on the prongs in proposed Rule 2-01(f)(4)(i). As such, 
we are proposing amendments to the ICC definition in Rule 2-01(f)(14) 
to focus the definition from the perspective of the entity under audit 
and align certain portions of the ICC definition with the amendments 
discussed in the preceding section.
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    \21\ Proposed Rule 2-01(f)(4)(ii).
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    Consistent with the discussion in the preceding section, while the 
proposed amendments to the ICC definition may alter the composition of 
entities that are deemed affiliates of the audit client principally due 
to materiality being added for sister entities, the overarching general 
standard in Rule 2-01(b) continues to apply.
i. Entity Under Audit and Unregistered Funds
    We propose to clarify that auditors of investment companies, 
including unregistered funds,\22\ or investment advisers or sponsors 
must assess whether other entities are affiliates of

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the audit client by focusing solely on proposed Rule 2-01(f)(14).
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    \22\ We use the term ``unregistered fund'' in this release to 
refer to entities that are not considered investment companies 
pursuant to the exclusions in Section 3(c) of Investment Company Act 
of 1940. Registered investment advisers acting as qualified 
custodians that have custody of client funds or securities 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 that is registered with, and subject 
to regular inspection by, the PCAOB or, for pooled investment 
vehicles, may be deemed to comply with the requirement by 
distributing financial statements audited by an independent public 
accountant that is registered with, and subject to regular 
inspection by, the PCAOB to the pooled investment vehicle's 
investors.
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    Unlike the current ICC definition, the proposed amendments would 
reference the entity under audit in proposed paragraph (f)(14)(i)(A) as 
the starting point for the analysis of which entities are to be 
considered part of an ICC. As a result, when the entity under audit is 
an investment company, an investment adviser or a sponsor, the auditor 
would focus solely on proposed Rule 2-01(f)(14) to determine what other 
entities are part of the ICC and, therefore, affiliates of the audit 
client. We also are proposing to include within the meaning of the term 
investment company, for the purposes of the ICC definition, entities 
``that would be an investment company but for the exclusions provided 
by section 3(c) of the Investment Company Act.'' \23\ As such, proposed 
paragraph (f)(14)(iv) would cover registered investment companies, 
business development companies, and entities that would be investment 
companies but for the exclusions provided by section 3(c) of the 
Investment Company Act, such as private funds that rely on section 
3(c)(1) or 3(c)(7). If an auditor is auditing only these entities, it 
would look solely to proposed Rule 2-01(f)(14) to determine which 
entities are affiliates of the audit client. This would more 
effectively focus the independence analysis for unregistered funds 
under audit and align with the analysis to be undertaken for registered 
investment companies.
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    \23\ See proposed Rule 2-01(f)(14)(iv). This is in contrast to 
current Rule 2-01(f)(14)(i)(C) which includes an unregistered fund 
only if it has an investment adviser or sponsor already included 
within the definition of investment company complex. Revision of the 
Commission's Auditor Independence Requirements, Release No. 33-7870 
(June 30, 2000) [65 FR 43147, 43181 (July 12, 2000)].
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    If an auditor audits both a portfolio company and an investment 
company or an investment adviser or sponsor, then the auditor would 
have to apply both proposed Rules 2-01(f)(4)(i) and (f)(14) to identify 
the entities that are affiliates of the audit client and where it would 
need to monitor for prohibited relationships and services. To 
demonstrate this using the example from the preceding section, where 
the accountant is serving as the auditor of both Unregistered Fund D 
and Portfolio Company C, which is controlled by Unregistered Fund D, 
the auditor would apply both proposed Rules 2-01(f)(4)(i) and (f)(14) 
in connection with its independence analysis. Specifically, the auditor 
of Portfolio Company C would conduct its analysis under proposed Rule 
2-01(f)(4)(i), while the same auditor, with respect to its audit of 
Unregistered Fund D, would conduct its analysis under proposed Rule 2-
01(f)(14) to determine the affiliate status of entities within the same 
ICC as Unregistered Fund D. However, if an auditor audits only an 
investment company or investment adviser or sponsor, as defined by 
proposed Rule 2-01(f)(14), then it would look solely to proposed Rule 
2-01(f)(14) to determine the affiliates it would have to monitor for 
prohibited relationships and services.
Request for Comment
    6. Should the proposed ICC definition specifically reference the 
entity under audit and explicitly define investment companies, for the 
purpose of proposed paragraph (f)(14), to include unregistered funds, 
as proposed?
    7. Is it appropriate to direct auditors of an investment adviser, 
sponsor, or investment company to the investment company complex 
definition, as we propose to amend it, to determine the entities that 
will be considered affiliates of the audit client? Why or why not? 
Would that lead to more consistent independence analyses by auditors of 
these entities?
ii. Common Control With Any Investment Company, Investment Adviser or 
Sponsor
    Under the current ICC definition, any entity under common control 
with an investment adviser or sponsor of an investment company \24\ 
audit client that is also an investment adviser or sponsor (``sister 
investment adviser or sponsor'') is considered part of the ICC, and 
thereby an affiliate of the audit client.\25\ Additionally, the current 
ICC definition includes not just the investment companies that share an 
investment adviser or sponsor with an investment company audit client, 
it also includes any investment company advised by a sister investment 
adviser or has a sister sponsor.\26\
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    \24\ As noted in the preceding section, since proposed Rule 2-
01(f)(14)(iv) defines investment company to include entities that 
would be considered investment companies but for the exclusions 
provided by Section 3(c) of the Investment Company Act of 1940, when 
we use the term investment company in this release to discuss the 
proposed amendments, the term also includes such entities.
    \25\ Rule 2-01(f)(14)(i)(B)(1).
    \26\ Rule 2-01(f)(14)(i)(C).
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    To demonstrate the application of the current definition of ICC, 
consider the following example: An investment company, Investment 
Company A, is the entity under audit. Investment Company A is advised 
by Investment Adviser B. Investment Adviser B is under common control 
with Investment Adviser C and Investment Adviser D. Under current Rule 
2-01(f)(14)(i)(B)(1), Investment Adviser C and Investment Adviser D are 
considered sister investment advisers and, therefore, are affiliates of 
the audit client Investment Company A. Moreover, every investment 
company advised by Investment Adviser C and Investment Adviser D falls 
within the definition of ICC and, therefore, is also an affiliate of 
the audit client Investment Company A because of the application of 
current Rule 2-01(f)(14)(i)(C). In this instance, the auditor could not 
have any prohibited services or relationships with any of the sister 
investment advisers or any of the investment companies they advise.
    We are proposing to align the common control prong of the proposed 
ICC definition (proposed Rule 2-01(f)(14)(i)(D)) with the proposed 
common control prong for operating companies (proposed Rule 2-
01(f)(4)(i)(B)), for the same reasons we discuss in Section II.A.1.a. 
As a result, proposed paragraph (f)(14)(i)(D)(1) of the ICC definition 
includes only sister investment companies, advisers, and sponsors that 
are material to the controlling entity. If the sister investment 
company, adviser, or sponsor is not material to the controlling entity, 
the general standard under Rule 2-01(b) would still apply, as discussed 
above.
    Under the current ICC definition, an investment company seeking an 
auditor to audit its financial statements is precluded from considering 
any accountant with services or relationships prohibited by Rule 2-
01(c) with sister investment advisers, sponsors, or any of the 
investment companies they advise or sponsor. As such, an investment 
company's choices among qualified auditors may be limited. The 
inclusion of a materiality qualifier in proposed paragraph 
(f)(14)(i)(D)(1) may broaden the pool of prospective accountants the 
potential investment company audit client can evaluate and consider to 
engage as its auditor while being unlikely to increase the potential 
threat to an auditor's objectivity and impartiality. Proposed paragraph 
(f)(14)(i)(D) is not meant to change the population of controlling 
entities an auditor should consider when assessing common control under 
the current Rule 2-01(f)(14)(i)(B), but rather to be consistent with 
the common control provision in proposed Rule 2-01(f)(4)(i)(B), with 
the primary change being the inclusion of a materiality qualifier. 
Because of the changes to the ICC definition discussed in the preceding 
section, which direct auditors

[[Page 2337]]

and the audit client to look solely to proposed Rule 2-01(f)(14) to 
identify affiliates of the audit client with respect to an entity under 
audit that is an investment company or an investment adviser or 
sponsor, the proposed amendment discussed in this section simply aligns 
with the change in proposed Rule 2-01(f)(4)(i)(B).
    Additionally, current Rule 2-01(f)(14)(i)(B) does not include 
investment companies whereas proposed paragraph (f)(14)(i)(D)(1) does 
include investment companies in the assessment of sister entities. We 
are introducing the reference to investment companies in the proposed 
ICC common control provision because, under current Rule 2-
01(f)(14)(i)(C), any investment company advised or sponsored by a 
sister investment adviser is already included as an affiliate, 
regardless of materiality. With the addition of the materiality 
requirement in proposed paragraph (f)(14)(i)(D)(1), we did not want to 
exclude investment companies that are material to the controlling 
entity from the ICC when such investment companies' investment advisers 
or sponsors are not material to the controlling entity. This is 
intended to ensure that a controlling entity's investment directly in 
an investment company is considered in the affiliate analysis in the 
event that the adviser to that investment company is deemed not 
material to the controlling entity. We do not believe that this would 
expand the scope of entities determined to be affiliates based on the 
current application of Rule 2-01(f)(14)(i)(B) and (C).
    Furthermore, we proposed to add a reference to proposed paragraph 
(f)(14)(i)(C) within proposed paragraph (f)(14)(i)(D) to align with the 
concept of parent and subsidiaries found in proposed paragraph 
(f)(4)(i)(B). This is intended to ensure that entities downstream and 
upstream to the entity under audit are considered in the analysis for 
common control.
Request for Comment
    8. Should we include a materiality qualifier in Rule 2-
01(f)(14)(i)(D), as proposed, so that only sister investment companies 
or investment advisers or sponsors that are material to the controlling 
entity are included in the proposed definition of ICC and, as a result, 
are deemed to be an affiliate of the audit client? Should we focus on 
whether sister investment companies, advisers, or sponsors are material 
to the investment company, adviser, or sponsor under audit, in addition 
to whether they are material to the controlling entity? Should we 
consider aggregating sister entities in the materiality assessment 
rather than the assessment being done on an individual basis? Or is 
aggregation of multiple sister entities sufficiently covered by the 
general standard under Rule 2-01(b)?
    9. Does the proposed amendment sufficiently focus the common 
control prong of the ICC definition on those relationships and services 
that are most likely to threaten auditor objectivity and impartiality? 
Should the analysis focus on the materiality of sister entities to the 
controlling entity, as proposed?
    10. Would auditors and audit clients face challenges in applying 
the materiality concept in this context? Would auditors face particular 
challenges assessing materiality in connection with unregistered funds? 
If so, what are the challenges and how could they be addressed?
    11. Would focusing only on sister entities that are material to the 
controlling entity increase the risk that auditors will be performing 
audits when they are not objective and impartial? If so, is the 
overarching consideration of all relevant facts and circumstances, as 
required by Rule 2-01(b), sufficient to mitigate this risk? Would 
focusing on sister entities that are material to the controlling entity 
increase the risk of appearance issues?
    12. Is it appropriate for auditors to assess whether or not sister 
investment companies are material to the controlling entity even when a 
sister fund's investment adviser may not be material to the controlling 
entity? Should we include a reference to paragraph (f)(14)(i)(C) within 
paragraph (f)(14)(i)(D), as proposed?
iii. Investment Companies That Share an Investment Adviser or Sponsor 
Included Within the ICC Definition
    Under current paragraph (f)(14)(i)(C) of the ICC definition, an 
auditor of an investment company has to monitor for prohibited services 
and relationships with sister investment companies that have the same 
investment adviser or sponsor or have an investment adviser or sponsor 
that is under common control, regardless of whether the sister 
investment companies are material to such investment adviser or 
sponsor. The proposed amendments would not change the analysis of 
sister investment companies that have an investment adviser or sponsor 
included within the ICC definition. This is because proposed paragraph 
(f)(14)(i)(F) would include within the ICC definition any investment 
company that has any investment adviser or sponsor that is an affiliate 
of the audit client pursuant to proposed paragraphs (f)(14)(i)(A) 
through (D).
    For example, proposed paragraph (f)(14)(i)(B) includes the 
investment adviser or sponsor of an investment company under audit. As 
the language in neither proposed paragraph (f)(14)(i)(B) nor proposed 
paragraph (F) includes a materiality requirement, under proposed 
paragraph (f)(14)(i)(F), an auditor would need to consider as part of 
its independence analysis, sister investment companies that have the 
same investment adviser or sponsor as the investment company under 
audit, regardless of whether such sister investment companies are 
material to the shared investment adviser or sponsor. Consistent with 
current paragraph (f)(14)(i)(C), we continue to believe that the nature 
of the relationship between an investment adviser or sponsor and the 
investment companies it advises is such that once an investment adviser 
or sponsor is included within the proposed ICC definition, the 
investment companies it advises should be included as well.
Request for Comment
    13. Should paragraph (f)(14)(i)(F) be adopted as proposed? Should 
we instead include a materiality qualifier for sister investment 
companies in proposed paragraph (f)(14)(i)(F)?
iv. Significant Influence Within the ICC Definition
    As discussed above, the proposed ICC definition would clarify that 
when the entity under audit is an investment company or an investment 
adviser or sponsor, the auditor should look to the proposed ICC 
definition in proposed Rule 2-01(f)(14) to determine which entities are 
considered affiliates of the audit client. As such, we propose 
including in the proposed ICC definition a significant influence prong 
to align, in part, with the current significant influence analysis 
applicable to operating companies in the definition of affiliate of the 
audit client in Rule 2-01(f)(4)(ii) and (iii).\27\ Given that 
``significant influence'' is used in other parts of the Commission's 
independence rules, including within the affiliate definition, the 
concept of ``significant influence'' is one with which audit firms and 
their clients are already required to be familiar.\28\
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    \27\ The proposed amendments to the affiliate of the audit 
client definition include conforming amendments to list these two 
prongs as proposed Rule 2-01(f)(4)(i)(C) and (D).
    \28\ The Loan Provision Adopting Release clarified what 
constitutes significant influence in an investment company context 
and that analysis would apply here as well. See Section II.C.3 of 
the Loan Provision Adopting Release.

