# Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2019-13429

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** July 5, 2019
- **Citation:** 84 FR 32040

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 210
[Release No. 33-10648; 34-86127; FR-85; IA-5255; IC-33511; File No. S7-10-18]
RIN 3235-AM01
Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is adopting amendments to its auditor independence rules to refocus the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period. The amendments focus the analysis on beneficial ownership rather than on both record and beneficial ownership; replace the existing 10 percent bright-line shareholder ownership test with a “significant influence” test; add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities; and exclude from the definition of “audit client,” for a fund under audit, any other funds, that otherwise would be considered affiliates of the audit client under the rules for certain lending relationships. The amendments will more effectively identify debtor-creditor relationships that could impair an auditor's objectivity and impartiality, as opposed to certain more attenuated relationships that are unlikely to pose such threats, and thus will focus the analysis on those borrowing relationships that are important to investors.

DATES:

The final rules are effective on October 3, 2019.

FOR FURTHER INFORMATION CONTACT:

Peggy Kim, Senior Special Counsel, Office of the Chief Accountant, or Giles T. Cohen, Acting Chief Counsel, at (202) 551-5300; Daniel Rooney, Assistant Chief Accountant, Chief Accountant's Office, Division of Investment Management, at (202) 551-6918; or Joel Cavanaugh, Senior Counsel, Investment Company Regulation Office, Division of Investment Management, at (202) 551-6792, U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

We are adopting amendments to 17 CFR 210.2-01 (“Rule 2-01 of Regulation S-X”).

Table of Contents

I. Introduction

II. Final Amendments

A. Overview of the Final Amendments

B. Focus the Analysis on Beneficial Ownership

1. Proposed Amendments

2. Comments

3. Final Amendments

C. Significant Influence Test

1. Proposed Amendments

2. Comments

3. Final Amendments

D. Reasonable Inquiry Compliance Threshold

1. Proposed Amendments

2. Comments

3. Final Amendments

E. Excluding Other Funds That Would Be Considered Affiliates of the Audit Client

1. Proposed Amendments

2. Comments

3. Final Amendments

F. Other Comments

1. Materiality Qualifier

2. Other Potential Changes to the Auditor Independence Rules

III. Other Matters

IV. Paperwork Reduction Act

V. Economic Analysis

A. General Economic Considerations

B. Baseline

C. Anticipated Benefits and Costs

1. Anticipated Benefits

2. Anticipated Costs and Potential Unintended Consequences

D. Effects on Efficiency, Competition, and Capital Formation

E. Alternatives

VI. Final Regulatory Flexibility Analysis

A. Need for the Amendments

B. Significant Issues Raised by Public Comment

C. Small Entities Subject to the Final Rules

D. Projected Reporting, Recordkeeping and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

VII. Codification Update

VIII. Statutory Basis

I. Introduction

The Commission's auditor independence standard set forth in Rule 2-01 of Regulation S-X requires auditors
1

to be independent of their audit clients both “in fact and in appearance.”
2

Rule 2-01(b) provides that the Commission will not recognize

an accountant as independent with respect to an audit client if the accountant is not (or if a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not) capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement.
3

Furthermore, in determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between an accountant and the audit client.
4

1
Rule 2-01 refers to “accountants” rather than “auditors.” We use these terms interchangeably in this Release.

2

See
Preliminary Note 1 to Rule 2-01 and Rule 2-01(b) of Regulation S-X.
See also United States
v.
Arthur Young & Co.,
465 U.S. 805, 819 n.15 (1984) (“It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional.”).

3

See
Rule 2-01(b) of Regulation S-X.

4

See id.

Rule 2-01(c) sets forth a nonexclusive list of circumstances that the Commission considers to be inconsistent with the independence standard in Rule 2-01(b), including certain direct financial relationships between an accountant and audit client and other circumstances where the accountant has a financial interest in the audit client.
5

In particular, the existing restriction on debtor-creditor relationships in Rule 2-01(c)(1)(ii)(A) (the “Loan Provision”) generally provides that an accountant is not independent when (a) the accounting firm, (b) any covered person
6

in the accounting firm (
e.g.,
the audit engagement team and those in the chain of command), or (c) any of the covered person's immediate family members has any loan (including any margin loan) to or from (x) an audit client, or (y) an audit client's officers, directors, or (z) record or beneficial owners of more than 10 percent of the audit client's equity securities.
7

Simply because a lender to an auditor holds 10 percent or less of an audit client's equity securities does not, in itself, establish that the auditor is independent under Rule 2-01 of Regulation S-X. The general standard under Rule 2-01(b) and the remainder of Rule 2-01(c) still apply to auditors and their audit clients regardless of the applicability of the Loan Provision.

5

See
Rule 2-01(c) of Regulation S-X;
see also
Revision of the Commission's Auditor Independence Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)] (“2000 Adopting Release”)
available at https://www.sec.gov/rules/final/33-7919.htm,
at 65 FR 76009 (“The amendments [to Rule 2-01 adopted in 2000] identify certain relationships that render an accountant not independent of an audit client under the standard in Rule 2-01(b). The relationships addressed include, among others, financial, employment, and business relationships between auditors and audit clients . . . .”).

6

See
Rule 2-01(f)(11) of Regulation S-X (defining the term “covered person”).

7

See
2000 Adopting Release,
supra
footnote 5 at 65 FR 76035.

In the below illustration, pursuant to the Loan Provision, a lending relationship between any entity in the left hand column and any entity in the right-hand column impairs independence, unless an exception applies.

ER05JY19.000

When the Commission proposed the Loan Provision in 2000, it noted that a debtor-creditor relationship between an auditor and its audit client reasonably could be viewed as “creating a self-interest that competes with the auditor's obligation to serve only investors' interests.”
8

The Commission's concern about a competing self-interest extended beyond loans directly between the auditor and its audit client to loans between the auditor and those shareholders of the audit client who have a “special and influential role” with the audit client.
9

As a proxy for identifying a “special and influential role,” the Commission adopted a bright-line test for loans to or from a record or beneficial owner of more than 10 percent of an audit client's equity securities.
10

8

See
Proposed Rule: Revision of the Commission's Auditor Independence Requirements, Release No. 33-7870 (June 30, 2000) [65 FR 43148 (July 12, 2000)] (“2000 Proposing Release”),
available at https://www.sec.gov/rules/proposed/34-42994.htm,
at 65 FR 43161.

9

See
2000 Adopting Release,
supra
footnote 5, at 65 FR 76035.

10
The Commission proposed that the Loan Provision include a five-percent equity ownership threshold, but raised the threshold to 10 percent when it adopted the Loan Provision.
See
2000 Adopting Release,
supra
footnote 5, at 65 FR 76035. As the basis for its use of a 10 percent threshold, the Commission pointed to similar 10 percent ownership thresholds elsewhere in the federal securities laws, including 17 CFR 210.1-02(r) (Rule 1-02(r) of Regulation S-X) (defining “principal holder of equity securities”), Rule 1-02(s) of Regulation S-X (defining “promoter”), and Section 16 of the Securities Exchange Act of 1934 [15 U.S.C. 78a
et seq.
] (the “Exchange Act”) (requiring reporting to the Commission of beneficial ownership information by directors, officers, and beneficial owners of more than 10 percent of any class of equity securities of an issuer).
Id.

Under Rule 2-01(f)(6) of Regulation S-X, the term “audit client” is defined to include any affiliate of the entity whose financial statements are being

audited.
11

Rule 2-01(f)(4) provides that “affiliates of the audit client” include entities that control, are controlled by, or are under common control with the audit client.
12

As a result, generally, an accounting firm is not independent under the Loan Provision if it has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of the equity securities of either (a) the firm's audit client; or (b) any entity that is a controlling parent company of the audit client, a controlled subsidiary of the audit client, or an entity under common control with the audit client.

11

See
Rule 2-01(f)(6) of Regulation S-X.

12

See
Rule 2-01(f)(4) of Regulation S-X, in which an “affiliate of the audit client” includes the following: (1) An entity that has control over the audit client, or over which the audit client has control, or which is under common control with the audit client, including the audit client's parents and subsidiaries; (2) An entity over which the audit client has significant influence, unless the entity is not material to the audit client; (3) An entity that has significant influence over the audit client, unless the audit client is not material to the entity; and (4) Each entity in the investment company complex when the audit client is an entity that is part of an investment company complex.

In addition, the term “affiliate of the audit client” includes each entity in an investment company complex (“ICC”) of which the audit client is a part.
13

Accordingly, in the ICC context, an accounting firm is considered not independent under the Loan Provision if it has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of any entity within the ICC, regardless of which entities in the ICC are audited by the accounting firm.

13

See id.
“Investment company complex” in Rule 2-01(f)(14) of Regulation S-X includes: (1) An investment company and its investment adviser or sponsor; (2) Any entity controlled by or controlling an investment adviser or sponsor in paragraph (f)(14)(i)(A), or any entity under common control with an investment adviser or sponsor in paragraph (f)(14)(i)(A) if the entity: (i) Is an investment adviser or sponsor; or (ii) Is engaged in the business of providing administrative, custodian, underwriting, or transfer agent services to any investment company, investment adviser, or sponsor; and (3) Any investment company or entity that would be an investment company but for the exclusions provided by section 3(c) of the Investment Company Act of 1940 (15 U.S.S. 80a-3(c) that has an investment adviser or sponsor included in the definition by either paragraph (f)(14)(i)(A) or (B).

The Commission has become aware that, in certain circumstances, the existing Loan Provision may not be functioning as it was intended. Registered investment companies, other pooled investment vehicles, and registered investment advisers have expressed concerns about the Loan Provision in both public disclosures and, together with their auditors, in extensive consultations with Commission staff.
14

It has become clear that there are certain fact patterns in which an auditor's objectivity and impartiality are not impaired despite a failure to comply with the requirements of the Loan Provision. These fact patterns have arisen most frequently with respect to funds, although as noted in the Proposing Release, non-fund issuers also have faced challenges associated with the Loan Provision.
15

14

See
Section I.B. of Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018) [83 FR 20753 (May 8, 2018)] (“Proposing Release”), at 83 FR 20756.

15

See
footnote 20 of the Proposing Release. As discussed below, our amendments to Rule 2-01 will define “fund” as it relates to the Loan Provision as: (i) An investment company or an entity that would be an investment company but for the exclusions provided by Section 3(c) (15 U.S.C. 80a-3(c)) of the Investment Company Act of 1940 (the “Investment Company Act”); or (ii) a commodity pool as defined in Section 1a(10) of the U.S. Commodity Exchange Act, as amended (“CEA”) that is not an investment company or does not rely on Section 3 of the Investment Company Act.
See
Rule 2-01(c)(1)(ii)(A)(
2
)(
ii
).

The Commission understands that accounting firms use loans to help finance their core business operations. Accounting firms frequently obtain financing to pay for their labor and out-of-pocket expenses before they receive payments from audit clients for those services. Accounting firms also use financing to fund current operations and provide capital to fund ongoing investments in their audit methodologies and technology. Accounting firms borrow from commercial banks or through private placement debt issuances, typically purchased by large financial institutions, both of which give rise to debtor-creditor relationships.
16

For creditor diversification purposes, credit facilities provided or arranged by commercial banks are often syndicated among multiple financial institutions, thereby expanding the number of lenders to an accounting firm. As a result, accounting firms typically have a wide array of borrowing arrangements. These arrangements facilitate firms' provision of audit services to investors and other market participants, but also multiply the number of lenders that may be record or beneficial owners of securities in audit clients and that must be analyzed under the Loan Provision.

