83 FR 20753 - Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships
SECURITIES AND EXCHANGE COMMISSION Federal Register Volume 83, Issue 89 (May 8, 2018)
Federal Register Volume 83, Issue 89 (May 8, 2018)
| Page Range | 20753-20773 | |
| FR Document | 2018-09721 |
[Federal Register Volume 83, Number 89 (Tuesday, May 8, 2018)] [Proposed Rules] [Pages 20753-20773] From the Federal Register Online [www.thefederalregister.org] [FR Doc No: 2018-09721] ======================================================================= ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 210 [Release No. 33-10491; 34-83157; IC-33091; IA-4904; 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: Proposed rule. ----------------------------------------------------------------------- SUMMARY: The Securities and Exchange Commission (``Commission'') is proposing to amend 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 proposed amendments would focus the analysis solely 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 amend 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 is also requesting comment on certain other potential amendments to its auditor independence rules. DATES: Comments should be received on or before July 9, 2018. ADDRESSES: Comments may be submitted by any of the following methods: Electronic CommentsUse the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or Send an email to rule-comments@sec.gov. Please include File Number S7-10-18 on the subject line. Paper Comments Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090. All submissions should refer to File Number S7-10-18. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available [[Page 20754]] publicly. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the ``Stay Connected'' option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT: Giles T. Cohen, Deputy Chief Counsel, or Peggy Kim, Senior Special Counsel, Office of the Chief Accountant, at (202) 551-5300; Alison Staloch, Chief Accountant, Chief Accountant's Office, Division of Investment Management, at (202) 551-6918; or Joel Cavanaugh, Senior Counsel, Investment Company Regulation Office, Division of Investment Management, at (202) 551-6792, U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549. SUPPLEMENTARY INFORMATION: We are proposing amendments to Rule 2-01 of Regulation S-X.\1\ --------------------------------------------------------------------------- \1\ 17 CFR 210.2-01. --------------------------------------------------------------------------- Table of Contents I. Background A. The Loan Provision of Regulation S-X B. Application of the Current Loan Provision II. Proposed Amendments A. Overview of the Proposed Amendments B. Focus the Analysis Solely on Beneficial Ownership C. Significant Influence Test D. Reasonable Inquiry Compliance Threshold E. Excluding Other Funds That Would Be Considered Affiliates of the Audit Client III. Request for Comment A. Materiality B. Accounting Firms' ``Covered Persons'' and Immediate Family Members C. Evaluation of Compliance D. Secondary Market Purchases of Debt E. Other Changes to the Commission's Auditor Independence Rules IV. Paperwork Reduction Act V. Economic Analysis A. General Economic Considerations B. Baseline C. Anticipated Benefits and Costs, and Unintended Consequences 1. Anticipated Benefits 2. Anticipated Costs and Potential Unintended Consequences D. Effects on Efficiency, Competition and Capital Formation E. Alternatives F. Request for Comment VI. Initial Regulatory Flexibility Act Analysis A. Reasons for and Objectives of the Proposed Action B. Legal Basis C. Small Entities Subject to the Proposed Rules D. Projected Reporting, Recordkeeping and Other Compliance Requirements E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives G. Solicitation of Comment VII. Small Business Regulatory Enforcement Fairness Act VIII. Statutory Basis I. Background A. The Loan Provision of Regulation S-X We are proposing to amend certain provisions of our auditor independence rules. The Commission has long considered auditor independence to be essential to reliable financial reporting and critical to the effective functioning of the U.S. capital markets.\2\ Independent auditors have an important public trust.\3\ Many Commission regulations require entities to file or furnish financial statements that have been audited by an independent auditor; such entities include operating companies, registered investment companies, registered investment advisers, pooled investment vehicles,\4\ and registered broker-dealers.\5\ --------------------------------------------------------------------------- \2\ See generally Proposed Rule: Revision of the Commission's Auditor Independence Requirements, Release No. 33-7870 (June 30, 2000) (``2000 Proposing Release''), available at https://www.sec.gov/rules/proposed/34-42994.htm. \3\ The U.S. Supreme Court in describing the independent auditor's responsibility, stated that the accountant's ``public watchdog'' function ``demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.'' United States v. Arthur Young, 465 U.S. 805, 818 (1984). \4\ In this Release, we use the term ``pooled investment vehicle'' to refer to a limited partnership, limited liability company, or another type of pooled investment vehicle for which the pooled investment vehicle's investment adviser relies on paragraph (b)(4) of Rule 206(4)-2 (the ``Custody Rule'') under the Advisers Act. In general, paragraph (b)(4) of the Custody Rule provides conditions under which an investment adviser is not required to comply with provisions of the Custody Rule relating to the delivery of certain notices and account statements and is deemed to have complied with the surprise examination requirements of the rule with respect to an account that is a limited partnership, limited liability company or other pooled investment vehicle that is subject to audit (as defined in Rule 1-02(d) of Regulation S-X). In order to rely on this ``audit exception,'' the audit must be performed by an independent public accountant that: (i) Meets the standards in Rule 2-01(b) and (c) of Regulation S-X; and (ii) is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the Public Company Accounting Oversight Board (``PCAOB'') in accordance with its rules. Many advisers to private funds rely on the audit exception. A ``private fund'' is an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act, but for Section 3(c)(1) or 3(c)(7) of that Act. See Section 202(a)(29) of the Investment Advisers Act. \5\ For example, Items 25 and 26 of Schedule A to the Securities Act of 1933 (``Securities Act'') [15 U.S.C. 77aa(25) and (26)] and Section 17(e) of the Securities Exchange Act of 1934 (``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 of 1940 (``Investment Company Act'') [15 U.S.C. 80a-8 and 80a-29], and Section 203(c)(1)(D) of the Investment Advisers Act of 1940 (``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. Paragraph (f)(1) of Rule 17a-5 under the Exchange Act [17 CFR 240.17a-5(f)(1)] 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 Advisers Act). --------------------------------------------------------------------------- The Commission's auditor independence standard is set forth in Rule 2-01 of Regulation S-X, which requires auditors \6\ to be independent of their audit clients both ``in fact and in appearance.'' \7\ 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.\8\ --------------------------------------------------------------------------- \6\ Rule 2-01 refers to ``accountants'' rather than ``auditors.'' We use these terms interchangeably in this Release. \7\ 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.''). \8\ See Rule 2-01(b) of Regulation S-X. --------------------------------------------------------------------------- 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.\9\ In particular, the restriction on debtor-creditor relationships in Rule 2-01(c)(1)(ii)(A) (the ``Loan Provision'') generally provides that an accountant is not [[Page 20755]] independent when (a) the accounting firm, (b) any covered person \10\ 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.\11\ We note that 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. --------------------------------------------------------------------------- \9\ 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 . . . .''). \10\ See Rule 2-01(f)(11) of Regulation S-X. \11\ See 2000 Adopting Release, supra footnote 9, at 65 FR 76035. [GRAPHIC] [TIFF OMITTED] TP08MY18.006 Thus, in the above 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. When the Commission proposed the Loan Provision, 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.'' \12\ 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.\13\ 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.\14\ --------------------------------------------------------------------------- \12\ See 2000 Proposing Release, supra footnote 2, at 65 FR 76034-76035. \13\ See 2000 Adopting Release, supra footnote 9, at 65 FR 76035. \14\ 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 9, 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 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 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.\15\ 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. 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. --------------------------------------------------------------------------- \15\ See Rule 2-01(f)(6) of Regulation S-X. --------------------------------------------------------------------------- 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.\16\ 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 [[Page 20756]] which entities in the ICC are audited by the accounting firm. --------------------------------------------------------------------------- \16\ See Rule 2-01(f)(4)(iv) of Regulation S-X (defining ``affiliate of the audit client''). ``Investment company complex'' is defined in Rule 2-01(f)(14) of Regulation S-X to include: ``(A) An investment company and its investment adviser or sponsor; (B) Any entity controlled by or controlling an investment adviser or sponsor in paragraph (f)(14)(i)(A) of this section, or any entity under common control with an investment adviser or sponsor in paragraph (f)(14)(i)(A) of this section if the entity: (1) Is an investment adviser or sponsor; or (2) Is engaged in the business of providing administrative, custodian, underwriting, or transfer agent services to any investment company, investment adviser, or sponsor; and (C) Any investment company or entity that would be an investment company but for the exclusions provided by section 3(c) of the [1940 Act] that has an investment adviser or sponsor included in this definition by either paragraph (f)(14)(i)(A) or (f)(14)(i)(B) of this section.'' --------------------------------------------------------------------------- B. Application of the Current Loan Provision The Commission has become aware that, in certain circumstances, the existing Loan Provision may not be functioning as it was intended, under current market conditions. It also presents significant practical challenges.\17\ Registered investment companies, pooled investment vehicles, and registered investment advisers have articulated concerns about the Loan Provision in both public disclosures \18\ and, together with their auditors, in extensive consultations with Commission staff.\19\ It has become clear that there are certain fact patterns where an auditor's objectivity and impartiality is not impaired despite a failure to comply with the requirements of the Loan Provision. \20\ --------------------------------------------------------------------------- \17\ The audit committees of registered investment companies may 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 funds' independent auditors. See Rule 10A-3 under the Exchange Act [17 CFR 240.10A-3]. In addition, for audits conducted pursuant to PCAOB standards, the auditor is required to notify the audit committee of matters that may reasonably bear upon the independence of the auditor. See PCAOB Rule 3526. \18\ Several funds and investment advisers have noted concerns regarding the Loan Provision in their public filings with the Commission. See, e.g., AIM Investment Securities Funds (Invesco Investment Securities Funds) Form N-CSR filed on May 12, 2016; Invesco Mortgage Capital Inc. Form 10-Q filed on May 10, 2016; iShares Trust Form N-CSR filed on June 6, 2016; Delaware Investments Colorado Municipal Income Fund, Inc. Form N-CSR filed on June 6, 2016; Goldman Sachs Trust Form N-CSR filed on June 6, 2016; Advent International Corp. Form ADV filed on March 30, 2016; NB Alternatives Advisers LLC Form ADV filed on June 29, 2016; Indaba Capital Management, L.P. Form ADV filed on March 30, 2016; and MFS Government Markets Income Trust Schedule 14A filed on August 31, 2016. \19\ Staff in the Office of the Chief Accountant (OCA staff) regularly engage in consultations with issuers regarding accounting, financial reporting, and auditing concerns or questions, including application of the auditor independence rules. \20\ Challenges associated with the Loan Provision have also arisen with issuers other than funds, although not to the same extent. For example, a foreign private issuer (``FPI'') and its external auditor encountered compliance issues with the Loan Provision as a result of the FPI's use of a depositary bank to hold its American Depositary Shares. In that case, the depositary bank was the record holder, but not the beneficial owner, of more than 10 percent of the underlying equity shares of the FPI while also having a lending relationship with the auditor. See, e.g., JMU Ltd. Form 20-F, filed on May 26, 2017. --------------------------------------------------------------------------- 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 \21\ 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.\22\ 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. They also may not have control over whether they are ``record'' owners of more than 10 percent of the issuer's shares. --------------------------------------------------------------------------- \21\ See infra footnote 23. \22\ 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). [GRAPHIC] [TIFF OMITTED] TP08MY18.007 [[Page 20757]] 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. To be more specific, 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.\23\ 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, or the auditor may not know that the 10 percent threshold had been exceeded until after the fact. --------------------------------------------------------------------------- \23\ 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. --------------------------------------------------------------------------- Another practical challenge is that the auditor independence rules' broad definition of the term ``audit client'' gives rise to results that are out of step with the purpose of the rule and that can have adverse effects when applied in the specific context of the Loan Provision. As described above, the Loan Provision applies not only to an entity that the audit firm is auditing but also to those entities that are ``affiliated'' with the audit client.\24\ The auditor independence rules broadly define an ``affiliate of the audit client'' to include, among other things, both (a) an entity that is under common control with the audit client; and (b) each entity in an ICC when the audit client is part of that ICC.\25\ --------------------------------------------------------------------------- \24\ See Rule 2-01(f)(6) of Regulation S-X. \25\ See Rule 2-01(f)(4) of Regulation S-X, in which an ``affiliate of the audit client'' is defined to include the following: (i) 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; (ii) An entity over which the audit client has significant influence, unless the entity is not material to the audit client; (iii) An entity that has significant influence over the audit client, unless the audit client is not material to the entity; and (iv) Each entity in the investment company complex when the audit client is an entity that is part of an investment company complex. --------------------------------------------------------------------------- Open-end funds are often part of large and varied ICCs, and multiple accounting firms may be retained to perform audits of various entities within the ICC. If an accounting firm is not independent under the Loan Provision with respect to only one of a given ICC's funds, no fund or other entity in the ICC can engage or retain that accounting firm as an independent auditor consistent with Rule 2-01 of Regulation S-X. An auditor to one fund in an ICC thus must seek information regarding the record and beneficial owners of the equity securities of all of the other funds (and other entities) in the ICC and such owner's affiliates (see Figure 3 below for illustration). Other funds in the ICC that are not audited by the requesting auditor are not required to provide this information, and may only provide it, if at all, after negotiation and the establishment of information-sharing protocols, all of which can require substantial time and expense incurred by auditors and funds. Even where funds not audited by this auditor do provide information regarding the owners of their equity securities, the fact that fund shares often are held in omnibus accounts registered in the name of financial intermediaries creates further challenges in identifying the shares' beneficial owners to determine if they are lenders to the auditing firm that own more than 10 percent of the fund's equity securities.\26\ --------------------------------------------------------------------------- \26\ In some cases, financial intermediaries such as broker- dealers or banks hold fund shares on behalf of other financial intermediaries, such as retirement plan administrators or other broker-dealers, creating multiple layers of intermediaries between the fund and the beneficial owners of its shares. See also, e.g., Mutual Fund Redemption Fees, Release No. IC-27504 (Sept. 27, 2006) [71 CFR 58257 (Oct. 3, 2006)] at 58258 (discussing application of Rule 22c-2 under the Investment Company Act to ``chains of intermediaries''). --------------------------------------------------------------------------- Further, not only loans to accounting firms but also loans to certain ``covered persons'' at such firms and their immediate family members may implicate the Loan Provision.\27\ As a result, certain lending relationships with members of the audit engagement team, individuals generally in the supervisory reporting chain for the audit, certain accounting firm employees in the same primary office as the lead engagement partner, and other accounting firm employees--or with immediate family members of any of those persons--could be found to impair the audit firm's independence.\28\ --------------------------------------------------------------------------- \27\ See Rule 2-01(c)(1)(ii) of Regulation S-X. \28\ See Rule 2-01(f)(11) of Regulation S-X (definition of ``covered persons''). --------------------------------------------------------------------------- [[Page 20758]] [GRAPHIC] [TIFF OMITTED] TP08MY18.008 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.\29\ 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 lending arrangements. These arrangements facilitate firms' provision of audit services to investors and other market participants, but also multiply the number of lenders that may also be record or beneficial owners of securities in audit clients and that must be analyzed under the Loan Provision. --------------------------------------------------------------------------- \29\ 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. --------------------------------------------------------------------------- The current market conditions that have enabled 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 may feel obligated to devote substantial resources to evaluating potential instances of noncompliance 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.\30\ Audit committees' receipt of a high volume of communications of such relationships may dilute the impact of communications that identify issues that may actually raise concerns about an auditor's independence.\31\ --------------------------------------------------------------------------- \30\ 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. \31\ 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 as may be the case for certain private funds, for example, those responsible for the governance of the fund. --------------------------------------------------------------------------- Similarly, numerous violations of the independence rules that no reasonable person would view as implicating an auditor's objectivity and impartiality could desensitize market participants to other, more significant violations of the [[Page 20759]] independence rules. Respect for the seriousness 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 noncompliance 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 costs are ultimately borne by shareholders. These costs are unlikely to entail 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.\32\ 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.\33\ 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.\34\ Accordingly, noncompliance with the auditor independence rules in some cases can result in affected funds not being able to 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. --------------------------------------------------------------------------- \32\ Registered investment advisers that have custody of client funds or securities also face compliance challenges from the Loan Provision. These advisers generally are required under the Custody Rule 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. \33\ See generally Section 10(a)(3) of the Securities Act [15 U.S.C. 77j(a)(3)] and Item 27 of Form N-1A. \34\ See 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 regarding the application of the Loan Provision (``Fidelity No-Action Letter'').\35\ 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).\36\ Staff continue 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. --------------------------------------------------------------------------- \35\ 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. \36\ 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.'' --------------------------------------------------------------------------- II. Proposed Amendments A. Overview of the Proposed Amendments Given the dynamics identified above, we are proposing amendments to Rule 2-01 of Regulation S-X that would result in a rule that we believe would effectively identify those debtor-creditor relationships that could impair an auditor's objectivity and impartiality, yet would not include certain extended relationships that are unlikely to present threats to objectivity or impartiality.