SEC Modifies Auditor Independence Standards

November 4, 2020

On Oct. 16, 2020, the U.S. Securities and Exchange Commission (SEC) adopted final rules amending the auditor independence requirements of Rule 2-01 of Regulation S-X.

The SEC noted that amendments to the auditor independence rule, originally enacted in 2000 and largely unchanged since then, maintain the bedrock principle that auditors must be independent in fact and in appearance. The changes are intended to improve the relevance of the auditor independence standards in light of existing market conditions by more effectively focusing the independence analysis on those relationships or services that are more likely to threaten an auditor’s objectivity and impartiality. The SEC stated that the amendments also will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose.

The final rules are generally consistent with the proposed rules issued in December 2019.

 “Audit Client” and New Term “Entity Under Audit”

To avoid misapplication of the new dual materiality threshold described below, the SEC adopted a new term, “entity under audit,” to replace the previous, broader term of “audit client” in Rules 2-01(f)(4)(i) and (ii). “Entity under audit” refers to the actual entity being audited, while the broader term, “audit client,” includes affiliates and will remain applicable in the significant influence provisions (Rules 2-01(f)(4)(iii) and (iv)).

Dual Materiality Threshold

The amendments establish a dual materiality threshold for determining whether a sister entity will be included as an affiliate of the audit client. This modified rule should result in fewer affiliates and therefore fewer independence disqualifications for auditors and their clients.

A sister entity will be considered an affiliate of the audit client if both (1) the sister entity is material to the controlling entity, and (2) the entity under audit is material to the controlling 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. The SEC explained that when the entity under audit is not material to the controlling entity, an auditor’s relationships with or services provided to sister entities would normally not impair the auditor’s objectivity and impartiality.

However, an auditor’s non-audit services and relationships with sister entities that, due to applying the dual materiality threshold, are no longer deemed affiliates will still be subject to the general independence standard of Rule 2-01(b).

In response to inquiries for clarification, the SEC’s press release announcing the rule change and the final rule provide various examples and scenarios to help practitioners and audit clients better understand how to assess materiality and monitor independence. The SEC explained that it is “not providing any specific guidance on materiality at this time because we understand that auditors and their audit clients have developed approaches to determine materiality in compliance with current rules, and we expect those approaches would continue to be applicable under the final amendments.”

The SEC pointed out that monitoring auditor independence is a “shared responsibility between auditors and audit clients,” including monitoring affiliates and obtaining information necessary to assess materiality. The SEC noted that company management can assist auditors by providing:

  • timely notification to auditors of changes in circumstances that may affect the population of potential affiliates (e.g., notice of acquisitions before they become effective); and
  • advance notice to auditors of registration statements to be filed.

 “Investment Company Complex”

When identifying affiliates, Rule 2-01(f)(4) now directs an auditor of an investment company or investment adviser or sponsor to apply the definition of “investment company complex” (ICC) in Rule 2-01(f)(14) (which incorporates the new dual materiality threshold, the new term “entity under audit” and includes certain sister investment companies regardless of materiality). Additionally, the amendments modified the definition of “investment company” to include unregistered funds.

The SEC noted that the “final rule should lead to improved clarity in applying the ICC definition and, for the purpose of auditor independence analysis, could facilitate compliance by audit firms and the entities they audit within an ICC with the auditor independence requirements. The improved clarity under the amended definition may also result in compliance cost savings that benefit audit firms and audit clients.”

Audit and Professional Engagement Period (Look-Back Period)

Under the independence standards before these latest amendments, auditors of domestic private companies seeking to go public must have been independent for all financial statement periods included in the issuer’s registration statement filed with the SEC (generally two to three years of audited financial statements), but auditors of foreign private issuers were subject to a shorter, one-year look-back period. The amendments provide that all first-time filers (i.e., domestic issuers and foreign private issuers) will be subject to the same one-year look-back period for assessing independence requirements under Rule 2-01. The SEC explained that shortening the look-back period for the independence assessment would place all first-time filers on equal footing, which could in turn benefit capital formation.

Loans or Debtor-Creditor Relationships

The amendments revise standards for evaluating loan and debtor-creditor relationships to recognize that certain student, home equity and consumer loans do not impair an auditor’s objectivity and impartiality.

Under Rule 2-01(c)(1)(ii)(A) (the Loan Provision), an auditor is not independent if it has any loan to or from an audit client and certain other persons related to the audit client unless that particular loan is exempted from the Loan Provision.