16
The Commission further understands that insurance companies may purchase accounting firms' private placement notes. Insurance companies may also act as sponsors of insurance products and may be record owners, on behalf of contract holders, of certain investment companies' equity securities.

These accounting firms' financing methods appear to have resulted in various scenarios in which the Loan Provision deems an accounting firm's independence to be impaired, notwithstanding that the relevant facts and circumstances regarding the relationships between the auditor and the audit client suggest that in most cases the auditor's objectivity and impartiality do not appear to be affected as a practical matter. Nevertheless, auditors and audit committees
17

may feel obligated to devote substantial resources to evaluating potential instances of non-compliance with the existing Loan Provision, which could distract auditors' and audit committees' attention from matters that may be more likely to bear on the auditor's objectivity and impartiality.
18

Audit committees' receipt of a high volume of communications of such relationships could dilute the impact of communications that identify issues that may actually raise concerns about an auditor's independence.

17
The audit committees of issuers, including registered investment companies, may also be focused on this issue because, under the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”), audit committees are responsible for the selection, compensation, and oversight of such issuers' independent auditors.
See
17 CFR 240.10A-3 (Rule 10A-3 under the Exchange Act). In this Release, we use the term “audit committee,” when referring to funds, generally to refer to audit committees established by a fund's board of directors or trustees or, where no formal audit committee exists (
e.g.,
for certain private funds), those responsible for the governance of the fund. In the absence of an audit committee, the entire board of directors will be considered to be the audit committee.
See, e.g.,
Standards Relating to Listed Company Audit Committees, Release No. 33-8220 (Apr. 3, 2003) [68 FR 18788 (Apr. 16, 2003)].

18
For audits conducted pursuant to the standards of the Public Company Accounting Oversight Board (“PCAOB”), auditors are required to communicate any relationships, including lending relationships, with the audit client that may reasonably be thought to bear on independence to the audit committee at least annually.
See, e.g.,
PCAOB Rule 3526 (requiring a registered public accounting firm, at least annually with respect to each of its audit clients, to: (1) Describe, in writing, to the audit committee of the audit client, all relationships between the registered public accounting firm or any affiliates of the firm and the audit client or persons in financial reporting oversight roles at the audit client that, as of the date of the communication, may reasonably be thought to bear on independence; (2) discuss with the audit committee of the audit client the potential effects of the relationships described in subsection (b)(1) on the independence of the registered public accounting firm; (3) affirm to the audit committee of the audit client, in writing, that, as of the date of the communication, the registered public accounting firm is independent in compliance with Rule 3520; and (4) document the substance of its discussion with the audit committee of the audit client).

Similarly, numerous violations of the independence rules that no reasonable investor would view as implicating an auditor's objectivity and impartiality could desensitize market participants to other, more significant violations of the independence rules. Respect for the

seriousness of these obligations, and attention to any breach or potential breach of these obligations, is better fostered through limiting violations to those instances in which the auditor's independence would be impaired in fact or in appearance.

Moreover, searching for, identifying, and assessing non-compliance or potential non-compliance with the Loan Provision and reporting these instances to audit committees also may generate significant costs for entities and their advisers and auditors, which are ultimately borne by shareholders. These costs are unlikely to have corresponding benefits to the extent that the Loan Provision's breadth identifies and requires analysis of circumstances that are unlikely to bear on the auditor's independence.

In addition, the compliance challenges associated with the Loan Provision can have broader disruptive effects, particularly for funds.
19

For example, in order for a registered open-end fund to make a continuous offering of its securities, it must maintain a current prospectus by periodically filing post-effective amendments to its registration statement that contain updated financial information audited by an independent public accountant in accordance with Regulation S-X.
20

In addition, the federal securities laws require that investment companies registered under the Investment Company Act transmit annually to shareholders and file with the Commission financial statements audited by an independent registered public accounting firm.
21

Accordingly, non-compliance with the auditor independence rules in some cases could result in affected funds not being able to offer or sell shares, investors not being able to rely on affected financial statements, or funds (and, indirectly, but importantly, their investors) having to incur the costs of re-audits.

19
Registered investment advisers that have custody of client funds or securities also face compliance challenges from the Loan Provision. These advisers generally are required by 17 CFR 275.206(4)-2 (Rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (the “Investment Advisers Act”)) to obtain a surprise examination conducted by an independent public accountant or, for pooled investment vehicles, may be deemed to comply with the requirement by distributing financial statements audited by an independent public accountant to the pooled investment vehicle's investors. An auditor's inability, or potential inability, to comply with the Loan Provision raises questions concerning an adviser's ability to satisfy the requirements of the Custody Rule.

20

See generally
Section 10(a)(3) of the Securities Act of 1933 (the “Securities Act”) [15 U.S.C. 77a
et seq.
] and Item 27 of Form N-1A.

21
15 U.S.C. 80a-1
et seq. See
17 CFR 270.30e-1 and 17 CFR 270.30b2-1 (Rules 30e-1 and 30b2-1 under the Investment Company Act).

In order to provide time for the Commission to address these challenges, and recognizing that funds and their advisers were most acutely affected by the Loan Provision, the Commission staff issued a no-action letter to Fidelity Management & Research Company in 2016 regarding the application of the Loan Provision (“Fidelity No-Action Letter”).
22

In the Fidelity No-Action Letter, the staff stated that it would not recommend enforcement action to the Commission, even though certain Fidelity entities identified in the letter used audit firms that were not in compliance with the Loan Provision, subject to certain conditions specified in the letter (
e.g.,
that notwithstanding such non-compliance, the audit firm had concluded that it is objective and impartial with respect to the issues encompassed within the engagement).
23

Staff has continued to receive inquiries from registrants and accounting firms regarding the application of the Loan Provision, clarification of the Fidelity No-Action Letter, and requests for consultation regarding issues not covered in the Fidelity No-Action Letter.

22

See
No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (June 20, 2016) (“June 20, 2016 Letter”),
available at https://www.sec.gov/divisions/investment/noaction/2016/fidelity-management-research-company-062016.htm.
The June 20, 2016 Letter provided temporary no-action relief and was to expire 18 months from the issuance date. On September 22, 2017, the staff extended the June 20, 2016 Letter until the effective date of any amendments to the Loan Provision adopted by the Commission that are designed to address the concerns expressed in the June 20, 2016 Letter.
See
No-Action Letter from the Division of Investment Management to Fidelity Management & Research Company (Sept. 22, 2017) (“September 22, 2017 Letter”),
available at https://www.sec.gov/divisions/investment/noaction/2017/fidelity-management-research-092217-regsx-rule-2-01.htm.
The Fidelity No-Action Letter therefore will be withdrawn on the effective date of the amendments we are adopting in this release.

23
The June 20, 2016 Letter described the following circumstances, each of which could have potential implications under the Loan Provision: (i) “An institution that has a lending relationship with an Audit Firm holds of record, for the benefit of its clients or customers (for example, as an omnibus account holder or custodian), more than 10 percent of the shares of a Fidelity Entity;” (ii) “An insurance company that has a lending relationship with an Audit Firm holds more than 10 percent of the shares of a Fidelity Fund in separate accounts that it maintains on behalf of its insurance contract holders;” and (iii) “An institution that has a lending relationship with an Audit Firm and acts as an authorized participant or market maker to a Fidelity ETF and holds of record or beneficially more than 10 percent of the shares of a Fidelity ETF.”

In order to address the compliance challenges discussed above, on May 2, 2018, the Commission proposed amendments to its auditor independence rules to refocus the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period.
24

The proposed amendments to the Loan Provision were intended to more effectively identify debtor-creditor relationships that could impair an auditor's objectivity and impartiality, as opposed to certain more attenuated relationships that are unlikely to present threats to objectivity or impartiality. To achieve this objective, the proposed amendments to the Loan Provision would have: (1) Focused the analysis solely on beneficial ownership rather than on both record and beneficial ownership; (2) replaced the existing 10 percent bright-line shareholder ownership test with a “significant influence” test; (3) added a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities; and (4) amended the definition of “audit client” for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client. The Commission also requested comment on certain other potential amendments to its auditor independence rules.

24

See generally
Proposing Release.

In developing the final amendments, we considered the thirty-one comment letters received in response to the Proposing Release.
25

Most commenters expressed general support for the proposed amendments, and only a few commenters did not.

25
The comment letters received in response to the Proposing Release are available at
https://www.sec.gov/comments/s7-10-18/s71018.htm.

II. Final Amendments

A. Overview of the Final Amendments

We are adopting amendments to Rule 2-01 of Regulation S-X that we believe would more effectively identify those debtor-creditor relationships that could impair an auditor's objectivity and impartiality, yet would not include certain attenuated relationships that are unlikely to present threats to objectivity or impartiality.
26

Because compliance challenges associated with applying the Loan Provision have arisen with entities other than funds, and given that we did not receive comments objecting to our proposal to apply these amendments broadly, the final amendments will apply to entities beyond the investment management industry, including

operating companies and registered broker-dealers.

26

See
Rule 2-01(b) of Regulation S-X.

We are adopting the amendments generally as proposed with a few additional changes. As was proposed, we are focusing the analysis on beneficial ownership rather than on both record and beneficial ownership. Also, as proposed, we are replacing the existing 10 percent bright-line shareholder ownership test with a “significant influence” test and adding a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities. In addition, we are excluding from the definition of “audit client,” for a fund under audit, any other funds that otherwise would be considered affiliates of the audit client under the Loan Provision. In a change from the proposal and in response to comments, the final amendments define “fund” for these purposes to also exclude commodity pools and we clarify that foreign funds (as described below) are excluded for purposes of the definition of audit client. Finally, the Chairman has directed the staff to formulate recommendations to the Commission for possible additional changes to the auditor independence rules, as discussed further below.

B. Focus the Analysis on Beneficial Ownership

Where a lender to an auditor holds more than 10 percent of the equity securities of that auditor's audit client either as a beneficial owner or as a record owner, current rules dictate that the auditor is not independent of the audit client. As noted in the Proposing Release, one challenge associated with the Loan Provision is that it applies to both “record” and “beneficial” owners of the audit client's equity securities. However, publicly traded shares, as well as certain fund shares, often are registered in the name of a relatively small number of financial intermediaries
27

as “record” owners for the benefit of their clients or customers. Certain of these financial intermediaries may also be lenders to public accounting firms or be affiliated with financial institutions that may be lenders to public accounting firms. As a result, audit clients may have financial intermediaries that own, on a “record” basis, more than 10 percent of the issuer's shares and are also lenders to public accounting firms, covered persons of accounting firms, and their immediate family members, or are affiliated with companies that are lenders to public accounting firms (see Figure 2 below for illustration). However, these financial intermediaries are not “beneficial” owners and may not have control over whether they are “record” owners of more than 10 percent of the issuer's shares.

27

See infra
footnote 28.

ER05JY19.001

For example, open-end funds, such as mutual funds, may face significant challenges, because the record ownership percentages of open-end funds may fluctuate greatly within a given period for reasons completely out of the control or knowledge of a lender who is also a fund shareholder of record, regardless of their diligence in monitoring compliance. Specifically, as a result of underlying customer activity in an omnibus account (such as when beneficial owners purchase or redeem their shares in an open-end fund) or as a result of the activity of other record or beneficial owners, the record ownership of a lender that is a financial intermediary holding fund shares for customers may exceed, or conversely fall below, the 10 percent threshold within a given period without any

affirmative action on the part of the financial intermediary.
28

In this scenario, the financial intermediary's holdings might constitute less than 10 percent of a mutual fund and, as a result of subsequent redemptions by beneficial owners through other non-affiliated financial intermediaries, the same investment could then constitute more than 10 percent of the mutual fund. However, regardless of their diligence in monitoring compliance, the financial intermediary, the fund, and the auditor may not know that the 10 percent threshold had been exceeded until after the fact.