\37\ Specifically, we are proposing amendments that would: --------------------------------------------------------------------------- \37\ See Rule 2-01(b) of Regulation S-X. --------------------------------------------------------------------------- Focus the analysis solely on beneficial ownership; replace the existing 10 percent bright-line shareholder ownership test with a ``significant influence'' test; add a ``known through reasonable inquiry'' standard with respect to identifying beneficial owners of the audit client's equity securities; and amend the definition of ``audit client'' for a fund under audit to exclude from the provision funds that otherwise would be considered ``affiliates of the audit client.'' The proposed amendments are designed to better focus the Loan Provision on those relationships that, whether in fact or in appearance, could threaten an auditor's ability to exercise objective and impartial judgment. We also are soliciting input on other potential changes to the Loan Provision or Rule 2-01 of Regulation S-X that may be appropriate. Given that compliance challenges associated with applying the Loan Provision have arisen with entities other than funds, the proposed amendments would apply broadly to entities beyond the investment management industry, including operating companies and registered broker-dealers. B. Focus the Analysis Solely 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, the Commission's rules indicate that the auditor is not independent of the audit client. The record owner exceeding 10 percent may be a broker-dealer, custodian, or an intermediary omnibus account holder for its customers. Thus, as noted in Section I.B., the existing Loan Provision applies where a lender holds the audit client's equity securities of record, even though the lender may be unable to influence an audit client through its holdings of the audit client's equity securities, and may have no economic incentive to do so.\38\ --------------------------------------------------------------------------- \38\ The financial gain of beneficial owners is tied to the performance of their investment and as such, beneficial owners may have stronger incentives to influence the auditor's report. Record owners, on the other hand, likely do not benefit directly from the performance of securities of which they are record owners, and as such, they may have low incentives to affect the report of the auditor. For example, record holders' discretion to vote the shares on behalf of their beneficial owners is typically limited. See the New York Stock Exchange (NYSE) Rule 452. The NYSE allows brokers to vote on certain items on behalf of their clients, if the broker has received no voting instructions from those clients within 10 days of the annual meeting. Brokers are only allowed to cast these discretionary votes on ``routine'' matters, which are generally uncontested and do not include a merger, consolidation, or any matter which may affect substantially the rights or privileges of such stock. Rule 452 lists the types of matters that brokers may not vote without customer instructions, which include executive compensation or uncontested elections of directors (other than uncontested director elections of companies registered under the Investment Company Act of 1940). --------------------------------------------------------------------------- [[Page 20760]] 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 maintain the audit client's equity securities as a holder of record on behalf of their beneficial owners.\39\ We believe 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.\40\ --------------------------------------------------------------------------- \39\ 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. \40\ See 2000 Adopting Release, supra footnote 9. --------------------------------------------------------------------------- C. Significant Influence Test Furthermore, we believe that 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 applies even in situations where the lender may be unable to influence the audit client through its holdings.\41\ 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 could exert significant influence over the audit client through contractual or other means.\42\ 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. Although other portions of Rule 2-01 of Regulation S-X apply, the Loan Provision's existing 10 percent bright-line test by itself would not capture this debtor- creditor relationship even though the relationship potentially raises questions about an auditor's objectivity and impartiality.\43\ --------------------------------------------------------------------------- \41\ Cf. Accounting Standards Codification (``ASC'') 323, infra footnote 49 (providing examples where a holder may not have significant influence). \42\ Cf. ASC 323, infra footnote 49 (providing examples where a holder may have significant influence). \43\ See supra Section I.A for a discussion of the general standard under Rule 2-01(b) of Regulation S-X. --------------------------------------------------------------------------- We therefore propose 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 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\ --------------------------------------------------------------------------- \44\ See Rule 2-01(c)(1)(i)(E)(1)(i), (E)(1)(ii), (E)(2), (E)(3), (f)(4)(ii) and (f)(4)(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. --------------------------------------------------------------------------- We believe the proposed significant influence test would more effectively identify shareholders ``having a special and influential role with the issuer'' and therefore would better capture those debtor- creditor relationships that may impair an auditor's independence.\46\ This test focuses on a lender shareholder's ability to influence the policies and management of an audit client, based on a totality of the facts and circumstances. While this analysis would include a consideration of the lender's beneficial ownership level in an audit client's equity securities, a bright-line percentage ownership of an audit client's securities alone would no longer determine an auditor's independence with respect to an audit client. --------------------------------------------------------------------------- \46\ See 2000 Adopting Release, supra footnote 9, at 65 FR 76035 (describing the 10 percent bright-line test as identifying shareholders ``having a special and influential role with the issuer'' that ``would be considered to be in a position to influence the policies and management of that client.''). --------------------------------------------------------------------------- Specifically, under the ``significant influence'' test we are proposing today, an audit firm, together with its audit client, would be required to assess whether a lender (that is also a beneficial owner of the audit client's equity securities) has the ability to exert significant influence over the audit client's operating and financial policies.\47\ Although not specifically defined, the term ``significant influence'' appears in other parts of Rule 2-01 of Regulation S-X,\48\ and we intend to use the term ``significant influence'' in the proposed amendment to refer to the principles in the Financial Accounting Standards Board's (``FASB's'') ASC Topic 323, Investments--Equity Method and Joint Ventures.\49\ The concept of ``significant influence'' has been part of the Commission's auditor independence rules since 2000 and has been part of the accounting standards since 1971.\50\ Given its use in other parts of the Commission's independence rules,\51\ the concept of ``significant influence'' is one with which audit firms and their clients are already required to be familiar. While audit firms and audit committees of operating companies already should be familiar with application of the ``significant influence'' concept, this concept is not as routinely applied today in the investment fund context for financial reporting purposes.\52\ Nonetheless, the concept of significant [[Page 20761]] influence is applicable to funds under existing auditor independence rules.\53\ --------------------------------------------------------------------------- \47\ See ASC 323, infra footnote 49. See also infra Section II.C for a discussion of an audit client's operating and financial policies in the fund context. \48\ 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). \49\ See ASC 323 Investments--Equity Method and Joint Ventures (``ASC 323''). See 2000 Adopting Release, supra footnote 9, 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). \50\ See Accounting Principles Board (APB) Opinion No. 18 (March 1971) (``The Board concludes that the equity method of accounting for an investment in common stock should also be followed by an investor whose investment in voting stock gives it the ability to exercise significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock.''). \51\ See supra footnote 44. \52\ See ASC 946. Financial Services--Investment Companies. \53\ See Rule 2-01(c)(1)(i)(E)(1)(i), (E)(1)(ii), (E)(2), and (E)(3) of Regulation S-X. --------------------------------------------------------------------------- Under the proposed test, the ability to exercise significant influence over the operating and financial policies of an audit client would be based on the facts and circumstances, and under the existing accounting framework, could be indicated in several ways, including: Representation on the board of directors; Participation in policy-making processes; Material intra-entity transactions; Interchange of managerial personnel; or Technological dependency.\54\ --------------------------------------------------------------------------- \54\ See ASC 323, supra footnote 49. --------------------------------------------------------------------------- The lender's beneficial ownership of an audit client's equity securities also would be considered in determining whether a lender has significant influence over an audit client's operating and financial policies.\55\ Unlike the existing Loan Provision, however, the significant influence test would not set a bright-line threshold above which a lender is assumed to be in a position to influence the policies and management of that client. Instead, the proposed significant influence test would be consistent with ASC 323 by establishing a rebuttable presumption that a lender beneficially owning 20 percent or more of an audit client's voting securities is presumed to have the ability to exercise significant influence over the audit client, absent predominant evidence to the contrary.\56\ Conversely, and consistent with ASC 323, under the proposed significant influence test, if the ownership percentage were less than 20 percent, there would be a rebuttable presumption that the lender does not have significant influence over the audit client, unless it could be demonstrated that the lender has the ability to exert significant influence over the audit client.\57\ Thus, significant influence could exist in circumstances where ownership is less than 20 percent. --------------------------------------------------------------------------- \55\ The extent of a lender's ownership interest would be considered in relation to the concentration of other shareholders, but substantial or majority ownership of an audit client's voting stock by another shareholder would not necessarily preclude the ability to exercise significant influence by the lender. See id. \56\ ASC 323 contains a presumption that in the absence of predominant evidence to the contrary, an investor of 20% or more of the voting stock has the ability to exercise significant influence over the investee. See ASC 323-10-15-8. See also 2000 Adopting Release, supra footnote 9, at 65 FR 76034, note 497 and accompanying text. \57\ Under ASC 323, an investment of less than 20% of the voting stock shall lead to the presumption that an investor does not have the ability to exercise significant influence over the investee unless such ability can be demonstrated. See ASC 323-10-15-8. --------------------------------------------------------------------------- ASC 323 lists several indicators that, as applied to the proposed significant influence test, would suggest a shareholder that owns 20 percent or more of the audit client's voting securities nonetheless may be unable to exercise significant influence over the operating and financial policies of the audit client, including the following: Opposition by the audit client, such as litigation or complaints to governmental regulatory authorities, challenging the shareholder's ability to exercise significant influence; An agreement (such as a standstill agreement) under which the shareholder surrenders significant rights as a shareholder; Majority ownership of the audit client is concentrated among a small group of shareholders who operate the audit client without regard to the views of the shareholder; The shareholder needs or wants more financial information than is available to other shareholders, tries to obtain that information, and fails; \58\ and --------------------------------------------------------------------------- \58\ We recognize that there may be reasons other than a lack of influence--such as concerns under Regulation FD or the antifraud provisions of the federal securities laws generally--that might result in an issuer declining to provide financial information to a shareholder. --------------------------------------------------------------------------- The shareholder tries and fails to obtain representation on the audit client's board of directors.\59\ --------------------------------------------------------------------------- \59\ See ASC 323-10-15-10. --------------------------------------------------------------------------- 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 whether significant influence over the fund's portfolio management processes exists based on an initial 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. 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. 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. On the other hand, 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 circumstances where significant influence could exist, the audit firm would then evaluate whether an entity that is a beneficial owner of shares of a fund audit client has the ability to exercise significant influence over the fund and has a debtor-creditor relationship with the audit firm, any covered person in the firm, or any of his or her immediate family members.\60\ 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, we believe that 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. --------------------------------------------------------------------------- \60\ See infra Part II.D for a discussion of the proposed ``known through reasonable inquiry'' standard. --------------------------------------------------------------------------- We believe that moving to a ``significant influence'' test would be advantageous. First, the ``significant influence'' test, which applies qualitative factors to broadly capture influence over an audit client, would be more effective in identifying lender shareholders that threaten an auditor's impartiality and independence than the current 10 percent bright-line test. Second, the concept of ``significant influence'' already exists in the auditor independence rules and in ASC 323. For example, Rule 2- 01(c)(1)(i)(E) of Regulation S-X, which generally governs investments in entities that invest in audit clients and investments in entities in which audit clients invest, requires the auditor to assess whether [[Page 20762]] investments are material and whether the investment results in the ability to exercise significant influence over that entity.\61\ Similarly, the ``affiliate of the audit client'' definition in the auditor independence rules requires that a determination be made as to whether there are entities over which the audit client has significant influence (unless the entity is not material to the audit client) or any entities that have significant influence over the audit client (unless the audit client is not material to the entity).\62\ The parties that would be tasked with implementing a ``significant influence'' test in the Loan Provision--accounting firms, issuers and their audit committees--thus are already required to be familiar with this concept under the auditor independence rules. We believe that these entities likely would be able to leverage any existing practices, processes and controls for determining significant influence to comply with the proposed changes to the Loan Provision. --------------------------------------------------------------------------- \61\ See 2000 Adopting Release, supra footnote 9, at 65 FR 76034. Rule 2-01(c)(1)(i)(E) of Regulation S-X contains several provisions that use a materiality qualifier. For example, an accountant would not be independent if it ``[h]as any material investment in an entity over which an audit client has the ability to exercise significant influence. . . .'' See Rule 2- 01(c)(1)(i)(E)(2) of Regulation S-X. Rule 2-01(c)(1)(i)(E) of Regulation S-X also contains a significant influence provision without a materiality qualifier, in which an accountant would not be independent of its audit client when the accountant ``[h]as the ability to exercise significant influence over an entity that has the ability to exercise significant influence over an audit client.'' See Rule 2-01(c)(1)(i)(E)(3) of Regulation S-X. \62\ See Rule 2-01(f)(4) of Regulation S-X. --------------------------------------------------------------------------- D. Reasonable Inquiry Compliance Threshold As described above, another challenge in the application of the current Loan Provision involves the difficulty in accessing information regarding the ownership percentage of an audit client for the purposes of the current 10 percent bright-line test. For example, the shares of closed-end funds are commonly held of record by broker-dealers, which may be reluctant to share information about the underlying beneficial owners. In addition, also as indicated above, institutions may be the holder of record of shares in an audit client merely as custodian or as an omnibus account holder, adding a layer, and in some cases multiple layers, of complexity to obtaining information about the underlying beneficial ownership. Moreover, a beneficial owner may object to disclosure of its name, address, and securities position to the issuer, so that issuers may be unable to obtain the beneficial ownership information for these owners.\63\ --------------------------------------------------------------------------- \63\ Pursuant to Rule 14a-13(b) under the Exchange Act, an issuer may obtain from broker-dealers and banks a list of the names, addresses and securities positions of only the beneficial owners who either have consented or have not objected to having such information provided to issuers. See 17 CFR 240.14a-13(b). --------------------------------------------------------------------------- We therefore propose to amend the Loan Provision to address the 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 analyze beneficial owners of the audit client's equity securities who are known through reasonable inquiry. We believe 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. This ``known through reasonable inquiry'' standard is generally consistent with regulations implementing the Investment Company Act, the Securities Act and the Exchange Act,\64\ and therefore is a concept that already should be familiar to those charged with compliance with the provision. --------------------------------------------------------------------------- \64\ See, e.g., Rule 3b-4 under the Exchange Act (stating, with respect to the definition of foreign private issuer, that ``[i]f, 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.); Rule 144(g) under the Securities Act (noting, with respect to ``brokers' transactions'' that ``[t]he term brokers' transactions in section 4(4) of the [Securities] Act shall for the purposes of this rule be deemed to include transactions by a broker in which such broker: . . . (4) 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''); Rule 502(d) under the Securities Act (stating, with respect to limits on resales under Regulation D, that ``[t]he 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 the following: (1) 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.''). --------------------------------------------------------------------------- E. Excluding Other Funds That Would Be Considered Affiliates of the Audit Client 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 non-compliance with the Loan Provision as to a broad range of entities, even where an auditor does not audit that entity.\65\ 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. --------------------------------------------------------------------------- \65\ 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, 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.\66\ Indeed, auditors often have little transparency into the investors of other funds in an ICC (unless they also audit those funds), and [[Page 20763]] therefore, are likely to have little ability to collect such beneficial ownership information. --------------------------------------------------------------------------- \66\ See 2000 Adopting Release, supra footnote 9, 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.''). --------------------------------------------------------------------------- As a result, we propose, for purposes of the Loan Provision, to exclude 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.