Exemptions:

1. Student Loans

Student loans obtained from a financial institution under its normal lending procedures, terms and requirements for a covered person’s educational expenses are now exempted from the Loan Provision, provided that the individual obtained the loan before becoming a “covered person” in the firm. Student loans obtained by a covered person’s “immediate family members” are also exempt and, moreover, there is no numerical cap on the amount of outstanding student loans held by a covered person or immediate family member that is exempt.

2. Mortgage Loans

While “a mortgage loan” (singular) was already exempt under the Loan Provision, the amendments expand the exemption threshold to encompass “mortgage loans” (plural). The SEC explained that the revision served to clarify that the rules did not intend to exclude only one outstanding mortgage loan on a borrower’s primary residence. Moreover, the SEC clarified that “where the borrower becomes a covered person only because of a change in the ownership in the loan, and provided there is no modification in the original terms or conditions of the loan or obligation after the borrower becomes, or in contemplation of the borrower becoming, a covered person, the loan would be included within this exception.”

3. Consumer Loans

The amendments also revised the “Credit Card Rule” under Rule 2-01(c)(1)(ii)(E), such that a consumer loan held by any covered person (or his or her immediate family members) routinely obtained for personal consumption (e.g., retail installment loans, cell phone installment plans and home improvement loans not secured by a mortgage on a primary residence), owed to a lender that is an audit client must be reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period to qualify as an exempt loan. Additionally, the SEC noted that it did not provide a definition of “consumer loan” to avoid complicating and causing the rule to become “outdated as consumer lending arrangements evolve.”

Ongoing General Independence Standard Under Rule 2-01(b)

The amendments do not change the application of Rule 2-01(b); i.e., relationships and services deemed immaterial under new Rule 2-01(c) will nonetheless remain subject to the general independence standard in Rule 2-01(b).

Rule 2-01(b), in part, states that an accountant will not be recognized as “independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.” The SEC noted that in light of the amendments, relationships and services that should be evaluated under the general standard include those that are “known or should be known to the auditor because of the nature, extent, relative importance or other relevant aspects of the relationships or services.” For instance, auditors should have appropriate information to be aware of and prepare for changes in materiality that could lead to changes in affiliate status of entities in a large corporate or investment company complex structure.

Amendments to the Business Relationships Rule

The Business Relationships Rule generally prohibits the accounting firm or any covered person during the course of the audit and professional engagement period from having “any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors . . .”

The previous rule defined “persons associated with the audit client in a decision-making capacity” to include “an audit client’s officers, directors, or substantial stockholders.” In an effort to make this rule clearer and less complicated, the amendments replaced the term “substantial stockholders” with “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the entity under audit.” Further, the amendments clarify that the rule applies to relationships with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers or directors that “have the ability to affect decision-making at the entity under audit.” Nevertheless, relationships with officers or directors of the entity under audit are unchanged by the rule, as such persons are deemed to have the ability to affect decision-making at the entity under audit.

Regarding associated persons in a decision-making capacity of an audit client (as opposed to those direct or material indirect business relationships with an audit client that are deemed independence-impairing), the SEC explained the independence analysis should concern whether the beneficial owner has significant influence over the entity under audit that could impair the auditor’s objectivity and impartiality (as opposed to merely analyzing whether the beneficial owner owns equity securities of an audit client). Furthermore, amendments replaced references to “audit client” with “entity under audit” when identifying associated persons in a decision-making capacity, such as beneficial owners.

Inadvertent Violations in M&As

The amendments provide a transition provision for inadvertent independence violations that result from a corporate event (e.g., merger or acquisition) involving audit clients. This transition period does not cover a merger or acquisition in substance similar to an initial public offering, which instead would be subject to the look-back period, as amended.

More specifically, an accounting firm’s independence will not be impaired because an audit client undergoes a merger or acquisition that gives rise to a relationship or service that is independence-impairing if the accounting firm:

  1. is in compliance with the applicable independence standards related to such services or relationships when the services or relationships originated and throughout the period in which the applicable independence standards apply;
  2. has or will address such services or relationships promptly under relevant circumstances as a result of the occurrence of the merger or acquisition; and
  3. has in place a quality control system that contains procedures and controls that
    (i) monitor the audit client’s merger and acquisition activity to provide timely notice of a merger or acquisition, and
    (ii) allow for prompt identification of such services or relationships after initial notification of a potential merger or acquisition that may trigger independence violations but before the effective date of the transaction.