28
Financial intermediaries such as broker-dealers, banks, trusts, insurance companies, and retirement plan third-party administrators perform the recordkeeping of open-end fund positions and provide services to customers, including beneficial owners and other intermediaries and, in most cases, aggregate their customer records into a single or a few “omnibus” accounts registered in the intermediary's name on the fund transfer agent's recordkeeping system. Shares of other types of registered investment companies, such as closed-end funds, also are frequently held by broker-dealers and other financial intermediaries as record owners on behalf of their customers, who are not required and may be unwilling to provide, information about the underlying beneficial owners to accounting firms, and particularly accounting firms that do not audit the fund. In addition, a financial intermediary may act as an authorized participant or market maker to an exchange-traded fund (“ETF”) and be the holder of record or beneficial owner of more than 10 percent of an ETF.

An open-end fund, or open-end company, is a management company that is offering for sale or has outstanding any redeemable securities of which it is the issuer. A closed-end fund, or closed-end company, is any management company other than an open-end company.
See
Section 5 of the Investment Company Act [15 U.S.C. 80a-5]. ETFs registered with the Commission are organized either as open-end management companies or unit investment trusts.
See
Section 4 of the Investment Company Act [15 U.S.C. 80a-4] (defining the terms “management company” and “unit investment trust”). References to “funds” in this Release include ETFs, unless specifically noted.

1. Proposed Amendments

Under the proposed amendments, the Loan Provision would apply only to beneficial owners of the audit client's equity securities and not to those who merely hold the audit client's equity securities as a holder of record on behalf of their beneficial owners.
29

The Proposing Release noted that tailoring the Loan Provision to focus on the beneficial ownership of the audit client's equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor's independence.
30

29
An equity holder who acquired such ownership by buying a certificated share would be both a record owner and a beneficial owner and thus would continue to be analyzed under the Loan Provision.

30

See
Proposing Release at 20760.

2. Comments

Commenters generally supported the proposed amendment to focus the analysis on beneficial owners,
31

and several of these commenters agreed that tailoring the Loan Provision to focus only on the beneficial ownership of the audit client's equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor's independence.
32

One commenter expressed the view that auditors should not have any lending relationship with any shareholders of an audit client.
33

Several commenters requested clarification of the definition of “beneficial owner” and expressed support for defining “beneficial owner” to refer to those owners with an economic interest in the relevant securities.
34

A number of commenters requested that the Commission reiterate the guidance set forth in footnote 22 of the Proposing Release,
35

describing the entities that are excluded from the scope of the Loan Provision (
e.g.,
entities that are under common control with or controlled by the beneficial owner are excluded from the scope).
36

31

See, e.g.,
CII; Letter from Deloitte LLP, dated June 29, 2018 (“Deloitte”); Letter from PricewaterhouseCoopers LLP, dated June 29, 2018 (“PwC”); Letter from KPMG LLP, dated July 3, 2018 (“KPMG”); Letter from Crowe LLP, dated July 3, 2018 (“Crowe”); Letter from Center for Audit Quality, dated July 3, 2018 (“CAQ”); Letter from National Association of State Boards of Accountancy, dated July 5, 2018 (“NASBA”); Letter from New York State Society of Certified Public Accountants, dated July 6, 2018 (NYSCPA”); Letter from Piercy, Bowler, Taylor & Kern, dated July 6, 2018 (“PBTK”); Letter from MFS Funds Board Audit Committee, dated July 6, 2018 (“MFS Funds”); Letter from Prof. Joseph A. Grundfest, dated July 9, 2018 (“Grundfest”); Letter from Grant Thornton LLP, dated July 9, 2018 (“Grant Thornton”); Letter from Mutual Fund Directors Forum, dated July 9, 2018 (“MFDF”); Letter from BDO USA, LLP, dated July 9, 2018 (“BDO”); Letter from Ernst & Young LLP, dated July 9, 2018 (“EY”); Letter from Fidelity Management Research Company, dated July 9, 2018 (“Fidelity”); Letter from Association of the Bar of the City of New York, dated July 9, 2018 (“NYC Bar”); Letter from Investment Company Institute and Independent Directors Council, dated July 9, 2018 (“ICI/IDC”); Letter from U.S. Chamber of Commerce Center for Capital Markets Competitiveness, dated July 9, 2018 (“CCMC”); Letter from RSM US LLP, dated July 9, 2018 (“RSM”); Letter from T. Rowe Price Funds, dated July 9, 2018 (“T. Rowe Price”); Letter from Financial Executives International, dated July 9, 2018 (“FEI”); Letter from American Institute of Certified Public Accountants, dated July 9, 2018 (“AICPA”); Letter from American Investment Council, dated Jul 9, 2018 (“AIC”); Letter from Securities Industry and Financial Markets Association, dated July 9, 2018 (“SIFMA”); Letter from Invesco Funds, dated July 9, 2018 (“Invesco”); and Letter from Federated Investors, Inc., dated July 10, 2018 (“Federated”).

32

See, e.g.,
CII, Deloitte, PwC, CAQ, BDO, EY, RSM, and ICI/IDC.

33

See
Letter from Tinee Carraker, dated May 20, 2018 (“Carraker”).

34

See, e.g.,
Deloitte, PwC, KPMG, CAQ, Grant Thornton, ICI/IDC, and Invesco.

35

See
footnote 22 of the Proposing Release: “We note that the Loan Provision can be implicated by lending relationships between an auditing firm and those that control the record or beneficial owner of more than 10 percent of the shares of an audit client (
i.e., entities that are under common control with or controlled by the record or beneficial owner are not as such implicated by the Loan Provision
)” (emphasis added).
See also
footnote 5 of the Fidelity No-Action Letter.

36

See, e.g.,
Deloitte, PwC, KPMG, Grant Thornton, ICI/IDC, Invesco, MFS Funds, T. Rowe Price, SIFMA, and Federated.

A few commenters agreed that the proposed amendment would ease compliance burdens,
37

and two commenters stated that the proposed amendment did not raise other auditor independence concerns.
38

Two commenters expressed the view that, even if the Commission amended the Loan Provision to provide for evaluation of beneficial ownership alone, the other proposed amendments would still be necessary and appropriate.
39

37

See, e.g.,
KPMG, Crowe, CAQ, and EY.

38

See
KPMG and EY.

39

See
KPMG and EY.

3. Final Amendments

After considering the comments received, and consistent with the proposal, we are adopting amendments that focus the analysis on beneficial ownership rather than on both record and beneficial ownership. We continue to believe that tailoring the Loan Provision to focus on the beneficial ownership of the audit client's equity securities would more effectively identify shareholders “having a special and influential role with the issuer” and therefore better capture those debtor-creditor relationships that may impair an auditor's independence.

In response to commenters who requested clarification of the term “beneficial owner,” we are providing additional guidance that financial intermediaries, who hold shares as record owners, and who have limited authority to make or direct voting or investment decisions on behalf of the underlying shareholders of the audit clients, are not considered “beneficial owners” for purposes of the Loan Provision.
40

Furthermore, if the financial intermediary undertakes steps to remove its discretion over the voting

or disposition of shares, the financial intermediary generally will not be considered to be a beneficial owner for purposes of the Loan Provision. Such steps could include, for example: (1) Mirror voting (
i.e.,
the intermediary is obligated to vote the shares held by it in the same proportion as the vote of all other shareholders); (2) the financial intermediary holds the shares in an irrevocable voting trust without discretion for the institution to vote the shares; (3) an agreement to pass through the voting rights to an unaffiliated third-party entity; or (4) the intermediary has otherwise relinquished its right to vote such shares.
41

As requested by commenters, we also are reiterating the guidance set forth in the Proposing Release,
42

but with certain conforming changes because the final amendments remove the reference to “record owners” from the Loan Provision and replace the 10 percent bright-line test with a significant influence test.
43

Accordingly, entities that are under common control with or controlled by the beneficial owner of the audit client's equity securities when such beneficial owner has significant influence over the audit client, are excluded from the scope of the Loan Provision.

40
By providing this guidance, we are not interpreting 17 CFR 240.13d-3 (Exchange Act Rule 13d-3), applying the existing standards for determining who is a beneficial owner under Rule 13d-3, or altering these standards.

41

See
2000 Adopting Release,
supra
footnote 5.

42

See supra
footnote 35.

43

See supra
Section II.C.

C. Significant Influence Test

As discussed in the Proposing Release, the current bright-line 10 percent test may be both over- and under-inclusive as a means of identifying those debtor-creditor relationships that actually impair the auditor's objectivity and impartiality. For example, the existing Loan Provision may apply even in situations where the lender may be unable to influence the audit client through its holdings (such as with omnibus accounts that hold as record owner more than 10 percent of the equity shares of an audit client). In such circumstances, the lender's ownership of an audit client's equity securities alone would not threaten an audit firm's objectivity and impartiality. Conversely, the existing Loan Provision does not apply if the auditor's lender owns 10 percent or less of the audit client's equity securities, despite the fact that such an owner may be able to exert significant influence over the audit client through contractual or other means. A holder of 10 percent or less of an audit client's equity securities could, for example, have the contractual right to remove or replace a pooled investment vehicle's investment adviser.

1. Proposed Amendments

The Commission proposed to replace the existing 10 percent bright-line test in the Loan Provision with a “significant influence” test similar to that referenced in other parts of the Commission's auditor independence rules.
44

Specifically, the proposed amendment would provide, in part, that an accountant would not be independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has any loan (including any margin loan) to or from an audit client, or an audit client's officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client's equity securities where such beneficial owner has significant influence over the audit client.
45

Although not specifically defined, the term “significant influence” appears in other parts of Rule 2-01 of Regulation S-X,
46

and the Proposing Release noted that use of the term “significant influence” in the proposed amendment was intended to refer to the principles in the Financial Accounting Standards Board's (“FASB's”) ASC Topic 323, Investments—Equity Method and Joint Ventures.
47

44

See
Rule 2-01(c)(1)(i)(E)(
1
)(
i
) and (
ii
), (c)(1)(i)(E)(
2
) and (
3
), and (f)(4)(ii) and (iii) of Regulation S-X.

45

See
proposed Rule 2-01(c)(1)(ii)(A) (replacing the phrase “record or beneficial owners of more than ten percent of the audit client's equity securities” with “beneficial owners (known through reasonable inquiry) of the audit client's equity securities, where such beneficial owner has significant influence over the audit client”). Under the proposed amendments, the rule would continue to have exceptions for four types of loans: (1) Automobile loans and leases collateralized by the automobile; (2) loans fully collateralized by the cash surrender value of an insurance policy; (3) loans fully collateralized by cash deposits at the same financial institution; and (4) a mortgage loan collateralized by the borrower's primary residence provided the loan was not obtained while the covered person in the firm was a covered person. We discuss the proposed “known through reasonable inquiry” standard below.
See infra
Section II.D.

46

See
Rule 2-01(c)(1)(i)(E) (“investments in audit clients”) and Rule 2-01(f)(4) of Regulation S-X (“affiliate of the audit client” definition).

47

See
Proposing Release at section II.C; ASC 323 Investments—Equity Method and Joint Ventures (“ASC 323”).
See also
2000 Adopting Release,
supra
footnote 5, at 65 FR 76034, note 284 (referring to Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (Mar. 1971), which was codified at ASC 323).