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[[Page 2338]]

    Again, because of the changes to the ICC definition discussed 
above, which direct auditors and the audit client to look solely to 
proposed Rule 2-01(f)(14) to identify affiliates of the audit client 
with respect to an entity under audit that is an investment company or 
an investment adviser or sponsor, the proposed amendment discussed in 
this section simply aligns with the significant influence prongs in the 
current definition of affiliate of the audit client.
    Additionally, we are also proposing a conforming amendment to the 
definition of the term audit client in Rule 2-01(f)(6) to include a 
reference to proposed Rule 2-01(f)(14)(i)(E) to be consistent with the 
existing references in such definition to the significant influence 
prongs of the affiliate of the audit client definition. Currently Rule 
2-01(f)(6), for the purposes of considering investment relationship 
prohibitions under current Rule 2-01(c)(1)(i), excludes from the audit 
client definition entities that are deemed affiliates solely because of 
the significant influence prongs in current paragraphs (f)(4)(ii) and 
(iii). This conforming amendment would add a reference to proposed Rule 
2-01(f)(14)(i)(E) to those exclusions.
Request for Comment
    14. Should we incorporate a significant influence prong into the 
ICC definition, as proposed?
    15. Should we also adopt the proposed conforming amendment to Rule 
2-01(f)(6) to include the reference to proposed paragraph 
(f)(14)(i)(E)?
2. Proposed Amendment To Audit and Professional Engagement Period
    Currently, paragraphs (c)(1) through (5) of Rule 2-01 enumerate 
certain circumstances that, if they occur during the ``audit and 
professional engagement period,'' are inconsistent with the general 
independence standard of Rule 2-01(b).\29\ Under the current rule, the 
term ``audit and professional engagement period'' is defined 
differently for domestic issuers and foreign private issuers (``FPIs'') 
\30\ with respect to situations in which a company first files, or is 
required to file, a registration statement or report with the 
Commission. Specifically, Rule 2-01(f)(5)(i) and (ii) defines the audit 
and professional engagement period as including both the ``period 
covered by any financial statements being audited or reviewed'' and the 
``period of the engagement to audit or review the . . . financial 
statements or to prepare a report filed with the Commission. . . .'' 
However, paragraph (iii) of the definition narrows the audit and 
professional engagement period to just the ``first day of the last 
fiscal year before the foreign private issuer first filed, or was 
required to file, a registration statement or report with the 
Commission, provided there has been full compliance with home country 
independence standards in all prior periods covered by any registration 
statement or report filed with the Commission'' (emphasis added).
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    \29\ See Preliminary Note 2 and paragraphs (c)(1), (2), (3), 
(4), and (5) to Rule 2-01.
    \30\ 17 CFR 240.3b-4(c). A foreign private issuer is any foreign 
issuer other than a foreign government, except for an issuer that 
(1) has more than 50% of its outstanding voting securities held of 
record by U.S. residents; and (2) any of the following: (i) A 
majority of its executive officers or directors are citizens or 
residents of the United States; (ii) more than 50% of its assets are 
located in the United States; or (iii) its business is principally 
administered in the United States. See 17 CFR 240.3b-4(c).
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    The narrower definition applicable to FPIs creates a disparate 
application of the auditor independence rules between domestic issuers 
and FPIs when, for example, both types of audit clients are engaging in 
an IPO. The auditor of a domestic issuer engaging in an IPO has to be 
independent in accordance with Rule 2-01 during all periods included in 
the issuer's registration statement filed with the Commission. For 
example, if the registration statement includes three years of 
financial statements, then the auditor of a domestic issuer engaging in 
an IPO would have to look back three years and assess independence 
under Rule 2-01 during all such prior years. Conversely, the auditor of 
an FPI engaging in an IPO has to be independent in accordance with Rule 
2-01 only during the immediately preceding fiscal year. Even if the 
registration statement for the FPI includes three years of financial 
statements, the auditor and the FPI would, for purposes of Rule 2-01, 
look back and assess independence only during the most recently 
completed fiscal year provided the FPI has been in full compliance with 
its home country independence standards in all prior periods covered by 
any registration statement or report filed with the Commission.
    As a consequence, a domestic private company may need to delay its 
IPO or engage a new auditor in order to comply with the auditor 
independence rules, which would put it at a potential economic 
disadvantage when compared to an FPI. Several commenters specifically 
suggested that the definition of ``audit and professional engagement 
period'' be amended so that domestic issuers would be subject to the 
same audit and professional engagement period as FPIs when they are 
first filing, or are required to file, a registration statement or 
report with the Commission.\31\ Commenters also suggested that 
shortening the look-back period may encourage capital formation for 
domestic issuers contemplating an IPO (e.g., for those issuers that may 
have to delay an IPO to comply with Rule 2-01), or at least put them on 
the same footing as FPIs.\32\
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    \31\ See e.g., letters from PwC, CAQ, BDO, AICPA, and AIC.
    \32\ See e.g., letters from CAQ, AICPA, and AIC.
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    In addition, the staff has observed, from its independence 
consultation experience related to potential filings of initial 
registration statements, that often one factor, among many, in the 
auditor's objectivity and impartiality analysis is how far back in time 
the prohibited service or relationship ended. If the prohibited service 
or relationship ended in the early years of the financial statements 
included in the initial registration statement, that fact may lend 
support to a conclusion that the auditor is objective and impartial 
under Rule 2-01 at the time the IPO is consummated.
    In light of this feedback and our experience, we are proposing to 
amend Rule 2-01(f)(5)(iii) so that the one year look back provision for 
issuers filing or required to file a registration statement or report 
with the Commission for the first time (``first-time filers'') will 
apply to all such filers.\33\ As proposed, an auditor for a first time 
filer that is either a domestic issuer or an FPI would apply Rule 2-01 
for the most recently completed fiscal year included in its first 
filing provided there has been full compliance with applicable 
independence standards in all prior periods covered by any registration 
statement or report filed with the Commission. We believe that the 
proposed requirement to comply with applicable independence standards 
in all prior periods sufficiently mitigates the risk associated with 
shortening the look back provision for domestic first-time filers. 
Also, as it relates to relationships and services in prior years that 
would not be included in the look back period as a result of the 
proposed amendment, such relationships and services should still be 
considered under the general standard of Rule 2-01(b). Similar to the 
discussion in Section II.A.1, for the relationships and services to be 
evaluated under Rule 2-01(b), individually and in the aggregate,

[[Page 2339]]

we would expect those relationships and services would be easily known 
by the auditor as such services and relationships might be thought to 
reasonably bear on an auditor's independence due to the nature, extent, 
relative importance, or other aspects of the service or relationship.
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    \33\ The proposed amendments would not impact the compliance 
analysis related to the partner rotation provisions in Rule 2-
01(c)(6).
---------------------------------------------------------------------------

Request for Comment
    16. We are proposing to amend rule 2-01(f)(5) to shorten the look-
back period for all first-time filers to the most recently completed 
fiscal year, which would result in treating all first-time filers 
(including domestic issuers and FPIs) similarly for purposes of our 
independence requirements under Rule 2-01. Should we amend Rule 2-
01(f)(5) as proposed? Alternatively, should we consider instead 
lengthening the lookback period for FPIs to all periods in which the 
financial statements are being audited or reviewed to harmonize the 
lookback periods?

B. Proposed Amendments to Loans or Debtor-Creditor Relationships

    Currently, under Rule 2-01(c)(1)(ii)(A) (the ``Loan Provision''), 
an accountant is not independent if the accounting firm, any covered 
person in the firm, or any of his or her immediate family members has 
any loans (including any margin loan) to or from an audit client, or 
certain other entities or persons related to the audit client.\34\ The 
Commission originally adopted this provision because certain creditor 
or debtor relationships ``reasonably may be viewed as creating a self-
interest that competes with the auditor's obligation to serve only 
investors' interest.'' \35\ Recognizing that not all creditor or debtor 
relationships threaten an auditor's objectivity and impartiality, the 
Commission included in Rule 2-01(c)(1)(ii)(A) a list of loans that are 
excepted from the prohibition. Under the current rule, the following 
loans from a financial institution under its normal lending procedures, 
terms, and requirements are excepted from the prohibition:
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    \34\ In the Loan Provision Adopting Release, the Commission 
amended this rule to replace ``record or beneficial owners of more 
than ten percent of the audit client's equity securities'' with 
beneficial owners known through reasonable inquiry that have 
``significant influence over the audit client.'' The Commission also 
added new paragraphs (2)(i) and (ii) to Rule 2-01(c)(1)(ii)(A) to 
address how the amended rule applies to a fund that is an audit 
client.
    \35\ Revision of the Commission's Auditor Independence 
Requirements, Release No. 33-7870 (June 30, 2000) [65 FR 43147 (July 
12, 2000)].
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     Automobile loans and leases collateralized by the 
automobile;
     Loans fully collateralized by the cash surrender value of 
an insurance policy;
     Loans fully collateralized by cash deposits at the same 
financial institution; and
     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.
    Additionally, Rule 2-01(c)(1)(ii)(E) (the ``Credit Card Rule'') 
provides that an accountant is not independent if the accounting firm, 
any covered person in the firm, or any of his or her immediate family 
members has any aggregated outstanding credit card balance owed to a 
lender that is an audit client that is not reduced to $10,000 or less 
on a current basis taking into consideration the payment due date and 
any available grace period.
    In response to the requests for comment in the Loan Provision 
Proposing Release, we received feedback suggesting other potential 
exceptions to the Loan Provision.\36\
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    \36\ See e.g., letters from Grant Thornton LLP (July 9, 2018) 
(``Grant Thornton''), BDO, EY, RSM US LLP (July 9, 2018) (``RSM''), 
Financial Executives International (July 9, 2018) (``FEI''), MFS 
Funds Board Audit Committee (July 6, 2018) (``MFS Funds''), T. Rowe 
Price (July 9, 2018), and the Securities Industry and Financial 
Markets Association, Asset Management Group (July 9, 2018) 
(``SIFMA'').
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1. Proposed Amendment To Except Student Loans
    In the Loan Provision Proposing Release, we asked whether student 
loans should be excepted from the Loan Provision and received feedback 
supporting such exception.\37\ In arriving at the proposed amendments, 
we considered the different characteristics associated with student 
loans, such as whether the student loan was obtained specifically for 
accounting and auditing education, obtained by the covered persons when 
they were pursuing their undergraduate education, or obtained by the 
covered persons for their immediate family members.
---------------------------------------------------------------------------

    \37\ See e.g., letters from Grant Thornton, BDO, EY, RSM, and 
FEI.
---------------------------------------------------------------------------

    We propose to add student loans obtained from a financial 
institution under its normal lending procedures, terms, and 
requirements for a covered person's educational expenses provided the 
loan was obtained by the individual prior to becoming a covered person 
in the firm as defined under Rule 2-01(f)(11). The limitation on the 
student loan exclusion (i.e., not obtained while a covered person in 
the firm) is consistent with the current provision in Rule 2-
01(c)(1)(ii)(A)(1)(iv) limiting the mortgage exclusion to mortgage 
loans ``not obtained while the covered person in the firm was a covered 
person,'' and provides a familiar principle for compliance purposes.
    Moreover, we believe obtaining a student loan as a covered person 
poses a higher risk to the auditor's objectivity and impartiality 
because loans obtained while a covered person are likely more recent 
and thus may have a larger balance than loans obtained when such person 
was not a covered person. Additionally, a covered person obtaining a 
student loan from an audit client creates, at a minimum, an 
independence appearance issue that is not present when a non-covered 
person obtained a similar student loan from such audit client. In 
addition, the proposed exception would not encompass student loans 
obtained for a covered person's immediate family members. We are 
concerned that the amount of student loan borrowings could be 
significant when considering student loans obtained for multiple 
immediate family members and thus could impact an auditor's objectivity 
and impartiality. We are therefore limiting the exclusion to student 
loans obtained for the covered person's educational expenses. 
Considered together, we believe these proposed limitations 
appropriately balance the benefits of the proposed exception with its 
potential impact on the auditor's objectivity and impartiality.
Request for Comment
    17. We are proposing to except student loans obtained for a covered 
person's educational expenses that were not obtained while the covered 
person in the firm was a covered person. Should we adopt this new 
exception as proposed? Should we limit the proposed exception to 
student loans not obtained while the covered person in the firm was a 
covered person and to student loans obtained only for the individual's 
educational expenses (i.e., not the loans of immediate family members), 
as proposed?
    18. Should all student loans be excepted from the application of 
the Loan Provision? Should the proposed exception include any other 
limitations, such as being limited only to the covered person's 
accounting and auditing educational expenses? Alternatively, should we 
expand the proposed exception to student loans of immediate family 
members? If we expand the exception to student loans of immediate 
family members, should we adopt a dollar limit on the aggregate amount 
of student loans that may be excepted? Is the overarching

[[Page 2340]]

consideration of all relevant facts and circumstances related to the 
auditor's objectivity and impartiality, as required by Rule 2-01(b), 
sufficient to mitigate against any potential risk that student loans 
obtained for multiple immediate family members could be significant?
    19. Should the proposed student loan exception include a limit on 
the amount that may be outstanding? If so, what is the appropriate 
amount?
2. Proposed Amendment To Clarify the Reference to ``a Mortgage Loan''
    We are proposing to clarify that the reference to ``a mortgage 
loan'' in Rule 2-01(c)(1)(ii)(A)(1)(iv) was not intended to exclude 
just one outstanding mortgage loan on a borrower's primary residence. 
As currently drafted, the reference to ``a mortgage loan'' may be read 
to suggest that only a single loan would qualify for the exception. 
Over the years, the SEC staff has received questions about how the 
exclusion applies to second mortgages, home improvement loans, equity 
lines of credit, and similar mortgage obligations collateralized by a 
primary residence.\38\ To provide further clarity on this point, we are 
proposing to revise Rule 2-01(c)(1)(ii)(A)(1)(iv) to refer to 
``mortgage loans'' instead of ``a mortgage loan.''
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    \38\ See Section B. Question 1 Office of the Chief Accountant: 
Application of the Commission's Rules on Auditor Independence 
Frequently Asked Questions (June 27, 2019) (originally issued August 
13, 2003) (indicating the staff's view that the rationale for a 
mortgage on a primary residence also applies to second mortgages, 
home improvement loans, equity lines of credit and similar mortgage 
obligations collateralized by a primary residence obtained from a 
financial institution under its normal lending procedures, terms and 
requirements and while not a covered person in the firm).
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    Further, where the borrower becomes a covered person only because 
of a change in the ownership in the loan, and provided there is no 
modification in the original terms or conditions of the loan or 
obligation after the borrower becomes, or in contemplation of the 
borrower becoming, a covered person, the loan would be included within 
this exception.\39\
---------------------------------------------------------------------------