If a service or relationship that gives rise to an independence violation is identified after the effective date of a transaction, the audit firm and the audit client’s audit committee will need to consider all relevant facts and circumstances in their evaluation of the auditor’s objectivity and impartiality and may further consult the SEC’s Office of the Chief Accountant.

Prompt Transition

While the SEC expects that independence-impairing services or relationships can and should be addressed before a merger or acquisition becomes effective, it acknowledged instances where this might not be possible without causing significant disruption to the audit client. In these instances, the SEC expects the independence violation to be transitioned promptly but no later than six months post-merger or acquisition. However, the SEC specifically did not include a six-month maximum transition period in the final rule, acknowledging that meeting a set maximum transition period would not be possible in every transaction.

The transition period should reduce disruptive and costly termination of auditor engagements that become impermissible due to mergers and acquisitions.

Effectiveness

The amendments will become effective 180 days after publication in the Federal Register. Auditors may choose to voluntarily comply with the amendments in their entirety on an earlier basis at any time after the amendments are published in the Federal Register. Auditors may retroactively rely on these amendments only with respect to student loans, consumer loans and multiple mortgages that originated before the effective or early compliance date but that comply with the conditions of the final amendments as of the effective or compliance date. Although the SEC’s amendments to Rule 2-01 allow for voluntary early compliance, audit firms must comply with any other independence requirements that are more restrictive. The staff of the Public Accounting Oversight Board (PCAOB) has stated that without amendments to conform the definitions in PCAOB Rule 3501 and the PCAOB’s interim independence standards (i.e., interpretations and rulings under Rule 101 of the AICPA Code, as previously adopted by the PCAOB) to the SEC’s amendments to Rule 2-01, the objectives of the SEC’s rulemaking may not be fully achieved. The PCAOB staff has reported that it anticipates making a recommendation for the PCOAB’s consideration in the 2020 fourth quarter.

Next Steps for Companies

  1. Focus on overall independence. Auditors, audit committees and management teams will appreciate that the amendments may allow them to avoid spending time and attention to review non-substantive rule breaches and other situations that did not practically impair an auditor’s independence and impartiality.
  2. Review portfolio companies. Holding companies should assess the materiality of their portfolio companies to determine if these more flexible rules will open the door to a change in the portfolio companies’ accounting service providers. Refer to the SEC’s press release for an example of how to apply the new dual materiality test to portfolio companies.
  3. Review M&A activity. Companies involved in mergers and acquisitions should continue to monitor the impact of the merger or acquisition on their auditors’ independence but will now have a transition period of up to six months after the transaction’s effective date to eliminate impermissible services or relationships.
  4. Review auditor communication procedures. Companies should confirm that their communication procedures with their auditors provide timely notice to auditors of changes in circumstances that may affect the population of potential affiliates (e.g., notice of acquisitions before they become effective), and registration statements to be filed.
  5. Update D&O questionnaires. Companies should update their director and officer questionnaire questions that relate to the Business Relationship Rule and other auditor independence inquiries that are affected by these Rule 2-01 amendments.
  6. Confirm audit committee processes. Companies should keep in mind that auditors and audit committees are both responsible for evaluating auditor independence. Audit committees should have effective procedures to assess auditor independence on an ongoing basis, and are advised to review their committee charters to update applicable provisions for the Rule 2-01 amendments.

For additional guidance on the information in this alert, please contact any of the authors below, any member of McGuireWoods’ securities compliance or securities enforcement teams or your primary McGuireWoods contact.

McGuireWoods’ securities compliance team assists public companies with their reporting obligations under the Securities Exchange Act of 1934, including forms 10-K, 10-Q and 8-K, Section 16 reports and DEF 14A (proxy statements), as well as with Regulation FD and Regulation G compliance. We prepare insider trading policies, develop training programs and assist with other aspects of securities transactions engaged in by company officers, directors and significant security holders, including 10b5-1 plans and Rule 144 compliance.

McGuireWoods is a national leader in securities enforcement defense. The firm’s securities enforcement and litigation team is part of an elite Government Investigations and White Collar Litigation Department that has been twice recognized as a Law360 Practice Group of the Year. Our team comprises former senior SEC enforcement attorneys and litigators, as well as high-level federal prosecutors, and we are experienced at managing every stage of complex securities investigations. Our team builds upon decades of experience of practicing before government agencies and regularly represents audit committees, public companies, and their members, professionals and executives in internal and government criminal and civil investigations involving financial reporting, disclosures and internal controls.

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