2. Comments

(a) Significant Influence Test

Most commenters supported the proposed amendment to replace the 10 percent bright-line shareholder ownership test with a significant influence test.
48

Generally, these commenters agreed that significant influence is a more appropriate framework to identify those lending relationships that impair an accountant's objectivity and impartiality.
49

A few commenters supported codifying the significant influence test found in ASC 323 (or specific elements of that test) in our rules to promote consistent application,
50

but one commenter did not support codification in our rules so as to avoid confusion in the future if changes are made to ASC 323.
51

A few commenters requested that we affirm that the Commission's auditor independence standards involve a shared responsibility of the audit client and the auditor.
52

One commenter did not support replacing the 10 percent bright-line test with a significant influence test in part because the commenter questioned the quality of the equity method of accounting in general.
53

48

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, NYSCPA, PBTK, MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity, NYC Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, First Data, FEI, AICPA, AIC, SIFMA, Invesco, and Federated.

49

See, e.g.,
Deloitte, PwC, KPMG, CAQ, NYSCPA, Grant Thornton, BDO, EY, ICI/IDC, Fidelity, RSM, FEI, AICPA, and Invesco.

50

See, e.g.,
KPMG, NYSCPA, and Grant Thornton.

51

See
EY.

52

See e.g.,
Deloitte, CAQ, and Crowe.

53

See
CII.

(b) ASC 323

Many commenters agreed that the framework in ASC 323 is generally appropriate for assessing significant influence.
54

Several commenters, however, asserted that the concepts in ASC 323 may not be useful to apply to funds or may not be routinely applied in the fund context.
55

Two commenters asserted that ASC 323 is not an appropriate framework for the “significant influence” test, and instead proposed a decision framework with a “singular focus on the beneficial owner's ability to exert significant influence over the audit client's operating and financial policies,” based on the totality of the facts and circumstances.
56

A number of commenters requested that the Commission reiterate the fund guidance

from the Proposing Release,
57

which clarified that in the fund context, the operating and financial policies relevant to the significant influence test would include the fund's portfolio management processes. A few commenters recommended that the Commission provide additional guidance regarding the application of the significant influence test in the fund context (
e.g.,
mutual funds, preferred stockholders in closed-end funds, and exchange-traded funds).
58

54

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, NYSCPA, Grant Thornton, BDO, EY, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, RSM, and FEI.

55

See, e.g.,
PwC, KPMG, Crowe, CAQ, EY, and Grant Thornton.

56

See
KPMG and Invesco.

57

See, e.g.,
Deloitte, Crowe, CAQ, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, Fidelity, and Invesco.
See also
the discussion of fund guidance in the Proposing Release at 20761.

58

See, e.g.,
PwC, KPMG, Grant Thornton, ICI/IDC, and EY.

Several commenters agreed that it would be appropriate to consider the nature of the services provided by the investment adviser as a factor in determining whether a beneficial owner has significant influence.
59

Several commenters also supported analyzing the concept of “portfolio management processes” as the first step to the significant influence test for investment companies. These commenters agreed that, in circumstances in which the advisory contract grants the investment adviser significant discretion with respect to the fund's portfolio management processes, it is unlikely that a shareholder will have significant influence and the factors in ASC 323 would not have to be further analyzed.
60

Some commenters recommended that the Commission confirm that an audit firm need not monitor beneficial ownership if it initially determines that, based on portfolio management processes, the audit client cannot be subject to significant influence and periodically determines that there are no changes to the fund's governance structure and governing documents.
61

Two commenters proposed a framework that focused on the beneficial owner's ability to exert significant influence over the audit client's operating and financial policies, based on the totality of the circumstances, and to avoid the exclusive reliance on the ASC 323 framework in the investment fund context.
62

59

See, e.g.,
Deloitte, Grant Thornton, KPMG, EY, and CAQ.

60

See, e.g.,
Deloitte, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, and Invesco. Deloitte added this as a first step for limited partnerships and general partners.

61

See, e.g.,
ICI/IDC and T. Rowe Price.

62

See
KPMG and Invesco.

(c) Rebuttable Presumption

ASC 323 incorporates a rebuttable presumption of significant influence once beneficial ownership meets or exceeds 20 percent of an investee's voting securities.
63

Two commenters recommended codifying the rebuttable presumption assessment under the proposed significant influence test consistent with the accounting standard,
64

and one commenter stated that although ASC 323 includes a rebuttable presumption with respect to 20 percent ownership, it is merely a guide and may be raised or lowered depending on the facts and circumstances.
65

A few commenters did not support applying the 20 percent rebuttable presumption to funds, but rather supported an analysis of the rights of fund owners under the fund's governance provisions.
66

Two commenters viewed the 20 percent rebuttable presumption as substituting a new 20 percent bright-line test for the existing 10 percent bright-line test, in the absence of the fund guidance set forth in the Proposing Release.
67

One commenter was concerned that the 20 percent rebuttable presumption could potentially conflict with the analysis of “control” under the federal securities laws by introducing a new standard that could increase compliance costs.
68

63
Conversely, ASC 323 also incorporates a rebuttable presumption of no significant influence if beneficial ownership is less than twenty percent of investee's voting securities.

64

See
FEI and Grant Thornton.

65

See
NYSCPA.

66

See, e.g.,
ICI/IDC, T. Rowe Price, Invesco, KPMG, EY, and Fidelity.

67

See
Fidelity and Invesco.

68

See
NYC Bar.

(d) Participation on an Advisory Committee

The Proposing Release noted that if a shareholder in a private fund, for example, has a side letter agreement outside of the standard partnership agreement that allows for participation in portfolio management processes (including participation on a fund advisory committee), then the shareholder would likely have significant influence.
69

A few commenters asserted that although participation on an advisory committee should be one factor in assessing significant influence, this factor alone is not likely to indicate significant influence.
70

Two commenters noted that the responsibilities of an advisory committee can vary.
71

One of these commenters noted that, when the board or advisory committee has substantive oversight responsibility or decision-making capacity over operating and financial policies significant to the fund, the commenter would likely view a shareholder on the board or advisory committee as having significant influence. In the absence of those characteristics, the commenter indicated that it would likely not consider a member of the board or advisory committee to have significant influence.
72

The other commenter stated that the purpose of an advisory committee generally is to provide suggestions to the investment adviser or general partner, and that advisory committees typically do not oversee the investment adviser or general partner and do not participate in the portfolio management process.
73

69

See
Proposing Release, at 83 FR 20761.

70

See, e.g.,
Deloitte, KPMG, and CAQ.

71

See
Deloitte and PwC.

72

See
PwC.

73

See
Deloitte.

Two commenters asserted that the right to remove a general partner or adviser was unlikely to indicate significant influence.
74

Another commenter supported drawing a distinction between rights that provide a shareholder with an ability to actively participate in fund investment decisions (
e.g.,
approval or veto rights over a new fund investment), which would indicate significant influence, and rights that allow a shareholder to address inappropriate behavior on the part of the investment adviser (
e.g.,
a right to remove an adviser for cause or the right to approve material changes to the fund governance documents), which would not indicate significant influence.
75

74

See
Deloitte and PwC.

75

See
EY.

(e) Authorized Participants

Authorized participants (“APs”) for ETFs deposit or receive basket assets in exchange for creation units of the fund. The Proposing Release noted that the deposit or receipt of basket assets by an AP that is also a lender to the auditor alone would not constitute significant influence over an ETF audit client. Several commenters agreed that the deposit or receipt of basket assets by an authorized participant that is also a lender to the auditor would not alone constitute significant influence over an ETF audit client.
76

A few commenters stated that market makers also should not be considered to have significant influence over an ETF audit client since their objective is not to influence the fund or the portfolio management process, but to provide liquidity to ETFs.
77

One commenter recommended that the Commission clarify that market makers typically would not be

considered to have significant influence for purposes of the Loan Provision.
78

76

See, e.g.,
Deloitte, KPMG, EY, PwC, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, and Federated.

77

See, e.g.,
Deloitte, EY, and PwC.

78

See
Deloitte.

(f) Evaluation of Compliance With the Loan Provision

The Proposing Release indicated that, if the auditor determines that significant influence does not exist based on the facts and circumstances at the time of the auditor's initial evaluation,
79

the auditor should monitor the Loan Provision on an ongoing basis, which could be done, for example, by reevaluating its determination when there is a material change in the fund's governance structure and governing documents, publicly available information about beneficial owners, or other information that may implicate the ability of a beneficial owner to exert significant influence of which the audit client or auditor becomes aware. Several commenters agreed with this proposal.
80

A few commenters indicated that communications with shareholders or documentation regarding investor rights could be examples of other information implicating significant influence of which the audit client or auditor becomes aware.
81

79
For funds, the auditor's initial determination would be based on an evaluation of a fund's governance structure and governing documents, the manner in which its shares are held or distributed, and any contractual arrangements, among any other relevant factors.

80

See, e.g.,
Deloitte, PwC, Crowe, CAQ, Grant Thornton, and EY.

81

See e.g.,
PwC, Crowe, and CAQ.

The Proposing Release also requested comment on whether the Commission should permit the Loan Provision or other financial relationships to be addressed at specific dates during the audit and professional engagement period, or the beginnings or ends of specific periods, or under specified circumstances. Rule 2-01(c)(1) of Regulation S-X provides that an accountant is not independent if the accountant has an independence-impairing relationship specified in the rule at any point during the audit and professional engagement period. Certain existing disclosure requirements require information about beneficial owners as of a specified date.
82

Several commenters expressed the view that specific dates were not needed to assess compliance with the Loan Provision, and that the frequency and timing of the evaluation should be developed based on the particular facts and circumstances relevant to the audited entity.
83

82

See, e.g.,
Item 18 of Form N-1A and Item 19 of Form N-2.

83

See, e.g.,
Deloitte, PwC, Crowe, CAQ, Grant Thornton, BDO, EY, and RSM.

A few commenters supported including specific dates or periods, such as:

• The onset of the engagement period and the balance sheet date for each audit;
84

84

See
KPMG.

• At the planning and reporting stages of the audit and potentially significant or material events;
85

or

85

See
FEI.

• The beginning of the engagement, prior to accepting a new engagement, and when the governance structure (including any contractual relationships) of the audit client changes.
86

86

See
Invesco.

(g) Alternatives to the Significant Influence Test

Two commenters proposed alternatives to the significant influence test: (1) Focusing on material direct financial interests,
87

and (2) focusing the analysis on beneficial ownership, but maintaining the existing 10 percent bright-line shareholder ownership test.
88

The commenter that recommended maintaining the existing 10 percent bright-line ownership test but applying it to beneficial owners argued that this alternative approach would be simpler and easier to understand than the proposed significant influence test.
89

This commenter also asserted that the alternative approach would address most of the issues raised in the Fidelity No-Action Letter and avoid replacing the 10 percent bright-line test with a significant influence test that incorporates a 20% rebuttable presumption.
90

87

See
Invesco.

88

See
CII. A separate commenter suggested that auditors should resign or the engagement partner be replaced in circumstances involving both significant influence and related party transactions, but did not provide further explanation.
See
Letter from Elisabeth Rossen, dated June 3, 2018 (“Rossen”).

89

See
CII.

90

See id.