    \39\ Id.
---------------------------------------------------------------------------

Request for Comment
    20. Should we revise Rule 2-01(c)(1)(ii)(A)(1)(iv) to refer to 
``mortgage loans'' instead of ``mortgage loan,'' as proposed?
3. Proposed Amendment To Revise the Credit Card Rule To Refer to 
``Consumer Loans''
    We received feedback from commenters on the Loan Provision 
Proposing Release that certain de minimis financings and immaterial 
loans may not threaten an auditor's objectivity and impartiality.\40\ 
We agree that a limited amount of debt that is routinely incurred for 
personal consumption, even if the audit client is the lending entity, 
would typically not impair an auditor's objectivity and impartiality. 
As such, we propose revising Rule 2-01(c)(1)(ii)(E) to replace the 
reference to ``credit cards'' with ``consumer loans'' and revise the 
provision to reference any consumer loan balance owed to a lender that 
is an audit client that is not reduced to $10,000 or less on a current 
basis taking into consideration the payment due date and available 
grace period. Consistent with the payment terms in current Rule 2-
01(c)(1)(ii)(E), in assessing the current basis of a consumer loan 
balance, the borrower would consider the payment due date, plus any 
available grace period, which is typically monthly for credit cards. 
For example, if a covered person has an outstanding consumer loan 
balance above $10,000 with an audit client, such covered person would 
have to reduce the balance to $10,000 or less by the monthly due date, 
plus any available grace period, in order to comply with the proposed 
amendment. The proposed amendment would expand the current Credit Card 
Rule to encompass the types of consumer financing borrowers routinely 
obtain for personal consumption, such as retail installment loans, cell 
phone installment plans, and home improvement loans that are not 
secured by a mortgage on a primary residence. We expect the types of 
consumer loans contemplated by the proposed amendment would typically 
have a payment due date consistent with credit cards (e.g., monthly).
---------------------------------------------------------------------------

    \40\ See e.g., letters from Grant Thornton, Investment Company 
Institute and Independent Directors Council (July 9, 2018) (``ICI/
IDC''), MFS Funds, T. Rowe Price, SIFMA, and Federated Investors, 
Inc. (July 10, 2018) (``Federated'').
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Request for Comment
    21. We propose amending Rule 2-01(c)(1)(ii)(E) to replace ``credit 
cards'' with ``consumer loans'' and revise the provision to reference 
any consumer loan balance owed to a lender that is an audit client that 
is not reduced to $10,000 or less on a current basis taking into 
consideration the payment due date and available grace period. Should 
we amend Rule 2-01(c)(1)(ii)(E), as proposed?
    22. Is the outstanding balance limit of $10,000 appropriate? If 
not, what would be a more appropriate limit?
    23. Is further guidance needed regarding how ``current basis'' 
applies for different types of consumer loans? If so, what additional 
guidance should we provide?
    24. Is further guidance needed regarding the types of loans that 
would be considered ``consumer loans'' under the proposed amendment? If 
so, what additional guidance should we provide?

C. Proposed Amendment to the Business Relationships Rule

    1. Proposed Amendment to the Reference to ``Substantial 
Stockholder''
    Currently, Rule 2-01(c)(3) (the ``Business Relationships Rule'') 
prohibits, at any point during the audit and professional engagement 
period, the accounting firm or any covered person from having ``any 
direct or material indirect business relationship with an audit client, 
or with persons associated with the audit client in a decision-making 
capacity, such as an audit client's officers, directors, or substantial 
stockholders. . . .'' (emphasis added). In response to the Loan 
Provision Proposing Release, commenters suggested aligning this rule 
with the then proposed amendments to the Loan Provision by replacing 
the reference to substantial stockholders with a significant influence 
analysis.\41\
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    \41\ See e.g., letters from Deloitte LLP (June 29, 2018) 
(``Deloitte''), PwC, KPMG LLP (July 3, 2018) (``KPMG''), Crowe LLP 
(July 3, 2018) (``Crowe''), CAQ, Professor Joseph A. Grundfest, 
Stanford Law School (July 9, 2018) (``Grundfest''), Grant Thornton, 
EY, U.S. Chamber of Commerce, Center for Capital Markets 
Competitiveness (July 9, 2018) (``CCMC''), FEI, and AIC.
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    We agree that referring to ``beneficial owners (known through 
reasonable inquiry) of the audit client's equity securities where such 
beneficial owner has significant influence over the audit client'' 
instead of ``substantial stockholders'' would improve the rule by 
making it more clear and less complex. In this regard, we note that 
``substantial stockholder'' is not currently defined in Regulation S-X, 
whereas the concept of significant influence is used in the Loan 
Provision \42\ and other aspects of the independence rules.\43\ As 
such, we recommend proposing to replace the term ``substantial 
stockholders'' in the Business Relationships Rule with the phrase 
``beneficial owners (known

[[Page 2341]]

through reasonable inquiry) of the audit client's equity securities 
where such beneficial owner has significant influence over the audit 
client.''
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    \42\ Consistent with the recently adopted amendments discussed 
in the Loan Provision Adopting Release, the use of ``significant 
influence'' in these proposed amendments is intended to refer to the 
principles in the Financial Accounting Standards Board's 
(``FASB's'') ASC Topic 323, Investments--Equity Method and Joint 
Ventures. See Section II.C.3 of the Loan Provision Adopting Release. 
Similarly, as it relates to the application of significant influence 
to investment companies, please refer to Section II.C.3 of the Loan 
Provision Adopting Release.
    \43\ See e.g., Rule 2-01(f)(ii) and (iii).
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2. Additional Guidance on the Reference to ``Audit Client'' When 
Referring to Persons Associated With the Audit Client in a Decision-
Making Capacity, Including the Beneficial Owner With Significant 
Influence
    The current Business Relationships Rule prohibits business 
relationships, in part, with persons associated with the audit client 
in a decision-making capacity, such as an audit client's officers, 
directors, or substantial stockholders.\44\ A commenter suggested that 
for this part of the Business Relationships Rule, the focus should be 
on those business relationships with persons in a decision-making 
capacity that are associated with the entity whose financial statements 
or other information is being audited, as opposed to the ``audit 
client'' more broadly which, by definition, includes affiliates of the 
audit client.\45\ In other words, the commenter suggested the focus 
should be on those business relationships with persons in a decision-
making capacity that are associated with the entity under audit.\46\
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    \44\ Rule 2-01(c)(3).
    \45\ See letter from AIC (July 26, 2019).
    \46\ As discussed in Section II.A.1, we refer to the entity 
whose financial statements or other information is being audited, 
reviewed, or attested, as the entity under audit.
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    We agree that the focus should be on those business relationships 
with persons in a decision-making capacity as it relates to the entity 
under audit. In fact, our staff consultation experience regarding this 
portion of the Business Relationships Rule generally focuses on the 
persons associated with an affiliate of the audit client only where 
such persons would be able to exert decision-making capacity over the 
entity under audit. As such, as it relates to the proposed amendment 
discussed in the preceding section, regardless of whether the 
beneficial owner owns equity securities of an audit client, including 
an affiliate of the audit client, the independence analysis should 
focus on whether the beneficial owner has significant influence over 
the entity under audit, since business relationships with persons with 
such influence could be reasonably expected to impact an auditor's 
objectivity and impartiality.\47\
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    \47\ This guidance is limited to the analysis related to 
associated persons in a decision-making capacity of an audit client. 
This guidance does not change the analysis when evaluating ``any 
direct or material indirect business relationships with an audit 
client.'' Under the current and proposed rule, an auditor is still 
prohibited from having any direct or material indirect business 
relationships with an audit client, which includes any affiliates of 
the audit client.
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    We are also providing this clarification based on recent staff 
experience with consultations concerning implementation of the recently 
amended Loan Provision. As noted in the preceding section, in June 2019 
we adopted similar language for the Loan Provision to that being 
proposed as a replacement for ``substantial stockholders'' in this 
release (i.e., ``beneficial owners (known through reasonable inquiry) 
of the audit client's equity securities where such beneficial owner has 
significant influence over the audit client.'').\48\ Staff 
consultations since the adoption of the amended Loan Provision are 
consistent with our past experience that, with regard to lending 
relationships with beneficial owners of equity securities of the audit 
client, including affiliates, the focus is on significant influence as 
it relates to the entity under audit when considering if the auditor's 
objectivity and impartiality is impaired.
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    \48\ See supra note 7.
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    As a result, the guidance in the second paragraph of this section 
also applies to the audit client references in the Loan Provision 
referring to ``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,'' as we believe that a threat to an auditor's 
objectivity and impartiality is more likely when the beneficial owner 
of the equity securities of the audit client, including affiliates, has 
significant influence over the entity under audit.
    In summary, when an auditor is evaluating lending or business 
relationships with officers, directors, or beneficial owners with 
significant influence over an affiliate of the entity under audit 
pursuant to the Loan Provision or the current or proposed Business 
Relationships Rule, the auditor should focus on whether the significant 
influence exists at the entity under audit.
Request for Comment
    25. Should we replace the reference to ``substantial stockholders'' 
in the Business Relationships Rule with the concept of beneficial 
owners with significant influence, as proposed? Would the proposed 
amendment make the rule more clear and reduce complexity, given that 
``substantial stockholder'' is not currently defined in Regulation S-X? 
Alternatively, should substantial stockholder be defined? If so, how 
should we define it?
    26. Would the proposed amendment result in more or fewer instances 
of business relationships that are prohibited by Rule 2-01(c)(3)? Does 
the concept of beneficial owners with significant influence, as 
proposed, more appropriately identify relationships that are likely to 
impair an auditor's objectivity and impartiality than the current rule?
    27. We understand that it is more common today for companies to 
enter into multi-company arrangements in delivering products or 
services and that audit firms may contribute to such multi-company 
arrangements, such as through intellectual property or access to data 
using common technology platforms. Do these arrangements present 
instances where an auditor's objectivity and impartiality would not be 
impaired even after considering the proposed amendments discussed in 
this release? If so, what further amendments should be considered to 
appropriately focus on relationships where it is more likely an 
auditor's objectivity and impartiality would be impaired?
    28. Is the guidance related to ``persons associated with the audit 
client in a decision-making capacity'' and its application to the 
amended Loan Provision appropriate? Is further guidance needed to 
assist auditors and their clients in applying the recently amended Loan 
Provision and the proposed amendments? If so, what additional guidance 
is needed? Should we codify this guidance in our rules?

D. Proposed Amendments for Inadvertent Violations for Mergers and 
Acquisitions

    We understand from the staff's independence consultation experience 
that in certain instances an independence violation can arise as a 
result of a corporate event, such as a merger or acquisition, where the 
services or relationships that are the basis for the violation were not 
prohibited by applicable independence standards before the consummation 
of such corporate event.\49\ For example, an audit firm could have an 
existing audit relationship with an issuer that acquires another 
company for which the audit firm was not the auditor but provided 
services or had relationships that would be prohibited under Rule 2-01. 
Through no action of the audit firm, the acquisition would cause what 
had been

[[Page 2342]]

