SEC Adopts Amendments to Auditor Independence Requirements

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On October 16, 2020, the Securities and Exchange Commission (SEC) adopted final amendments to certain of the auditor independence requirements in Rule 2-01 of Regulation S-X (Reg. S-X), referred to as the auditor independence rule. Under the SEC's auditor independence rule, auditors are required to be independent of their audit clients "both in fact and in appearance."1 The rule includes a non-exclusive list of relationships and circumstances, including certain financial, employment, and business relationships, under which an auditor would not be considered independent from its audit client.

The amendments are intended to "reflect updates based on recurring fact patterns that the [SEC] staff has observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor's objectivity and impartiality." The SEC adopted the final amendments generally as proposed in December 2019 (see our prior alert for a discussion of the proposed amendments), but with some modifications. The following is a high-level summary of the amendments, as adopted:

  • IPO Look-Back Period. There is a look-back period when evaluating the financial, employment, business, and other relationships that might impair an auditor's independence from its audit client, which is referred to as the "audit and professional engagement period."2 Under the existing rule, auditors of domestic first-time filers must be independent during all periods included in the company's registration statement (i.e., up to three years), while auditors of foreign private issuer (FPI) first-time filers need only be independent during the immediately preceding fiscal year.

    Adopted as proposed, the final amendments revise the definition of "audit and professional engagement period" to shorten the look-back period for domestic first-time filers to the immediately preceding fiscal year, making this period consistent with the look-back period for FPI first-time filers. In the adopting release, the SEC clarified that where a company withdraws an initial registration statement, and re-files a new registration statement, the re-filing of the new registration statement would be considered the company's first-time filing.

  • Business Relationships. Certain business relationships between an auditor and an audit client will preclude a finding of independence. Under the existing business relationships rule, an auditor will not be independent from the audit client if "the accounting firm or any covered person in the firm has 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."3

    Adopted substantially as proposed, the final amendments narrow the focus of the business relationships rule to those persons who have decision-making authority over the specific "entity under audit." This formulation is narrower than "audit client" because it does not include affiliates. Thus, as adopted, the rule applies to the audit client's officers and directors "who have the ability to affect decision-making at the entity under audit." [Emphasis added.] In addition, the final amendments replace the reference to "substantial stockholders" with "beneficial owners (known through reasonable inquiry) of the audit client's equity securities where such beneficial owner has significant influence over the entity under audit." [Emphasis added.]

  • Common Control. In assessing auditor independence, the SEC looks to the auditor's relationships with the audit client, including any affiliates of the audit client.4 Affiliates of the audit client include, among other things, entities under common control with the audit client, such as sister entities. Thus, any relationships between the auditor and sister entities of the audit client would be considered in determining auditor independence. This can be problematic when, as with many venture-backed or private equity-backed companies, there are numerous portfolio companies that are under common control (i.e., controlled by the fund).

    The proposed amendments sought to focus the independence analysis on only those sister entities that are material to the controlling entity. The final amendments go a step further and provide for a dual materiality threshold, meaning that a sister entity of the audit client will only be considered an "affiliate of the audit client" if the sister entity and the entity under audit are each material to the controlling entity. For added clarity, the adopting release provides a series of fact patterns to illustrate the application of the final amendments.

  • Investment Company Complex. Adopted largely as proposed, the final amendments revise the definition of "investment company complex" for purposes of determining independence where an audit client is an investment company or an investment adviser or sponsor. Among other things, the final amendments: (1) provide that the auditor of an investment company or investment adviser or sponsor should look to the definition of "investment company complex" rather than "affiliates of the audit client" in identifying the affiliates of such audit client; (2) provide for a dual materiality threshold similar to the common control provision discussed above; and (3) expand the meaning of the term "investment company" to include unregistered funds.
  • Loan Provision. Under the existing loan provision rule, an auditor will not be independent from the audit client "when the accounting firm, any covered person in the firm, or any of his or her immediately family members has" any 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," with exceptions for four types of loans obtained under "normal lending procedures, terms, and requirements," including mortgage or automobile loans. Similar to the amendments to the business relationships rule discussed above, the final amendments narrow the focus of the loan provision rule to those persons who have decision-making authority over the specific "entity under audit." The final amendments also add a new exception to the list of permissible lending relationships and update the mortgage loan exception.
    • Student Loans. Adopted substantially as proposed, the final amendments add a new exception for student loans obtained for a covered person's educational expenses and also, in the final amendments, for a covered person's immediate family members' educational expenses, in all cases provided that the loans were obtained when the person was not a covered person. In addition, the adopting release clarifies that this exception does not apply to loans drawn to pay for another person's educational expenses.
    • Mortgage Loans. Adopted as proposed, the final amendments make plural the reference to "mortgage loan" to clarify that this exception to independence-impairing lending relationships may apply to more than just one outstanding mortgage on a covered person's primary residence.
  • Credit Card Rule. Under the existing credit card rule, an auditor will not be independent from the audit client "when the accounting firm, any covered person in the firm, or any of his or her immediately members has any aggregate outstanding credit card balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and any available grace period." Adopted as proposed, the final amendments replace the reference to "credit card" with the broader "consumer loan balance," which would include, for example, cell phone installment plans or retail installment loans, which typically have payment due dates that are consistent with credit cards (e.g., monthly).
  • M&A Transition Framework. The final amendments adopt, with some modifications, a transition framework to address inadvertent independence violations that may arise as a result of merger and acquisition transactions. Note, however, that this transition framework would not apply to merger or acquisition transactions "that are in substance similar to IPOs," such as, presumably, de-SPAC transactions. In these latter circumstances, the adopting release states that the "auditor should evaluate compliance using the look-back period contained within the 'audit and professional engagement period' definition, as amended."

What to Do Now?

The amendments will be effective 180 days after publication in the Federal Register; provided, however, that voluntary early compliance is permitted after the final amendments are published in the Federal Register so long as the final amendments are applied in their entirety from the date of early compliance. The adopting release also notes that compliance is required on a prospective basis and that "[a]uditors are not permitted to retroactively apply the final amendments to relationships and services in existence prior to the effective date or the early compliance date if selected by an audit firm."


[1] Preliminary Note to 17 CFR § 210.2-01 (referred to as Rule 2-01 of Reg. S-X). In pertinent part, Rule 2-01(b) of Reg. S-X provides the general independence standard, stating that the SEC “will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.”

[2] See Rule 2-01(f)(5)(iii) of Reg. S-X.

[3] Rule 2-01(c)(3) of Reg. S-X. “Covered person in the firm” is defined as “the following partners, principals, shareholders, and employees of an accounting firm: (i) the ‘audit engagement team’; (ii) the ‘chain of command’; (iii) any other partner, principal, shareholder, or managerial employee of the accounting firm who has provided ten or more hours of non-audit services to the audit client for the period beginning on the date such services are provided and ending on the date the accounting firm signs the report on the financial statements for the fiscal year during which those services are provided, or who expects to provide ten or more hours of non-audit services to the audit client on a recurring basis; and (iv) any other 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.”

[4] See Rule 2-01(f)(6) of Reg. S-X.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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