\67\ 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, without implicating an auditor's objectivity and impartiality, address 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. --------------------------------------------------------------------------- \67\ See proposed Rule 2-01(c)(1)(ii)(A)(2) of Regulation S-X: ``For purposes of paragraph (c)(1)(ii)(A) of this section, 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)).'' --------------------------------------------------------------------------- III. Request for Comment We request and encourage any interested person to submit comments on any aspect of our proposed amendments, other matters that might have an effect on the proposed amendments, and any suggestions for additional changes to other parts of Rule 2-01 of Regulation S-X. We note that comments are of greatest assistance where accompanied by supporting data and analysis of the issues addressed in those comments. We also specifically seek comment on the following changes to the Loan Provision: 1. Focus the Analysis Solely on Beneficial Ownership [cir] Should the Loan Provision be analyzed by reference to beneficial owners rather than record owners? Why or why not? [cir] Would eliminating the requirement to analyze record owners under the Loan Provision ease compliance challenges described above under Section 1.B.? Is there any further guidance the Commission should provide, or should the Commission consider alternatives? [cir] Would eliminating the requirement to analyze record owners under the Loan Provision raise other concerns about the independence of auditors? If so, what concerns would it raise and why? [cir] If the Commission merely amended the Loan Provision to provide for evaluation of the beneficial owner, rather than record owner, would other proposed amendments be necessary or appropriate? Why or why not? 2. ``Significant Influence'' Test [cir] Should we amend the Loan Provision to replace the 10 percent bright-line test with a ``significant influence'' test? Why or why not? [cir] Would the proposed reference to ASC's 323's provisions for ``significant influence'' effectively identify those lending relationships that may compromise auditor independence? [cir] Would amending the Loan Provision to replace the 10 percent bright-line test with a ``significant influence'' test, along with the other proposed amendments, address the compliance challenges that we identify above? [cir] Application of ``significant influence'' for financial reporting purposes and evaluation of auditor independence may not necessarily be congruent. Accordingly, does ASC 323--Investments-- Equity Method and Joint Ventures, provide an appropriate framework for analyzing ``significant influence'' in the context of the Loan Provision? Why or why not? [cir] Are there challenges associated with implementing the ``significant influence'' test that we should consider? Will accounting firms' and audit clients' relative experience with application of the ``significant influence'' test, given its use in other contexts, mitigate any such challenges? To what extent do audit clients lack experience with application of the significant influence test, and what costs would such audit clients bear in learning to apply the test? Will funds, which may have relatively less experience than operating companies with the significant influence test, face any particular challenges in applying the test? [cir] Is the proposed ``significant influence'' test sufficiently clear? Are there specific circumstances for which we should provide additional guidance? For example, we discuss above the application of the significant influence test in the fund context. Is the guidance sufficiently clear? Would the application of the significant influence test as applied to funds be effective in addressing the compliance challenges generated by the current Loan Provision while also identifying debtor-creditor relationships that may bear on an auditor's independence with respect to a fund client? Why or why not? Is there further guidance that we should provide or other approaches that we should consider? [cir] Should the ``significant influence'' test (or specific elements) be codified in our rules? Why or why not? [cir] Authorized participants (``APs'') for ETFs deposit or receive basket assets in exchange for creation units of the fund. We believe 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. Should we provide additional guidance about the proposed ``significant influence'' test with respect to APs? Similarly, should we provide additional guidance about the proposed ``significant influence'' test with respect to a market maker that is also a lender to the auditor and that engages an AP on an agency basis to create or redeem creation units of the ETF on its behalf? [cir] ASC 323 includes a rebuttable presumption of 20 percent. For purposes of the Loan Provision and the proposed significant influence test, should the rebuttable presumption be lower or higher than 20 percent? Would a lower threshold (e.g., 10 percent) be more likely to capture relevant independence-impairing relationships, or to result in additional false positives that the proposed rule seeks to avoid? Would setting our threshold differently than ASC 323 diminish the benefits that we seek to achieve by using an existing standard--e.g., by requiring the reperformance of certain analyses at a greater degree of sensitivity? How much more complex would it be to apply a threshold other than 20 percent? Are there further relevant facts about a lower or higher threshold that we should consider? [cir] Would the proposed amendment raise any new concerns regarding auditor independence (e.g., are there circumstances related to lending relationships in which an auditor's independence should be considered impaired that would not be identified under the proposed ``significant influence'' test)? Conversely, would the proposed ``significant influence'' test result in an auditor's independence being considered impaired in circumstances under which the auditor should otherwise be considered independent? [cir] Should we consider alternatives to this test? If so, what tests should we consider, and what would be the anticipated costs and benefits? For example, should the modifier [[Page 20764]] ``significant'' be removed, such that the test hinges on whether a lender shareholder has influence over an audit client? Why or why not? What is the difference between ``influence'' and ``significant influence'' in the auditor independent context and how does that difference inform the test? [cir] Should the nature of the services provided by the investment adviser be part of the significant influence test as proposed? Why or why not? 3. ``Known Through Reasonable Inquiry'' [cir] Should the Loan Provision include a ``known through reasonable inquiry'' standard? Why or why not? What alternatives should we consider? [cir] Would the proposed ``known through reasonable inquiry'' standard with respect to identifying beneficial owners help to address compliance challenges associated with the Loan Provision? [cir] Are there specific circumstances for which we should provide additional guidance about the proposed ``known through reasonable inquiry'' standard? [cir] Does the ``known through reasonable inquiry'' standard raise any new concerns regarding auditor independence (e.g., are there circumstances related to lending relationships in which an auditor's independence should be considered impaired that would not be identified under the proposed amendment and the use of ``known through reasonable inquiry'' standard)? [cir] Alternatively, should we amend the Loan Provision to apply the significant influence test to ``known beneficial owners'' of an audit client's equity securities, without also including a reasonable inquiry standard, consistent with the way beneficial owners are treated elsewhere in Regulation S-X (that is, when assessing compliance with the Loan Provision, the determination would encompass assessing whether the known beneficial owners have significant influence over the audit client)? \68\ --------------------------------------------------------------------------- \68\ Under Rule 1-02(r) of Regulation S-X, ``principal holder of equity securities,'' when used in respect of a registrant or other person named in a particular statement or report, is defined to mean: ``a holder of record or a known beneficial owner of more than 10 percent of any class of equity securities of the registrant or other person, respectively, as of the date of the related balance sheet filed.'' (emphasis added). This approach also would be consistent with the disclosure requirements for registered funds, which require a fund to disclose information about known beneficial owners of five percent or more of the fund's securities. 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.''). --------------------------------------------------------------------------- 4. Proposed Amendment To Exclude From ``Audit Client'' Other Funds That Would Be Considered an ``Affiliate of the Audit Client'' [cir] Should affiliates of an audit client be excluded from the definition of ``audit client'' as it relates to the Loan Provision? Why or why not? [cir] Would the proposed amendment to exclude from the term ``audit client'' for a fund under audit any other fund that otherwise would be considered an ``affiliate of the audit client'' address compliance challenges associated with the Loan Provision while still effectively identifying lending relationships that may impair auditor independence? [cir] Would the proposed amendment appropriately exclude funds of an ``investment company complex'' (other than the fund under audit) that are currently within the Loan Provision's ambit? [cir] Alternatively, are there other changes we should consider to the Loan Provision to appropriately exclude certain affiliated funds? In addition to any comments regarding the proposed amendments, we also seek comment on the following potential changes to the Loan Provision and to other provisions in Rule 2-01 that we considered but determined not to propose at this time. A. Materiality The proposed amendments to the Loan Provision do not consider whether the lender's investment in the equity securities of the audit client is material to the lender or to the audit client.\69\ We believe that adding a materiality qualifier to the proposed significant influence test is unnecessary to achieve our goal of effectively and appropriately identifying lending relationships that could pose threats to auditor independence. Nevertheless, we request comment on whether there should be a materiality qualifier as part of the Loan Provision. --------------------------------------------------------------------------- \69\ Certain other provisions of the existing auditor independence rules utilize a materiality qualifier. For example, an accountant is deemed not to be independent if the accountant has ``any direct financial interest or material indirect financial interest in the accountant's audit client.'' See Rule 2-01(c)(1) of Regulation S-X. (emphasis added) --------------------------------------------------------------------------- [cir] For example, should we include a provision for assessing materiality in the Loan Provision such that an auditor's independence would only be impaired as a result of certain relationships where the lender to the auditing firm has beneficial ownership in the audit client's equity securities and that investment is material to the lender or to the audit client (and the lender has the ability to exercise significant influence over the audit client)? Would that approach more effectively identify lending relationships that are likely to threaten the auditor's objectivity and impartiality? Would focusing on the perspective of the lender, the audit client, or both be the most effective barometer of independence? [cir] If we were to add a materiality qualifier to the Loan Provision as described above, which qualitative and quantitative factors should be considered in making the materiality assessment? Would such a materiality assessment add unnecessary complexity to the significant influence analysis? Would a materiality qualifier tend to exclude most lending relationships from the Loan Provision? What guidance, if any, should the Commission provide? B. Accounting Firms' ``Covered Persons'' and Immediate Family Members The Loan Provision is implicated with respect to loans both to and from an accounting firm, and also any ``covered person'' in the firm or any of his or her immediate family members.\70\ Some of the consultations the Commission staff have had with audit firms, funds, and operating companies involved lending relationships to or from covered persons or their immediate family members. --------------------------------------------------------------------------- \70\ See Rule 2-01(c)(1)(ii)(A) and (f)(11) of Regulation S-X. --------------------------------------------------------------------------- [cir] Should we amend the definition of ``covered person'' for purposes of the Loan Provision or elsewhere in the auditor independence rules, and if so, how should the definition of ``covered person'' be amended? [cir] In particular, taking into account the proposed ``significant influence'' test, should we, for example, remove or revise the part of the current definition that includes any partner, principal, or shareholder from an ``office'' of the accounting firm in which the lead audit engagement partner primarily practices in connection with the audit? Should all of these persons practicing out of an office from which an audit is conducted be included? Should immediate family members be removed from the definition? Why or why not? [cir] In addition, the Loan Provision provides that it does not apply to certain loans made by a financial institution under its normal lending procedures, terms, and requirements, such as automobile loans and leases [[Page 20765]] collateralized by the automobile. Should we consider expanding or otherwise modifying the specific types of loans that will not implicate the Loan Provision, given that the Loan Provision applies to covered persons of the accounting firm and their immediate family members? For example, should the Loan Provision address student loans or partner capital account loans? If so, how should it address them? For example, should it exclude them altogether or exclude them under certain conditions? If so, under what conditions? C. Evaluation of Compliance 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. Some existing disclosure requirements require information about beneficial owners as of a specified date.\71\ --------------------------------------------------------------------------- \71\ See e.g., Item 18 of Form N-1A and Item 19 of Form N-2. --------------------------------------------------------------------------- [cir] Should the rule provide that auditor independence may be assessed in reliance on such disclosures? Should we make any changes related to the frequency with which, the date as of which, or circumstances under which, an auditor must assess compliance with the Loan Provision or other provisions of Rule 2-01 of Regulation S-X? More specifically, should we permit the Loan Provision or other financial relationships to be assessed at specific dates during the audit and professional engagement period, or the beginnings or ends of specific periods, or under specified circumstances? If so, what would be appropriate dates, periods, or circumstances? We believe that if the auditor determines that significant influence over the fund's management processes could not exist,\72\ the auditor could 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, publicly available information about beneficial owners, 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. --------------------------------------------------------------------------- \72\ 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. --------------------------------------------------------------------------- [cir] Would this approach be sufficient for evaluating compliance with the Loan Provision? Why or why not? D. Secondary Market Purchases of Debt The existing Loan Provision encompasses lending arrangements that may change depending upon secondary market purchases of syndicated or other debt. For example, audit firms may issue private placement notes for financing purposes, which could then be sold on the secondary market to new purchasers thereby creating new lending relationships between the audit firm and these new secondary market purchasers. [cir] Should such secondary market relationships be taken into account or excluded from the Loan Provision? Do secondary market relationships raise concerns about auditor independence? E. Other Changes to the Commission's Auditor Independence Rules [cir] Should we make other changes to our auditor independence rules? If so, which rules and why? [cir] Would our proposed amendments have any unintended impact on other professional standards that may exist, such as the requirements of the PCAOB, professional societies, or state boards of accountancy? IV. Paperwork Reduction Act The amendments we are proposing do not impose any new ``collections of information'' within the meaning of the Paperwork Reduction Act of 1995 (``PRA''),\73\ nor do they create any new filing, reporting, recordkeeping, or disclosure requirements. Accordingly, we are not submitting the proposed amendments to the Office of Management and Budget for review in accordance with the PRA.\74\ We request comment on whether our conclusion that there are no collections of information is correct. --------------------------------------------------------------------------- \73\ 44 U.S.C. 3501 et. seq. \74\ 44 U.S.C. 3507(d) and 5 CFR 1320.11. --------------------------------------------------------------------------- V. Economic Analysis The Commission is proposing to amend the Loan Provision in Rule 2- 01 of Regulation S-X by: (1) Focusing the analysis solely on beneficial ownership; (2) replacing the existing 10 percent bright-line equity shareholder ownership test with a ``significant influence'' test; (3) adding a ``known through reasonable inquiry'' standard with respect to identifying beneficial owners of the audit client's equity securities; and (4) amending the definition of ``audit client'' for a fund under audit to exclude from the provision funds that otherwise would be considered affiliates of the audit client. Under existing rules, the bright-line 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 any loan 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 terms of the scope of the ``audit client'' definition, the existing rule is generally broad, including as it relates to an audit client in an ICC.\75\ 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 compliance 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. --------------------------------------------------------------------------- \75\ See supra footnote 16 and accompanying text. --------------------------------------------------------------------------- We are mindful of the costs imposed by and the benefits obtained from our rules and amendments.\76\ The following economic analysis seeks to identify and consider the likely benefits and costs that would result from the proposed amendments, including their effects on efficiency, competition, and capital formation. The discussion below elaborates on the likely economic effects of the proposed rules. --------------------------------------------------------------------------- \76\ 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 us, 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 Given that the actions of fund and operating company management are not usually observable, the information contained in mandated financial reports is important to investors, because it serves as a summary measure of outcomes of managerial actions and [[Page 20766]] decisions.\77\ However, financial reports are prepared by agents, and given the possibility that agents may have incentives to take actions that are not in the best interest of shareholders, agents may also have incentives to misreport such decisions and their outcomes. 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 create reliability in financial reports.\78\ Any potential conflicts of interest between companies or funds and their auditors may impair the objectivity and impartiality of the auditors in certifying the 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.\79\ These studies generally find that better audit quality improves financial reporting by increasing the credibility of the financial reports. --------------------------------------------------------------------------- \77\ We use the terms agent and manager interchangeably. \78\ See M. Defond & J. Zhang, A Review of Archival Auditing Research, 58 J. Acct. & Econ. 275-326 (2014). \79\ 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[hyphen]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 (a) the firm's audit client; or (b) 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, 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 as well as the type of ownership are likely to be relevant factors in determining whether incentives exist for actions that could impair auditor independence. Beneficial ownership of more than 10 percent 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 more than 10 percent 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.\80\ --------------------------------------------------------------------------- \80\ We are unable to estimate the extent to which the 10 percent ownership threshold may over- or under-identify threats to independence because public data do not exist. --------------------------------------------------------------------------- We are not aware of academic studies that specifically examine the economic effects of the Loan Provision. The remainder of the economic analysis presents the baseline, anticipated benefits and costs from the proposed amendments, potential effects on efficiency, competition and capital formation, and alternatives to the proposed amendments. B. Baseline The proposed amendments would change the Loan Provision compliance requirements for the universe of affected registrants. We believe the main affected parties would 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 proposed amendment would affect audit clients' investors. We are not able to precisely estimate the number of current auditor engagements that would be immediately affected by the proposed 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 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, 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 8.5percent of a company's voting stock.\81\ They 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. --------------------------------------------------------------------------- \81\ See Y. Dou, O. Hope, W. Thomas & Y. Zou, Blockholder Heterogeneity and Financial Reporting Quality, working paper (2013). --------------------------------------------------------------------------- As mentioned above, the proposed amendments would 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 proposed amendments would affect entities outside of this space.\82\ --------------------------------------------------------------------------- \82\ According to the SEC's EDGAR database, during the period from January 1, 2017 to December 31, 2017, there were a total of 7,585 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. --------------------------------------------------------------------------- In Table 1, as of December 2017, there were around 12,000 fund series, with total net assets of $21 trillion, that file Form N-SAR with identified accounting firms.\83\ In addition, there were 23 [[Page 20767]] accounting firms performing audits for these investment companies, though these auditing services were concentrated among the four largest accounting firms. Indeed, about 88 percent of the funds were audited by the four largest accounting firms, corresponding to 98percent of the aggregate fund asset value.\84\ --------------------------------------------------------------------------- \83\ There are certain limitations regarding information reported on Form N-SAR and, as a result, this does not include information for all registered investment companies. If we were to incorporate private funds, the number would be significantly larger; the assets under management of private funds are also large. \84\ According to the 2017 PCAOB Annual Report, there were 535 audit firms registered with the PCAOB that have issued audit reports for issuers (of which 338 are domestic audit firms, with the remaining 197 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 76% of accelerated and large accelerated filers, which account for 97.9% of the market capitalization for public companies. See Who Audits Larger Public Companies-2016 Edition, available at http://www.auditanalytics.com/blog/who-audits-larger-public-companies-2016-edition. Table 1--Investment Company Auditors and Their Audited Fund Series [N-SARs filed for period dates: June 2017-December 2017] ------------------------------------------------------------------------ ------------------------------------------------------------------------ Total number of Fund Series................................. 