permitted non-audit services or relationships to become prohibited non-
audit services or relationships in violation of the auditor 
independence rules when the prohibited services or relationships 
occurred within the audit or professional engagement period as defined 
in Rule 2-01(f)(5). We also received comments in response to the Loan 
Provision Proposing Release suggesting that a transition framework 
should be available for inadvertent independence violations triggered 
by corporate events, such as IPOs and mergers and acquisitions.\50\
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    \49\ In this section, we refer to these types of violations that 
only arise due to a corporate event, such as mergers and 
acquisitions, as ``inadvertent violations.''
    \50\ See e.g., letters from Deloitte, PwC, KPMG, Crowe, CAQ, 
Grundfest, Grant Thornton, BDO, EY, CCMC, FEI, AICPA, and AIC.
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    With respect to IPOs, we preliminarily believe the proposed 
amendments discussed in Section II.A.2 could significantly mitigate the 
challenges associated with these transactions because only one year of 
previous compliance with Rule 2-01 would be required. In an IPO, the 
auditor generally has an existing auditor-client relationship with the 
audit client and the IPO is generally contemplated well in advance of 
its consummation. As a result, focusing the independence analysis on 
the most recent preceding fiscal year should significantly mitigate the 
challenges associated with consummating an IPO under our rules.
    We believe that the root cause of auditor independence issues 
arising from mergers and acquisitions, however, generally differs from 
that arising from IPOs. In situations involving mergers and 
acquisitions, a pre-existing auditor-client relationship between the 
auditor and the merged company or the company being acquired is less 
likely, as compared to an IPO, and the timing of the transaction is 
generally shorter and more uncertain. As such, these transactions can 
give rise to auditor independence violations that are inadvertent and 
often difficult to contemplate in advance.\51\ The prospect of auditor 
independence issues arising as a result of a corporate acquisition 
transaction can have an adverse effect on the audit client, as it may 
result in the termination of audit work midstream or termination of the 
non-audit service that is in progress in a manner that is costly to the 
audit client.\52\ Alternatively, it could result in a delay of a merger 
or acquisition while the auditor and its audit client attempt to 
resolve the potential independence matters to the possible detriment of 
the audit client and investors.\53\ Accordingly, we believe it is 
appropriate to provide, in a manner that preserves investor protection, 
a transition framework for mergers and acquisitions to address 
inadvertent violations related to such transactions so the auditor and 
its audit client can transition out of prohibited services and 
relationships in an orderly manner.
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    \51\ Given that these violations arise out of relationships or 
services that were in place before the relationships or services 
became prohibited as a result of being subject to our independence 
requirements, the staff has generally not objected, as part of the 
independence consultation process, to the auditor and the audit 
client's determination that the auditor's objectivity and 
impartiality were not impaired in these circumstances.
    \52\ See e.g., letters from Deloitte and Grundfest.
    \53\ Id.
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    As such, we are proposing amendments to Rule 2-01 to address the 
challenges discussed above that may result from a merger or 
acquisition. The proposed framework follows the consideration of the 
audit firm's quality controls similar to Rule 2-01(d).\54\ Under the 
proposed amendments, the auditor must:
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    \54\ The Commission adopted Rule 2-01(d) as a limited exception 
to address a covered person's violations in certain circumstances 
that would be attributed to an entire firm. The effect of Rule 2-
01(d) is that an accounting firm with ``appropriate quality controls 
will not be deemed to lack independence when an accountant did not 
know of the circumstances giving rise to the impairment and, upon 
discovery, the impairment is quickly resolved.'' 2000 Adopting 
Release, at 65 FR 76052.
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     Be in compliance with the applicable independence 
standards related to the services or relationships when the services or 
relationships originated and throughout the period in which the 
applicable independence standards apply;
     Correct the independence violations arising from the 
merger or acquisition as promptly as possible under relevant 
circumstances associated with the merger or acquisition;
     Have in place a quality control system as described in 
Rule 2-01(d)(3) that has the following features:
    [cir] Procedures and controls that monitor the audit client's 
merger and acquisition activity to provide timely notice of a merger or 
acquisition; and
    [cir] Procedures and controls that allow for prompt identification 
of potential violations after initial notification of a potential 
merger or acquisition that may trigger independence violations, but 
before the transaction has occurred.
    Regarding the first provision, the auditor must be in compliance 
with the independence standards applicable to the entities involved in 
the merger or acquisition transaction from the origination of the 
relationships or services in question and throughout the period prior 
to the SEC and PCAOB independence standards applying as a result of 
such transaction.
    With respect to correction of the independence violation as 
promptly as possible, our expectation is that the violation, in most 
instances, should and could be corrected before the effective date of 
the merger or acquisition. However, we understand in some situations it 
might not be possible for the audit client and the auditor to 
transition the prohibited non-audit service or relationship in an 
orderly manner without causing significant disruption to the audit 
client. In those situations, we would expect the relationship or 
service to be corrected as promptly as possible after the effective 
date of the merger or acquisition. Whether a post-transaction 
transition is considered ``as promptly as possible'' depends on all 
relevant facts and circumstances used to support the delayed 
correction. However, under the proposed transition framework, we expect 
all corrective action would be taken no later than six months after the 
effective date of the merger or acquisition that triggered the 
independence violation. Audit firms and audit clients already manage to 
this timeline as it is consistent with international ethical standards 
for accountants.\55\
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    \55\ See The International Code of Ethics for Professional 
Accountants (including International Independence Standards, section 
titled, ``Mergers and Acquisitions'' under, ``Part 4A-Independence 
for Audit and Review Engagements'' available at https://www.ifac.org/system/files/publications/files/Final-Pronouncement-The-Restructured-Code_0.pdf.
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Request for Comment
    29. Should we provide the transition framework to address 
inadvertent independence violations arising from mergers and 
acquisitions, as proposed? Should we expand the proposed framework to 
encompass IPOs? If so, would this eliminate the need for the proposed 
amendments in Section II.A.2? If we expand the proposed framework to 
encompass IPOs, are there additional criteria we should include in the 
quality control requirement? Are there other transactions that should 
be covered by the proposed framework?
    30. Are the proposed criteria for the quality control requirement 
sufficiently clear? If not, how could they be clarified?
    31. Are there other criteria that should be added to the quality 
control requirement?
    32. Should certain prohibited services and relationships continue 
to be an independence violation regardless of the transition framework 
such as if the

[[Page 2343]]

service or relationship results in the auditor auditing its own work?
    33. The proposed framework requires any independence violations 
resulting from a merger or acquisition to be corrected as promptly as 
possible. What is a reasonable period of time after the consummation of 
a merger or acquisition that would allow for an auditor to correct most 
types of violations covered by the proposed framework? Should the 
proposed amendments specify a maximum period of time for such 
corrections?
    34. Should we exclude certain types of merger and acquisition 
transactions from the proposed transition framework? If so, what 
transactions should be excluded? For example, should the framework 
exclude transactions that are in substance more like an IPO, such as 
when the acquirer is a public shell company? In these situations, would 
it be more appropriate to apply the proposed amendments related to the 
look-back period for IPOs?

E. Proposed Amendments for Miscellaneous Updates

1. Proposed Amendments To Update the Reference to Concurring Partner 
Within Rule 2-01
    On August 17, 2018, the Commission updated a number of rules as 
part of its disclosure effectiveness initiative.\56\ Prior to the 
adoption of these amendments, Rule 2-01(f)(7)(ii)(B) explained that the 
``partner[s] performing a second level of review to provide additional 
assurance . . .'' are considered ``concurring or reviewing partners.'' 
\57\ In its recent amendments, the Commission revised the language in 
Rule 2-01(f)(7)(ii)(B) to be consistent with current auditing 
standards. As a result, the rule no longer uses the term ``concurring 
partner'' and instead uses the terms ``Engagement Quality Reviewer'' 
and ``Engagement Quality Control Reviewer'' to describe the ``partner 
conducting a quality review.'' As such, we propose conforming 
amendments throughout Rule 2-01 to replace references to ``concurring 
partner'' with the term ``Engagement Quality Reviewer.''
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    \56\ Disclosure Update and Simplification, Release No. 33-10532 
(Aug. 17, 2018) [83 FR 50148 (Oct. 4, 2018)].
    \57\ See 2018 Annual Edition of the Code of Federal Regulations, 
17 CFR 210.2-01, available at https://www.govinfo.gov/content/pkg/CFR-2018-title17-vol3/pdf/CFR-2018-title17-vol3-part210.pdf.
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2. Proposed Amendment to Preliminary Note to Rule 2-01
    We propose a technical amendment to convert the current Preliminary 
Note to Rule 2-01 into introductory text to Rule 2-01, as this is 
consistent with current Federal Register practices. This proposed 
amendment is in no way intended to affect the application of the 
auditor independence rules.
3. Proposed Amendment To Delete Outdated Transition and Grandfathering 
Provision
    Rule 2-01(e) was added as part of the 2003 amendments discussed in 
Section I to address the existence of relationships and arrangements 
that predated those amendments.\58\ Based on the passage of time, these 
transition and grandfathering provisions are no longer necessary. We 
propose deleting the current Rule 2-01(e) and reserving it for the 
proposed amendments discussed in Section II.D.
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    \58\ See supra note 6.
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Request for Comment
    35. Should we make the miscellaneous updates described above? Are 
there other conforming amendments we should make in light of these 
updates?

III. Economic Analysis

A. Introduction

    We are proposing to amend the auditor independence requirements in 
Rule 2-01 by: (1) Amending the definition of an affiliate of an audit 
client to address certain affiliate relationships in common control 
scenarios and the definition of investment company complex; (2) 
shortening the look-back period for domestic first time filers in 
assessing compliance with the independence requirements; (3) adding 
certain student loans and de minimis consumer loans to the categorical 
exclusions from independence-impairing lending relationships; (4) 
replacing the reference to ``substantial stockholders'' in the Business 
Relationships Rule with the concept of beneficial owners with 
significant influence; and (5) introducing a transition framework for 
merger and acquisition transactions to consider whether an auditor's 
independence is impaired, among other updates.
    We are sensitive to the costs and benefits of the proposed 
amendments. The discussion below addresses the potential economic 
effects of the proposed amendments, including the likely benefits and 
costs, as well as the likely effects on efficiency, competition, and 
capital formation.\59\
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    \59\ 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. Further, Section 23(a)(2) of the 
Exchange Act [17 U.S.C. 78w(a)(2)] requires the Commission, when 
making rules under the Exchange Act, to consider the impact that the 
rules would have on competition, and prohibits the Commission from 
adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the Exchange Act.
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    We note that, where possible, we have attempted to quantify the 
benefits, costs, and effects on efficiency, competition, and capital 
formation expected to result from the proposed amendments. In many 
cases, however, we are unable to quantify the economic effects because 
we lack information necessary to provide a reasonable estimate. For 
example, we are unable to quantify, with precision, the costs to 
auditors and audit clients of complying with the selected aspects of 
the auditor independence rules and the potential compliance cost 
savings and changes in audit quality that may arise from the proposed 
amendments to Rule 2-01.
    The remainder of the economic analysis presents the baseline, 
anticipated benefits and costs from the proposed amendments, potential 
effects of the proposed amendments on efficiency, competition and 
capital formation, and reasonable alternatives to the proposed 
amendments.

B. Baseline and Affected Parties

    The proposed amendments would update the auditor independence 
requirements, which would impact auditors, audit clients, and any other 
entity that is currently or may become an affiliate of the audit 
client. Other parties that may be affected by the proposed amendments 
include ``covered persons'' of accounting firms and their immediate 
family members. As discussed further below, the proposed amendments are 
likely to affect investors indirectly.
    We are not able to estimate precisely the number of current audit 
engagements that would be immediately affected by the proposed 
amendments. We also do not have precise data on audit clients' 
ownership and control structure. With respect to the proposed 
amendments relating to treatment of student loans and consumer loans, 
there is no data readily available to us relating to how ``covered 
persons'' and their immediate family members arrange their financing. 
Similarly there is no data readily available to quantify the number of 
business relationships that audit firms have with beneficial owners of 
an

[[Page 2344]]

audit client's equity securities where the beneficial owner has 
significant influence over the audit client. As such, we are not able 
to identify those auditor-client relationships that would be impacted 
by the proposed amendments to the Business Relationships Rule. We 
therefore are not able to quantify the effects of these aspects of the 
proposed amendments.
    We have relied on information from PCAOB Forms 2 to approximate the 
potential universe of auditors that may be impacted by the proposed 
amendments.\60\ According to aggregated information from PCAOB 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). According to a 
report provided by Audit Analytics in 2018, the four largest accounting 
firms audit about 75 percent of accelerated and large accelerated 
filers \61\ and about 46 percent of all registrants.\62\
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    \60\ All registered accounting firms must file annual reports on 
Form 2 with the PCAOB. To determine the number of audit firms 
registered with the PCAOB, we aggregated the total number of 
entities who filed a Form 2 with the PCAOB.
    \61\ Accelerated filers and large accelerated filers are defined 
in Rule 12b-2 of the Exchange Act of 1934 [17 CFR 240.12b-2].
    \62\ See Who Audits Public Companies-2018 Edition, available at 
https://blog.auditanalytics.com/who-audits-public-companies-2018-edition.
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    We estimate that approximately 6,919 issuers filing on domestic 
forms \63\ and 393 FPIs filing on foreign forms would be affected by 
the proposed amendments.\64\ Among the issuers that file on domestic 
forms, approximately 29 percent are large accelerated filers, 19 
percent are accelerated filers, 19 percent are non-accelerated filers, 
and 33 percent are smaller reporting companies.\65\ In addition, we 
estimate that approximately 21.3 percent of domestic issuers are 
emerging growth companies.\66\
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    \63\ This number includes fewer than 25 foreign issuers that 
file on domestic forms and approximately 100 business development 
companies.
    \64\ The number of issuers that file on domestic forms is 
estimated as the number of unique issuers, identified by Central 
Index Key (CIK), that filed Forms 10-K and 10-Q, or an amendment 
thereto, with the Commission during calendar year 2018. We believe 
that these filers are representative of the issuers that would 
primarily be affected by the proposed amendments. For purposes of 
this economic analysis, these estimates do not include issuers that 
filed only initial domestic Securities Act registration statements 
during calendar year 2018, and no Exchange Act reports, in order to 
avoid including entities, such as certain co-registrants of debt 
securities, which may not have independent reporting obligations and 
therefore would not be affected by the proposed amendments. 
Nevertheless, the proposed amendments would affect any registrant 
that files a Securities Act registration statement and assumes 
Exchange Act reporting obligations. We believe that most registrants 
that have filed a Securities Act registration statement, other than 
the co-registrants described above, would be captured by this 
estimate through their Form 10-K and Form 10-Q filings. The 
estimates for the percentages of smaller reporting companies, 
accelerated filers, large accelerated filers, and non-accelerated 
filers are based on data obtained by Commission staff using a 
computer program that analyzes SEC filings, with supplemental data 
from Ives Group Audit Analytics.
    \65\ ``Smaller reporting company'' is defined in 17 CFR 
229.10(f) as an issuer that is not an investment company, an asset-
backed issuer (as defined in 17 CFR 229.1101), or a majority-owned 
subsidiary of a parent that is not a smaller reporting company and 
that: (i) Had a public float of less than $250 million; or (ii) had 
annual revenues of less than $100 million and either: (A) No public 
float; or (B) a public float of less than $700 million.
    \66\ An ``emerging growth company'' is defined as an issuer that 
had total annual gross revenues of less than $1.07 billion during 
its most recently completed fiscal year. See 17 CFR 230.405 and 17 
CFR 240.12b-2. See Rule 405; Rule 12b-2; 15 U.S.C. 77b(a)(19); 15 
U.S.C. 78c(a)(80); and Inflation Adjustments and Other Technical 
Amendments under Titles I and II of the JOBS Act, Release No. 33-
10332 (Mar. 31, 2017) [82 FR 17545 (Apr. 12, 2017)]. We based the 
estimate of the percentage of emerging growth companies on whether a 
registrant claimed emerging growth company status, as derived from 
Ives Group Audit Analytics data.
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    The proposed amendment related to the ``look-back'' period for 
assessing independence compliance would impact future domestic first 
time filers, but not future FPI first time filers. To assess the 
effects of this amendment, we utilized historical data for domestic 
IPOs. According to Thompson Reuters' Security Data Company (``SDC'') 
database, there were approximately 421 domestic IPOs during the period 
between June 30, 2016, and June 30, 2019.
    The proposed amendment related to a transition framework for merger 
and acquisition transactions would impact issuers that might engage in 
mergers and acquisitions at some point in time. To assess the overall 
market activity for mergers and acquisitions, we examined mergers and 
acquisitions data from SDC. During the period from January 1, 2016, to 
December 31, 2018, there were 6,310 mergers and acquisitions entered 
into by publicly listed U.S. firms.
    The proposed amendments to the ICC definition would potentially 
affect registered investment companies and unregistered funds.\67\ We 
estimate that there were 3,160 registered investment companies with an 
``Active'' status as of December 2018. As of September 2019, there were 
10,201 mutual funds (including money market funds) with $24,725 billion 
in total net assets, 1,918 ETFs with $3,455 billion in total net 
assets, 666 UITs (excluding ETFs) with $1,509 billion in total net 
assets, 664 registered closed-end funds with $294 billion in total net 
assets, and 13 variable annuity separate accounts registered as 
management investment companies on Form N-3 with $224 billion in total 
net assets.\68\ In addition, as of June 2019, there were 99 BDCs with 
$63 billion in total net assets.\69\
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    \67\ Based on the current reporting requirements for 
unregistered funds, we do not have data readily available regarding 
unregistered funds that would allow us to quantify the number of 
unregistered funds that would be affected by the proposed 
amendments.
    \68\ Estimates of the number of registered investment companies 
and their total net assets are based on a staff analysis of Form N-
CEN filings as of September 5, 2019. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class 
as a separate fund and use data from Morningstar to determine the 
amount of total net assets reported on Form N-CEN attributable to 
the ETF share class.
    \69\ Estimates of the number of BDCs and their net assets are 
based on a staff analysis of Form 10-K and Form 10-Q filings as of 
June 30, 2019. Our estimate includes BDCs that may be delinquent or 
have filed extensions for their filings, and it excludes 6 wholly 
owned subsidiaries of other BDCs.
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C. Potential Costs and Benefits

