If adopted, the Proposal would significantly narrow the universe of lending relationships that implicate the Loan Provision and reduce the compliance burden for audit firms and their audit clients. The Proposal would address significant concerns over audit firms’ ability to comply with the Loan Provision with respect to registered investment companies. These concerns were initially publicized in 2016 and temporarily addressed by a no-action letter issued that year by the SEC’s Division of Investment Management (No-Action Letter).2
The Proposal would introduce four amendments to the Loan Provision. Specifically, it would:
A marked comparison reflecting the proposed changes to the Loan Provision is presented in the Appendix.
In the release accompanying the Proposal (Release), the SEC acknowledged that, in the case of registered investment companies and other pooled investment vehicles, application of the existing Loan Provision may be out of step with its original purpose to identify relationships likely to compromise an audit firm’s independence, and presents “significant practical challenges” both for audit firms and for the audit committees of their audit clients. Citing the original proposing and adopting releases for the Loan Provision, the Release indicates that the rule was designed to prohibit lending relationships that “reasonably could be viewed as creating a self-interest that competes with the auditor’s obligation to serve only investors’ interests,” and that such concerns extended to those shareholders of an audit client that have “a special and influential role with the audit client.” The Proposal’s four amendments are intended to: (i) more closely align the Loan Provision with those aims; and (ii) reduce the focus on fact patterns that do not impair an audit firm’s objectivity and impartiality.
The Proposal would limit the Loan Provision’s scope to beneficial ownership of an audit client’s equity securities (and those of the audit client’s non-fund affiliates), and would not extend to mere record holders of those securities. The SEC recognized in the Release that shares of registered investment companies are commonly held by financial intermediaries in omnibus accounts on behalf of their clients, and that such intermediaries may be unable (or lack economic incentive) to exercise voting control over the shares or to otherwise be in a position to influence the issuer. The SEC indicated that a beneficial ownership test would more effectively capture those relationships that implicate the Loan Provision’s objectives. This change, if adopted, is expected to drastically reduce the number of broker-dealers, custodians, and other financial intermediaries that are implicated by the Loan Provision solely as a result of their holding shares on behalf of clients.
Significant Influence Test
The Proposal would replace the Loan Provision’s existing quantitative, bright-line equity ownership test with a qualitative “significant influence test.” In the Release, the SEC characterized the Loan Rule’s existing 10% beneficial or record ownership test as both under- and over-inclusive for purposes of identifying shareholders that have a “special and influential role” with an audit client. In its place, the Proposal would adopt a facts-and-circumstances-based test to determine whether a shareholder has the ability to exercise “significant influence” over an issuer. The Release states that the Proposal’s “significant influence” test is intended to correspond with the Financial Accounting Standards Board’s Accounting Standards Codification Topic 323 (ASC 323) and, therefore, should be familiar to audit firms. Under ASC 323, share ownership is only one of a number of factors that may indicate “significant influence.”3 Further, the Release states that, consistent with ASC 323, a shareholder’s ownership of less than 20% of an issuer’s voting securities would give rise to a rebuttable presumption that the shareholder does not have the ability to exercise significant influence over that issuer.4 Thus, absent other indicia of influence, this change would effectively raise the threshold for implicating the Loan Provision to beneficial ownership of 20% of an issuer’s shares. In the fund context, the Release indicates that such indicia of influence would include influence over a fund’s portfolio management processes, such as the selection and valuation of investments or decisions concerning the distribution of income and capital gains. In cases where an investment adviser has significant discretion over a fund under the terms of an advisory agreement, the Release states that a shareholder that does not possess the ability to influence the investment adviser generally would not be deemed to have significant influence over the fund.5
Known Through Reasonable Inquiry Standard
The Proposal would establish a “known through reasonable inquiry” standard to be applied when identifying the beneficial owners of an audit client’s shares. The Release notes that, due to the manner in which shares of investment companies are distributed and held, shareholders’ identities may not be readily known to issuers or their audit firms and, in some instances, banks or broker-dealers holding those shares on behalf of customers may be prohibited from disclosing beneficial owners’ identities. The SEC acknowledged that if, following reasonable inquiry and in coordination with an audit client, an audit firm is not aware that an entity with which it has a lending relationship beneficially owns shares of the audit client, it is unlikely that such a relationship would impact the audit firm’s objectivity and impartiality. While the Release does not provide specific guidance as to what would constitute a “reasonable inquiry” in this context, it states that such a standard is “generally consistent with regulations implementing the [Investment Company Act of 1940 (1940 Act), the Securities Act of 1933 and the Securities Exchange Act of 1934]” and should, therefore, be familiar to issuers.