11,666 Average number of Fund Series Per Auditor................... 507 Average Net Assets (in millions) Per Auditor................ 907,813 Four Largest Audit Firms.................................... .......... Total number of Fund Series................................. 10,177 Average number of Fund Series Per Auditor................... 2,544 Average Net Assets (in millions) Per Auditor................ 5,137,472 % of Four Audit Firms by Series............................. 87 % of Four Audit Firms by Net Assets......................... 98 ------------------------------------------------------------------------ One key feature of the current rule is that 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, 2017, 586 out of 977 fund families \85\ (excluding closed-end funds) have more than one fund, 180 have at least 10 funds, 59 have more than 50 funds, and 38 have more than 100 funds. According to the Investment Company Institute, also as of December 31, 2017, there were more than 11,188 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 hundreds of 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 hundreds of other funds within the same ICC. --------------------------------------------------------------------------- \85\ These fund statistics are based on information available from Morningstar Direct, and may not represent the universe of fund companies. --------------------------------------------------------------------------- In response to compliance challenges and as discussed above, Commission staff issued the Fidelity No-Action Letter to provide relief from the uncertainty surrounding compliance with the Loan Provision. The Fidelity No-Action Letter, however, did not resolve all compliance uncertainty, was limited in scope and provided staff-level relief to the requestor based on the specific facts and circumstances in the request, and did not amend the underlying rule. Staff continues to receive inquiries from registrants and accounting firms regarding the application of the Loan Provision, clarification of the application 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, and Unintended Consequences 1. Anticipated Benefits Overall, we anticipate monitoring for non-compliance throughout the reporting period would be less burdensome for registrants under the proposed 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. Further, a higher threshold (20 percent) for presumed significant influence, as well as a qualitative framework for assessing what constitutes significant influence, could better identify a lack of independence. 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 incentives as well as the ability of the lender to use any leverage (due to the lending relationship) over the auditor exist 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. By taking into account the nature as well as the magnitude of ownership, the proposed amendments would 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, as when the lender is only a holder of record, the proposed amendments would exclude relationships that are not likely to be a risk to auditor independence. The proposed amendments would thus provide benefits to the extent that they would alleviate compliance and related burdens that auditors and funds would otherwise undertake to analyze debtor-creditor relationships that are not likely to threaten an auditor's objectivity and impartiality. Affected registrants also would 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.\86\ If specialized auditors are considered not to be independent due to the Loan Provision, then an auditor without the relevant specialization may be selected by companies 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, and therefore the users of information contained in audited financial reports. In addition, 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 proposed amendments likely would positively impact audit quality for scenarios such as the one described above. Relatedly, if the proposed amendments expand the pool of eligible auditors, we expect increased competition among auditors, which could reduce the cost of audit services [[Page 20768]] 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.\87\ --------------------------------------------------------------------------- \86\ 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). \87\ The proposed amendments could result in some crowding-out effect, as the four largest audit firms may be deemed to be independent with more clients under the proposed amendments, crowding out small audit firms. We discuss this effect in more detail in Section V.D below. However, we believe that better matching between auditor specialization and their clients and the reduced unnecessary auditor turnovers could potentially prevent audit quality decline and in the long run may improve audit quality. --------------------------------------------------------------------------- Another potential benefit of the proposed 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. 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 itself would differentially classify these two hypothetical situations, despite their similarity. To the extent that the proposed amendments are able to improve identification of potential risks to auditor independence through the use of qualitative criteria, then investors are likely to benefit from the proposed amendments. In the example above, under the proposed amendments, an audit firm 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. In addition, there may be instances in which non-compliance with the Loan Provision may occur during the reporting year, after an auditor is selected by the registrant or fund. Particularly for companies in the investment management industry, an auditor may be deemed to comply with the Loan Provision using the bright-line test when the auditor is hired by the fund but, due to external factors, such as redemption of investments by other owners of the fund during the period, the lender's ownership level may increase and exceed 10 percent. Such outcomes would be less likely under the proposed amendments, which take into account multiple qualitative factors in determining whether the Loan Provision is implicated during the period.\88\ We anticipate that the proposed amendments would likely mitigate changes in auditors' independence status and mitigate any negative consequences that can arise from uncertainty about compliance and the associated costs to the funds or companies involved and their investors. --------------------------------------------------------------------------- \88\ The concept of significant influence, as described in ASC Topic 323, Investments--Equity Method and Joint Ventures, incorporates a rebuttable presumption of significant influence once beneficial ownership exceeds 20% of an audit client's securities. We discuss the effects of this provision in Section II.C above. --------------------------------------------------------------------------- The proposed amendment to add a ``known through reasonable inquiry'' standard could potentially improve the practical application of the significant influence test. As described above, some of the challenges to compliance with the existing Loan Provision involve the lack of access to information about the ownership percentage of a fund that was also an audit client. If an auditor does not know that one of its lenders is also an investor in an audit client, including because that lender invests in the audit client indirectly through one or more financial intermediaries, the auditor's objectivity and impartiality may be less likely to be impacted by its debtor-creditor relationship with the lender. The proposed ``known through reasonable inquiry'' standard is generally consistent with regulations implementing the Investment Company Act, the Securities Act and the Exchange Act,\89\ and therefore is a concept that already should be familiar to those charged with compliance with the provision. The proposed standard is expected to reduce the compliance costs for audit firms as they could significantly reduce their search costs for information and data to determine beneficial ownership. Given that this would not be a new standard in the Commission's regulatory regime, we do not expect a significant adjustment to apply the ``known through reasonable inquiry'' standard for auditors and their audit clients. --------------------------------------------------------------------------- \89\ See supra footnote 64. --------------------------------------------------------------------------- The proposal to amend the definition of ``audit client'' to exclude any fund not under audit but that otherwise would be considered an ``affiliate of the audit client'' could potentially lead to a larger pool of eligible auditors, potentially reducing the costs of switching auditors, and potentially creating better matches between auditors and clients. In addition, the larger set of potentially eligible auditors could lead to an increase in competition among auditors for clients, and improved matching between auditor specialization and client needs. Though the concentrated nature of the audit industry may not give rise to a significant increase in competition, the improved matching between specialized auditors and their clients should have a positive effect on audit quality. The proposed amendments could also have a positive impact on the cost of audit firms' financing. The proposed amendments may result in an expanded set of choices among existing sources of financing. This could lead to more efficient financing activities for audit firms, thus potentially lowering the cost of capital for audit firms.\90\ If financing costs for audit firms decrease as a result of the proposed amendments, then such savings may be passed on to the audit client in the form of lower audit fees. Investors also may benefit from reduced audit fees if the savings are passed on to investors. The Commission understands, however, that audit firms likely already receive favorable financing terms. Therefore, this effect may not be significant in practice. --------------------------------------------------------------------------- \90\ Studies on capital markets across countries suggest that better access to financing leads to more investment efficiency. See e.g., T. Rice & P. Strahan, Does Credit Competition Affect Small- Firm Finance, 65 J. Fin. 861-889 (2010); R. Mclean, T. Zhang & M. Zhao, Why does the Law Matter? Investor Protection and its Effects on Investment, Finance, and Growth, 67 J. Fin. 313-350 (2012); and J. Wurgler, Financial Markets and the Allocation of Capital, 58 J. Fin. 187-214 (2000). --------------------------------------------------------------------------- The replacement of the bright-line 10 percent test with the significant influence test also potentially allows more financing channels for the covered persons in accounting firms and their immediate family members.\91\ For example, the covered persons may not be able to borrow money from certain lenders due to potential non- compliance with the existing Loan Provision. A larger set of financing channels may potentially lead to lower cost of capital for covered persons, increasing their opportunities for investment. --------------------------------------------------------------------------- \91\ See supra footnote 11. --------------------------------------------------------------------------- 2. Anticipated Costs and Potential Unintended Consequences The proposed significant influence test may increase the demands on the time of auditors and audit clients to familiarize themselves with the test and gather and assess the relevant information to apply the test. However, given that the significant influence test has been part of the Commission's auditor independence rules since 2000 and has existed in U.S. GAAP since 1971, we do not expect a significant learning curve in applying the test. We also do not expect significant compliance costs for auditors to implement the significant influence test [[Page 20769]] in the context of the Loan Provision given that they already are required to apply the concept in other parts of the auditor independence rules. We recognize that funds do not generally apply a significant influence test for financial reporting purposes. As such, despite the fact that they are required to apply the significant influence test to comply with the existing Commission independence rules, their overall familiarity in other contexts may be less. As a result, the proposed significant influence test may increase the demands on the time of funds and their auditors to gather and assess the relevant information and attendant costs. The replacement of the bright-line threshold test with the significant influence test and the ``known through reasonable inquiry'' standard would introduce more judgment in the determination of compliance with the Loan Provision. As discussed earlier, the significant influence test contains multiple qualitative elements to be considered in determining whether an investor has significant influence over the operating and financial policies of the investee. These elements include, but are not limited to, representation on the board of directors; participation in policy-making processes; material intra- entity transactions; interchange of managerial personnel; and technological dependency. To the extent an auditor and audit client need to adjust their compliance activities to now focus on these new elements, there may be additional transition costs. The judgment involved in application of the significant influence test also could lead to potential risks regarding auditor independence. In particular, because the significant influence test relies on qualitative factors that necessarily involve judgment, there is a risk that the significant influence test could result in mistakenly classifying a non-independent auditor as independent under the Loan Provision. However, auditor reputational concerns may impose some discipline on the application of the significant influence test in determining compliance with the Loan Provision, thus mitigating this risk. D. Effects on Efficiency, Competition and Capital Formation The Commission believes that the proposed amendments are likely to improve the practicality of the Loan Provision, enhance efficiency of implementation, and reduce compliance burdens. They also may facilitate capital formation. The proposed amendments may expand a particular audit client's choices by expanding the number of auditors that meet the auditor independence rules under the Loan Provision. As discussed earlier, the current bright-line test may be over-inclusive under certain circumstances. If more audit firms are eligible to undertake audit engagements without implicating the Loan Provision, then audit clients will have more options and as a result audit costs may decrease, although given the highly concentrated nature of the audit industry, this effect may not be significant. Moreover, the potential expansion of choice among eligible audit firms and the reduced threat of being required to switch auditors may lead to better matching between the audit client and the auditor. Improved matching between auditor specialties and audit clients could enable auditors to perform auditing services more efficiently, thus potentially reducing audit fees and increasing audit quality over the long term. Higher audit quality is linked to better financial reporting, which could result in a lower cost of capital. Reduced expenses and higher audit quality may decrease the overall cost of investing as well as the cost of capital, with potential positive effects on capital formation. However, due to the concentrated nature of the audit industry, we acknowledge that any such effects may not be significant. The replacement of the existing bright-line test with the significant influence test could more effectively capture those relationships that may pose a threat to an auditor's objectivity and impartiality. To the extent that the proposed amendments do so, the quality of financial reporting is likely to improve, and the amount of board attention to independence questions when impartiality is not at issue is likely to be reduced, thus allowing a fund board to focus on its role as an independent check on fund management. An operating company's board might focus on hiring the best management, choosing the most value-enhancing investment projects, and monitoring management to maximize shareholder value. This sharpened focus could potentially benefit shareholders. Furthermore, we expect that improved identification of threats to auditor independence would increase investor confidence about the quality and accuracy of the information reported. Reduced uncertainty about the quality and accuracy of financial reporting should attract capital, and thus facilitate capital formation. Under the proposed amendments, audit firms would potentially be able to draw upon a larger set of lenders. This potentially could lead to greater competition among the lending institutions, leading to lower borrowing costs for audit firms. Again, this could result in lower audit fees, lower fund fees, lower compliance expenses, and help facilitate capital formation, to the extent that lower borrowing costs for audit firms get passed on to their audit clients. The proposed amendments also may potentially lead to changes in the competitive structure of the audit industry. We expect more accounting firms to be eligible to provide auditing services and be in compliance with auditor independence under the proposed amendments. If the larger audit firms are the ones more likely to engage in significant financing transactions and are more likely to not be in compliance with the existing Loan Provision, then these firms are more likely to be positively affected by the proposed amendments. In particular, these firms may be able to compete for or retain a larger pool of audit clients. At the same time, the larger firms' potentially increased ability to compete for audit clients could potentially crowd out the auditing business of smaller audit firms. However, we estimate that four audit firms already perform 88 percent of audits in the registered investment company space.\92\ As a result, we do not expect any potential change in the competitive dynamics among auditors for registered investment companies to be significant. --------------------------------------------------------------------------- \92\ The market share of the four largest accounting firms in other industries is significantly high as well. According to the sample of 7,180 registrants covered by Audit Analytics in 2016, the four largest accounting firms' mean (median) market share across industries (based on two digit standard industry code) is 58% (57%). The upper quartile is as high as 78% with low quartile of the distribution being 45%. --------------------------------------------------------------------------- E. Alternatives The existing Loan Provision covers loans to and from the auditor by ``record or beneficial owners of more than 10 percent of the audit client's equity securities.'' As discussed earlier, record owners are relatively less likely to have incentives to take actions that would threaten auditor independence than are beneficial owners. An alternative approach to the proposed amendments would be to maintain the 10 percent bright-line test, but to distinguish between types of ownership under the 10 percent bright-line test and tailor the rule accordingly. For example, record owners could be excluded from the 10 percent bright-line test, to which beneficial owners would remain subject. The potential benefit of distinguishing [[Page 20770]] between types of ownership while retaining the 10 percent bright-line test is that applying a bright-line test would involve less judgment than the proposed significant influence test. Excluding record holders that may not have strong enough economic incentives or power to impair auditor independence could partially overcome the over-inclusiveness of the exiting rule. However, it still would not overcome the issues of over- or under-inconclusiveness with respect to beneficial owners. A second alternative would be to use the materiality of a stock holding to the lender in conjunction with the significant influence test as a proxy for incentives that could threaten auditor independence. Specifically, the significance of the holding to the lender could be assessed based on the magnitude of the stock holding to the lender (i.e., what percentage of the lender's assets are invested in the audit client's equity securities), after determining whether the lender has significant influence over the audit client. For example, two institutions that hold 15 percent of a fund may be committing materially different amounts of their capital to the specific investment. The incentives to influence the auditor's report are likely to be stronger for the lender that commits the relatively larger amount of capital to a specific investment. As such, the materiality of the investment to a lender with significant influence could be used as an indicator of incentives by the lender to attempt to influence the auditor's report. Materiality of a holding may better capture the incentives that could pose a threat to auditor independence. The potential cost to the auditors and audit clients could be that they need additional information and an additional layer of judgment in assessing their compliance with the Loan Provision. Also, given the size of most lenders, a materiality component might effectively exclude most, if not all, lending relationships that pose a threat to an auditor's objectivity and impartiality. A third potential approach would be to assess the materiality of the lending relationship between the auditor and the lending institution. The materiality of the lending relationship between the lender and the auditor, from both the lender's and the auditor's point of views, could act as an indicator of the leverage that the lender may have if it attempts to influence the auditor's report. However, again, given the size of most impacted audit firms and lenders, a materiality component might effectively exclude most, if not all, lending relationships that pose a threat to an auditor's objectivity and impartiality. F. Request for Comment We request and encourage any interested person to submit comments regarding the proposed amendments and all aspects of our analysis of the potential effects of the amendments. Comments are particularly helpful to us if accompanied by quantified estimates or other detailed analysis and supporting data regarding the issues addressed in those comments. We also are interested in comments on the alternatives presented in this release as well as any additional alternatives to the proposed amendments that should be considered. To assist in our consideration of these costs and benefits, we specifically request comment on the following: The costs and benefits of the proposed amendment to eliminate the requirement that audit firms analyze record holders under the Loan Provision. The costs and benefits