    In this section, we discuss the anticipated economic benefits and 
costs of the proposed amendments. We first analyze the overall economic 
effects of the proposed amendments. We then discuss the potential costs 
and benefits of specific proposed amendments.
1. Overall Potential Benefits and Costs
    We anticipate the proposed amendments would benefit audit firms and 
audit clients in several ways. First, the proposal is likely to reduce 
compliance costs for both audit firms and their clients by updating 
certain aspects of the auditor independence requirements that may be 
unduly burdensome. The proposed amendments may reduce the emphasis in 
our rules on relationships and services that are less likely to 
threaten auditor objectivity and impartiality. As a result, the 
proposed amendments likely would allow auditors and audit clients to 
focus their resources and attention on those relationships and services 
that are more likely to pose threats to auditor objectivity and 
impartiality. In turn, compliance costs likely would decrease for both 
auditors and audit clients.
    A reduction in compliance costs also may be realized because of the 
potential larger pool of eligible auditors due to the proposed 
amendments. With a larger pool of eligible auditors, audit clients 
could potentially avoid costs associated with searching for an 
independent auditor and related costs resulting from switching from one 
audit firm to

[[Page 2345]]

another. Larger pools of potentially qualified independent auditors may 
promote competition among audit firms, which may lower audit fees. 
Reduction in audit fees would lead to cash savings for audit clients, 
who could utilize the savings to make further investments or return 
excess savings to investors, all which may accrue to the benefit of 
investors. However, this competition effect may be limited because the 
audit industry is highly concentrated \70\ with the four largest audit 
firms auditing about 46 percent of all registrants. More specifically, 
the four largest audit firms audit about 75 percent of accelerated and 
large accelerated filers.\71\
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    \70\ See United States Government Accountability Office. Audits 
of Public Companies--Continued Concentration in Audit Market for 
Large Public Companies Does Not Call for Immediate Action, available 
at www.gao.gov/new.items/d08163.pdf (2008).
    \71\ See supra note 62.
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    The potential expansion of auditor choices as a result of the 
proposed amendments could also allow audit clients to align audit 
expertise better with the audit engagement, which may lead to an 
improvement in audit quality and financial statement quality.\72\ For 
example, audit clients in certain industries might have more 
complicated or very specialized businesses, requiring auditors of those 
clients to possess certain expertise or experience. If the pool of 
potential independent auditors is restricted due to prohibitions under 
current Rule 2-01 that are the subject of the proposed amendments, an 
audit client might have to choose what it regards as a ``suboptimal'' 
audit firm, which may not provide the highest quality audit services. 
Since audit quality is correlated with financial reporting quality,\73\ 
the improved financial reporting quality under the proposed amendments 
also would benefit audit clients as the higher quality of financial 
reporting could potentially reduce information asymmetry between 
auditors and their investors, improve firms' liquidity and decrease 
cost of capital.\74\ Investors would similarly benefit from any 
resulting improvement in financial reporting quality.
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    \72\ See Mark Defond and Jieying Zhang, A Review of Archival 
Auditing Research, 58 J. Acct. Econ. 275 (2014).
    \73\ See id.
    \74\ See Siew H. Teoh and T.J. Wong, Perceived Auditor Quality 
and the Earnings Response Coefficient, 68 Acct. Rev. (1993) 346-366. 
See also Jeffery A. Pittman and Steve Fortin, Auditor Choice and the 
Cost of Debt Capital for Newly Public Firms, 37. J. Acct. Econ. 
(2004). 113-136; Jere R. Francis and Bin Ke, Disclosure of Fees Paid 
to Auditors and the Market Valuation of Earnings Surprises, 11 Rev. 
Acct. Stud. (2006) 495-523; Chan Li, Yuan Xie, and Jian Zhou, 
National Level, City Level Auditor Industry Specialization and Cost 
of Debt, 24 Acct. Horizon. (2010) 395-417; and Jagan Krishnan, Chan 
Li, and Qian Wang, Auditor Industry Expertise and Cost of Equity, 27 
Acct. Horizon. (2013) 667-691.
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    Auditors also could benefit from the proposed amendments as they 
may have a broader spectrum of audit clients and clients for non-audit 
services. If the proposed amendments reduce certain burdensome 
constraints on auditors in complying with the independence 
requirements, auditors likely would incur fewer compliance costs. In 
addition, the proposed amendments could potentially reduce auditor 
turnover due to changes in audit clients' organizational structure 
arising from certain merger and acquisition activities. The proposal 
may also benefit auditors that provide non-auditing services, as those 
audit firms, under the proposed amendments, would be permitted to 
provide such services to an entity that is under common control with 
the audit client, so long as that entity is not material to the 
controlling entity.
    There also could be certain costs associated with the proposed 
amendments. For example, if the proposed amendments increase the risk 
of auditors' objectivity and impartiality being threatened by newly 
permissible relationships and services, investors could have less 
confidence in the quality of financial reporting, which could lead to 
less efficient investment allocations and increased cost of capital. 
Overall, however, we do not anticipate significant costs to investors 
or other market participants associated with the proposal because the 
proposed amendments address those relationships and services that are 
less likely to threaten auditors' objectivity and impartiality.
2. Benefits and Costs of Specific Proposed Amendments
    We expect the proposed amendments would result in benefits and 
costs to auditors, audit clients, and investors, and we discuss those 
benefits and costs qualitatively, item by item, in this section.
a. Proposed Amendments to the Definition of an Affiliate of the Audit 
Client and Investment Company Complex
i. Affiliate of the Audit Client
    Currently, the term affiliate of the audit client includes not only 
``an entity that has control over the audit client or over which the 
audit client has control,'' but also those ``under common control with 
the audit client, including the audit client's parents and 
subsidiaries'' \75\ (emphasis added). Under this definition, affiliates 
of the audit client include all entities under common control with the 
audit client, including those that are not material to the controlling 
entity. The current inclusion of sister entities that are not material 
to the controlling entity in the auditor independence analysis creates 
practical challenges and imposes compliance costs on both auditors and 
audit clients, especially those with complex organizational structures. 
As it relates to entities under common control, the proposed amendment 
includes as affiliates of the audit client only sister entities that 
are material to the controlling entity for the auditor independence 
analyses. Excluding sister entities that are not material to the 
controlling entity likely would reduce compliance costs associated with 
having to consider and potentially monitor independence impairing 
relationships and services involving such entities.\76\ The proposed 
amendment also would help avoid the costs that audit clients could 
incur to switch auditors. Additionally, the proposed amendment could 
reduce instances of lost revenues from non-audit services (e.g., 
management functions) that auditors must give up where an independence 
impairing relationship or service exists with a sister entity that is 
not material to the controlling entity. These cost savings could be 
especially pronounced for entities with complex organizational 
structures (e.g., private equity structures) that have an expansive and 
constantly changing list of affiliates because the proposal may 
significantly reduce the number of entities that fall within the 
definition of affiliates of the audit client.
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    \75\ Rule 2-01(f)(4)(i).
    \76\ As noted in Section II.A above, notwithstanding the 
proposed amendments, auditors and their clients would continue to be 
required to consider ``all relevant facts and circumstances,'' 
consistent with the general independence standard in Rule 2-01(b). 
Thus, audit firms and their clients may continue to incur some costs 
to consider such entities as part of their independence analysis. 
However, for those relationships and services that might 
nevertheless impact the auditor's independence under the general 
standard in Rule 2-01(b), we would expect those relationships and 
services individually or in the aggregate would be easily known by 
the auditor and the audit client because such services and 
relationships might be thought to reasonably bear on an auditor's 
independence due to the nature, extent, relative importance or other 
aspects of the service or relationship. We note that a similar 
qualification applies with respect to other aspects of the proposed 
amendments that could have the potential benefit of reducing 
compliance costs associated with considering and monitoring 
independence impairing relationships and services.
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    According to the current definition of affiliate of the audit 
client, an auditor

[[Page 2346]]

with desired expertise may be excluded from a firm's audit engagement 
consideration because the auditor currently provides management 
functions for the firm's sister entity that is not material to the 
controlling entity. The exclusion of certain specialized auditors from 
an audit engagement due to their prohibited relationships or services 
with a sister entity that is not material to the sister entity under 
the current rule might lead to the audit engagement not being matched 
with the most qualified auditors. Such an outcome could compromise the 
audit quality and decrease financial reporting quality, thereby 
imposing compliance costs on audit clients and investors. In addition, 
the lack of matching between auditor expertise and audit tasks might 
result in inefficiency in the auditing processes, which likely 
increases the costs of audit services (e.g., audit fees).
    The proposed amendment to the definition of affiliate of the audit 
client may result in an expansion of the pool of qualified auditors. 
With an expanded pool of eligible auditors, competition among auditors 
might increase, thereby reducing audit fees for audit clients.\77\ 
However, the auditor market is highly concentrated, and such cost 
savings are likely to be limited. The expanded pool of qualified 
auditors also might improve matching between auditor expertise and 
audit task, thereby improving audit efficiency and reducing audit 
costs.\78\ Furthermore, the proposed amendment might positively 
influence audit quality and financial reporting quality through 
improved auditor-client alignment.\79\
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    \77\ See Paul K. Chaney, Debra C. Jeter, and Pamela E. Shaw, 
Client-Auditor Realignment and Restrictions on Auditor Solicitation, 
72 Acct. Rev. (1997) 433. See also Emilie R. Feldman, A Basic 
Quantification of the Competitive Implications of the Demise of 
Arthur Andersen, 29 R. Ind. Org. (2006) 193; Michael Ettredge, Chan 
Li, and Susan Scholz. Audit Fees and Auditor Dismissals in the SOX 
Era, 21 Acct Horizon (2011) 371; Wieteke Numan and Marleen 
Willekens, An Empirical Test of Spatial Competition in the Audit 
Market. 20 J. Acct Econ. 450 (2012); and Joseph Gerakos and Chad 
Syverson, Competition in the Audit Market: Policy Implications, 53 
J. Acct Res. 725 (2015).
    \78\ The proposed amendments could result in some crowding-out 
effect, as the four largest audit firms may be deemed to be 
independent with more clients under the proposed amendments, 
crowding out smaller audit firms. However, we believe that better 
matching between auditor specialization and their clients and the 
reduction in unnecessary auditor turnovers could potentially prevent 
any decline in audit quality and in the long run may improve audit 
quality.
    \79\ See Chen-Lung Chin, and Hsin-Yi Chin, Reducing Restatements 
with Increased Industry Expertise, 26 Cont. Acct. Res., (2009) 729; 
Michael Ettredge, James Heintz, Chan Li, and Susan Scholz, Auditor 
Realignments Accompanying Implementation of SOX 404 ICFR Reporting 
Requirements, 25 Acct Horizon (2011) 17; and Jacob Z. Haislip, Gary 
F Peters, and Vernon J Richardson, The Effect of Auditor IT 
Expertise on Internal Controls, 20 Int. J. Acct. Inf. Sys. 1 (2016).
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    The proposed amendments are likely to benefit investors indirectly. 
First, the potentially expanded auditor choices under the proposed 
amendment might improve audit quality through better matching between 
auditor expertise and audit engagement, thus potentially enhancing 
financial reporting quality.\80\ Better financial reporting quality 
would help investors make more efficient investment decisions, thereby 
improving market efficiency. Second, the potential reduction in audit 
fees from possible increased competition among auditors and improved 
audit efficiency might generate cash savings to audit clients, which 
might be passed to investors.
---------------------------------------------------------------------------

    \80\ See supra note 72.
---------------------------------------------------------------------------

    The proposed ``materiality test'' in the amended definition of 
audit client might require more efforts from audit firms and audit 
clients to familiarize themselves with and to apply the test. This 
might potentially increase the compliance costs. However, given that 
the materiality concept is already part of the Commission's auditor 
independence rules,\81\ we do not expect a significant learning curve 
in applying the test or significant incremental compliance costs for 
auditors.
---------------------------------------------------------------------------