Exclusion of Funds from Affiliate Definition
The Proposal would no longer require registered investment companies and other pooled investment vehicles within the same investment company complex to be deemed to be affiliates of one another for purposes of the Loan Provision. As noted above, under the existing Loan Provision, an audit firm’s “audit client” is defined to include affiliates of the audit client, which, for a registered investment company, includes all entities within the investment company complex, regardless of whether the audit firm actually provides audit services to those other entities. The Release notes that fund shareholders generally are not able to exercise influence over the management of other funds in the same fund complex. The Proposal would amend the definition of “audit client” as it applies to a “fund” (which is defined in the Proposal as an investment company or an issuer that would be an investment company but for the exceptions provided in Section 3(c) of the 1940 Act) to exclude any other fund that otherwise would be considered an affiliate of the audit client. Most notably, this change would eliminate the requirement that an audit firm expend resources assessing the owners of every fund within an investment company complex rather than focusing only on those funds for which it provides audit services. Further, the Proposal would prevent an audit firm from failing to comply with the Loan Provision due to a lender’s ownership of shares of a fund for which the audit firm does not provide audit services.
If adopted, the Proposal would provide relief for audit firms that have continued to allocate significant resources to complying with the requirements of the No-Action Letter. In addition, the Proposal would reduce the outsized degree of attention that fund audit committees have been required to devote to Loan Provision considerations.
The deadline for submitting comments on the Proposal is July 9, 2018.
Read the Appendix »
1) “Audit client” is defined to include affiliates of the audit client, which, for a registered investment company, includes all entities within the “investment company complex,” regardless of whether the audit firm actually provides audit services to those other entities.
An investment company’s “investment company complex” is defined in Rule 2-01(f)(14) to include, among other things: (1) the company’s investment adviser; (2) any affiliates of the investment adviser that are investment advisers or provide administrative, custodian, underwriting or transfer agent services to registered funds; and (3) any other investment companies advised by the investment adviser.
2) Fidelity Management & Research Company, et al., SEC No-Action Letter (June 20, 2016). For further information, please refer to SEC Staff Issues No-Action Relief on Auditor Independence and the “Loan Provision” and SEC Staff Extends Effectiveness of No-Action Relief on Auditor Independence and the “Loan Provision.”
3) ASC 323 provides a non-exclusive list of factors that could give rise to significant influence over an issuer, including: representation on the board of directors; participation in policy-making processes; material intra-entity transactions; interchange of managerial personnel; technological dependency; and extent of ownership by an investor in relation to the concentration of other shareholdings.
4) Conversely, ASC 323 establishes a rebuttable presumption that a shareholder that owns 20% or more of an issuer’s equity securities would have the ability to exercise significant influence over the issuer. As the Release notes, ASC 323 provides a list of factors to be considered in rebutting that presumption, including, among others, the existence of an agreement under which the shareholder surrenders significant rights or the shareholder’s attempt and failure to obtain representation on the issuer’s board of directors.
5) The Release also notes that a shareholder’s ability to vote on a pro rata basis with other shareholders concerning the approval of a fund’s management agreement or its fundamental policies generally should not be viewed to signify significant influence over the fund. The Release adds, however, that in the private fund context, a side letter agreement permitting an investor to participate in portfolio management (including its participation on an advisory committee) would likely lead to a determination that the investor has significant influence over the private fund.