of the proposed significant influence test. The costs and benefits of the proposed addition of a ``known through reasonable inquiry'' standard in applying the significant influence test. The costs and benefits of the proposed exclusion of the funds (other than the fund under audit) from being considered an affiliate of the audit client. The effect of the proposed amendments on the competitive structure of the audit industry. The effect of the proposed amendments on the quality of financial reporting. The effect of the proposed amendments on audit quality. The effect of the proposed amendments on capital formation. The effect of the proposed amendments on audit firms and their covered persons' financing. VI. Initial Regulatory Flexibility Act Analysis The Regulatory Flexibility Act (``RFA'') \93\ requires the Commission, in promulgating rules under section 553 of the Administrative Procedure Act,\94\ to consider the impact of those rules on small entities. We have prepared this Initial Regulatory Flexibility Act Analysis (``IRFA'') in accordance with 5 U.S.C. 603. This IRFA relates to the proposed amendments to Rule 2-01 of Regulation S-X. --------------------------------------------------------------------------- \93\ 5 U.S.C. 601 et seq. \94\ 5 U.S.C. 553. --------------------------------------------------------------------------- A. Reasons for and Objectives of the Proposed Action As discussed above, the primary reason for, and objective of, the proposed amendments is to address certain significant compliance challenges for audit firms and their clients resulting from application of the Loan Provision that do not otherwise appear to affect the impartiality or objectivity of the auditor. Specifically, the proposed amendments would: Focus the analysis solely on beneficial ownership; replace the existing 10 percent bright-line shareholder ownership test with a ``significant influence'' test; add a ``known through reasonable inquiry'' standard with respect to identifying beneficial owners of the audit client's equity securities; and amend the definition of ``audit client'' for a fund under audit to exclude from the provision funds that otherwise would be considered affiliates of the audit client. The reasons for, and objectives of, the proposed rules are discussed in more detail in Sections I and II above. B. Legal Basis We are proposing the amendments pursuant to Schedule A and Sections 7, 8, 10, and 19 of the Securities Act, Sections 3, 10A, 12, 13, 14, 17, and 23 of the Exchange Act, Sections 8, 30, 31, and 38 of the Investment Company Act, and Sections 203 and 211 of the Investment Advisers Act. C. Small Entities Subject to the Proposed Rules The proposed amendments would affect small entities that file registration statements under the Securities Act, the Exchange Act, and the Investment Company Act and periodic reports, proxy and information statements, or other reports under the Exchange Act or the Investment Company Act, as well as smaller registered investment advisers and smaller accounting firms. The RFA defines ``small entity'' to mean ``small business,'' ``small organization,'' or ``small governmental jurisdiction.'' \95\ The Commission's rules define ``small business'' and ``small organization'' for purposes of the Regulatory Flexibility Act for each of the types of entities regulated by the Commission. Securities Act Rule 157 \96\ and Exchange Act Rule 0-10(a) \97\ defines an issuer, other than [[Page 20771]] an investment company, to be a ``small business'' or ``small organization'' if it had total assets of $5 million or less on the last day of its most recent fiscal year. We estimate that there are approximately 1,163 issuers, other than registered investment companies, that may be subject to the proposed amendments.\98\ The proposed amendments would affect small entities that have a class of securities that are registered under Section 12 of the Exchange Act or that are required to file reports under Section 15(d) of the Exchange Act. In addition, the proposed amendments would affect small entities that file, or have filed, a registration statement that has not yet become effective under the Securities Act and that has not been withdrawn. --------------------------------------------------------------------------- \95\ 5 U.S.C. 601(6). \96\ 17 CFR 230.157. \97\ 17 CFR 240.0-10(a). \98\ This estimate is based on staff analysis of XBRL data submitted with EDGAR filings of Forms 10-K, 20-F and 40-F and amendments filed during the calendar year of January 1, 2017 to December 31, 2017. --------------------------------------------------------------------------- An investment company is considered to be a ``small business'' for purposes of the RFA, if it, together with other investment companies in the same group of related investment companies, has net assets of $50 million or less at the end of the most recent fiscal year.\99\ We believe that the proposed amendments would affect small entities that are investment companies. Commission staff estimates that, as of December 31, 2017, there were 54 open-end investment companies (within 52 fund complexes) that would be considered small entities. This number includes open-end ETFs.\100\ --------------------------------------------------------------------------- \99\ 17 CFR 270.0-10(a). \100\ This estimate is derived from an analysis of data obtained from Morningstar Direct as well as data reported on Form N-SAR filed with the Commission for the period ending June 30, 2017. --------------------------------------------------------------------------- For purposes of the RFA, an investment adviser is a small entity if it: (1) Has assets under management having a total value of less than $25 million; (2) did not have total assets of $5 million or more on the last day of the most recent fiscal year; and (3) does not control, is not controlled by, and is not under common control with another investment adviser that has assets under management of $25 million or more, or any person (other than a natural person) that had total assets of $5 million or more on the last day of its most recent fiscal year.\101\ We estimate that there are approximately 557 investment advisers that would be subject to the proposed amendments that may be considered small entities.\102\ --------------------------------------------------------------------------- \101\ 17 CFR 275.0-7. \102\ This estimate is based on Commission-registered investment adviser responses to Form ADV, Part 1A, Items 5.F and 12. --------------------------------------------------------------------------- For purposes of the RFA, a broker-dealer is considered to be a ``small business'' if its total capital (net worth plus subordinated liabilities) is less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared pursuant to Rule 17a-5(d) under the Exchange Act,\103\ or, if not required to file such statements, a broker-dealer with total capital (net worth plus subordinated liabilities) of less than $500,000 on the last day of the preceding fiscal year (or in the time that it has been in business, if shorter); and that is not affiliated with any person (other than a natural person) that is not a small business or small organization.\104\ As of the year end of 2017, there are approximately 1,042 small entity broker-dealers that may be subject to the proposed amendments.\105\ --------------------------------------------------------------------------- \103\ 17 CFR 240.17a-5(d). \104\ 17 CFR 240.0-10(c). \105\ This estimate is based on the most recent information available, as provided in Form X-17A-5 Financial and Operational Combined Uniform Single Reports filed pursuant to Section 17 of the Exchange Act and Rule 17a-5 thereunder. --------------------------------------------------------------------------- Our rules do not define ``small business'' or ``small organization'' for purposes of accounting firms. The Small Business Administration (SBA) defines ``small business,'' for purposes of accounting firms, as those with under $20.5 million in annual revenues.\106\ We have limited data indicating revenues for accounting firms, and we cannot estimate the number of firms with less than $20.5 million in annual revenue. We request comment on the number of accounting firms with revenue under $20.5 million. --------------------------------------------------------------------------- \106\ 13 CFR 121.201 and North American Industry Classification System (NAICS) code 541211. The SBA calculates ``annual receipts'' as all revenue. See 13 CFR 121.104. --------------------------------------------------------------------------- D. Projected Reporting, Recordkeeping and Other Compliance Requirements The proposed amendments would not impose any reporting, recordkeeping, or disclosure requirements. The proposed amendments would impose new compliance requirements with respect to the Loan Provision. Although we are proposing to replace the 10 percent bright-line test with a ``significant influence'' test that requires the application of more judgment, we believe that the proposed amendments would not significantly increase costs for smaller entities, including smaller accounting firms. The concept of ``significant influence'' already exists in the auditor independence rules and in U.S. GAAP,\107\ and accounting firms, issuers and their audit committees are already required to apply the concept in these contexts and may have developed practices, processes or controls for complying with these provisions.\108\ We believe that these entities likely would be able to leverage any existing practices, processes or controls to comply with the proposed amendments. --------------------------------------------------------------------------- \107\ See supra footnote 48; see also ASC 323, supra footnote 49. \108\ Although the concept of ``significant influence'' is not as routinely applied today in the funds context for financial reporting purposes, nevertheless, the concept of significant influence is applicable to funds under existing auditor independence rules. See supra Section II.C. --------------------------------------------------------------------------- We also believe that the proposed ``known through reasonable inquiry'' standard would not significantly increase costs for smaller entities, including smaller accounting firms. The ``known through reasonable inquiry'' standard is generally consistent with regulations implementing the Investment Company Act, the Securities Act and the Exchange Act.\109\ Smaller entities, including smaller accounting firms, should therefore already be familiar with the concept. --------------------------------------------------------------------------- \109\ See supra footnote 64. --------------------------------------------------------------------------- In addition, we believe that the proposed amendments to exclude record owners and certain fund affiliates for purposes of the Loan Provision would reduce costs for smaller entities, including smaller accounting firms. Compliance with the proposed amendments would require the use of professional skills, including accounting and legal skills. The proposed amendments are discussed in detail in Section II above. We discuss the economic impact, including the estimated costs, of the proposed amendments in Section V (Economic Analysis) above. E. Duplicative, Overlapping, or Conflicting Federal Rules We believe that the proposed amendment would not duplicate, overlap or conflict with other federal rules. F. Significant Alternatives The RFA directs us to consider alternatives that would accomplish our stated objectives while minimizing any significant adverse impacts on small entities. In connection with the proposed amendments, we considered certain types of alternatives, including: (1) The establishment of differing compliance or reporting requirements or timetables that take into account the resources available to small entities; (2) The clarification, consolidation or simplification of compliance and reporting requirements under the rule for small entities; (3) The use of performance rather than design standards; and [[Page 20772]] (4) An exemption from coverage of the rule, or any part of the rule, for small entities. In connection with our proposed amendments to Rule 2-01 of Regulation S-X, we do not think it feasible or appropriate to establish different compliance or reporting requirements or timetables for small entities. The proposed amendments are designed to address compliance challenges for both large and small issuers and audit firms. With respect to clarification, consolidation or simplification of compliance and reporting requirements for small entities, the proposed amendments do not contain any new reporting requirements. While the proposed amendments would create a new compliance requirement that focuses on ``significant influence'' over the audit client to better identify those lending relationships that could impair an auditor's objectivity and impartiality, that standard is more qualitative in nature and its application would vary according to the circumstances. This more flexible standard would be applicable to all issuers, regardless of size. With respect to using performance rather than design standards, we note that our proposed amendments establishing a ``significant influence'' test and adding a ``known through reasonable inquiry'' standard are more akin to performance standards. Rather than prescribe the specific steps necessary to apply such standards, the proposed amendments recognize that ``significant influence'' and ``known through reasonable inquiry'' can be implemented in a variety of ways. We believe that the use of these standards would accommodate entities of various sizes while potentially avoiding overly burdensome methods that may be ill-suited or unnecessary, given the facts and circumstances. The proposed amendments are intended to address significant compliance challenges for audit firms and their clients, including those that are small entities. In this respect, exempting small entities from the proposed amendments would increase, rather than decrease, their regulatory burden relative to larger entities. G. Solicitation of Comment We encourage the submission of comments with respect to any aspect of this Initial Regulatory Flexibility Analysis. In particular, we request comments regarding: The number of small entities that may be subject to the proposed amendments; The existence or nature of the potential impact of the proposed amendments on small entities discussed in the analysis; How to quantify the impact of the proposed amendments; and Alternatives that would accomplish our stated objectives while minimizing any significant adverse impact on small entities. Respondents are asked to describe the nature of any impact and provide empirical data supporting the extent of the impact. Such comments will be considered in the preparation of the Final Regulatory Flexibility Analysis, if the proposed amendments are adopted, and will be placed in the same public file as comments on the proposed amendments. VII. Small Business Regulatory Enforcement Fairness Act For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 (``SBREFA''),\110\ the Commission must advise the Office of Management and Budget as to whether a proposed regulation constitutes a ``major'' rule. Under SBREFA, a rule is considered ``major'' when, if adopted, it results or is likely to result in: --------------------------------------------------------------------------- \110\ Public Law 104-121, Tit. II, 110 Stat. 857 (1996). --------------------------------------------------------------------------- An annual effect on the economy of $100 million or more (either in the form of an increase or a decrease); A major increase in costs or prices for consumers or individual industries; or Significant adverse effects on competition, investment or innovation. If a rule is ``major,'' its effectiveness will generally be delayed for 60 days pending Congressional review. We request comment on whether our proposed amendments would be a ``major rule'' for purposes of SBREFA. We solicit comment and empirical data on: The potential effect on the U.S. economy on an annual basis; Any potential increase in costs or prices for consumers or individual industries; and Any potential effect on competition, investment or innovation. We request those submitting comments to provide empirical data and other factual support for their views to the extent possible. VIII. Statutory Basis The amendment described in this release is being adopted under the authority set forth in Schedule A and Sections 7, 8, 10, and 19 of the Securities Act, Sections 3, 10A, 12, 13, 14, 17, and 23 of the Exchange Act, Sections 8, 30, 31, and 38 of the Investment Company Act, and Sections 203 and 211 of the Investment Advisers Act. List of Subjects in 17 CFR Parts 210 Accountants, Accounting, Banks, Banking, Employee benefit plans, Holding companies, Insurance companies, Investment companies, Oil and gas exploration, Reporting and recordkeeping requirements, Securities, Utilities. In accordance with the foregoing, the Commission proposes to amend title 17, chapter II of the Code of Federal Regulations as follows: PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975 0 1. The authority citation for part 210 continues to read as follows: Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 77nn(25), 77nn(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-20, 80a-29, 80a-30, 80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, and sec. 102(c), Public Law 112-106, 126 Stat. 310 (2012), unless otherwise noted. 0 2. Amend Sec. 210.2-01 by revising paragraph (c)(1)(ii)(A) to read as follows: Sec. 210.2-01 Qualifications of accountants. * * * * * (c) * * * (1) * * * (ii) * * * (A) Loans/debtor-creditor relationship. (1) Any loan (including any margin loan) to or from an audit client, or an audit client's officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client's equity securities where such beneficial owner has significant influence over the audit client, except for the following loans obtained from a financial institution under its normal lending procedures, terms, and requirements: (i) Automobile loans and leases collateralized by the automobile; (ii) Loans fully collateralized by the cash surrender value of an insurance policy; (iii) Loans fully collateralized by cash deposits at the same financial institution; and (iv) A mortgage loan collateralized by the borrower's primary residence [[Page 20773]] provided the loan was not obtained while the covered person in the firm was a covered person. (2) For purposes of paragraph (c)(1)(ii)(A) of this section: (i) The term audit client for a fund under audit excludes any other fund that otherwise would be considered an affiliate of the audit client; (ii) The term fund means an investment company or an entity that would be an investment company but for the exclusions provided by Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a- 3(c)). * * * * * By the Commission. Dated: May 2, 2018. Brent J. Fields, Secretary. [FR Doc. 2018-09721 Filed 5-7-18; 8:45 am] BILLING CODE 8011-01-P
![Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules 20753
List of Subjects in 14 CFR Part 39 (f) Alternative Methods of Compliance proposing to amend its auditor
(AMOCs) independence rules to refocus the
Air transportation, Aircraft, Aviation (1) The Manager, Safety Management analysis that must be conducted to
safety, Incorporation by reference, Section, Rotorcraft Standards Branch, FAA, determine whether an auditor is
Safety. may approve AMOCs for this AD. Send your independent when the auditor has a
proposal to: Matt Fuller, Senior Aviation lending relationship with certain
The Proposed Amendment Safety Engineer, Safety Management Section,
Rotorcraft Standards Branch, FAA, 10101 shareholders of an audit client at any
Accordingly, under the authority Hillwood Pkwy., Fort Worth, TX 76177; time during an audit or professional
delegated to me by the Administrator, telephone (817) 222–5110; email 9-ASW- engagement period. The proposed
the FAA proposes to amend 14 CFR part FTW-AMOC-Requests@faa.gov. amendments would focus the analysis
39 as follows: (2) For operations conducted under a 14 solely on beneficial ownership rather
CFR part 119 operating certificate or under than on both record and beneficial
PART 39—AIRWORTHINESS 14 CFR part 91, subpart K, we suggest that ownership; replace the existing 10
DIRECTIVES you notify your principal inspector, or
lacking a principal inspector, the manager of
percent bright-line shareholder
the local flight standards district office or ownership test with a ‘‘significant
■ 1. The authority citation for part 39 certificate holding district office before influence’’ test; add a ‘‘known through
continues to read as follows: operating any aircraft complying with this reasonable inquiry’’ standard with
Authority: 49 U.S.C. 106(g), 40113, 44701. AD through an AMOC. respect to identifying beneficial owners
(g) Additional Information of the audit client’s equity securities;
§ 39.13 [Amended] and amend the definition of ‘‘audit
(1) Eurocopter Service Bulletin No. 332–
■ 2. The FAA amends § 39.13 by adding 52.00.28, Revision 1, dated April 29, 1998, client’’ for a fund under audit to exclude
the following new airworthiness which is not incorporated by reference, funds that otherwise would be
directive (AD): contains additional information about the considered affiliates of the audit client.
subject of this AD. For service information The Commission is also requesting
Airbus Helicopters: Docket No. FAA–2017– identified in this AD, contact Airbus comment on certain other potential
1124; Product Identifier 2017–SW–073– Helicopters, 2701 N Forum Drive, Grand
AD. amendments to its auditor
Prairie, TX 75052; telephone (972) 641–0000 independence rules.
(a) Applicability or (800) 232–0323; fax (972) 641–3775; or at
http://www.helicopters.airbus.com/website/ DATES: Comments should be received on
This AD applies to Airbus Helicopters en/ref/Technical-Support_73.html. You may or before July 9, 2018.
Model AS332C, AS332C1, AS332L, and review the referenced service information at ADDRESSES: Comments may be
AS332L1 helicopters, certificated in any the FAA, Office of the Regional Counsel, submitted by any of the following
category, with a cabin sliding plug door Southwest Region, 10101 Hillwood Pkwy., methods:
installed in accordance with Airbus Room 6N–321, Fort Worth, TX 76177.
Helicopters modification (MOD) 0722338, (2) The subject of this AD is addressed in Electronic Comments
except helicopters with a plug door jettison European Aviation Safety Agency (EASA) AD
system installed in accordance with MOD No. 2017–0022, dated February 8, 2017. You • Use the Commission’s internet
0725366. may view the EASA AD on the internet at comment form (http://www.sec.gov/
http://www.regulations.gov in the AD Docket. rules/proposed.shtml); or
(b) Unsafe Condition
(h) Subject
• Send an email to rule-comments@
This AD defines the unsafe condition as sec.gov. Please include File Number S7–
failure of a cabin sliding door to jettison, Joint Aircraft Service Component (JASC) 10–18 on the subject line.
which could prevent helicopter occupants Code: 5200, Doors.
from evacuating the helicopter during an Paper Comments
Issued in Fort Worth, Texas, on May 1,
emergency.