One commenter stated that alternatives to the significant influence test are not needed.
91

The Proposing Release also requested comment on whether the modifier “significant” should be removed, such that the test would hinge on whether a lender shareholder has influence over an audit client. Two commenters opposed the removal of the modifier “significant” from the significant influence test, arguing that it would not achieve the objective of more effectively identifying those lending relationships that impair objectivity and impartiality.
92

Another commenter did not support an alternative test based on mere “influence,” describing significant influence as being able to alter management's decision-making process, whereas mere “influence” could be disregarded by management.
93

91

See
Grant Thornton.

92

See
KPMG and EY.

93

See
NYSCPA.

3. Final Amendments

After carefully considering the comments received, and consistent with the proposal, we are adopting amendments to replace the existing 10 percent bright-line test in the Loan Provision with a “significant influence” test similar to that referenced in other parts of the Commission's auditor independence rules and based on the concepts applied in ASC 323. We are not adopting an alternative framework, as suggested by two commenters,
94

that focuses on the beneficial owner's ability to exert significant influence over the audit client's operating and financial policies, based on the totality of the facts and circumstances, rather than the concepts applied in ASC 323. We continue to believe that given its use in other parts of the Commission's independence rules,
95

the concept of “significant influence” is one with which audit firms and their clients are already required to be familiar and would effectively identify those debtor-creditor relationships that could impair an auditor's objectivity and impartiality. In this regard, introducing a separate significant influence determination for these purposes would introduce additional complexity to the auditor independence rules without, in our view, necessarily resulting in more accurate assessments of auditor independence.

94

See
Invesco and KPMG.

95

See supra
footnote 44.

While the term “significant influence” in the final amendment refers to the principles in ASC 323, we agree with the commenter who stated that the specific considerations described in the significant influence test in ASC 323 should not be codified in our rules so as to avoid confusion in the future if changes are made to ASC 323.
96

For similar reasons, we are not codifying ASC 323's 20 percent rebuttable presumption in our rules.

96

See
EY.

While audit firms and audit committees of operating companies already should be familiar with application of the “significant influence” concept, we appreciate that this concept is not as routinely applied

by funds for financial reporting purposes. Therefore, in response to comments requesting that the Commission reiterate the fund guidance from the Proposing Release
97

and comments recommending additional guidance regarding the application of the significant influence test in the fund context,
98

we are reiterating the fund guidance in the Proposing Release, with further clarification about the application in this context of the rebuttable presumption and other fund specific issues. In the fund context, we believe that the operating and financial policies relevant to the significant influence test would include the fund's investment policies and day-to-day portfolio management processes, including those governing the selection, purchase and sale, and valuation of investments, and the distribution of income and capital gains (collectively “portfolio management processes”). An audit firm could analyze, in its initial assessment under the rule, whether significant influence over the fund's portfolio management processes exists based on an evaluation of the fund's governance structure and governing documents, the manner in which its shares are held or distributed, and any contractual arrangements, among any other relevant factors.

97

See supra
footnote 57.

98

See supra
footnote 58.

We believe that it would be appropriate to consider the nature of the services provided by the fund's investment adviser(s) pursuant to the terms of an advisory contract with the fund as part of this analysis. In circumstances where the terms of the advisory agreement grant the adviser significant discretion with respect to the fund's portfolio management processes and the shareholder does not have the ability to influence those portfolio management processes, significant influence generally would not exist and the evaluation of significant influence would be complete unless there is a material change in the fund's governance structure and governing documents (as discussed below). This should be the case even if the shareholder holds 20 percent or more of a fund's equity securities, which would otherwise trigger the rebuttable presumption under application of the concepts described in ASC 323.

The ability to vote on the approval of a fund's advisory contract or a fund's fundamental policies on a
pro rata
basis with all holders of the fund alone generally should not lead to the determination that a shareholder has significant influence. Similarly, the ability to remove or terminate a fund's advisory contract alone generally should not lead to a determination that a shareholder has significant influence.

As the Commission observed in the Proposing Release, if a shareholder in a private fund, for example, has a side letter agreement outside of the standard partnership agreement that allows for participation in portfolio management processes (including participation on a fund advisory committee), then the shareholder would likely have significant influence. In response to commenters noting that the responsibilities of an advisory committee can vary,
99

we are further clarifying that a shareholder in a private fund that participates on a fund advisory committee would likely have significant influence if that committee involves substantive oversight responsibility or decision-making capacity over operating and financial policies significant to the fund.

99

See
Deloitte and PwC.

In addition, we believe that the deposit or receipt of basket assets by an AP that is also a lender to the auditor would not alone constitute significant influence over an ETF audit client. Similarly, in circumstances where a market maker is a lender to the auditor, the deposit or receipt of basket assets by a market maker (acting through an AP) would not alone constitute significant influence over such an ETF audit client.

Holders of a closed-end fund's preferred stock have certain rights that may be relevant to a significant influence analysis.
100

The determination of whether preferred stockholders have significant influence over the fund would be based on an evaluation of the relevant facts and circumstances.

100

See
section 18(a)(2)(C) of the Investment Company Act.
See also
ICI/IDC.

Further to the guidance set forth above, we wish to emphasize that auditor independence is a shared responsibility between the audit firm and audit client.
101

The reliability of the process for identifying beneficial owners will be enhanced when both auditors and audit clients take responsibility for promoting the accuracy of information required to assess the auditor's independence.

101

See
Commission Final Rule,
Revision of the Commission's Auditor Independence Requirements,
Release No. 33-7919 (Nov. 21, 2000) (“[Issuers and other registrants] have the legal responsibility to file the financial information with the Commission, as a condition to accessing the public securities markets, and it is their filings that are legally deficient if auditors who are not independent certify their financial statements”). Moreover, many Commission regulations require entities to file or furnish financial statements that have been audited by an independent auditor. For example, Items 25 and 26 of Schedule A to the Securities Act [15 U.S.C. 77aa(25) and (26)] and Section 17(e) of the Exchange Act [15 U.S.C. 78q] expressly require that financial statements be certified by independent public or certified accountants. In addition, Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act [15 U.S.C. 78l and 78m], Sections 8(b)(5) and 30(e) and (g) of the Investment Company Act [15 U.S.C. 80a-8 and 80a-29], and Section 203(c)(1)(D) of the Investment Advisers Act [15 U.S.C. 80b-3(c)(1)] authorize the Commission to require the filing of financial statements that have been audited by independent accountants. Title 17 CFR 240.17a-5(f)(1) (Paragraph (f)(1) of Rule 17a-5 under the Exchange Act) requires that for audits under paragraph (d) of Rule 17a-5 of broker-dealers registered with the Commission, an independent public accountant must be independent in accordance with Rule 2-01 of Regulation S-X.
See also id.
(discussing Rule 206(4)-2 under the Investment Advisers Act).

If the auditor determines that significant influence over the fund's management processes does not exist at the time of the initial application of the rule, the auditor should monitor the Loan Provision on an ongoing basis.
102

We continue to believe, as expressly supported by several commenters,
103

that the auditor could satisfy this obligation to monitor its independence on an ongoing basis by reevaluating its determination in response to a material change in the fund's governance structure and governing documents, Commission filings about beneficial owners,
104

or other information which may implicate the ability of a beneficial owner to exert significant influence of which the audit client or auditor becomes aware. Outside of the fund context, audit firms and their audit clients should continue to monitor the auditor's independence on an ongoing basis by using their existing processes for determining whether significant influence exists consistent with the principles of ASC 323. In this regard, we agree with those commenters
105

who indicated that the frequency and timing of the significant influence evaluation should be based on the particular facts and circumstances relevant to the audited entity, consistent with the requirement that the auditor be independent throughout the audit and professional engagement period. Accordingly, we have not included specific dates, periods or circumstances upon which the significant influence evaluation should occur.

102

See
Proposing Release at 20761.

103

See, e.g.,
Deloitte, PwC, Crowe, CAQ, Grant Thornton, and EY.

104
This language is a slight change from the guidance provided in the Proposing Release, which referenced “publicly available information about beneficial owners.”
See
Proposing Release at 20765. We believe reference to Commission filings is more precise and will clarify the scope of monitoring that is discussed above.

105

See
KPMG, FEI, and Invesco.

Finally, although we carefully considered the comments regarding alternatives to the significant influence test, we have not been persuaded to retain the existing 10 percent bright-line shareholder ownership test. We believe that in situations where the lender is unable to influence the audit client through its holdings, the lender's ownership of an audit client's equity securities alone would not threaten an audit firm's objectivity and impartiality. In these situations, we continue to believe that the significant influence test would more effectively determine which shareholders have “a special and influential role with the issuer” by focusing on a shareholder's ability to influence the policies and management of an audit client.

We disagree with the commenter who expressed support for retaining a 10 percent bright-line test based on beneficial ownership.
106

We continue to believe that a test based on significant influence, rather than one based on numerical bright lines, will better address the compliance challenges associated with the Loan Provision while also more effectively identifying debtor-creditor relationships that could impair an auditor's objectivity and impartiality. One potential benefit of the final amendments is that the significant influence test could potentially identify risks to auditor independence that might not have been identified under the existing 10 percent bright-line test. For example, a beneficial owner that holds slightly less than 10 percent of an audit client's equity securities is likely to have similar incentives and ability to influence the auditor's report than a beneficial owner that holds slightly more than 10 percent of the same audit client's equity securities. The existing 10 percent threshold in the Loan Provision would differentially classify these two hypothetical situations, despite their similarity. Under the final amendments, an audit firm, where it is evaluating beneficial owners for significant influence, would evaluate both beneficial owners to determine if they have significant influence, thus providing a consistent analysis under the Loan Provision for these economically similar fact patterns. Regarding the alternative of focusing on material direct financial interests, we discuss our reasons for not adopting a materiality qualifier below.
107

106

See
CII.

107

See infra
Section II.F.1.

One commenter raised concerns that the 20 percent rebuttable presumption included in the significant influence analysis would introduce a new standard and require performing multiple layers of overlapping and potentially conflicting analysis.
108

The commenter cited to the definition of “affiliate of the audit client” set forth in Rule 2-01(f)(4) of Regulation S-X to suggest that the reference to “control” under that definition could overlap with the application of the significant influence test.
109

However, the concept of “significance influence” in ASC 323 is distinct from any reference to “control” in Rule 2-01(f)(4) or elsewhere under the federal securities laws. Specifically, the determination of whether an entity has control of another entity is distinct from whether an entity has significant influence over the audit client. For this reason, we do not believe the concept of “significant influence” in ASC 323 overlaps with other definitions. Moreover, the concept of “significant influence,” which includes the 20 percent rebuttable presumption, is not a new standard but has been part of the Commission's auditor independence rules since 2000 and part of the accounting standards since 1971.
110

108

See
NYC Bar.

109

See id.

110

See
Accounting Principles Board (APB) Opinion No. 18 (March 1971).

D. Reasonable Inquiry Compliance Threshold

1. Proposed Amendments

As noted in the Proposing Release, another challenge in the application of the current Loan Provision involves the difficulty in accessing information about the ownership percentage of an audit client for purposes of the current 10 percent bright-line test. The proposed amendments to the Loan Provision would have addressed concerns about accessibility to records or other information about beneficial ownership by adding a “known through reasonable inquiry” standard with respect to the identification of such owners. Under this proposed amendment, an audit firm, in coordination with its audit client, would be required to assess beneficial owners of the audit client's equity securities who are known through reasonable inquiry. The Proposing Release noted that if an auditor does not know after reasonable inquiry that one of its lenders is also a beneficial owner of the audit client's equity securities, including because that lender invests in the audit client indirectly through one or more financial intermediaries, the auditor's objectivity and impartiality is unlikely to be impacted by its debtor-creditor relationship with the lender. The Proposing Release also noted that this “known through reasonable inquiry” standard is generally consistent with regulations implementing the Investment Company Act, the Securities Act, and the Exchange Act,
111

and therefore is a concept that already should be familiar to those charged with compliance with the Loan Provision.

