On October 16, 2020, the Securities and Exchange Commission (the SEC) announced the adoption of final amendments to the auditor independence requirements set forth in Rule 2-01 of Regulation S-X (the Amendments). The final rule adopting the Amendments (the Final Rule) can be found here, and the SEC’s adopting press release can be found here. The Final Rule and the adopting press release provide helpful examples to inform application of the Amendments.
The auditor independence rules set forth in Rule 2-01 of Regulation S-X require, among other things, auditors to be independent of their audit clients. Rule 2-01(b) sets forth the general auditor independence standard, which focuses on the objectivity and impartiality of the auditor, and Rule 2-01(c) provides a non-exclusive list of relationships and circumstances, including certain financial, employment, and business relationships, in which an auditor would not be considered “independent” from an audit client.
The Amendments update the auditor independence rules to address recurring fact patterns in which certain relationships and services triggered technical rule violations under the current auditor independence rules without necessarily impairing the auditor’s objectivity and impartiality. By adopting the Amendments, the SEC seeks to increase investor protection by focusing the auditor independence rules (and thereby the attention of audit clients, audit committees and auditors) on relationships and services that are more likely to jeopardize the objectivity and impartiality of auditors, while avoiding potentially time-consuming audit committee review of technical rule violations and similar non-substantive matters. The Amendments are particularly helpful for private equity firms and investment companies with numerous portfolio companies and investments.
Among other things, the Amendments:
- address potential independence issues arising when portfolio companies with a common private equity fund owner, or investment companies within the same investment company complex, have engaged an audit firm to provide audit and non-audit services that could impair the independence of the audit firm;
- shorten the look-back period for domestic first-time filers in assessing compliance with the independence requirements;
- clarify the application of the business relationship rule under Rule 2-01(c)(3); and
- introduce a transition framework to address inadvertent independence violations that only arise as a result of mergers or acquisitions.
Independence Issues Involving Affiliated Sister Entities
Under current Rule 2-01(c), the requirement to identify and monitor for relationships that could impair the independence of the audit firm applies to affiliated entities under common control, regardless of whether the affiliated entities are material to the controlling entity, which implicates sister portfolio companies with a common private equity fund owner and sister entities that are part of the same investment company complex. The Amendments amend the definitions of “affiliate of the audit client,” in Rule 2-01(f)(4), and “investment company complex,” in Rule 2-01(f)(14), to incorporate a dual materiality threshold such that a sister entity will be included as an affiliate of the audit client if the sister and the entity under audit are each material to the controlling entity. If either the sister entity or the entity under audit is not material to the controlling entity, then the sister entity will not be deemed to be an affiliate of the audit client. As a result, the Amendments will address and resolve certain auditor independence issues that private equity funds, investment companies and their affiliates currently face as a result of relationships and services that do not ultimately jeopardize the objectivity and impartiality of the audit firm.
In relation to sister entities within the same investment company complex, the Amendments apply the dual materiality threshold with respect to sister investment advisers or sponsors with a common controlling entity, but the SEC has clarified that the dual materiality threshold will not apply to sister investment companies under the control of a shared investment adviser or sponsor. In the Final Rule, the SEC notes that the nature of the relationship between an investment adviser or sponsor and an investment company under audit presents risks to an auditor’s objectivity and impartiality when the auditor has relationships with or provides services to investment companies advised by the same investment adviser or sponsor. As a result, such entities should continue to be included as part of the investment company complex in evaluating the auditor’s independence, regardless of materiality.
The SEC also notes in the Final Rule that nothing in the Amendments is intended to change the application of the general independence standard in Rule 2-01(b). Rather, the Amendments are designed to more effectively focus the independence rules and the attention of auditors and audit committees on substantive compliance challenges. However, the continued application of Rule 2-01(b) will require auditors and audit committees to maintain sufficient knowledge of the auditor’s services to, and relationships with, non-affiliate sister entities to continue to evaluate whether the general standard of Rule 2-01(b) is met with respect to relationships and services that are not otherwise deemed to impair independence by Rule 2-01(c).
IPO Look-Back Period
The Amendments also amend the definition of “audit and professional engagement period,” in Rule 2-01(f)(5)(iii), to shorten the look-back period for domestic first-time filers to one year, rather than covering all periods included in the issuer’s registration statement (which can be up to three years). The result of this amendment is that all first-time filers (i.e., domestic issuers and foreign private issuers) are treated similarly for purposes of the independence requirements under Rule 2-01.
Clarifications to the Business Relationship Rule
Under current Rule 2-01(c)(3), an auditor or other covered person is prohibited from having any “direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors or substantial stockholders” (emphasis added). In order to clarify the application of Rule 2-01(c)(3), the Amendments replace the term “substantial stockholder” with “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the entity under audit.” This amendment focuses the independence analysis under Rule 2-01(c)(3) on whether a beneficial owner has significant influence over the entity under audit, rather than the level of such beneficial owner’s ownership, as business relationships with persons with such influence could be reasonably expected to affect an auditor’s objectivity and impartiality.
Transition Framework for Mergers and Acquisitions
The Amendments also introduce a transition framework to address inadvertent independence violations arising only as a result of a merger or acquisition under circumstances in which the services or relationships that are the basis for the violation would not have violated applicable independence standards prior to the corporate event. Under amended Rule 2-01(e), an auditor’s independence will not be impaired if an audit client engages in a merger or acquisition transaction resulting in a service or relationship that would otherwise be inconsistent with Rule 2-01 if:
- the auditor has been in compliance with the applicable independence standards related to the services or relationships when the services or relationships originated and throughout the period in which the applicable independence standards apply;
- the auditor addresses such services or relationships promptly under relevant circumstances as a result of the occurrence of the merger or acquisition; and
- the auditor has in place a quality control system as described in Rule 2-01(d)(3) that has the following features: (i) procedures and controls that monitor the audit client’s merger and acquisition activity to provide timely notice of a merger or acquisition; and (ii) procedures and controls that allow for prompt identification of potential violations after an initial notification of a potential merger or acquisition that may trigger independence violations, but before the effective date of the merger or acquisition.
Effectiveness of Amendments
The Amendments will be effective 180 days after publication in the Federal Register. Companies and audit firms may elect voluntary early compliance after the Amendments are published in the Federal Register and in advance of the effective date, provided that the company or audit firm applies the Amendments in their entirety from the date of voluntary early compliance. Auditors are not permitted to retroactively apply the Amendments to relationships and services in existence prior to the effective date or, if voluntary early compliance is selected by an audit firm, the date of voluntary early compliance.
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