2018. • Send paper comments to Brent J.
(c) Comments Due Date Lance T. Gant, Fields, Secretary, Securities and
We must receive comments by July 9, 2018. Director, Compliance & Airworthiness Exchange Commission, 100 F Street NE,
Division, Aircraft Certification Service. Washington, DC 20549–1090.
(d) Compliance All submissions should refer to File
[FR Doc. 2018–09740 Filed 5–7–18; 8:45 am]
You are responsible for performing each Number S7–10–18. This file number
BILLING CODE 4910–13–P
action required by this AD within the should be included on the subject line
specified compliance time unless it has if email is used. To help us process and
already been accomplished prior to that time. review your comments more efficiently,
SECURITIES AND EXCHANGE
(e) Required Actions COMMISSION please use only one method. The
Within 110 hours time-in-service (TIS) or Commission will post all comments on
before the next operation over water, 17 CFR Part 210 the Commission’s website (http://
whichever occurs first, inspect the jettisoning www.sec.gov/rules/proposed.shtml).
[Release No. 33–10491; 34–83157; IC– Comments are also available for website
mechanism of the left-hand and right-hand
33091; IA–4904; FILE NO. S7–10–18]
cabin doors for correct operation: viewing and printing in the
(1) Pull the jettisoning handle and RIN 3235–AM01 Commission’s Public Reference Room,
determine whether the cable clamp contacts 100 F Street NE, Washington, DC 20549,
the top or bottom horizontal cables, using as Auditor Independence With Respect to on official business days between the
sradovich on DSK3GMQ082PROD with PROPOSALS
a reference the photographs under paragraph Certain Loans or Debtor-Creditor hours of 10:00 a.m. and 3:00 p.m. All
3.B.2 of Airbus Helicopters ASB No. AS332– Relationships comments received will be posted
52.00.56, Revision 0, dated January 30, 2017
(ASB). AGENCY: Securities and Exchange without change. Persons submitting
(2) If there is contact between a cable Commission. comments are cautioned that we do not
clamp and a horizontal cable, before further ACTION: Proposed rule. redact or edit personal identifying
flight, install both cable clamps as depicted information from comment submissions.
in the bottom photograph under paragraph SUMMARY:The Securities and Exchange You should submit only information
3.B.2 of the ASB. Commission (‘‘Commission’’) is that you wish to make available
VerDate Sep<11>2014 16:44 May 07, 2018 Jkt 244001 PO 00000 Frm 00016 Fmt 4702 Sfmt 4702 E:\FR\FM\08MYP1.SGM 08MYP1](https://thefederalregister.org/doc/83_FR_20842/page/1.svg)
![20754 Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules
publicly. Studies, memoranda, or other D. Projected Reporting, Recordkeeping and The Commission’s auditor
substantive items may be added by the Other Compliance Requirements independence standard is set forth in
Commission or staff to the comment file E. Duplicative, Overlapping, or Conflicting Rule 2–01 of Regulation S–X, which
Federal Rules
during this rulemaking. A notification of F. Significant Alternatives
requires auditors 6 to be independent of
the inclusion in the comment file of any G. Solicitation of Comment their audit clients both ‘‘in fact and in
such materials will be made available VII. Small Business Regulatory Enforcement appearance.’’ 7 Rule 2–01(b) provides
on the Commission’s website. To ensure Fairness Act that the Commission will not recognize
direct electronic receipt of such VIII. Statutory Basis an accountant as independent with
notifications, sign up through the ‘‘Stay respect to an audit client if the
I. Background
Connected’’ option at www.sec.gov to accountant is not (or if a reasonable
receive notifications by email. A. The Loan Provision of Regulation investor with knowledge of all relevant
FOR FURTHER INFORMATION CONTACT: S–X facts and circumstances would conclude
Giles T. Cohen, Deputy Chief Counsel, We are proposing to amend certain that the accountant is not) capable of
or Peggy Kim, Senior Special Counsel, provisions of our auditor independence exercising objective and impartial
Office of the Chief Accountant, at (202) rules. The Commission has long judgment on all issues encompassed
551–5300; Alison Staloch, Chief considered auditor independence to be within the accountant’s engagement.8
Accountant, Chief Accountant’s Office, essential to reliable financial reporting Rule 2–01(c) sets forth a nonexclusive
Division of Investment Management, at and critical to the effective functioning list of circumstances that the
(202) 551–6918; or Joel Cavanaugh, of the U.S. capital markets.2 Commission considers to be
Senior Counsel, Investment Company inconsistent with the independence
Independent auditors have an important
Regulation Office, Division of standard in Rule 2–01(b), including
public trust.3 Many Commission
Investment Management, at (202) 551– certain direct financial relationships
regulations require entities to file or
6792, U.S. Securities and Exchange between an accountant and audit client
furnish financial statements that have
Commission, 100 F Street NE, and other circumstances where the
been audited by an independent
Washington, DC 20549. accountant has a financial interest in the
auditor; such entities include operating
audit client.9 In particular, the
SUPPLEMENTARY INFORMATION: We are companies, registered investment
restriction on debtor-creditor
proposing amendments to Rule 2–01 of companies, registered investment
relationships in Rule 2–01(c)(1)(ii)(A)
Regulation S–X.1 advisers, pooled investment vehicles,4
(the ‘‘Loan Provision’’) generally
and registered broker-dealers.5 provides that an accountant is not
Table of Contents
I. Background 2 See generally Proposed Rule: Revision of the
Commission’s Auditor Independence Requirements, Securities Exchange Act of 1934 (‘‘Exchange Act’’)
A. The Loan Provision of Regulation S–X [15 U.S.C. 78q] expressly require that financial
B. Application of the Current Loan Release No. 33–7870 (June 30, 2000) (‘‘2000
statements be certified by independent public or
Proposing Release’’), available at https://
Provision certified accountants. In addition, Sections
www.sec.gov/rules/proposed/34-42994.htm.
II. Proposed Amendments 3 The U.S. Supreme Court in describing the
12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act
A. Overview of the Proposed Amendments [15 U.S.C. 78l and 78m], Sections 8(b)(5) and 30(e)
independent auditor’s responsibility, stated that the and (g) of the Investment Company Act of 1940
B. Focus the Analysis Solely on Beneficial accountant’s ‘‘public watchdog’’ function ‘‘demands (‘‘Investment Company Act’’) [15 U.S.C. 80a–8 and
Ownership that the accountant maintain total independence 80a–29], and Section 203(c)(1)(D) of the Investment
C. Significant Influence Test from the client at all times and requires complete Advisers Act of 1940 (‘‘Advisers Act’’) [15 U.S.C.
D. Reasonable Inquiry Compliance fidelity to the public trust.’’ United States v. Arthur 80b–3(c)(1)] authorize the Commission to require
Threshold Young, 465 U.S. 805, 818 (1984). the filing of financial statements that have been
4 In this Release, we use the term ‘‘pooled
E. Excluding Other Funds That Would Be audited by independent accountants. Paragraph
Considered Affiliates of the Audit Client investment vehicle’’ to refer to a limited (f)(1) of Rule 17a–5 under the Exchange Act [17 CFR
partnership, limited liability company, or another 240.17a–5(f)(1)] requires that for audits under
III. Request for Comment
type of pooled investment vehicle for which the paragraph (d) of Rule 17a–5 of broker-dealers
A. Materiality pooled investment vehicle’s investment adviser registered with the Commission, an independent
B. Accounting Firms’ ‘‘Covered Persons’’ relies on paragraph (b)(4) of Rule 206(4)–2 (the public accountant must be independent in
and Immediate Family Members ‘‘Custody Rule’’) under the Advisers Act. In general, accordance with Rule 2–01 of Regulation S–X. See
C. Evaluation of Compliance paragraph (b)(4) of the Custody Rule provides also id. (discussing Rule 206(4)–2 under the
D. Secondary Market Purchases of Debt conditions under which an investment adviser is Advisers Act).
E. Other Changes to the Commission’s not required to comply with provisions of the 6 Rule 2–01 refers to ‘‘accountants’’ rather than
Auditor Independence Rules Custody Rule relating to the delivery of certain ‘‘auditors.’’ We use these terms interchangeably in
notices and account statements and is deemed to this Release.
IV. Paperwork Reduction Act
have complied with the surprise examination 7 See Preliminary Note 1 to Rule 2–01 and Rule
V. Economic Analysis requirements of the rule with respect to an account 2–01(b) of Regulation S–X. See also United States
A. General Economic Considerations that is a limited partnership, limited liability v. Arthur Young & Co., 465 U.S. 805, 819 n.15
B. Baseline company or other pooled investment vehicle that is (1984) (‘‘It is therefore not enough that financial
C. Anticipated Benefits and Costs, and subject to audit (as defined in Rule 1–02(d) of statements be accurate; the public must also
Unintended Consequences Regulation S–X). In order to rely on this ‘‘audit perceive them as being accurate. Public faith in the
1. Anticipated Benefits exception,’’ the audit must be performed by an reliability of a corporation’s financial statements
2. Anticipated Costs and Potential independent public accountant that: (i) Meets the depends upon the public perception of the outside
standards in Rule 2–01(b) and (c) of Regulation S– auditor as an independent professional.’’).
Unintended Consequences
X; and (ii) is registered with, and subject to regular 8 See Rule 2–01(b) of Regulation S–X.
D. Effects on Efficiency, Competition and inspection as of the commencement of the 9 See Rule 2–01(c) of Regulation S–X; see also
Capital Formation professional engagement period, and as of each Revision of the Commission’s Auditor
E. Alternatives calendar year-end, by the Public Company
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Independence Requirements, Release No. 33–7919
F. Request for Comment Accounting Oversight Board (‘‘PCAOB’’) in (Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)] (‘‘2000
VI. Initial Regulatory Flexibility Act Analysis accordance with its rules. Many advisers to private Adopting Release’’) available at https://
A. Reasons for and Objectives of the funds rely on the audit exception. A ‘‘private fund’’ www.sec.gov/rules/final/33-7919.htm, at 65 FR
Proposed Action is an issuer that would be an investment company, 76009 (‘‘The amendments [to Rule 2–01 adopted in
as defined in Section 3 of the Investment Company 2000] identify certain relationships that render an
B. Legal Basis
Act, but for Section 3(c)(1) or 3(c)(7) of that Act. See accountant not independent of an audit client
C. Small Entities Subject to the Proposed Section 202(a)(29) of the Investment Advisers Act. under the standard in Rule 2–01(b). The
Rules 5 For example, Items 25 and 26 of Schedule A to relationships addressed include, among others,
the Securities Act of 1933 (‘‘Securities Act’’) [15 financial, employment, and business relationships
1 17 CFR 210.2–01. U.S.C. 77aa(25) and (26)] and Section 17(e) of the between auditors and audit clients . . . .’’).
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For example, open-end funds, such as owners through other non-affiliated S–X. An auditor to one fund in an ICC
mutual funds, may face significant financial intermediaries, the same thus must seek information regarding
challenges, because the record investment could then constitute more the record and beneficial owners of the
ownership percentages of open-end than 10 percent of the mutual fund. equity securities of all of the other funds
funds may fluctuate greatly within a However, regardless of their diligence in (and other entities) in the ICC and such
given period for reasons completely out monitoring compliance, the financial owner’s affiliates (see Figure 3 below for
of the control or knowledge of a lender intermediary, the fund, or the auditor illustration). Other funds in the ICC that
who is also a fund shareholder of may not know that the 10 percent are not audited by the requesting
record. To be more specific, as a result threshold had been exceeded until after auditor are not required to provide this
of underlying customer activity in an the fact. information, and may only provide it, if
omnibus account (such as when Another practical challenge is that the at all, after negotiation and the
beneficial owners purchase or redeem auditor independence rules’ broad establishment of information-sharing
their shares in an open-end fund) or as definition of the term ‘‘audit client’’ protocols, all of which can require
a result of the activity of other record or gives rise to results that are out of step substantial time and expense incurred
beneficial owners, the record ownership with the purpose of the rule and that by auditors and funds. Even where
of a lender that is a financial can have adverse effects when applied funds not audited by this auditor do
intermediary holding fund shares for in the specific context of the Loan
provide information regarding the
customers may exceed, or conversely Provision. As described above, the Loan
owners of their equity securities, the
fall below, the 10 percent threshold Provision applies not only to an entity
fact that fund shares often are held in
within a given period without any that the audit firm is auditing but also
omnibus accounts registered in the
affirmative action on the part of the to those entities that are ‘‘affiliated’’
with the audit client.24 The auditor name of financial intermediaries creates
financial intermediary.23 In this
independence rules broadly define an further challenges in identifying the
scenario, the financial intermediary’s
‘‘affiliate of the audit client’’ to include, shares’ beneficial owners to determine if
holdings might constitute less than 10
among other things, both (a) an entity they are lenders to the auditing firm that
percent of a mutual fund and, as a result
of subsequent redemptions by beneficial that is under common control with the own more than 10 percent of the fund’s
audit client; and (b) each entity in an equity securities.26
23 Financial intermediaries such as broker- ICC when the audit client is part of that Further, not only loans to accounting
dealers, banks, trusts, insurance companies and ICC.25 firms but also loans to certain ‘‘covered
retirement plan third-party administrators perform Open-end funds are often part of large
the recordkeeping of open-end fund positions and
persons’’ at such firms and their
provide services to customers, including beneficial and varied ICCs, and multiple immediate family members may
owners and other intermediaries and, in most cases, accounting firms may be retained to implicate the Loan Provision.27 As a
aggregate their customer records into a single or a perform audits of various entities within result, certain lending relationships
few ‘‘omnibus’’ accounts registered in the the ICC. If an accounting firm is not
intermediary’s name on the fund transfer agent’s with members of the audit engagement
recordkeeping system. Shares of other types of independent under the Loan Provision team, individuals generally in the
registered investment companies, such as closed- with respect to only one of a given ICC’s supervisory reporting chain for the
end funds, also are frequently held by broker- funds, no fund or other entity in the ICC audit, certain accounting firm
dealers and other financial intermediaries as record can engage or retain that accounting
owners on behalf of their customers, who are not employees in the same primary office as
required and may be unwilling to provide, firm as an independent auditor the lead engagement partner, and other
information about the underlying beneficial owners consistent with Rule 2–01 of Regulation accounting firm employees—or with
to accounting firms, and particularly accounting
firms that do not audit the fund. In addition, a immediate family members of any of
24 See Rule 2–01(f)(6) of Regulation S–X.
financial intermediary may act as an authorized 25 See
those persons—could be found to
Rule 2–01(f)(4) of Regulation S–X, in which
participant or market maker to an exchange-traded
an ‘‘affiliate of the audit client’’ is defined to impair the audit firm’s independence.28
fund (‘‘ETF’’) and be the holder of record or
include the following:
beneficial owner of more than 10 percent of an ETF. 26 In some cases, financial intermediaries such as
(i) An entity that has control over the audit client,
An open-end fund, or open-end company, is a broker-dealers or banks hold fund shares on behalf
or over which the audit client has control, or which
management company that is offering for sale or has of other financial intermediaries, such as retirement
is under common control with the audit client,
outstanding any redeemable securities of which it plan administrators or other broker-dealers, creating
including the audit client’s parents and
is the issuer. A closed-end fund, or closed-end
subsidiaries; multiple layers of intermediaries between the fund
company, is any management company other than
(ii) An entity over which the audit client has and the beneficial owners of its shares. See also,
an open-end company. See Section 5 of the
significant influence, unless the entity is not e.g., Mutual Fund Redemption Fees, Release No.
Investment Company Act [15 U.S.C. 80a–5]. ETFs
registered with the Commission are organized either material to the audit client; IC–27504 (Sept. 27, 2006) [71 CFR 58257 (Oct. 3,
as open-end management companies or unit (iii) An entity that has significant influence over 2006)] at 58258 (discussing application of Rule
investment trusts. See Section 4 of the Investment the audit client, unless the audit client is not 22c–2 under the Investment Company Act to
Company Act [15 U.S.C. 80a–4] (defining the terms material to the entity; and ‘‘chains of intermediaries’’).
27 See Rule 2–01(c)(1)(ii) of Regulation S–X.
‘‘management company’’ and ‘‘unit investment (iv) Each entity in the investment company
trust’’). References to ‘‘funds’’ in this Release complex when the audit client is an entity that is 28 See Rule 2–01(f)(11) of Regulation S–X
include ETFs, unless specifically noted. part of an investment company complex. (definition of ‘‘covered persons’’).
