SEC Proposes Amendments to Auditor Independence Framework

Lisa Stimmell and Richard Blake are partners, and Courtney Mathes is a practice support lawyer at Wilson Sonsini Goodrich & Rosati. This post is based on their WSGR memorandum.

On December 30, 2019, the U.S. Securities and Exchange Commission (SEC) announced that it was proposing several amendments to “codify certain staff consultations and modernize certain aspects of its auditor independence framework.”

The auditor independence framework, set forth in Rule 2-01 of Regulation S-X, requires, among other things, auditors to be independent of their audit clients “both in fact and in appearance.” Rule 2-01(b) sets forth the general auditor independence standard [1] and Rule 2-01(c) provides a non-exclusive list of relationships and circumstances, including certain financial, employment, and business relationships, in which an accountant would not be considered “independent” from an audit client.

Proposed Amendments to Auditor Independence Framework

The proposed amendments are intended to “more effectively focus the independence analysis on those relationships and services that are more likely to pose threats to an auditor’s objectivity and impartiality,” and include, among others, the following:

  • IPO Look-Back Period. The existing definition of “audit and professional engagement period” in Rule 2-01(f)(5)(iii) provides that, for purposes of assessing auditor independence, auditors of domestic first-time filers must be independent during all periods included in the issuer’s registration statement (that is, up to three years), while auditors of foreign private issuer (FPI) first-time filers need only be independent during the immediately preceding fiscal year. The proposal would amend this definition 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.
  • Business Relationships. Rule 2-01(c)(3), referred to as the business relationship rule, “prohibits, at any point during the audit and professional engagement period, the accounting firm or any covered person 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….” Consistent with the loan provision discussed below, the proposal would 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 audit client.” The proposal would also clarify that “audit client,” for purposes of the business relationship rule and the loan provision, means the specific entity under audit, not the “audit client,” which is more expansive and would include affiliates of the entity under audit.
  • Common Control. In assessing auditor independence, the SEC looks to the auditor’s relationships with the “audit client.” The definition of “audit client” in Rule 2-01(f)(6) includes, generally, “any affiliates of the audit client,” and the definition of “affiliate of the audit client” in Rule 2-01(f)(4) includes, among other things, entities “under common control with the audit client.” Thus, entities under common control with the audit client, including sister entities, would be considered affiliates of the audit client, and any relationships between the auditor and these sister entities would be considered in determining auditor independence. This can be problematic when, as with many venture-backed or private equity-backed companies, there are portfolio companies that are under common control (i.e., controlled by the fund) who may receive non-audit services from an auditor seeking to be independent of one of the portfolio companies. The proposal would qualify this language with “unless the entity is not material to the controlling entity,” which is intended “to focus the independence analysis on sister entities that are material to the controlling entity.” [Emphasis added.] However, the SEC cautions that “a determination under the proposed amendments that sister entities are not material to the controlling entity, by itself, does not conclude the independence analysis” because “auditors and audit clients must consider ‘all relevant facts and circumstances’ when assessing independence pursuant to the general standard in Rule 2-01(b).”
  • Investment Company Complex (ICC). The proposal would make several clarifications and amendments to the ICC definition, some of which are described herein. The proposal would clarify that for purposes of an audit client that is an investment company or an investment adviser or sponsor, “the auditor and the audit client should look solely to proposed Rule 2-01(f)(14) (i.e., the ICC definition) to identify affiliates of the audit client” and the proposal “directs auditors of an investment company or an investment adviser or sponsor to include all entities within the proposed ICC definition as affiliates of the audit client instead of conducting an analysis based on the prongs in proposed Rule 2-01(f)(4)(i).” In addition, the proposal would expand the meaning of the term “investment company” under the ICC definition to include “registered investment companies, business development companies, and entities that would be investment companies but for the exclusions provided by Section 3(c) of the Investment Company Act, such as private funds that rely on section 3(c)(1) or 3(c)(7).” Also, similar to the proposed amendment to Rule 2-01(f)(4) discussed above, the proposal would amend the ICC definition to include “only sister investment companies, advisers, and sponsors that are material to the controlling entity.” [Emphasis added.]
  • Loan Provision. Rule 2-01(c)(1)(ii)(A), referred to as the loan provision, provides that, subject to certain exceptions, “an accountant is not independent if the accounting firm, any covered person in the firm, or any of his or her immediate family members has any loans (including any margin loan) to or from an audit client, or certain other entities or persons related to the audit client.”
    • Student Loans. In addition to existing exceptions, the proposal would add an exception for “student loans obtained from a financial institution under its normal lending procedures, terms, and requirements for a covered person’s educational expenses provided the loan was obtained from an individual prior to becoming a covered person in the firm as defined under Rule 2-01(f)(11).”
    • Mortgage Loans. The proposal would also amend the reference to “mortgage loan” in the list of exceptions to “mortgage loans” in order to clarify that this exception “was not intended to exclude just one outstanding mortgage loan on a borrower’s primary residence.” In other words, more than one loan could qualify for this exception, including second mortgages, home improvement loans, equity lines of credit, etc.
  • Credit Card Rule. Rule 2-01(c)(1)(ii)(E) provides that when “[a]ny aggregate outstanding credit card balance owed to a lender that is an audit client [] is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and any available grace period”, this lending activity becomes an independence-impairing relationship. Noting that “certain de minimis financings and immaterial loans may not threaten an auditor’s objectivity and impartiality,” the proposal would delete the reference to “credit card” and replace it with the broader “consumer loans,” which would include, for example, cell phone installment plans or retail installment loans, which “typically have a payment due date consistent with credit cards (e.g., monthly).”
  • M&A Transition Framework. The proposal would provide a transition framework to address inadvertent independence violations that may arise as a result of merger and acquisition transactions.

What to Do Now?

The SEC is accepting public comments on the proposed amendments within 60 days of their publication in the Federal Register. Comments can be submitted here.


1Rule 2-01(b) states that “[t]he Commission 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. In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the Commission.”(go back)

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