    \81\ See e.g., Rule 2-01(f)(4)(ii) and (iii).
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ii. Investment Company Complex
    As discussed in Section II.A.1.b, above, the proposed amendments 
(1) direct auditors of an investment company or an investment adviser 
or sponsor to include all entities within the proposed ICC definition 
as affiliates of the audit client; (2) focus the ICC definition from 
the perspective of the entity under audit; (3) include within the 
meaning of the term investment company, for the purposes of the ICC 
definition, unregistered funds; (4) amend the common control prong of 
the ICC definition to include only sister investment companies, 
advisers, and sponsors that are material to the controlling entity; and 
(5) include within the ICC definition entities where significant 
influence exists between those entities and an audit client.
    The proposed amendments to the ICC definition would impact the 
analysis used to identify entities that are considered affiliates of 
registered investment companies, unregistered funds, and investment 
advisers or sponsors that are under audit. The proposal would lead to 
improved clarity in the ICC definition and, for the purpose of auditor 
independence analysis, could facilitate audit firms, registered 
investment companies, unregistered funds, and investment advisors or 
sponsors in complying with the auditor independence requirements. The 
improved clarity under the amended definition may result in compliance 
cost savings, thus benefiting audit firms and audit clients.
    The economic implications of the materiality test under the amended 
definition of investment company complex are largely similar to those 
for operating companies as discussed above. For example, under the 
current ICC definition, an investment company audit client may have a 
rather restricted set of independence compliant auditors due to the 
current common control provisions. The proposed amendments could 
potentially reduce compliance costs for investment company audit 
clients because the proposed ICC definition excludes from the affiliate 
analysis sister entities that are not material to the controlling 
entity.
    In addition, the auditors with certain relationships or providing 
certain non-audit services to sister entities that are not material to 
the controlling entity may become eligible to serve as an auditor to 
the audit client under the proposed amendments. The potential expanded 
pool of compliant auditors could help registered investment companies 
and unregistered funds hire (and retain) auditors who have more 
relevant industry expertise, which potentially could lead to better 
financial reporting for investment companies. Better financial 
reporting quality, in turn, would benefit investors in registered 
investment companies and unregistered funds by allowing them to make 
more informed investment decisions.
    With respect to the proposed amendments that include unregistered 
funds within the meaning of the term investment company, for purposes 
of the ICC definition,\82\ we believe the proposed amendments provide a 
useful update to the ICC definition that was adopted in 2000. 
Specifically, we believe the proposed amendments provide clarity for 
unregistered funds, their investment advisers or sponsors, and their 
auditors. In addition to this clarity, defining investment company to 
include unregistered funds would promote consistency in the application 
of Rule 2-01 to registered investment companies and unregistered funds 
so that these two types of audit clients, which share some similar 
characteristics, would not be subject to

[[Page 2347]]

disparate application of the independence rules.
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    \82\ See proposed Rule 2-01(f)(14)(iv).
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    We do not anticipate significant incremental costs associated with 
the proposed amendments to the ICC definition for registered investment 
companies, unregistered funds, investment advisers or sponsors, or 
auditors as well as investment company investors. The proposed 
amendments may require additional effort from audit firms and 
registered investment companies, unregistered funds, and investment 
advisers or sponsors that are under audit to become familiar with the 
application of the proposed ICC definition. This may potentially lead 
to an initial increase in compliance costs. However, the proposed 
amendments would improve the clarity of the ICC definition and 
therefore likely would decrease overall compliance costs after affected 
parties adjust to the new definition. The proposed materiality test is 
already part of the Commission's auditor independence rules \83\ and 
also is aligned with the proposed common control prong of the affiliate 
of the audit client definition.\84\ Therefore, we do not expect a 
significant learning curve in applying the test or significant 
incremental compliance costs for auditors or registered investment 
companies, unregistered funds, and investment advisers or sponsors.
---------------------------------------------------------------------------

    \83\ See e.g., Rule 2-01(f)(4)(ii) and (iii).
    \84\ See Proposed Rule 2-01(f)(4)(i)(B).
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    We do not expect any significant economic effects associated with 
amending the definition of ICC to include the concept of ``significant 
influence.'' As discussed in Section II.A.1.b.iv above, audit clients 
and auditors are familiar with the concept as a result of the 
application of current Rule 2-01(f)(4)(ii) and (iii). The proposed 
amendment simply would align the ICC definition with the existing 
definition of affiliate of the audit client. Consistent with an auditor 
of an operating company, auditors of investment companies and 
investment advisers or sponsors who, under the proposed amendments, are 
directed to look solely to proposed Rule 2-01(f)(14), would be required 
to consider significant influence when identifying affiliates of the 
audit client.
b. Proposed Amendment to ``Audit and Professional Engagement Period''
    Currently, the term ``audit and professional engagement period'' is 
defined differently for domestic first time filers and FPI first time 
filers.\85\ A domestic IPO registration statement must include either 
two or three years of audited financial statements, and auditors of 
domestic first time filers need to comply with Rule 2-01 for all 
audited financial statement periods included in the registration 
statement.\86\ This may result in certain inefficiencies in the IPO 
process for domestic filers, such as the need to delay the offering or 
switch to a less well-qualified auditor to comply with independence 
requirements. In comparison, for FPIs, the corresponding ``audit and 
professional engagement period'' includes only the fiscal year 
immediately preceding the initial filing of the registration statement 
or report. As a consequence, the current definition of the ``audit and 
professional engagement period'' creates disparate application of the 
independence requirements between domestic issuers and FPIs. To address 
this disparate treatment, we propose to amend the definition such that 
the one-year look-back provision applies to all first time filers, 
domestic and foreign.
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    \85\ See Section II.A.2.
    \86\ For example, a specialized auditor may be excluded from 
consideration if the auditor provided a prohibited service (e.g., 
management functions) to a domestic filer in the third year before 
the firm files the registration statement for the first time. Even 
though the auditor has stopped providing such service to the filer 
starting two years prior to the firm's filing the registration 
statement, under the current definition, the auditor will not 
qualify as ``independent'' under Rule 2-01.
---------------------------------------------------------------------------

    The proposed amendment to the definition of ``audit and 
professional engagement period'' would require domestic first time 
filers to assess auditor independence over a shortened look-back period 
(i.e., a single immediate preceding year). The proposed change likely 
would alleviate the compliance challenges noted above for both domestic 
first time filers and their auditors. As a result, this proposed 
amendment could help domestic firms avoid the compliance costs 
associated with switching auditors or delaying the filing of an initial 
registration statement. These reduced compliance costs may facilitate 
additional domestic IPOs and thereby promote efficiency and capital 
formation.
    This proposed amendment might also expand the pool of eligible 
auditors for domestic first time filers. The potential increase in the 
number of eligible auditors for these filers could foster competition 
among eligible auditors and thus reduce the cost of audit services.\87\ 
Specifically, where an audit client is looking to potentially change 
auditors, an audit client would be able to select from a broader group 
of auditors to perform audit services related to the audit client's IPO 
even if the auditor had provided prohibited services or had prohibited 
relationships in the second or third year prior to filing the IPO. 
However, the audit industry is already highly concentrated, especially 
with respect to IPOs,\88\ and consequently, such a benefit may not be 
significant. The expanded pool of qualified auditors could allow the 
first time domestic filers to better match auditor expertise to audit 
engagements. We anticipate that the improved alignment between auditor 
expertise and audit engagement likely would positively influence audit 
and financial reporting quality, thereby benefiting investors and 
improving market efficiency.\89\
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    \87\ See supra note 77.
    \88\ See United State Government Accountability Office, Audits 
of Public Companies--Continued Concentration in Audit Market for 
Large Public Companies Does Not Call for Immediate Action (2008) 
available at www.gao.gov/new.items/d08163.pdf. See also Patrick 
Velte and Markus Stiglbauer, Audit Market Concentration and Its 
Influence on Audit Quality, 5 Intl. Bus. Res. (2012) 146; and 
Xiaotao Liu and Biyu Wu, Do IPO Firms Misclassify Expenses? Working 
paper, (2019). They show that 84.2% of IPO firms of their sample use 
Big 4 auditors before going public.
    \89\ See supra note 79 and accompanying text.
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    The proposed change in the look-back period for domestic first time 
filers might lead to some financial statements in early years being 
audited by auditors that do not meet the Commission's current 
independence requirements, thus potentially compromising the integrity 
and reliability of financial reporting information related to the 
earlier second and third years, if included in the first filing. 
However, this potential adverse effect would be mitigated by the 
requirement for these auditors to meet applicable independence 
requirements--such as AICPA independence requirements--for the audits 
of these periods and by the application of the general standard in Rule 
2-01(b) to the relationships and services in those earlier years. In 
addition, there are often, if not always, internal and external 
governance mechanisms (e.g., audit committee and underwriters) in place 
at first time filers, and auditors are subject to heightened litigation 
risk around IPOs.\90\
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    \90\ See Ray Ball and Lakshmana Shivakumar, Earnings Quality at 
Initial Public Offerings, 45, J. Acct. Econ. (2008) 324-349. See 
also Ramgopal Venkataraman, Joseph P. Weber and Michael Willenborg, 
Litigation Risk, Audit Quality, and Audit Fees: Evidence from 
Initial Public Offerings. 83 Acct Rev. (2008) 1315-1345.
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c. Proposed Amendments to Loans or Debtor-Creditor Relationships
    Currently, Rule 2-01 prohibits certain loans/debtor-creditor 
relationship and other financial interests with a few exceptions.\91\ 
Commenter feedback from the Loan Provision Proposing Release supported 
certain additional exceptions

[[Page 2348]]

(or exclusions) for these otherwise prohibited financial interests. As 
a result, the proposed amendments would make the following additional 
changes: (1) Include, as part of the exceptions, student loans for a 
covered person's educational expenses as long as the loan was obtained 
while the individual was not a covered person, and (2) update the 
Credit Card Rule to refer instead to ``consumer loans'' in order to 
except personal consumption loans such as retail installment loans, 
cell phone installment plans, and home improvement loans that are not 
secured by a mortgage on a primary residence.
---------------------------------------------------------------------------

    \91\ Rule 2-01(c)(1)(ii).
---------------------------------------------------------------------------

    The proposed amendments to except certain student and consumer 
loans that are less likely to raise threats to auditors' objectivity or 
impartiality may alleviate some compliance burdens. For instance, audit 
firms would no longer have to monitor such student and consumer loans 
as part of their compliance program. The proposed amendments would 
permit certain covered persons (including audit partners and staff) to 
be considered independent notwithstanding the existence of certain 
lending relationships, such as student loans or consumer loans. The 
potential expansion of qualified audit partners and staff may allow 
audit firms to more readily identify audit partners and staff for a 
given audit engagement and improve matching between partner and staff 
experience with audit engagements. The improved alignment between 
partner and staff experience and audit engagements can increase audit 
efficiency and reduce audit costs. Such efficiency gains may transfer 
to audit clients in the form of reduced audit fees and audit delays.
    Moreover, the better alignment between partner and staff experience 
and audit engagement may increase audit quality.\92\ Since audit 
quality improvement increases financial reporting quality, this benefit 
likely would accrue to the overall investment community.\93\ Finally, 
the proposed amendments likely would make it easier for covered persons 
and their immediate family members to obtain necessary consumer loans, 
as they would no longer need to be concerned about such loans 
categorically being deemed as independence impairing.
---------------------------------------------------------------------------

    \92\ See e.g., G. Bradley Bennett & Richard C. Hatfield, The 
Effect of the Social Mismatch between Staff Auditors and Client 
Management on the Collection of Audit Evidence, 88 Acct. Rev. (2013) 
31-50.
    \93\ See supra note 74 and accompanying text.
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    The exclusion of previously prohibited financial obligations may 
increase the likelihood that some covered persons may participate in an 
audit of a client even when the covered persons or their family members 
have some financial relationships with the audit client, or an audit 
client's officers, directors, or beneficial owners. However, we do not 
believe student loans obtained by covered persons prior to being a 
covered person or de minimis consumer loans are likely to threaten an 
auditor's objectivity and impartiality.
d. Proposed Amendments to the Reference to ``Substantial Stockholder'' 
in the Business Relationships Rule
    The Business Relationships Rule currently refers to ``substantial 
stockholders'' to identify a type of ``person associated with the audit 
client in a decision-making capacity.'' \94\ Under the current rule, a 
business relationship between a substantial stockholder of the audit 
client, among others, and the auditor or covered person would be 
considered independence-impairing. The proposed amendment would change 
the term ``substantial stockholders'' to ``beneficial owners (known 
through reasonable inquiry) of the audit client's equity securities 
where such beneficial owner has significant influence over the audit 
client'' to align this rule with changes recently made to the Loan 
Provision. The proposed amendment should improve compliance with the 
auditor independence rules by improving the clarity and reducing the 
complexity of application of the Business Relationships Rule.
---------------------------------------------------------------------------

    \94\ See Rule 2-01(c)(3).
---------------------------------------------------------------------------

    There may be some additional compliance costs to auditors and audit 
clients associated with having to comply with a standard that now 
requires identifying beneficial owners of equity securities that have 
``significant influence'' over the audit client, as opposed to 
identifying ``substantial stockholders.'' However, any such additional 
cost should be limited given that the concept of ``significant 
influence'' has been part of the Commission's auditor independence 
rules since 2000,\95\ and we do not expect a significant learning curve 
in applying the test for auditors and registrants.
---------------------------------------------------------------------------

    \95\ See e.g., Rule 2-01(f)(4)(ii) and (iii).
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e. Proposed Amendments for Inadvertent Violations for Mergers and 
Acquisitions
    Currently, certain aspects of Rule 2-01 require auditor 
independence compliance during the audit and professional engagement 
period, which may include periods before, during, and after merger and 
acquisition transactions. As a result, certain merger and acquisition 
transactions could give rise to inadvertent violations of auditor 
independence requirements. For example, an auditor may provide 
management functions to a target firm and auditing services to an 
acquirer prior to the occurrence of an acquisition. As a result, the 
acquisition may result in an auditor independence violation that had 
not existed prior to the acquisition. In this scenario, the auditor's 
objectivity and impartiality is likely not impaired.\96\
---------------------------------------------------------------------------

    \96\ See supra note 51.
---------------------------------------------------------------------------

    There may be compliance costs associated with the application of 
the current rule in that registrants might have to: (i) Delay mergers 
and acquisitions in order to comply with Rule 2-01, (ii) forgo 
potentially value-enhancing transactions altogether, or (iii) switch 
auditors or stop the prohibited relationships or services mid-stream, 
potentially resulting in disruption to the registrant.
    We are proposing amendments to Rule 2-01 to establish a transition 
framework for mergers and acquisitions to address these costs. Under 
the proposed amendments, auditors and their audit clients would be able 
to transition out of prohibited relationships or services in an orderly 
manner in certain situations. As such, the proposed amendments likely 
would reduce registrants' independence compliance costs in merger and 
acquisition transactions by reducing the uncertainty associated with 
incidences of inadvertent violations of auditor independence due to 
these corporate events. For example, the proposed transition framework 
would allow, in certain situations, up to six months after the 
transaction effective date to correct the prohibited relationship or 
service. As a result, the proposed framework would help registrants, 
especially those entities with complex organizational structures and 
those actively pursuing merger and acquisition transactions, to achieve 
full and timely compliance with the auditor independence requirements 
when they undertake mergers and acquisitions without missing out on the 
ideal timing for such transactions. In addition, investors may 
indirectly benefit from the value created through timely mergers and 
acquisitions and costs saved from managing inadvertent independence 
violations.
    There may be transitional costs to auditors and audits clients as 
they adapt to the proposed framework. However, given that the framework 
follows the consideration of the audit firm's quality controls similar 
to existing Rule 2-

[[Page 2349]]

01(d), we do not expect a significant learning curve in applying the 
proposed framework for auditors and audit clients. The proposed 
framework does not alter the independence requirements for entities 
involved in mergers and acquisitions per se; rather, the framework 
offers a more practical approach to, and timeline for, addressing 
inadvertent independence violations as a result of certain merger and 
acquisition transactions. Thus, we do not anticipate significant 
compliance costs associated with this amendment.