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independence rules. Respect for the challenges, and recognizing that funds relationships that could impair an
seriousness of these obligations is better and their advisers were most acutely auditor’s objectivity and impartiality,
fostered through limiting violations to affected by the Loan Provision, the yet would not include certain extended
those instances in which the auditor’s Commission staff issued a no-action relationships that are unlikely to present
independence would be impaired in fact letter to Fidelity Management & threats to objectivity or impartiality.37
or in appearance. Research Company regarding the Specifically, we are proposing
Moreover, searching for, identifying, application of the Loan Provision amendments that would:
and assessing noncompliance or (‘‘Fidelity No-Action Letter’’).35 In the • Focus the analysis solely on
potential non-compliance with the Loan Fidelity No-Action Letter, the staff beneficial ownership;
Provision and reporting these instances stated that it would not recommend • replace the existing 10 percent
to audit committees also may generate enforcement action to the Commission, bright-line shareholder ownership test
significant costs for entities and their even though certain Fidelity entities with a ‘‘significant influence’’ test;
advisers and auditors, which costs are identified in the letter used audit firms • add a ‘‘known through reasonable
ultimately borne by shareholders. These that were not in compliance with the inquiry’’ standard with respect to
costs are unlikely to entail Loan Provision, subject to certain identifying beneficial owners of the
corresponding benefits to the extent that conditions specified in the letter (e.g., audit client’s equity securities; and
the Loan Provision’s breadth identifies that notwithstanding such non- • amend the definition of ‘‘audit
and requires analysis of circumstances compliance, the audit firm had client’’ for a fund under audit to exclude
that are unlikely to bear on the auditor’s concluded that it is objective and from the provision funds that otherwise
independence. impartial with respect to the issues would be considered ‘‘affiliates of the
In addition, the compliance encompassed within the engagement).36 audit client.’’
challenges associated with the Loan Staff continue to receive inquiries from The proposed amendments are
Provision can have broader disruptive registrants and accounting firms designed to better focus the Loan
effects, particularly for funds.32 For regarding the application of the Loan Provision on those relationships that,
example, in order for a registered open- Provision, or clarification of the Fidelity whether in fact or in appearance, could
end fund to make a continuous offering No-Action Letter, and requests for threaten an auditor’s ability to exercise
of its securities, it must maintain a consultation regarding issues not objective and impartial judgment. We
current prospectus by periodically filing covered in the Fidelity No-Action also are soliciting input on other
post-effective amendments to its Letter. potential changes to the Loan Provision
registration statement that contain or Rule 2–01 of Regulation S–X that may
II. Proposed Amendments be appropriate.
updated financial information audited
by an independent public accountant in A. Overview of the Proposed Given that compliance challenges
accordance with Regulation S–X.33 In Amendments associated with applying the Loan
addition, the federal securities laws Given the dynamics identified above, Provision have arisen with entities other
require that investment companies we are proposing amendments to Rule than funds, the proposed amendments
registered under the Investment 2–01 of Regulation S–X that would would apply broadly to entities beyond
Company Act transmit annually to result in a rule that we believe would the investment management industry,
shareholders and file with the effectively identify those debtor-creditor including operating companies and
Commission financial statements registered broker-dealers.
audited by an independent registered 35 See No-Action Letter from the Division of
B. Focus the Analysis Solely on
public accounting firm.34 Accordingly, Investment Management to Fidelity Management & Beneficial Ownership
noncompliance with the auditor Research Company (June 20, 2016) (‘‘June 20, 2016
independence rules in some cases can Letter’’), available at https://www.sec.gov/divisions/ Where a lender to an auditor holds
investment/noaction/2016/fidelity-management- more than 10 percent of the equity
result in affected funds not being able to research-company-062016.htm. The June 20, 2016
sell shares, investors not being able to Letter provided temporary no-action relief, and was securities of that auditor’s audit client
rely on affected financial statements, or to expire 18 months from the issuance date. On either as a beneficial owner or as a
funds (and, indirectly, but importantly, September 22, 2017, the staff extended the June 20, record owner, the Commission’s rules
2016 Letter until the effective date of any indicate that the auditor is not
their investors) having to incur the costs amendments to the Loan Provision adopted by the
of re-audits. Commission that are designed to address the independent of the audit client. The
In order to provide time for the concerns expressed in the June 20, 2016 Letter. See record owner exceeding 10 percent may
Commission to address these No-Action Letter from the Division of Investment be a broker-dealer, custodian, or an
Management to Fidelity Management & Research intermediary omnibus account holder
Company (Sept. 22, 2017) (‘‘September 22, 2017
32 Registered investment advisers that have
Letter’’), available at https://www.sec.gov/divisions/ for its customers. Thus, as noted in
custody of client funds or securities also face investment/noaction/2017/fidelity-management- Section I.B., the existing Loan Provision
compliance challenges from the Loan Provision. research-092217-regsx-rule-2-01.htm. applies where a lender holds the audit
These advisers generally are required under the 36 The June 20, 2016 Letter described the
Custody Rule to obtain a surprise examination
client’s equity securities of record, even
following circumstances, each of which could have
conducted by an independent public accountant or, potential implications under the Loan Provision: (i)
though the lender may be unable to
for pooled investment vehicles, may be deemed to ‘‘An institution that has a lending relationship with influence an audit client through its
comply with the requirement by distributing an Audit Firm holds of record, for the benefit of its holdings of the audit client’s equity
financial statements audited by an independent clients or customers (for example, as an omnibus
public accountant to the pooled investment
securities, and may have no economic
account holder or custodian), more than 10 percent
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vehicle’s investors. An auditor’s inability, or of the shares of a Fidelity Entity;’’ (ii) ‘‘An
incentive to do so.38
potential inability, to comply with the Loan insurance company that has a lending relationship
Provision raises questions concerning an adviser’s with an Audit Firm holds more than 10 percent of 37 See Rule 2–01(b) of Regulation S–X.
ability to satisfy the requirements of the Custody the shares of a Fidelity Fund in separate accounts 38 The financial gain of beneficial owners is tied
Rule. that it maintains on behalf of its insurance contract to the performance of their investment and as such,
33 See generally Section 10(a)(3) of the Securities
holders;’’ and (iii) ‘‘An institution that has a lending beneficial owners may have stronger incentives to
Act [15 U.S.C. 77j(a)(3)] and Item 27 of Form relationship with an Audit Firm and acts as an influence the auditor’s report. Record owners, on
N–1A. authorized participant or market maker to a Fidelity the other hand, likely do not benefit directly from
34 See Rules 30e–1 and 30b2–1 under the ETF and holds of record or beneficially more than the performance of securities of which they are
Investment Company Act. 10 percent of the shares of a Fidelity ETF.’’ Continued
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![20762 Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules
investments are material and whether ownership information for these concept that already should be familiar
the investment results in the ability to owners.63 to those charged with compliance with
exercise significant influence over that We therefore propose to amend the the provision.
entity.61 Similarly, the ‘‘affiliate of the Loan Provision to address the concerns
E. Excluding Other Funds That Would
audit client’’ definition in the auditor about accessibility to records or other
independence rules requires that a Be Considered Affiliates of the Audit
information about beneficial ownership
determination be made as to whether Client
by adding a ‘‘known through reasonable
there are entities over which the audit inquiry’’ standard with respect to the The current definition of ‘‘audit
client has significant influence (unless identification of such owners. Under client’’ in Rule 2–01 of Regulation S–X
the entity is not material to the audit this proposed amendment, an audit includes all ‘‘affiliates of the audit
client) or any entities that have firm, in coordination with its audit client,’’ which broadly encompasses,
significant influence over the audit client, would be required to analyze among others, each entity in an ICC of
client (unless the audit client is not beneficial owners of the audit client’s which the audit client is a part. In the
material to the entity).62 The parties that equity securities who are known fund context, this expansive definition
would be tasked with implementing a through reasonable inquiry. We believe of ‘‘audit client’’ could result in non-
‘‘significant influence’’ test in the Loan that if an auditor does not know after compliance with the Loan Provision as
Provision—accounting firms, issuers reasonable inquiry that one of its to a broad range of entities, even where
and their audit committees—thus are lenders is also a beneficial owner of the an auditor does not audit that entity.65
already required to be familiar with this audit client’s equity securities, Yet, in the investment management
concept under the auditor including because that lender invests in context, investors in a fund typically do
independence rules. We believe that the audit client indirectly through one not possess the ability to influence the
these entities likely would be able to or more financial intermediaries, the policies or management of another fund
leverage any existing practices, auditor’s objectivity and impartiality is in the same fund complex. Although an
processes and controls for determining unlikely to be impacted by its debtor- investor in one fund in a series
significant influence to comply with the creditor relationship with the lender. company can vote on matters put to
proposed changes to the Loan Provision. This ‘‘known through reasonable shareholders of the company as a whole,
D. Reasonable Inquiry Compliance inquiry’’ standard is generally rather than only to shareholders of one
Threshold consistent with regulations particular series, even an investor with
implementing the Investment Company a substantial investment in one series
As described above, another challenge Act, the Securities Act and the would be unlikely to have a controlling
in the application of the current Loan Exchange Act,64 and therefore is a percentage of voting power of the
Provision involves the difficulty in company as a whole.
accessing information regarding the 63 Pursuant to Rule 14a–13(b) under the Exchange Moreover, for the purposes of the
ownership percentage of an audit client Act, an issuer may obtain from broker-dealers and Loan Provision, the inclusion of certain
for the purposes of the current 10 banks a list of the names, addresses and securities
entities in the ICC as a result of the
percent bright-line test. For example, positions of only the beneficial owners who either
have consented or have not objected to having such definition of ‘‘audit client’’ is in tension
the shares of closed-end funds are information provided to issuers. See 17 CFR with the Commission’s original goal to
commonly held of record by broker- 240.14a–13(b). facilitate compliance with the Loan
dealers, which may be reluctant to share 64 See, e.g., Rule 3b–4 under the Exchange Act
Provision without decreasing its
information about the underlying (stating, with respect to the definition of foreign
private issuer, that ‘‘[i]f, after reasonable inquiry, effectiveness.66 Indeed, auditors often
beneficial owners. In addition, also as you are unable to obtain information about the have little transparency into the
indicated above, institutions may be the amount of shares represented by accounts of investors of other funds in an ICC
holder of record of shares in an audit customers resident in the United States, you may (unless they also audit those funds), and
client merely as custodian or as an assume, for purposes of this definition, that the
customers are residents of the jurisdiction in which
omnibus account holder, adding a layer, the nominee has its principal place of business.); person who owns of record or is known by the
and in some cases multiple layers, of Rule 144(g) under the Securities Act (noting, with Registrant to own of record or beneficially five
complexity to obtaining information respect to ‘‘brokers’ transactions’’ that ‘‘[t]he term percent or more of any class of the Registrant’s
brokers’ transactions in section 4(4) of the outstanding equity securities.’’).
about the underlying beneficial 65 For example, under the current Loan Provision,
[Securities] Act shall for the purposes of this rule
ownership. Moreover, a beneficial be deemed to include transactions by a broker in an audit firm (‘‘Audit Firm B’’) could be deemed
owner may object to disclosure of its which such broker: . . . (4) After reasonable not to be independent as to an audit client under
name, address, and securities position inquiry is not aware of circumstances indicating the following facts: Audit Firm A audits an
to the issuer, so that issuers may be that the person for whose account the securities are investment company (‘‘Fund A’’) for purposes of
sold is an underwriter with respect to the securities the Custody Rule. A global bank (‘‘Bank’’) has a
unable to obtain the beneficial or that the transaction is a part of a distribution of greater than 10 percent interest in Fund A. Bank is
securities of the issuer’’); Rule 502(d) under the a lender to a separate Audit Firm B, but has no
61 See 2000 Adopting Release, supra footnote 9, lending relationship with Audit Firm A. Audit Firm
Securities Act (stating, with respect to limits on
at 65 FR 76034. Rule 2–01(c)(1)(i)(E) of Regulation resales under Regulation D, that ‘‘[t]he issuer shall B audits another investment company (‘‘Fund B’’)
S–X contains several provisions that use a exercise reasonable care to assure that the that is part of the same ICC as Fund A because it
materiality qualifier. For example, an accountant purchasers of the securities are not underwriters is advised by the same registered investment
would not be independent if it ‘‘[h]as any material within the meaning of section 2(a)(11) of the adviser as Fund A. Under these facts, Audit Firm
investment in an entity over which an audit client [Securities] Act, which reasonable care may be B would not be independent under the existing
has the ability to exercise significant demonstrated by the following: (1) Reasonable Loan Provision because the entire ICC would be
influence. . . .’’ See Rule 2–01(c)(1)(i)(E)(2) of inquiry to determine if the purchaser is acquiring tainted as a result of Bank’s investment relationship
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Regulation S–X. Rule 2–01(c)(1)(i)(E) of Regulation the securities for himself or for other persons’’). with Fund A.
S–X also contains a significant influence provision Registered investment companies also are subject to 66 See 2000 Adopting Release, supra footnote 9,
without a materiality qualifier, in which an a similar requirement to disclose certain known at 76035 (The Commission, in adopting an
accountant would not be independent of its audit beneficial owners. See Item 18 of Form N–1A ownership threshold of 10 percent, rather than the
client when the accountant ‘‘[h]as the ability to (‘‘State the name, address, and percentage of five percent proposed, stated that ‘‘[w]e have made
exercise significant influence over an entity that has ownership of each person who owns of record or this change because we believe that doing so will
the ability to exercise significant influence over an is known by the Fund to own beneficially 5% or not make the rule significantly less effective, and
audit client.’’ See Rule 2–01(c)(1)(i)(E)(3) of more of any Class of the Fund’s outstanding equity may significantly increase the ease with which one
Regulation S–X. securities.’’); and Item 19 of Form N–2 (‘‘State the can obtain the information necessary to assure
62 See Rule 2–01(f)(4) of Regulation S–X. name, address, and percentage of ownership of each compliance with this rule.’’).
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![Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules 20765
collateralized by the automobile. Should Æ Would this approach be sufficient provision funds that otherwise would be
we consider expanding or otherwise for evaluating compliance with the Loan considered affiliates of the audit client.
modifying the specific types of loans Provision? Why or why not? Under existing rules, the bright-line
that will not implicate the Loan test does not recognize an accountant as
D. Secondary Market Purchases of Debt
Provision, given that the Loan Provision independent if the accounting firm, any
applies to covered persons of the The existing Loan Provision
covered person in the firm, or any of his
accounting firm and their immediate encompasses lending arrangements that
may change depending upon secondary or her immediate family members has
family members? For example, should any loan to or from an audit client or an
the Loan Provision address student market purchases of syndicated or other
debt. For example, audit firms may audit client’s officers, directors, or
loans or partner capital account loans? record or beneficial owners of more than
If so, how should it address them? For issue private placement notes for
financing purposes, which could then 10 percent of the audit client’s equity
example, should it exclude them securities. In terms of the scope of the
altogether or exclude them under be sold on the secondary market to new
purchasers thereby creating new lending ‘‘audit client’’ definition, the existing
certain conditions? If so, under what rule is generally broad, including as it
conditions? relationships between the audit firm
and these new secondary market relates to an audit client in an ICC.75 As
C. Evaluation of Compliance purchasers. discussed above, Commission staff has
Æ Should such secondary market engaged in extensive consultations with
Rule 2–01(c)(1) of Regulation S–X relationships be taken into account or audit firms, funds, and operating
provides that an accountant is not excluded from the Loan Provision? Do companies regarding the application of
independent if the accountant has an secondary market relationships raise the Loan Provision. These consultations
independence-impairing relationship concerns about auditor independence? revealed that a number of entities face
specified in the rule at any point during significant practical challenges to
the audit and professional engagement E. Other Changes to the Commission’s compliance with the Loan Provision.
period. Some existing disclosure Auditor Independence Rules These discussions also revealed that in
requirements require information about Æ Should we make other changes to certain scenarios, in which the Loan
beneficial owners as of a specified our auditor independence rules? If so, Provision was implicated, the auditor’s
date.71 which rules and why? objectivity and impartiality in
Æ Should the rule provide that Æ Would our proposed amendments performing the required audit and
auditor independence may be assessed have any unintended impact on other interim reviews were not impaired.
in reliance on such disclosures? Should professional standards that may exist,
We are mindful of the costs imposed
we make any changes related to the such as the requirements of the PCAOB,
professional societies, or state boards of by and the benefits obtained from our
frequency with which, the date as of rules and amendments.76 The following
which, or circumstances under which, accountancy?
