On October 16, 2020, the Securities and Exchange Commission ("SEC") adopted amendments to certain auditor independence requirements in Rule 2-01 of Regulation S-X.1 The amendments modernize the rules and "more effectively focus the analysis on relationships and services that may pose threats to an auditor's objectivity and impartiality." The amendments, which were adopted substantially as proposed in December 2019, reflect the SEC staff's experience administering and consulting on the independence requirements, particularly in certain recurring situations where specific relationships and services triggered technical independence rule violations without necessarily impairing an auditor's objectivity and impartiality, as well as recent changes in capital market conditions, and feedback from commenters.
In addition to cutting compliance burdens and costs for registrants and auditors, the SEC expects that these amendments could expand the pool of auditors available to registrants, which would provide more relevant industry expertise, reduce audit costs and improve the quality of financial reporting. The final rules also change the auditor independence requirements related to initial public offerings ("IPOs"), M&A activity, and certain requirements around ordinary course debtor-creditor relationships. The changes are important not just for audit firms but for companies as well, as violations of the auditor independence rules can have serious consequences for a company, such as the withdrawal of the firm's audit report, requiring the company to engage another firm to perform another audit.
Background
Under SEC rules, an auditor is not independent with respect to the audit client if a reasonable, fully informed investor would conclude that the auditor is not capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement. "Audit client" includes affiliates, which are defined as entities that the audit client controls, that have control over the audit client or that are under common control. In more complex corporate structures, there can be a significant compliance burden in terms of identifying all affiliates and making independence determinations, while the relationship at issue might not reasonably threaten the auditor's objectivity and impartiality, based on the affiliate's remoteness, the fact that sister companies have engaged different audit firms or other factual circumstances. This issue is particularly relevant to private equity funds with a large number of affiliated portfolio companies.
While recognizing that "an audit by an objective, impartial, and skilled professional contributes to both investor protection and investor confidence," the newly adopted amendments address the fact that application of the current rules may be harmfully restraining competition for audit and non-audit services by limiting the pool of qualified auditors as a result of independence issues that should not reasonably threaten the auditor's objectivity or impartiality. Chairman Jay Clayton noted that the amendments will "increase investor protection by focusing audit clients, audit committees, and auditors on areas that may threaten an auditor's objectivity and impartiality. They also will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose."2
Summary of Key Changes
The final amendments will, among other things:
Amend the Definition of "Affiliate of the Audit Client" and the "Investment Company Complex"
The amendments will amend the definitions of "affiliate of the audit client," in Rule 2-01(f)(4), and "investment company complex," in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control. Specifically, the SEC has adopted a dual materiality threshold, meaning that for the "audit client" to include a sister entity, both the entity under audit and the sister entity must be material to the common entity. If either the sister entity or the entity under audit is not material to the controlling entity, then the sister entity will not be deemed an affiliate of the audit client.
Similarly, the SEC made specific changes to the independence requirements with respect to the auditor of an investment company or an investment adviser or sponsor, limiting the definition of affiliates to exclude certain investment companies, advisers and sponsors not material to the controlling entity. This will in some circumstances prevent investment companies advised by related investment advisers from being included in the definition of "affiliate."
Amend the Definition of "Audit and Professional Engagement Period" to Provide Relief to IPO Companies
The amendments will change the definition of "audit and professional engagement period" in Rule 2-01(f)(5)(iii) to shorten the look-back period for domestic first-time filers in assessing compliance with the independence requirements. Under the existing regime, the auditor of a company in an IPO had to be independent for the period co-extensive with the financial statements included in the registration statement, which might have necessitated a delay in the IPO or required the company to engage a new auditor in order to comply with the auditor independence requirements. The amended rules reduce the look-back period in an IPO to one year, regardless of the period of financial statements included in the registration statement. The amended rule has the effect of aligning the existing look-back period for first-time filers qualifying as foreign private issuers with now first-time domestic filers.
Loan Provision Rule – Add Certain Loans to Categorical Exclusions List
Under the existing requirements, an auditor is not considered independent if specified persons within the audit firm, or their family members, maintain loans to or from an audit client. Currently, most automobile loans/leases, loans collateralized by insurance policies or cash, and mortgages obtained under normal market conditions, as well as credit card debt reduced to $10,000 or less on a current basis, are excepted from these requirements. The amendments to Rule 2-01(c)(1)(ii)(A)(1) and (E) add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.3
Business Relationships Rule – Replace Reference to "Substantial Stockholders" with Concept of "Beneficial Owners with Significant Influence"
Regarding the prohibition against certain business relationships between the auditor and the audit client as well as substantial stockholders of the audit client, the SEC has replaced the reference to "substantial stockholders" in Rule 2-01(c)(3) with a reference to beneficial owners (known through reasonable inquiry) that have significant influence4 over the audit client. The SEC believes this will make the requirements clearer and less complex. In addition, the changes clarify that the "significant influence" inquiry should be focused on whether influence exists at the entity under audit and not merely at an affiliate entity.
Mergers and Acquisitions – Create Transition Framework to Address Inadvertent Violations Resulting from such Transactions
The amended rules replace the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions. For example, one or both of the respective auditors of two companies that agree to merge may find that they provide prohibited services to the combined company as a result of the merger. The SEC has created a framework to address such situations, detailing the expectation that the independence violations will be corrected as promptly as possible and in most instances prior to the effective date of the merger or acquisition. It is important to note that the transition framework will not apply to merger or acquisition transactions that are in substance similar to IPOs. This is particularly relevant to situations where a shell company reporting under the Securities Exchange Act of 1934, as amended, engages in a merger with a private operating company. The auditor of the financial statements to be included in a Commission filing resulting from such transaction will not be able to rely on the transition network in amended Rule 2-01(e).
Effective Date
The amendments will be effective 180 days after publication in the Federal Register. Voluntary early compliance is permitted after publication in advance of the effective date, provided that the final amendments are applied in their entirety from the date of early compliance. Auditors are not permitted to retroactively apply the final amendments to relationships and services in existence prior to the effective date or the early compliance date if selected by an audit firm.
1 The final rule.
2 See the SEC's press release.
3 The SEC's press release, provides the example of an audit firm with an audit partner based in Atlanta who continues to pay her student loans taken to attend college before starting her career at the audit firm, while a different audit partner in Atlanta audits the lender that provided the student loan. Under the rules prior to the amendments, the student loan of the audit partner who is not part of the audit would still lead to an independence violation for the audit engagement of the lender. Under the amended rules, that student loan would no longer result in an independence violation for the audit engagement of the lender.
4 Footnote 173 in the Adopting Release indicates that use of "significant influence" is intended to refer to the principles in the Financial Accounting Standards Board's ASC Topic 323-10-15-6.
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