D. Effects on Efficiency, Competition and Capital Formation

    We believe that the proposed amendments likely would improve the 
practical application of Rule 2-01, enhance efficiency of rule 
implementation, reduce compliance burdens, and increase competition 
among auditors. They also may facilitate capital formation.
    The proposed amendments to Rule 2-01 aim to reduce or remove 
certain practical challenges associated with the auditor independence 
analysis by focusing the analysis on those relationships and services 
that are more likely to pose a threat to an auditor's objectivity and 
impartiality. The proposed amendments are expected to expand the pool 
of eligible auditors and covered persons to undertake audit engagements 
without impairing auditors' independence. As a result, audit clients 
should have more options and audit costs may decrease. The potential 
expansion of eligible auditing service providers may also lead to 
better alignment between the audit client's needs and the auditor's 
expertise. The improved alignment between auditor specialties and audit 
clients could enable auditors to perform auditing services more 
efficiently and effectively, thus potentially reducing audit fees and 
increasing audit quality over the long term.
    The proposed amendments deemphasize relationships and services that 
are unlikely to threaten auditor objectivity and impartiality, thus 
allowing auditors and audit clients to focus on those relationships and 
services that are more likely to threaten the auditor's objectivity and 
impartiality. To the extent that the proposed amendments do so, the 
quality of financial reporting is likely to improve, and the amount of 
audit client audit committee attention to independence questions when 
objectivity and impartiality is not at issue will be reduced, thus 
allowing the board to focus on its other responsibilities. 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 reduce cost of capital, facilitate capital formation and improve 
overall market efficiency.\97\
---------------------------------------------------------------------------

    \97\ See supra note 74. See also Nilabhra Bhattacharya, Frank 
Ecker, Per Olsson, and Katherine Schipper, Direct and Mediated 
Associations among Earnings Quality, Information Asymmetry and the 
Cost Of Equity, 87, Acct Rev. (2012) 449-482; and Shuai Ma. Economic 
Links and the Spillover Effect of Earnings Quality on Market Risk. 
92 Acct Rev. (2017). 213-245.
---------------------------------------------------------------------------

    The proposed 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 
proposed Rule 2-01. If the larger audit firms are the ones more likely 
to engage in non-audit relationships and services, and therefore, are 
more likely not to be in compliance with the existing Rule 2-01, then 
these firms are more likely to be positively affected by the proposed 
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 the auditing business of smaller audit firms. 
However, we estimate that the four largest accounting firms already 
perform 46 percent of audits for all registrants (or about 75 percent 
of accelerated and large accelerated filers) and more than 80 percent 
in the registered investment company space.\98\ As a result, we do not 
expect any potential change in the competitive dynamics among auditor 
firms to be significant.
---------------------------------------------------------------------------

    \98\ See supra note 71. Also, 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. There were 23 accounting firms performing audits 
for these investment companies. These audit services were very 
concentrated, as 86% of the funds were audited by the four largest 
accounting firms.
---------------------------------------------------------------------------

E. Alternatives

    We considered certain alternative approaches to the proposed 
amendments, which we summarize below.
    The proposed amendments would exclude certain student loans of a 
covered person that were obtained prior to the individual becoming a 
covered person in the audit firm from consideration as part of the 
independence analysis, as such loans are less likely to influence an 
auditor's objectivity and impartiality. The proposed exclusion, 
however, would not encompass student loans to immediate family members 
of the covered person. An alternative approach would be to exclude all 
student loans of a covered person and the individual's immediate family 
members obtained before the individual became a covered person. Student 
loans for immediate family members are individually similar to those 
for the covered person and may be less likely to pose threats to the 
objectivity or impartiality of the covered person. Excluding such loans 
could further address auditors' constraints when seeking to maintain 
compliance with the auditor independence requirements. However, when 
all student loans of the covered person's immediate family members are 
considered, the aggregated amount could be significant and, as a 
result, excluding such loans could increase threats to the covered 
person's independence.
    Another alternative to the exclusion of student loans of the 
covered person would be a bright-line test in which, if the percentage 
of the aggregate amount of the student loans of a covered person and 
his or her immediate family members to the total wealth of the covered 
person's family is below a certain threshold, then all of the students 
loans would be excluded from the prohibition. This alternative has the 
advantage of better capturing the importance of the student loans to 
the covered person's financial interests. However, this alternative, 
because it is a bright-line test, may lead to over-identifying or 
under-identifying scenarios where the auditor's objectivity and 
impartiality are deemed impaired, especially in cases close to the 
selected percentage threshold. In addition, this alternative could 
present operational and privacy challenges in calculating and 
monitoring changes to a family's total wealth.
    The proposed transition framework for merger and acquisition 
transactions includes a provision that in certain situations allows 
affected auditors and audit clients up to six months following the 
completion of the transaction to promptly correct the prohibited 
relationship or service. An alternative approach would be to require 
correction within six months following the merger or acquisition 
announcement. A benefit of this alternative approach would be the 
improved timeliness of auditor compliance following merger and 
acquisition transactions. Under this alternative, auditors and 
registrants would assess independence compliance analysis immediately 
following the

[[Page 2350]]

announcement that a definite agreement has been reached. However, some 
mergers and acquisitions take a long time to be completed and a 
substantial portion of such transactions never reach completion. As a 
result, an alternative window of six months following announcement of 
the merger or acquisition may unnecessarily increase compliance burdens 
and associated costs (e.g., switching costs) for both affected 
companies and their auditors when such transactions are delayed or 
never successfully completed.
    Finally, an alternative approach to shortening the look-back period 
for domestic first time filers would be to increase the look-back 
period for foreign first time filers to align with the current 
requirement for domestic first time filers. While this alternative 
would help level the playing field for both domestic and foreign first 
time filers and reduce the likelihood of potential independence 
impairing relationships and services, it would increase compliance 
burdens for foreign first time issuers and thus may reduce the 
incentives for the foreign first time filers to list in the United 
States, thereby impeding capital formation and limiting investment 
opportunities for U.S. investors.

F. Request for Comment

    We request comment on all aspects of our economic analysis, 
including the potential costs and benefits of the proposed amendments 
and alternatives thereto, and whether the rules, if adopted, would 
promote efficiency, competition, and capital formation or have an 
impact on investor protection. Commenters are requested to provide 
empirical data, estimation methodologies, and other factual support for 
their views, in particular, on costs and benefits estimates.

IV. Paperwork Reduction Act

    The amendments we are proposing do not impose any new ``collections 
of information'' within the meaning of the Paperwork Reduction Act of 
1995 (``PRA''),\99\ nor do they create any new filing, reporting, 
recordkeeping, or disclosure requirements. Accordingly, we are not 
submitting the proposed amendments to the Office of Management and 
Budget for review in accordance with the PRA.\100\ We request comment 
on whether our conclusion that the proposed amendments would not impose 
any new collections of information is correct.
---------------------------------------------------------------------------

    \99\ 44 U.S.C. 3501 et seq.
    \100\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------

V. Initial Regulatory Flexibility Act Analysis

    The Regulatory Flexibility Act (``RFA'') \101\ requires the 
Commission, in promulgating rules under section 553 of the 
Administrative Procedure Act,\102\ to consider the impact of those 
rules on small entities. We have prepared this Initial Regulatory 
Flexibility Act Analysis (``IRFA'') in accordance with 5 U.S.C. 603. 
This IRFA relates to the proposed amendments to Rule 2-01 of Regulation 
S-X.
---------------------------------------------------------------------------

    \101\ 5 U.S.C. 601 et seq.
    \102\ 5 U.S.C. 553.
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Proposed Action

    As discussed above, the primary reason for, and objective of, the 
proposed amendments is to update certain provisions within the 
Commission's auditor independence rules to more effectively focus the 
analysis on those relationships or services that are more likely to 
pose threats to an auditor's objectivity and impartiality. 
Specifically, the proposed amendments would:
     Amend the definitions of affiliate of the audit client and 
ICC to address certain affiliate relationships;
     Shorten the look-back period for domestic first time 
filers in assessing compliance with the independence requirements;
     Add certain student loans and de minimis consumer loans to 
the categorical exclusions from independence-impairing lending 
relationships;
     Replace the reference to ``substantial stockholders'' in 
the business relationship rule with the concept of beneficial owners 
with significant influence;
     Introduce a transition framework for merger and 
acquisition transactions to consider whether an auditor's independence 
is impaired; and
     Make certain other updates.
    The reasons for, and objectives of, the proposed rules are 
discussed in more detail in Sections I and II above.

B. Legal Basis

    We are proposing the amendments pursuant to 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.

C. Small Entities Subject to the Proposed Rules

    The proposed amendments would 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.'' \103\ The Commission's rules define ``small business'' 
and ``small organization'' for purposes of the Regulatory Flexibility 
Act for each of the types of entities regulated by the Commission. 
Securities Act Rule 157 \104\ and Exchange Act Rule 0-10(a) \105\ 
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 small 
entities subject to the proposed amendments.\106\ The proposed 
amendments would 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 proposed amendments would 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.
---------------------------------------------------------------------------

    \103\ 5 U.S.C. 601(6).
    \104\ 17 CFR 230.157.
    \105\ 17 CFR 240.0-10(a).
    \106\ 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 thereto, 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.
---------------------------------------------------------------------------

    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.\107\ 
Commission staff estimates that, as of June 2019, approximately 42 
registered open-end mutual funds, 8 registered ETFs, 33 registered 
closed-end funds, and 16 BDCs (collectively, 99 funds) are small 
entities.\108\
---------------------------------------------------------------------------

    \107\ 17 CFR 270.0-10(a).
    \108\ This estimate is derived an analysis of data obtained from 
Morningstar Direct as well as data reported to the Commission for 
the period ending June 2019.

---------------------------------------------------------------------------

[[Page 2351]]

    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.\109\
---------------------------------------------------------------------------

    \109\ 17 CFR 275.0-7.
---------------------------------------------------------------------------

    We estimate, as June 30, 2019, that there are approximately 470 
investment advisers that would be subject to the proposed amendments 
that may be considered small entities.\110\
---------------------------------------------------------------------------

    \110\ This estimate is based on SEC registered investment 
adviser responses to Item 12 of Form ADV.
---------------------------------------------------------------------------

    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,\111\ 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.\112\ As of December 31, 2018, there are approximately 985 
small entity broker-dealers that will be subject to the final 
amendments.\113\
---------------------------------------------------------------------------

    \111\ 17 CFR 240.17a-5(d).
    \112\ 17 CFR 240.0-10(c).
    \113\ 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.
---------------------------------------------------------------------------

    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.\114\ 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 request comment on the number of 
accounting firms with revenue under $20.5 million.
---------------------------------------------------------------------------

    \114\ 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.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping and Other Compliance Requirements

    The proposed amendments would not impose any reporting, 
recordkeeping, or disclosure requirements. The proposed amendments 
would impose new compliance requirements with respect to Rule 2-01.
    With respect to the proposed amendments related to student loans, 
consumer loans, and the definition of the audit and engagement period 
for first time filers, we believe that such proposed amendments would 
not increase costs for smaller entities, including smaller accounting 
firms. With respect to the proposed amendments related to the 
definitions of affiliate of the audit client and ICC, the proposed 
amendments should serve to reduce, if at all, the number of entities 
that are deemed affiliates of the audit client. As such, any additional 
compliance effort related to the revised definitions would be offset by 
the less restrictive nature of the proposed definition as compared to 
the current definition.
    With respect to the proposed amendment adding a merger and 
acquisition transition framework, there would be a new compliance 
burden only if the auditor and its client seek to avail themselves of 
the framework. As such, any additional compliance effort would be 
offset in any circumstance where relationships and services prohibited 
under the current rule would be deemed not to impair independence under 
the proposed amendments.
    Regarding the amendment to the Business Relationship Rule to 
replace the reference to ``substantial stockholders'' with the concept 
of beneficial owners with significant influence, the concept of 
``significant influence'' already exists in other parts of the auditor 
independence rules, including the recently amended Loan Provision.\115\ 
As such, we believe that affected entities likely would be able to 
leverage any existing practices, processes or controls to comply with 
the proposed amendments compared to having separate compliance 
requirements by retaining the reference to substantial stockholder.
---------------------------------------------------------------------------

    \115\ See supra note 7.
---------------------------------------------------------------------------

    Compliance with the proposed amendments would require the use of 
professional skills, including accounting and legal skills. The 
proposed amendments are discussed in detail in Section II above. We 
discuss the economic impact, including the estimated costs, of the 
proposed amendments in Section III (Economic Analysis) above.