economic analysis seeks to identify and
an auditor must assess compliance with IV. Paperwork Reduction Act consider the likely benefits and costs
the Loan Provision or other provisions that would result from the proposed
of Rule 2–01 of Regulation S–X? More The amendments we are proposing do
not impose any new ‘‘collections of amendments, including their effects on
specifically, should we permit the Loan efficiency, competition, and capital
information’’ within the meaning of the
Provision or other financial formation. The discussion below
Paperwork Reduction Act of 1995
relationships to be assessed at specific elaborates on the likely economic effects
(‘‘PRA’’),73 nor do they create any new
dates during the audit and professional of the proposed rules.
filing, reporting, recordkeeping, or
engagement period, or the beginnings or
disclosure requirements. Accordingly,
ends of specific periods, or under A. General Economic Considerations
we are not submitting the proposed
specified circumstances? If so, what
amendments to the Office of Given that the actions of fund and
would be appropriate dates, periods, or
Management and Budget for review in operating company management are not
circumstances?
accordance with the PRA.74 We request usually observable, the information
We believe that if the auditor comment on whether our conclusion contained in mandated financial reports
determines that significant influence that there are no collections of is important to investors, because it
over the fund’s management processes information is correct. serves as a summary measure of
could not exist,72 the auditor could outcomes of managerial actions and
monitor its independence on an ongoing V. Economic Analysis
basis by reevaluating its determination The Commission is proposing to 75 See supra footnote 16 and accompanying text.
in response to a material change in the amend the Loan Provision in Rule 2–01 76 Section 2(b) of the Securities Act [15 U.S.C.
fund’s governance structure and of Regulation S–X by: (1) Focusing the 77b(b)], Section 3(f) of the Exchange Act [17 U.S.C.
governing documents, publicly available analysis solely on beneficial ownership; 78c(f)], Section 2(c) of the Investment Company Act
information about beneficial owners, or (2) replacing the existing 10 percent [15 U.S.C. 80a–2(c)], and Section 202(c) of the
Investment Advisers Act [15 U.S.C. 80b–2(c)]
other information which may implicate bright-line equity shareholder require the Commission, when engaging in
the ability of a beneficial owner to exert ownership test with a ‘‘significant rulemaking where it is required to consider or
significant influence of which the audit influence’’ test; (3) adding a ‘‘known determine whether an action is necessary or
through reasonable inquiry’’ standard appropriate in the public interest, to consider, in
sradovich on DSK3GMQ082PROD with PROPOSALS
client or auditor becomes aware.
addition to the protection of investors, whether the
with respect to identifying beneficial action will promote efficiency, competition and
71 See e.g., Item 18 of Form N–1A and Item 19 of owners of the audit client’s equity capital formation. Additionally, Section 23(a)(2) of
Form N–2. securities; and (4) amending the the Exchange Act [15 U.S.C. 78w(a)(2)] requires us,
72 For funds, the auditor’s initial determination when adopting rules under the Exchange Act, to
definition of ‘‘audit client’’ for a fund
would be based on an evaluation of a fund’s consider, among other things, the impact that any
governance structure and governing documents, the
under audit to exclude from the new rule would have on competition and not to
manner in which its shares are held or distributed, adopt any rule that would impose a burden on
73 44 U.S.C. 3501 et. seq.
and any contractual arrangements, among any other competition that is not necessary or appropriate in
relevant factors. 74 44 U.S.C. 3507(d) and 5 CFR 1320.11. furtherance of the Exchange Act.
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![Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules 20767
accounting firms performing audits for Loan Provision with respect to one auditor. For example, a lender that is a
these investment companies, though fund, under the current rule it cannot record owner of the audit client’s equity
these auditing services were audit any of the hundreds of other funds securities may be less likely to attempt
concentrated among the four largest within the same ICC. to influence the auditor’s report than a
accounting firms. Indeed, about 88 In response to compliance challenges lender that is a beneficial owner of the
percent of the funds were audited by the and as discussed above, Commission audit client’s equity securities. By
four largest accounting firms, staff issued the Fidelity No-Action taking into account the nature as well as
corresponding to 98percent of the Letter to provide relief from the the magnitude of ownership, the
aggregate fund asset value.84 uncertainty surrounding compliance proposed amendments would focus on
with the Loan Provision. The Fidelity additional qualitative information to
TABLE 1—INVESTMENT COMPANY No-Action Letter, however, did not assess the relationship between the
AUDITORS AND THEIR AUDITED FUND resolve all compliance uncertainty, was lender and the investee (e.g., a company
SERIES limited in scope and provided staff-level or fund). Thus, we believe that, where
[N–SARs filed for period dates: June 2017– relief to the requestor based on the there may be weak incentives by the
December 2017] specific facts and circumstances in the lender to influence the audit, as when
request, and did not amend the the lender is only a holder of record, the
Total number of Fund Series ..... 11,666 underlying rule. Staff continues to proposed amendments would exclude
Average number of Fund Series receive inquiries from registrants and relationships that are not likely to be a
Per Auditor .............................. 507 accounting firms regarding the risk to auditor independence. The
Average Net Assets (in millions) application of the Loan Provision, proposed amendments would thus
Per Auditor .............................. 907,813 clarification of the application of the provide benefits to the extent that they
Four Largest Audit Firms ............ .................. would alleviate compliance and related
Fidelity No-Action Letter, and requests
Total number of Fund Series ..... 10,177 burdens that auditors and funds would
Average number of Fund Series for consultation regarding issues not
Per Auditor .............................. 2,544 covered in the Fidelity No-Action otherwise undertake to analyze debtor-
Average Net Assets (in millions) Letter. As a result of the remaining creditor relationships that are not likely
Per Auditor .............................. 5,137,472 compliance uncertainty, auditors and to threaten an auditor’s objectivity and
% of Four Audit Firms by Series 87 audit committees may spend a impartiality. Affected registrants also
% of Four Audit Firms by Net significant amount of time and effort to would be less likely to disqualify
Assets ..................................... 98 comply with the Loan Provision. auditors in situations that do not pose
a risk to auditor independence, thereby
One key feature of the current rule is C. Anticipated Benefits and Costs, and reducing auditor search costs for these
that the scope of the auditor Unintended Consequences entities.
independence rules, including the Loan The potential expansion of the pool of
1. Anticipated Benefits
Provision, extends beyond the audit eligible auditors also could result in
client to encompass affiliates of the Overall, we anticipate monitoring for better matching between the auditor and
audit client. According to Morningstar non-compliance throughout the the client. For example, auditors tend to
Direct, as of December 31, 2017, 586 out reporting period would be less exhibit a degree of specialization in
of 977 fund families 85 (excluding burdensome for registrants under the certain industries.86 If specialized
closed-end funds) have more than one proposed amendments. For example, auditors are considered not to be
fund, 180 have at least 10 funds, 59 based on the 10 percent bright-line test, independent due to the Loan Provision,
have more than 50 funds, and 38 have an auditor may be in compliance at the then an auditor without the relevant
more than 100 funds. According to the beginning of the reporting period. specialization may be selected by
Investment Company Institute, also as of However, the percentage of ownership companies to perform the audit. Such
December 31, 2017, there were more may change during the reporting period, an outcome could impact the quality of
than 11,188 open-end funds and around which may result in an auditor the audit, and as a consequence
5,500 closed-end funds, with many becoming non-compliant, even though negatively impact the quality of
funds belonging to the same fund there may be no threat to the auditor’s financial reporting, and therefore the
family. Given that many fund objectivity or impartiality. Further, a users of information contained in
complexes have several funds with higher threshold (20 percent) for audited financial reports. In addition,
some complexes having several presumed significant influence, as well this outcome also may lead to less
hundreds of funds, if any auditor is as a qualitative framework for assessing specialized auditors expending more
deemed not in compliance with the what constitutes significant influence, time to perform the audit service,
could better identify a lack of thereby increasing audit fees for
significantly larger; the assets under management of independence. registrants. We anticipate that the
private funds are also large. There are also potential benefits
84 According to the 2017 PCAOB Annual Report, proposed amendments likely would
there were 535 audit firms registered with the
associated with excluding record positively impact audit quality for
PCAOB that have issued audit reports for issuers (of holders from the Loan Provision. scenarios such as the one described
which 338 are domestic audit firms, with the Currently, the Loan Provision uses the above. Relatedly, if the proposed
remaining 197 audit firms located outside the magnitude of ownership by an auditor’s
United States). The concentration in the provision amendments expand the pool of eligible
of audit services for investment companies is lender as an indication of the likelihood auditors, we expect increased
of a threat to auditor independence
sradovich on DSK3GMQ082PROD with PROPOSALS
indicative of the overall market as well. According competition among auditors, which
to a report by Audit Analytics, the four largest regardless of the nature of ownership. could reduce the cost of audit services
accounting firms audit 76% of accelerated and large From an economic standpoint, the
accelerated filers, which account for 97.9% of the
market capitalization for public companies. See nature of ownership also could 86 See e.g., N. Dopuch & D. Simunic, Symposium,
Who Audits Larger Public Companies-2016 Edition, determine whether incentives as well as Competition in Auditing: An Assessment, Fourth
available at http://www.auditanalytics.com/blog/ the ability of the lender to use any Symposium on Auditing Research, p 401–450
who-audits-larger-public-companies-2016-edition. (1982); and R.W. Knechel, V. Naiker & G. Pachecho,
85 These fund statistics are based on information
leverage (due to the lending Does Audit Industry Specialization Matter?
available from Morningstar Direct, and may not relationship) over the auditor exist that Evidence from Market Reaction to Auditor
represent the universe of fund companies. could affect the objectivity of the Switches, 26 Audit. J. Prac. & Theory 19–45 (2007).
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![Federal Register / Vol. 83, No. 89 / Tuesday, May 8, 2018 / Proposed Rules 20773
provided the loan was not obtained DATES: We will accept written I. Background on the Montana Program
while the covered person in the firm comments on this amendment until 4:00 Section 503(a) of the Act permits a
was a covered person. p.m., m.d.t., June 7, 2018. If requested, state to assume primacy for the
(2) For purposes of paragraph we will hold a public hearing on the regulation of surface coal mining and
(c)(1)(ii)(A) of this section: amendment on June 4, 2018. We will reclamation operations on non-federal
(i) The term audit client for a fund accept requests to speak at a hearing
under audit excludes any other fund and non-Indian lands within its borders
until 4:00 p.m., m.d.t. on May 23, 2018. by demonstrating that its program
that otherwise would be considered an ADDRESSES: You may submit comments,
affiliate of the audit client; includes, among other things, state laws
identified by Docket Number OSM– and regulations that govern surface coal
(ii) The term fund means an
2017–0001, by any of the following mining and reclamation operations in
investment company or an entity that
methods: accordance with the Act and consistent
would be an investment company but
• Mail/Hand Delivery: 1999 with the Federal regulations. See 30
for the exclusions provided by Section
Broadway, Suite 3320, Denver, CO U.S.C. 1253(a)(1) and (7). On the basis
3(c) of the Investment Company Act of
80202. of these criteria, the Secretary of the
1940 (15 U.S.C. 80a–3(c)).
• Fax: (303) 293–5017. Interior conditionally approved the
* * * * * • Federal eRulemaking Portal: http:// Montana program on April 1, 1980. You
By the Commission. www.regulations.gov. Follow the can find background information on the
Dated: May 2, 2018. instructions for submitting comments. Montana program, including the
Brent J. Fields, Instructions: All submissions received Secretary’s findings, the disposition of
Secretary. must include the agency name and comments, and conditions of approval
[FR Doc. 2018–09721 Filed 5–7–18; 8:45 am]
docket number for this rulemaking. For of the Montana program in the April 1,
detailed instructions on submitting 1980, Federal Register (45 FR 21560).
BILLING CODE 8011–01–P
comments and additional information You can also find later actions
on the rulemaking process, see the concerning the Montana program and
‘‘Public Comment Procedures’’ heading program amendments at 30 CFR 926.15,
DEPARTMENT OF THE INTERIOR
of the SUPPLEMENTARY INFORMATION 926.16, and 926.30.
Office of Surface Mining Reclamation section of this document.
Docket: For access to the docket to II. Description of the Proposed
and Enforcement
review copies of the Montana program, Amendment
30 CFR Part 926 this amendment, a listing of any By letter dated February 27, 2017
scheduled public hearings, and all (FDMS Document ID No. OSM–2017–
[SATS No. MT–036–FOR; Docket ID: OSM– written comments received in response
2017–0001; S1D1S SS08011000 SX064A000
0001–0002), Montana sent us a
to this document, you may go to the proposed amendment to its program
189S180110; S2D2S SS08011000
SX064A000 18XS501520] address listed below during normal under SMCRA (30 U.S.C. 1201 et seq.).
business hours, Monday through Friday, The proposed changes are the result of
Montana Regulatory Program excluding holidays. The full text of the a Montana state senate bill which
program amendment is also available for required adoption of regulations
AGENCY: Office of Surface Mining you to read at www.regulations.gov. You pertaining to in situ coal gasification.
Reclamation and Enforcement, Interior. may receive one free copy of the Specifically, Montana proposes to
ACTION: Proposed rule; public comment amendment by contacting OSMRE’s codify language from Senate Bill 292
period and opportunity for public Denver Field Division: Jeffrey under the Montana Strip and
hearing on proposed amendment. Fleischman, Chief, Denver Field Underground Mine Reclamation Act.
SUMMARY: We, the Office of Surface Division, Office of Surface Mining This language, approved by the 2011
Mining Reclamation and Enforcement Reclamation and Enforcement, Dick Montana Legislature, directs the
(OSMRE), are announcing receipt of a Cheney Federal Building, POB 11018, Montana Board of Environmental
proposed amendment to the Montana 150 East B Street, Casper, Wyoming Review (BER) to adopt rules pertaining
regulatory program (Montana program) 82601–7032, Telephone: (307) 261– to in situ coal processing and provides
under the Surface Mining Control and 6550, Email: jfleischman@osmre.gov. that those rules may not be more
Reclamation Act of 1977 (SMCRA or the In addition, you may receive a copy stringent than the comparable federal
Act). Montana proposes an addition to of the proposed amendment from the regulations or guidelines. The
the Montana Code Annotated, which Montana Department of Environmental Administrative Rules of Montana
requires the adoption of regulations Quality: Edward L. Coleman, Chief, Coal (ARMs) currently have two regulatory
pertaining to in situ coal gasification. and Opencut Mining Bureau, Montana provisions, ARM 17.24.902 and ARM
This change was necessitated by a Department of Environmental Quality, 17.24.904, that specifically address in
senate bill approved by the 2011 P.O. Box 200901, Helena, Montana, situ coal gasification and that list
Montana Legislature. Montana also 59620–0901, Telephone: (406) 444– subchapters of the ARMs that apply to
proposes revisions and additions to the 4973, Email: ecoleman@mt.gov. in situ coal gasification. Following
Administrative Rules of Montana to FOR FURTHER INFORMATION CONTACT: passage of Senate Bill 292, the Montana
satisfy the new statutory requirement. Howard Strand, Office of Surface Department of Environmental Quality
This document provides the times Mining Reclamation and Enforcement, reviewed Montana’s rules and
sradovich on DSK3GMQ082PROD with PROPOSALS
and locations that the Montana program 1999 Broadway, Suite 3320, Denver, CO determined that most of the rules
and this proposed amendment to 80202, Telephone: (303) 293–5026, relating to underground coal mining
Montana’s program are available for Email: hstrand@osmre.gov. should apply to in situ operations. It
your inspection; the comment period SUPPLEMENTARY INFORMATION: recommended that, rather than adopting
during which you may submit written I. Background on the Montana Program rules that would duplicate existing
comments on the amendment; and the II. Description of the Proposed Amendment rules, BER should simply list the rules
procedures that we will follow for the III. Public Comment Procedures that would not apply to in situ
public hearing, if one is requested. IV. Procedural Determinations operations. To reflect this approach,
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Document Created: 2018-05-08 01:31:40
Document Modified: 2018-05-08 01:31:40
| Category | Regulatory Information | |
| Collection | Federal Register | |
| sudoc Class | AE 2.7: GS 4.107: AE 2.106: | |
| Publisher | Office of the Federal Register, National Archives and Records Administration | |
| Section | Proposed Rules | |
| Action | Proposed rule. | |
| Dates | Comments should be received on or before July 9, 2018. | |
| Contact | Giles T. Cohen, Deputy Chief Counsel, or Peggy Kim, Senior Special Counsel, Office of the Chief Accountant, at (202) 551-5300; Alison Staloch, 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. | |
| FR Citation | 83 FR 20753 | |
| RIN Number | 3235-AM01 | |
| CFR Associated | Accountants; Accounting; Banks; Banking; Employee Benefit Plans; Holding Companies; Insurance Companies; Investment Companies; Oil and Gas Exploration; Reporting and Recordkeeping Requirements; Securities and Utilities |
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