111

See, e.g.,
17 CFR 240.3b-4 (Rule 3b-4 under the Exchange Act [15 U.S.C. 78a
et seq.
]) (stating, with respect to the definition of foreign private issuer, that if, after reasonable inquiry, you are unable to obtain information about the amount of shares represented by accounts of customers resident in the United States, you may assume, for purposes of this definition, that the customers are residents of the jurisdiction in which the nominee has its principal place of business.); 17 CFR 230.144(g) (Rule 144(g) under the Securities Act) (noting that the term brokers' transactions in section 4(4) of the Securities Act shall be deemed to include transactions by a broker in which such broker after reasonable inquiry is not aware of circumstances indicating that the person for whose account the securities are sold is an underwriter with respect to the securities or that the transaction is a part of a distribution of securities of the issuer); 17 CFR 230.502(d) (Rule 502(d) under the Securities Act) (stating, with respect to limits on resales under Regulation D, that the issuer shall exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(a)(11) of the Securities Act, which reasonable care may be demonstrated by reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons). Registered investment companies also are subject to a similar requirement to disclose certain known beneficial owners.
See
Item 18 of Form N-1A (“State the name, address, and percentage of ownership of each person who owns of record or is known by the Fund to own beneficially 5% or more of any Class of the Fund's outstanding equity securities.”); and Item 19 of Form N-2 (“State the name, address, and percentage of ownership of each person who owns of record or is known by the Registrant to own of record or beneficially five percent or more of any class of the Registrant's outstanding equity securities.”).

2. Comments

Commenters generally expressed support for the proposed amendment to add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities.
112

A number of these commenters agreed that the proposed amendment would address compliance challenges and further agreed that if an auditor does not know after reasonable inquiry that one of its lenders is also a beneficial owner of the audit client's equity securities, the auditor's objectivity and impartiality is unlikely to be impacted by its debtor-creditor relationship with the lender.
113

112

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, NYSCPA, PBTK, MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity, NYC Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, FEI, AICPA, AIC, SIFMA, Invesco, and Federated.

113

See, e.g.,
Deloitte, PwC, KPMG, CAQ, Grant Thornton, MFDF, BDO, RSM, FEI, and AICPA.

Other commenters requested guidance on what constituted “reasonable

inquiry,”
114

such as whether reviewing publicly available information or information readily available to the issuer would be sufficient for this purpose. Several commenters requested substituting the proposed “known through reasonable inquiry” standard with a “known” standard,
115

while two commenters viewed both the “known” and “known through reasonable inquiry” standards to be similar.
116

114

See, e.g.,
KPMG, CAQ, Grant Thornton, BDO, EY, ICI/IDC, MFS Funds, RSM, T. Rowe Price, FEI, SIFMA, and Federated.

115

See, e.g.,
ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Invesco, and Federated.

116

See
EY and FEI.

3. Final Amendments

After considering the comments received, we are adopting the amendment to add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities as proposed. In response to commenters, we believe auditors and their audit clients could conduct the reasonable inquiry analysis by looking to the audit client's governance structure and governing documents, Commission filings about beneficial owners, or other information prepared by the audit client which may relate to the identification of a beneficial owner.
117

117

See also supra
Section II.C.

In addition, we have determined not to substitute a “known through reasonable inquiry” standard with a “known” standard because we believe an inquiry by the auditor and the audit client in conjunction with the consideration of the audit client's governance structure, governing documents, Commission filings, or other information prepared by the audit client, would be a practical approach that would not impose an undue burden in identifying and evaluating beneficial owners of the audit client's equity securities.

E. Excluding Other Funds That Would Be Considered Affiliates of the Audit Client

As discussed in the Proposing Release, the current definition of “audit client” in Rule 2-01 of Regulation S-X includes all “affiliates of the audit client,” which broadly encompasses, among others, each entity in an ICC of which the audit client is a part. In the fund context, this expansive definition of “audit client” could result in an audit firm being deemed not to be independent as to a broad range of entities, even where an auditor does not audit that entity.
118

Yet, in the investment management context, investors in a fund typically do not possess the ability to influence the policies or management of another fund in the same fund complex. Although an investor in one fund in a series company can vote on matters put to shareholders of the company as a whole, rather than only to shareholders of one particular series, even an investor with a substantial investment in one series would be unlikely to have a controlling percentage of voting power of the company as a whole.

118
For example, under the current Loan Provision, an audit firm (“Audit Firm B”) could be deemed not to be independent as to an audit client under the following facts: Audit Firm A audits an investment company (“Fund A”) for purposes of the Custody Rule. A global bank (“Bank”) has a greater than 10 percent interest in Fund A. Bank is a lender to a separate Audit Firm B, but has no lending relationship with Audit Firm A. Audit Firm B audits another investment company (“Fund B”) that is part of the same ICC as Fund A because it is advised by the same registered investment adviser as Fund A. Under these facts, Audit Firm B would not be independent under the existing Loan Provision because the entire ICC would be tainted as a result of Bank's investment relationship with Fund A.

Moreover, as noted in the Proposing Release, for the purposes of the Loan Provision, the inclusion of certain entities in the ICC as a result of the definition of “audit client” is in tension with the Commission's original goal to facilitate compliance with the Loan Provision without decreasing its effectiveness.
119

Indeed, auditors often have little transparency into the investors of other funds in an ICC (unless they also audit those funds), and therefore, are likely to have little ability to collect such beneficial ownership information.

119

See
Proposing Release at 20762.
See also
2000 Adopting Release,
supra
footnote 5, at 76035 (The Commission, in adopting an ownership threshold of 10 percent, rather than the five percent proposed, stated that “[w]e have made this change because we believe that doing so will not make the rule significantly less effective, and may significantly increase the ease with which one can obtain the information necessary to assure compliance with this rule.”).

1. Proposed Amendments

In order to address these compliance challenges, the proposed rules, for purposes of the Loan Provision, would have excluded from the definition of audit client, for a fund under audit, any other fund that otherwise would be considered an affiliate of the audit client.
120

Thus, for example, if an auditor were auditing Fund ABC, a series in Trust XYZ, the audit client for purposes of the Loan Provision would exclude all other series in Trust XYZ and any other fund that otherwise would be considered an affiliate of the audit client. The proposed amendment would have, without implicating an auditor's objectivity and impartiality, addressed the compliance challenges associated with the application of the Loan Provision where the audit client is part of an ICC, such as when an accountant is an auditor of only one fund within an ICC, and the auditor must be independent of every other fund (and other entity) within the ICC, regardless of whether the auditor audits that fund.

120

See
proposed Rule 2-01(c)(1)(ii)(A)(
2
) of Regulation S-X which provided that for purposes of paragraph (c)(1)(ii)(A), the term
audit client
for a fund under audit excludes any other fund that otherwise would be considered an
affiliate of the audit client.
The term
fund
means an investment company or an entity that would be an investment company but for the exclusions provided by section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)).

2. Comments

Many commenters supported the proposal to amend the definition of “audit client” for a fund under audit to exclude funds that otherwise would be considered affiliates of the audit client.
121

Several of these commenters also agreed that the proposed amendment would address some of the compliance challenges associated with the Loan Provision while still effectively identifying lending relationships that may impair independence.
122

Two commenters, however, asserted that affiliates of an audit client should not be categorically excluded from the definition of “audit client” when evaluating significant influence.
123

Many commenters supported expanding the proposed amendment to exclude other non-fund affiliates in an investment company complex or private fund complex (
e.g.,
investment advisers, broker-dealers, and service providers, such as custodians, administrators, and transfer agents),
124

while other

commenters supported broadening the proposed exclusion to all audit clients, not just fund affiliates.
125

Several commenters recommended we address downstream affiliates of excluded funds, such as portfolio companies of the excluded funds.
126

These commenters generally argued that downstream affiliates of excluded funds that are not audit clients do not pose a threat to auditor independence since these affiliates, and investors in these affiliates, do not have the ability to exert significant influence over the entity under audit.
127

121

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, NASBA, PBTK, MFS Funds, Grundfest, Grant Thornton, MFDF, BDO, EY, Fidelity, NYC Bar, ICI/IDC, CCMC, RSM, T. Rowe Price, First Data, FEI, AICPA, AIC, SIFMA, Invesco, and Federated.

122

See, e.g.,
KPMG, BDO, EY, and FEI.

123

See
KPMG and NYSCPA. One of these commenters stated that affiliates of the audit client should be excluded from the definition of “audit client” for the purposes of the Loan Provision, and also described scenarios where it believes it is possible that an investor's significant influence over an entity can affect other affiliates of that entity. For example, the commenter described a scenario where the policies for the portfolio management of the fund under audit span a wider group of funds. Under this scenario, an investor may have significant influence in a large fund in the complex that could result in effective influence over a sister fund, where both funds are managed by the same team under the same policies.
See
KPMG.

124

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, MFS Funds, BDO, EY, Fidelity, ICI/IDC, RSM, T.

Rowe Price, AICPA, AIC, SIFMA, Invesco, and Federated.

125

See, e.g.,
Deloitte, PwC, KPMG, CAQ, Grant Thornton, BDO, EY, NYC Bar, RSM, First Data, FEI, and AICPA.

126

See, e.g.,
Crowe, CAQ, Grant Thornton, RSM, EY, and AICPA. Crowe supported excluding downstream entities unless they had significant influence over an entity being audited.

127

See, e.g.,
Crowe, CAQ, and RSM.

Several other commenters also suggested excluding from the definition of “audit client” other pooled investment vehicles in an investment company complex that may be deemed to be an affiliate of the audit client, including pooled products that are not investment companies and do not rely on Section 3(c) of the Investment Company Act (
e.g.,
commodity pools), as well as certain foreign funds.
128

These commenters were concerned that these types of pooled investment vehicles could be deemed to be “affiliates of the audit client,” even though a lender likely would not have the ability to influence these other funds in the fund complex.
129

Another commenter stated that investment advisers that are part of an ICC of which an audit client is a part may conduct business that is unrelated to serving as the investment adviser to registered investment companies.
130

A number of commenters also specifically discussed excluding certain entities in the typical private equity fund structure from the definition of audit client, including other funds advised by the private equity sponsor when the private equity sponsor is the audit client.
131

We also received other comments on the “affiliate of the audit client” definition, which would impact other provisions of the auditor independence rules and are discussed below.
132

128

See, e.g.,
ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, and Invesco. As discussed below, for purposes of Rule 2-01, a “commodity pool” would be a commodity pool as defined in Section 1a(10) of the CEA that is not an investment company and does not rely on Section 3(c) of the Investment Company Act.
See, e.g.,
Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operations and Commodity Trading Advisors on Form PF, Investment Company Act Release No. 3308 (Oct. 31, 2011) [76 FR 71128 (Nov. 16, 2011)]. We use the term “foreign fund” in this release to refer to an “investment company” as defined in Section 3(a)(1)(A) of the Investment Company Act that is organized outside the U.S. and that does not offer or sell its securities in the U.S. in connection with a public offering.
See
Section 7(d) of the Investment Company Act (prohibiting a foreign fund from using the U.S. mails or any means or instrumentality of interstate commerce to offer or sell its securities in connection with a public offering unless the Commission issues an order permitting the foreign fund to register under the Act). A foreign fund may conduct a private U.S. offering in the United States without violating Section 7(d) of the Act only if the foreign fund conducts its activities with respect to U.S. investors in compliance with either section 3(c)(1) or 3(c)(7) of the Act (or some other available exemption or exclusion).
See
Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3222 (June 22, 2011) [76 FR 39646 (July 6, 2011)].