E. Duplicative, Overlapping, or Conflicting Federal Rules

    We believe that the proposed amendments would not duplicate, 
overlap or conflict with other Federal rules.

F. Significant Alternatives

    The RFA directs us to consider alternatives that would accomplish 
our stated objectives while minimizing any significant adverse impacts 
on small entities. In connection with the proposed amendments, we 
considered certain types of alternatives, including:
    (1) The establishment of differing compliance or reporting 
requirements or timetables that take into account the resources 
available to small entities;
    (2) The clarification, consolidation or simplification of 
compliance and reporting requirements under the rule for small 
entities;
    (3) The use of performance rather than design standards; and
    (4) An exemption from coverage of the rule, or any part of the 
rule, for small entities.
    In connection with our proposed amendments to Rule 2-01, we do not 
think it feasible or appropriate to establish different compliance or 
reporting requirements or timetables for small entities. The proposed 
amendments are designed to address compliance challenges for both large 
and small audit clients and audit firms. With respect to clarification, 
consolidation or simplification of compliance and reporting 
requirements for small entities, the proposed amendments do not contain 
any new reporting requirements.
    While the proposed amendments establishing a materiality test for 
common control in the affiliate of the audit client definition, 
amending the ICC definition, providing a transition framework for 
mergers and acquisitions, and using a ``significant influence'' test in 
the Business Relationships Rule would create new compliance 
requirements, these proposed amendments are meant to better identify 
those relationships and services that could impair an auditor's 
objectivity and impartiality thereby resulting in fewer instances where 
certain relationships and services would cause the auditor to violate 
our independence requirements, as compared to the current rule. The 
flexibility that could result from the proposed amendments

[[Page 2352]]

would be applicable to all affected entities, regardless of size.
    With respect to using performance rather than design standards, we 
note that several of the proposed amendments are more akin to 
performance standards. Rather than prescribe the specific steps 
necessary to apply such standards, the proposed amendments recognize 
that ``materiality'' and ``significant influence'' can be implemented 
using reasonable judgment to achieve the intended result. Regarding the 
mergers and acquisitions transition framework, the proposed amendments 
do not prescribe specific procedures or processes and instead focus on 
requiring the performance that would lead to the identification of 
potential violations and how to address such violations. We believe 
that the use of these standards would accommodate entities of various 
sizes while potentially avoiding overly burdensome methods that may be 
ill-suited or unnecessary given the facts and circumstances.
    The proposed amendments are intended to update the independence 
rules to reflect recent feedback received from the public and our 
experience administering those rules since their adoption nearly two 
decades ago and address certain compliance challenges for audit firms 
and their clients, including those that are small entities. In this 
respect, exempting small entities from the proposed amendments would 
increase, rather than decrease, their regulatory burden relative to 
larger entities.

G. Solicitation of Comment

    We encourage the submission of comments with respect to any aspect 
of this IRFA. In particular, we request comments regarding:
     The number of small entities that may be subject to the 
proposed amendments;
     The existence or nature of the potential impact of the 
proposed amendments on small entities discussed in the analysis;
     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.
    Respondents are asked to describe the nature of any impact and 
provide empirical data supporting the extent of the impact. Such 
comments will be considered in the preparation of the Final Regulatory 
Flexibility Analysis, if the proposed amendments are adopted, and will 
be placed in the same public file as comments on the proposed 
amendments.

VI. Small Business Regulatory Enforcement Fairness Act

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996 (``SBREFA''),\116\ the Commission must advise the Office of 
Management and Budget as to whether a proposed regulation constitutes a 
``major'' rule. Under SBREFA, a rule is considered ``major'' when, if 
adopted, it results or is likely to result in:
---------------------------------------------------------------------------

    \116\ Public Law 104-121, Tit. II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more 
(either in the form of an increase or a decrease);
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effects on competition, investment or 
innovation.
    If a rule is ``major,'' its effectiveness generally will be delayed 
for 60 days pending Congressional review.
    We request comment on whether our proposed amendments would be a 
``major rule'' for purposes of SBREFA. We solicit comment and empirical 
data on:
     The potential effect on the U.S. economy on an annual 
basis;
     Any potential increase in costs or prices for consumers or 
individual industries; and
     Any potential effect on competition, investment or 
innovation.
    We request those submitting comments to provide empirical data and 
other factual support for their views to the extent possible.

VII. Statutory Basis

    The proposed amendments described in this release are being 
proposed 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 of 1940, and Sections 203 and 211 of the Investment 
Advisers Act of 1940.

List of Subjects in 17 CFR Part 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 proposes to amend 
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
0
a. Removing Preliminary Note to Sec.  210.2-01;
0
b. Adding an introductory paragraph;
0
c. Revising paragraph (c)(1)(ii)(A)(1)(iii);
0
d. Revising paragraph (c)(1)(ii)(A)(1)(iv);
0
e. Adding paragraph (c)(1)(ii)(A)(1)(v);
0
f. Revising paragraph (c)(1)(ii)(E);
0
g. Revising paragraph (c)(2)(iii)(B)(2)(i);
0
h. Revising paragraph (c)(2)(iii)(C)(3)(i);
0
i. Revising paragraph (c)(3);
0
j. Revising paragraph (c)(6)(i)(A)(1);
0
k. Revising paragraph (c)(6)(i)(B)(1);
0
l. Revising paragraph (e);
0
m. Revising paragraph (f)(4);
0
n. Revising paragraph (f)(5)(iii);
0
o. Revising paragraph (f)(6); and
0
p. Revising paragraph (f)(14), to read as follows:


Sec.  210.2-01   Qualifications of accountants.

    Section 210.2-01 is designed to ensure that auditors are qualified 
and independent of their audit clients both in fact and in appearance. 
Accordingly, the rule sets forth restrictions on financial, employment, 
and business relationships between an accountant and an audit client 
and restrictions on an accountant providing certain non-audit services 
to an audit client. Section 210.2-01(b) sets forth the general standard 
of auditor independence. Paragraphs (c)(1) to (c)(5) of this section 
reflect the application of the general standard to particular 
circumstances. The rule does not purport to, and the Commission could 
not, consider all circumstances that raise independence concerns, and 
these are subject to the general standard in Sec.  210.2-01(b). In 
considering this standard, the Commission looks in the first instance 
to whether a relationship or the provision of a service: Creates a 
mutual or conflicting interest between the

[[Page 2353]]

accountant and the audit client; places the accountant in the position 
of auditing his or her own work; results in the accountant acting as 
management or an employee of the audit client; or places the accountant 
in a position of being an advocate for the audit client. These factors 
are general guidance only, and their application may depend on 
particular facts and circumstances. For that reason, Sec.  210.2-01(b) 
provides that, in determining whether an accountant is independent, the 
Commission will consider all relevant facts and circumstances. For the 
same reason, registrants and accountants are encouraged to consult with 
the Commission's Office of the Chief Accountant before entering into 
relationships, including relationships involving the provision of 
services, that are not explicitly described in the rule.
* * * * *
    (c) * * *
    (1) * * *
    (ii) * * *
    (A) * * *
    (1) * * *
    (iii) Loans fully collateralized by cash deposits at the same 
financial institution;
    (iv) Mortgage loans collateralized by the borrower's primary 
residence provided the loans were not obtained while the covered person 
in the firm was a covered person; and
    (v) Student loans obtained for a covered person's educational 
expenses provided the loans were not obtained while the covered person 
in the firm was a covered person.
* * * * *
    (E) Consumer loans. Any aggregate outstanding consumer loan balance 
owed to a lender that is an audit client that is not reduced to $10,000 
or less on a current basis taking into consideration the payment due 
date and any available grace period.
* * * * *
    (2) * * *
    (iii) * * *
    (B) * * *
    (2) * * *
    (i) Persons, other than the lead partner and the Engagement Quality 
Reviewer, who provided 10 or fewer hours of audit, review, or attest 
services during the period covered by paragraph (c)(2)(iii)(B)(1) of 
this section;
* * * * *
    (C) * * *
    (3) * * *
    (i) Persons, other than the lead partner and the Engagement Quality 
Reviewer, who provided 10 or fewer hours of audit, review, or attest 
services during the period covered by paragraph (c)(2)(iii)(C)(2) of 
this section;
* * * * *
    (3) Business relationships. An accountant is not independent if, at 
any point during the audit and professional engagement period, the 
accounting firm or any covered person in the firm has any direct or 
material indirect business relationship with an audit client, or with 
persons associated with the audit client in a decision-making capacity, 
such as 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. The relationships described in this paragraph (c)(3) 
do not include a relationship in which the accounting firm or covered 
person in the firm provides professional services to an audit client or 
is a consumer in the ordinary course of business.
* * * * *
    (6) * * *
    (i) * * *
    (A) * * *
    (1) The services of a lead partner, as defined in paragraph 
(f)(7)(ii)(A) of this section, or Engagement Quality Reviewer, as 
defined in paragraph (f)(7)(ii)(B) of this section; for more than five 
consecutive years; or
* * * * *
    (B) * * *
    (1) Within the five consecutive year period following the 
performance of services for the maximum period permitted under 
paragraph (c)(6)(i)(A)(1) of this section, performs for that audit 
client the services of a lead partner, as defined in paragraph 
(f)(7)(ii)(A) of this section, or Engagement Quality Reviewer, as 
defined in paragraph (f)(7)(ii)(B) of this section, or a combination of 
those services; or
* * * * *
    (e) Transition provisions for mergers and acquisitions involving 
audit clients. An accounting firm's independence will not be impaired 
because an audit client engages in a merger or acquisition that gives 
rise to a relationship or service that is inconsistent with this rule, 
provided that:
    (i) The accounting firm is in compliance with the applicable 
independence standards related to the services or relationships when 
the services or relationships originated and throughout the period in 
which the applicable independence standards apply;
    (ii) The accounting firm's lack of independence under this rule has 
been or will be corrected as promptly as possible under relevant 
circumstances as a result of the occurrence of the merger or 
acquisition;
    (iii) The accounting firm has in place a quality control system as 
described in Rule 2-01(d)(3) that has the following features:
    (A) Procedures and controls that monitor the audit client's merger 
and acquisition activity to provide timely notice of a merger or 
acquisition; and
    (B) Procedures and controls that allow for prompt identification of 
potential violations after initial notification of a potential merger 
or acquisition that may trigger independence violations, but before the 
transaction has occurred.
    (f) * * *
    (4) Affiliate of the audit client means:
    (i) An entity:
    (A) That has control over the audit client or over which the audit 
client has control, including the audit client's parents and 
subsidiaries;
    (B) Which is under common control with the audit client, including 
the audit client's parents and subsidiaries, unless the entity is not 
material to the controlling entity;
    (C) Over which the audit client has significant influence, unless 
the entity is not material to the audit client; and
    (D) That has significant influence over the audit client, unless 
the audit client is not material to the entity; or
    (ii) Each entity in the investment company complex as determined in 
paragraph (f)(14) of this section when the entity under audit is an 
investment company or investment adviser or sponsor, as those terms are 
defined in paragraphs (f)(14)(ii), (iii), and (iv) of this section.
    (5) * * *
    (iii) The ``audit and professional engagement period'' does not 
include periods ended prior to the first day of the last fiscal year 
before the issuer first filed, or was required to file, a registration 
statement or report with the Commission, provided there has been full 
compliance with applicable independence standards in all prior periods 
covered by any registration statement or report filed with the 
Commission.
    (6) Audit client means the entity whose financial statements or 
other information is being audited, reviewed, or attested to and any 
affiliates of the audit client, other than, for purposes of paragraph 
(c)(1)(i) of this section, entities that are affiliates of the audit 
client only by virtue of paragraphs (f)(4)(i)(C), (f)(4)(i)(D), or 
(f)(14)(i)(E) of this section.
* * * * *

[[Page 2354]]

    (14) * * *
    (i) * * *
    (A) An entity under audit that is an:
    (1) Investment company; or
    (2) Investment adviser or sponsor;
    (B) The investment adviser or sponsor of any investment company 
identified in paragraph (f)(14)(i)(A)(1) of this section;
    (C) Any entity controlled by or controlling any investment adviser 
or sponsor identified in paragraph (f)(14)(i)(A)(2) or (B), or any 
investment company identified in paragraph (f)(14)(i)(A)(1), of this 
section;
    (D) Any entity under common control with any investment company 
identified in paragraph (f)(14)(i)(A)(1) of this section, any 
investment adviser or sponsor identified in paragraph (f)(14)(i)(A)(2) 
or (B) of this section, or any entity identified in paragraph 
(f)(14)(i)(C) of this section; if the entity:
    (1) Is an investment company, investment adviser or sponsor, unless 
the entity is not material to the controlling entity; or
    (2) Is engaged in the business of providing administrative, 
custodian, underwriting, or transfer agent services to any entity 
identified in paragraphs (f)(14)(i)(A) through (f)(14)(i)(B);
    (E) Any entity over which any entity identified in paragraph 
(f)(14)(i)(A) of this section has significant influence, unless the 
entity is not material to the entity identified in paragraph 
(f)(14)(i)(A), or any entity that has significant influence over any 
entity in paragraph (f)(14)(i)(A) of this section, unless the entity 
identified in paragraph (f)(14)(i)(A) is not material to the entity 
that has significant influence over it; and
    (F) Any investment company that has an investment adviser or 
sponsor included in this definition by paragraphs (f)(14)(i)(A) through 
(f)(14)(i)(D) of this section.
    (ii) An investment adviser, for purposes of this definition, does 
not include a sub-adviser whose role is primarily portfolio management 
and is subcontracted with or overseen by another investment adviser.
    (iii) Sponsor, for purposes of this definition, is an entity that 
establishes a unit investment trust.
    (iv) An investment company, for purposes of paragraph (f)(14) of 
this section, means 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.C. 80-a3(c)).
* * * * *

    By the Commission.

    Dated: December 30, 2019.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2019-28476 Filed 1-14-20; 8:45 am]
 BILLING CODE 8011-01-P