129

See
ICI/IDC.

130

See
Invesco.

131

See, e.g.,
AIC, EY, RSM, CCMC, Deloitte, CAQ, and Grundfest.

132

See infra
Section II.F.2.

3. Final Amendments

We are adopting, as proposed, the amendment to the Loan Provision to exclude from the definition of audit client, for a fund under audit, any other fund (
e.g.,
“sister fund”) that otherwise would be considered an affiliate of the audit client. Commenters generally supported this exclusion. However, in response to commenters that urged us to exclude commodity pools that are part of an ICC, we have expanded the definition of “fund” in the final amendments to provide that a commodity pool that is not an investment company or does not rely on Section 3 of the Investment Company Act also is not considered a fund for purposes of the Loan Provision.
133

A foreign fund that is part of an ICC would be covered by the exclusion for funds other than the fund under audit.

133
A commodity pool that is an investment company or that relies on Section 3 of the Investment Company Act would already be covered by the fund exclusion.

We agree that investors in a fund typically do not possess the ability to influence the policies or management of other “sister” funds and that this does not depend on whether the funds are investment companies or other types of pooled investment vehicles. We also believe that expanding the definition of “fund” to encompass commodity pools is consistent with our intent to exclude for a fund under audit any other funds that otherwise would be considered an affiliate of the audit client.

Commenters also urged that we exclude any downstream affiliates of excluded funds. We do not believe it is necessary to expressly carve these entities out of the audit client definition. However, to avoid any confusion, we are clarifying that, for purposes of the Loan Provision, the exclusion of sister funds from the audit client definition also excludes entities that would otherwise be included in the audit client definition solely by virtue of their association with an excluded sister fund. This clarification should remove any questions about whether entities in which a sister fund invests (and that have an even more attenuated relationship to a fund audit client) could themselves be treated as an audit client for purposes of the Loan Provision. We agree with commenters that these types of affiliates do not have the ability to exert significant influence over the entity under audit in these circumstances and, therefore, should not be treated as an audit client.

F. Other Comments

In the Proposing Release, the Commission also requested comment on other matters that might have an effect on the proposed amendments or the Loan Provision and any suggestions for additional changes to other parts of Rule 2-01 of Regulation S-X.

1. Materiality Qualifier

The Proposing Release did not include a materiality qualifier for the Loan Provision but requested comment on whether one should be included. Although a number of commenters expressed support for a materiality qualifier,
134

there were diverse recommendations about how it should be applied. A number of commenters expressed support for assessing the materiality of the loan to the auditor or covered person,
135

while other commenters supported assessing the materiality of the lender's investment in the audit client.
136

Several commenters held the view that if their recommendation to exclude all affiliates of the entity under audit was adopted, then a materiality qualifier would not be necessary.
137

134

See, e.g.,
Deloitte, PwC, KPMG, Crowe, CAQ, PTBK, Grant Thornton, BDO, EY, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, CCMC, RSM, First Data, FEI, AICPA, and Invesco.

135

See, e.g.,
Deloitte, PwC, KPMG, CAQ, BDO, EY, ICI/IDC, MFS Funds, T. Rowe Price, SIFMA, Federated, RSM, First Data, and Invesco.

136

See, e.g.,
PwC, Crowe, CAQ, PTBK, Grant Thornton, BDO, EY, CCMC, RSM, First Data, and FEI.

137

See, e.g.,
KPMG, Crowe, CAQ, EY, Grant Thornton, RSM, and AICPA.

After carefully considering the comments, we believe that the final amendments appropriately address the compliance challenges raised by the existing Loan Provision while

refocusing the rule on the qualitative nature of those lending relationships auditors may have with lenders that “hav[e] a special and influential role with the audit client.” Accordingly, we have retained the significant influence test, as proposed, rather than having the analysis turn on whether a specific loan may be material to the lender or audit firm. We also believe that given the size of the financial institutions, in terms of revenue or other quantitative measures, and the audit firms that have lending relationships with them, a materiality qualifier would result in scoping out from the Loan Provision a broad range of lending relationships and would not sufficiently address the threat to auditor independence, in fact or appearance, posed by at least some of these lending relationships. Furthermore, when determining whether an accountant is capable of exercising objective and impartial judgment, the auditor and audit client should consider all relevant circumstances between an accountant and the audit client,
138

which would include any qualitative and quantitative factors. Moreover, adding a materiality qualifier could cause the auditor independence inquiry to be affected by fluctuating market conditions, rather than an assessment that is market neutral.
139

138

See
Rule 2-01(b) of Regulation S-X.

139
For example, fluctuating market conditions could cause changes in the value of the assets securing a loan, thereby leading to different determinations at different times of the materiality of a lending relationship.

2. Other Potential Changes to the Auditor Independence Rules

The final amendments are intended to address the significant practical challenges associated with the existing Loan Provision. The Proposing Release also solicited comment on other changes to the Loan Provision and to the other auditor independence rules. Generally, these comments can be categorized as follows: (1) Relating to the Loan Provision, but not the significant compliance challenges that need to be immediately addressed (
e.g.,
other types of loans that commenters suggested should be excluded from the Loan Provision, such as student loans); (2) broadly impacting provisions of the auditor independence rules, including the Loan Provision (
e.g.,
comments relating to the “covered person” and “affiliate of the audit client” definitions); or (3) broadly impacting provisions of the auditor independence rules other than the Loan Provision (
e.g.,
suggestions to narrow the look-back period for domestic initial public offerings so that the period is similar to that for foreign private issuers). In response to these comments and the need for more information gathering as to how best to address these categories of comments, the Chairman has directed the staff to formulate recommendations to the Commission for possible additional changes to the auditor independence rules in a future rulemaking.

III. Other Matters

If any of the provisions of these amendments, or the application of these provisions to any person or circumstance, is held to be invalid, such invalidity shall not affect other provisions or application of such provisions to other persons or circumstances that can be given effect without the invalid provision or application.

Pursuant to the Congressional Review Act,
140

the Office of Information and Regulatory Affairs has designated these amendments as not a “major rule,” as defined by 5 U.S.C. 804(2).

140
5 U.S.C. 801
et seq.

IV. Paperwork Reduction Act

The final amendments do not impose any new “collections of information” within the meaning of the Paperwork Reduction Act of 1995 (“PRA”),
141

nor do they create any new filing, reporting, recordkeeping, or disclosure requirements. Accordingly, we are not submitting the final amendments to the Office of Management and Budget for review in accordance with the PRA.
142

We did not receive any comments about our conclusion that there are no collections of information.

141
44 U.S.C. 3501
et seq.

142
44 U.S.C. 3507(d) and 5 CFR 1320.11.

V. Economic Analysis

As discussed above, the Commission is adopting amendments to the Loan Provision in Rule 2-01 of Regulation S-X to focus the analysis on beneficial ownership rather than both record and beneficial ownership; replace the existing 10 percent bright-line shareholder ownership test with a “significant influence” test;
143

add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client's equity securities; and exclude from the definition of “audit client,” for a fund under audit, any other funds that otherwise would be considered affiliates of the audit client under the Loan Provision.

143

See
Section II.C for a discussion of the concept of “significant influence.”

Under the existing rules, the 10 percent bright-line shareholder ownership test does not recognize an accountant as independent if the accounting firm, any covered person in the firm, or any of his or her immediate family members has certain loans to or from an audit client or an audit client's officers, directors, or record or beneficial owners of more than 10 percent of the audit client's equity securities. In addition, under the existing rules, “audit client” is defined broadly to include any affiliate of the entity whose financial statements are being audited, which, for funds, would include each entity in an ICC of which the audit client is a part. As discussed above, Commission staff has engaged in extensive consultations with audit firms, funds, and operating companies regarding the application of the Loan Provision. These consultations revealed that a number of entities face significant practical challenges to comply with the Loan Provision. These discussions also revealed that in certain scenarios, in which the Loan Provision was implicated, the auditor's objectivity and impartiality in performing the required audit and interim reviews were not impaired.

We are mindful of the benefits obtained from and the costs imposed by our rules and amendments.
144

The following economic analysis seeks to identify and consider the likely benefits and costs that will result from the final amendments, including their effects on efficiency, competition, and capital formation. The discussion below elaborates on the likely economic effects of the final amendments.

144
Section 2(b) of the Securities Act [15 U.S.C. 77b(b)], Section 3(f) of the Exchange Act [17 U.S.C. 78c(f)], Section 2(c) of the Investment Company Act [15 U.S.C. 80a-2(c)], and Section 202(c) of the Investment Advisers Act [15 U.S.C. 80b-2(c)] require the Commission, when engaging in rulemaking where it is required to consider or determine whether an action is necessary or appropriate in the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation. Additionally, Section 23(a)(2) of the Exchange Act [15 U.S.C. 78w(a)(2)] requires the Commission, when adopting rules under the Exchange Act, to consider, among other things, the impact that any new rule would have on competition and not to adopt any rule that would impose a burden on competition that is not necessary or appropriate in furtherance of the Exchange Act.

A. General Economic Considerations

In order for the reported information to be useful to investors, it needs to be relevant and reliable. The independent audit of such information by impartial skilled professionals (
i.e.,
auditors) is intended to enhance the reliability of

financial reports.
145

Conflicts of interest between companies or funds and their auditors may impair the objectivity and impartiality of the auditors in certifying the audit client's reported performance, thus lowering the credibility and usefulness of these disclosures to investors. Academic literature discusses and documents the importance of the role of auditors as an external governance mechanism for the firm.
146

These studies generally find that better audit quality improves financial reporting by increasing the credibility of the financial reports.

145

See
M. Defond & J. Zhang,
A Review of Archival Auditing Research,
58 J. Acct. & Econ. 275-326 (2014).

146

See e.g.,
N. Tepalagul & L. Lin,
Auditor Independence and Audit Quality: A Literature Review,
30 J. Acct. Audit. & Fin. 101-121 (2015); M. Defond & J. Zhang,
A Review of Archival Auditing Research,
58 J. Acct. & Econ. 275-326 (2014); Y. Chen, S. Sadique, B. Srinidhi, & M. Veeraraghavan,
Does High-Quality Auditing Mitigate or Encourage Private Information Collection?;
and R. Ball, S. Jayaraman & L. Shivakumar,
Audited Financial Reporting and Voluntary Disclosure as Complements: A Test of the Confirmation Hypothesis,
J. Acct. & Econ. 53(1): 136-166 (2012).

An accounting firm is not independent under the Loan Provision's existing bright-line shareholder ownership test if the firm has a lending relationship with an entity having record or beneficial ownership of more than 10 percent of the equity securities of either: (1) The firm's audit client; or (2) any “affiliate of the audit client,” including, but not limited to, any entity that is a controlling parent company of the audit client, a controlled subsidiary of the audit client, or an entity under common control with the audit client. The magnitude of a party's investment in a company or fund is likely to be positively related with any incentive of that party to use leverage over the auditor with whom the party has a lending relationship in order to obtain personal gain.

The 10 percent bright-line test in the Loan Provision does not, however, distinguish between holders of record and beneficial owners even though beneficial owners are more likely to pose a risk to auditor independence than record owners given that the financial gain of beneficial owners is tied to the performance of their investment, and as such, beneficial owners may have strong incentives to influence the auditor's report. Record owners, on the other hand, may not benefit from the performance of securities of which they are record owners, and as such, they may have low incentives to influence the report of the auditor. Both the magnitude and the type of ownership in the audit client, are likely to be relevant factors in determining whether incentives exist for actions that could impair auditor independence. Beneficial ownership of a company's or fund's equity securities by a lender to the company's or fund's auditor is likely to pose a more significant risk to auditor independence than record ownership of the company's or fund's securities by the same lender.

The current Loan Provision may in some cases over-identify and in other cases under-identify threats to auditor independence. The likelihood that the provision over-identifies threats to auditor independence will tend to be higher when the lender is not a beneficial owner of an audit client and does not have incentives to influence the auditor's report, but has record holdings that exceed the 10 percent ownership threshold. On the other hand, under-identification of the threat to auditor independence may occur when the lender is a beneficial owner—implying the existence of potential incentives to influence the auditor's report—and the investment is close to, but does not exceed, the 10 percent ownership threshold.
147

147
We are unable to estimate the extent to which the 10 percent ownership threshold may over- or under-identify threats to independence because, among other reasons, fund ownership data is not readily available.

We are not aware of academic studies that specifically examine the economic effects of the Loan Provision. The remainder of the economic analysis in this section presents the baseline against which we perform our analysis, the anticipated benefits and costs of the final amendments, potential effects on efficiency, competition and capital formation, and an analysis of alternatives to the final amendments.

B. Baseline

The final amendments will change the Loan Provision compliance requirements for the universe of affected registrants. We believe the main affected parties will be audit clients, audit firms, and institutions engaging in financing transactions with audit firms and their partners and employees. Other parties that may be affected are covered persons and their immediate family members. Indirectly, the final amendments will affect audit clients' investors.

We are not able to precisely estimate the number of current auditor engagements that will be immediately affected by the final amendments. Specifically, precise data on how audit firms finance their operations and how covered persons arrange their personal financing are not available to us, and no commenters provided data to enable such an estimate. As such we are not able to identify pairs of auditors-institutions (lenders). Moreover, sufficiently detailed and complete data on fund ownership are not available to us, and no commenters provided such data, thus limiting our ability to estimate the prevalence/frequency of instances of significant fund ownership by institutions that are also lenders to fund auditors.

Although data on fund ownership are not readily available, academic studies of operating companies have shown that, for a selected sample of firms, the average blockholder (defined as beneficial owners of five percent or more of a company's stock) holds about 8.5 percent of a company's voting stock.
148

These studies also show that numerous banks and insurance companies are included in the list of blockholders. These findings suggest that the prevalence of instances of significant ownership by institutions that are also lenders to auditors could be high.

148

See
Y. Dou, O. Hope, W. Thomas & Y. Zou,
Blockholder Heterogeneity and Financial Reporting Quality,
working paper (2013).

As mentioned above, the final amendments will impact audits for the universe of affected entities. The baseline analysis below focuses mainly on the investment management industry because that is where the most widespread issues with Loan Provision compliance have been identified to date; however, the final rule will affect entities outside of this space, which are also subject to the auditor independence rules.
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Based on data in the SEC's EDGAR database, during the period from January 1, 2018 to December 31, 2018, there were a total of 6,919 entities that filed at least one Form 10-K, 20-F, or 40-F, or an amendment to one of these forms. This total does not include investment companies and business development companies.

As shown in Table 1 below, as of December 2018, there were approximately 12,577 fund series, with total net assets of $23 trillion, that are covered by Morningstar Direct with identified accounting firms.
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In addition, there were 23 accounting firms performing audits for these investment companies, though these auditing services were concentrated among the four largest accounting firms. Indeed, about 86 percent of the funds were audited by the four largest accounting firms, corresponding to 98 percent of the aggregate fund asset value.
151

150
These fund statistics are based on information available from Morningstar Direct, and may not represent the universe of fund families. The statistics include open-end funds, closed-end funds, and exchange traded funds.

151
According to aggregated information from Forms 2, as of December 31, 2018, there were 1,862

audit firms registered with the PCAOB (of which 984 are domestic audit firms, with the remaining 878 audit firms located outside the United States). The concentration in the provision of audit services for investment companies is indicative of the overall market as well. According to a report by Audit Analytics, the four largest accounting firms audit 75% of accelerated and large accelerated filers.
See Who Audits Larger Public Companies-2018 Edition, available at http://www.auditanalytics.com/blog/who-audits-larger-public-companies-2018-edition.

Table 1—Audited Fund Series and Their Investment Company Auditors
[As of December 31, 2018]

Total Number of Fund Series
12,577

Average Number of Fund Series Per Auditor
547

Average Net Assets (in millions) Per Auditor
1,023,086

Four Largest Audit Firms:

Total Number of Fund Series
10,876

Average Number of Fund Series Per Auditor
2,719

Average Net Assets (in millions) Per Auditor
5,757,533

% of Four Audit Firms by Series
86%

% of Four Audit Firms by Net Assets
98%

The scope of the auditor independence rules, including the Loan Provision, extends beyond the audit client to encompass affiliates of the audit client. According to Morningstar Direct, as of December 31, 2018, 543 out of 901 fund families
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have more than one fund, 162 have at least 10 funds, 57 have more than 50 funds, and 38 have more than 100 funds. According to the Investment Company Institute, also as of December 31, 2018, there were approximately 11,587 open-end funds and around 5,500 closed-end funds, with many funds belonging to the same fund family. Given that many fund complexes have several funds, with some complexes having several hundred funds, if any auditor is deemed not in compliance with the Loan Provision with respect to one fund, under the current rule it cannot audit any of the other funds within the same ICC.

152
These fund statistics are based on information available from Morningstar Direct and may not represent the universe of fund families. The statistics include open-end funds, closed-end funds and ETFs.

In response to compliance challenges, and as discussed above, Commission staff issued the Fidelity No-Action Letter. The Fidelity No-Action Letter, however, did not resolve all compliance uncertainty, was limited in scope, and provided staff-level no-action relief to the requestor based on the specific facts and circumstances in the request. Importantly, the Fidelity No-Action Letter did not amend the underlying rule. Staff has continued to receive inquiries from registrants and accounting firms regarding the application of the Loan Provision, or clarification of the Fidelity No-Action Letter, and requests for consultation regarding issues not covered in the Fidelity No-Action Letter. As a result of the remaining compliance uncertainty, auditors and audit committees may spend a significant amount of time and effort to comply with the Loan Provision.

C. Anticipated Benefits and Costs

1. Anticipated Benefits

Overall, we anticipate monitoring for non-compliance throughout the reporting period will be less burdensome for registrants under the final amendments. For example, based on the 10 percent bright-line test, an auditor may be in compliance at the beginning of the reporting period. However, the percentage of ownership may change during the reporting period, which may result in an auditor becoming non-compliant, even though there may be no threat to the auditor's objectivity or impartiality. A significant influence framework is likely to better identify a lack of independence and help avoid such anomalous outcomes.

There are also potential benefits associated with excluding record holders from the Loan Provision. Currently, the Loan Provision uses the magnitude of ownership by an auditor's lender as an indication of the likelihood of a threat to auditor independence regardless of the nature of ownership. From an economic standpoint, the nature of ownership also could determine whether the lender has incentives as well as the ability to use any leverage (due to the lending relationship) over the auditor that could affect the objectivity of the auditor. For example, a lender that is a record owner of the audit client's equity securities may be less likely to attempt to influence the auditor's report than a lender that is a beneficial owner of the audit client's equity securities because, unlike a record holder, a beneficial owner has an economic interest in the equity securities. By taking into account the nature as well as the magnitude of ownership, the final amendments will focus on additional qualitative information to assess the relationship between the lender and the investee (
e.g.,
a company or fund). Thus, we believe that, where there may be weak incentives by the lender to influence the audit, such as when the lender is only a holder of record, the final amendments will exclude relationships that are not likely to be a risk to auditor independence. The final amendments will thus provide benefits to the extent that they alleviate compliance and related burdens that auditors and audit clients would otherwise incur to analyze debtor-creditor relationships that are not likely to threaten an auditor's objectivity and impartiality. Affected registrants also will be less likely to disqualify auditors in situations that do not pose a risk to auditor independence, thereby reducing auditor search costs for these entities.

The potential expansion of the pool of eligible auditors also could result in better matching between the auditor and the client. For example, auditors tend to exhibit a degree of specialization in certain industries.
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If fewer auditors are considered to be independent due to the Loan Provision, then companies may have to select an auditor without the relevant specialization to perform the audit. Such an outcome could impact the quality of the audit and, as a consequence, negatively impact the quality of financial reporting to the detriment of the users of information contained in audited financial reports. Because they lack experience in the relevant industry, this outcome also may lead to less specialized auditors expending more time to perform the audit service, thereby increasing audit fees for registrants. We anticipate that the final amendments likely will positively impact audit quality for scenarios such as the one described above. Relatedly, if the final amendments expand the pool of eligible auditors, we expect increased competition among auditors, which could reduce the cost of audit services to affected companies and, if such cost savings are passed through to investors, could result in a lower cost to investors. However, as discussed in Section V.B above, the audit industry is highly concentrated, and as a consequence, such a benefit may not be significant.
154

153

See e.g.,
N. Dopuch & D. Simunic,
Symposium, Competition in Auditing: An Assessment,
Fourth Symposium on Auditing Research, p 401-450 (1982); and R.W. Knechel, V. Naiker & G. Pachecho,
Does Audit Industry Specialization Matter? Evidence from Market Reaction to Auditor Switches,
26 Audit. J. Prac. & Theory 19-45 (2007).

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The final amendments could result in some crowding-out effect, as the four largest audit firms may be deemed to be independent with more clients, potentially crowding out smaller audit firms. We discuss this effect in more detail in Section V.D below. However, we believe that better matching between auditors' specialization and their clients and reduced unnecessary auditor turnovers

could potentially prevent audit quality decline and in the long run may improve audit quality.

Another potential benefit of the final amendments is that the replacement of the bright-line test with the significant influence test could potentially identify risks to auditor independence that might not have been identified under the existing 10 percent bright-line test.
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For example, a beneficial owner that holds slightly less than 10 percent of an audit client's equity securities is likely to have similar incentives and ability to influence the auditor's report than a beneficial owner that holds the same audit client's equity securities at slightly above the 10 percent threshold. The existing Loan Provision differentially classifies these two hypothetical situations, despite their similarity. To the extent that the final amendments are able to improve identification of potential risks to auditor independence through the use of qualitative criteria, investors are likely to benefit from the final amendments. In the example above, under the final amendments, an audit firm will evaluate both beneficial owners to determine if they have significant influence, thus providing a consistent analysis under the Loan Provision for these economically similar fact patterns.

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This benefit will be limited to the extent that an auditor whose lending relationships are not implicated by the Loan Provision's existing 10 percent bright-line ownership test would be otherwise identified as not meeting the general independence requirement in Rule 2-01(b) of Regulation S-X.

Another potential benefit of replacing the bright-line ownership test with a significant influence test is that fluctuations in the ownership percentage that do not change the economics of the relationship between the auditor and the audit client likely will not result in the auditor being deemed not to be independent. For instance, there may be instances in which non-compliance with the Loan Provision may occur during the reporting year, after an auditor is selected by the registrant or fund. Particularly for companies in the investment management industry, an auditor may be deemed to comply with the Loan Provision using the bright-line test when the auditor is hired by the fund but, due to external factors, such as redemption of investments by other

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2019-13429. Public record. Not legal advice.