Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Independence and the "Loan Rule"

There has been much press recently about potential independence issues for certain Big Four auditors of mutual funds as a result of the SEC’s “Loan Rule.”  However, it is not uncommon for large audit firms to have independence issues outside of the “Loan Rule” given their volume of employees, relationships with banks, advisors, etc., as well as audit clients.

Loan_Rule The “Loan Rule” at issue prohibits accounting firms from having certain financial relationships with their audit clients and affiliated entities. The “Loan Rule” provides, in relevant part, that an accounting firm is not independent if it receives a loan from a lender that is a “record or beneficial owner of more than ten percent of the audit client’s equity securities.”

The issue currently at hand seems to relate to loans to audit firms by banks that also have a significant voting interest in certain mutual funds that are audit clients. In order to determine whether or not the audit firm has an issue, the audit firm would need to track any bank it does business with (i.e. Lines of credit, loans, etc.); then compare that listing to the beneficial owners of each client. In simple form, the concept is that the audit firm’s objectivity might be impaired given the fact that the audit firm owes the bank. This rule is not new, but audit firms have relied on the fact that given the nature of the relationship detailed above, a reasonable person would not expect the audit firm’s objectivity to be impaired. I agree – it’s unlikely the loan would impair the audit firm’s objectivity. However, the audit industry’s independence standards are conservative by nature. In summary, an auditor must maintain independence in both fact and appearance.

As hinted at above, larger firms have more potential for independence issues given the significant volume of employees, relationships, and other activities.  Not specific to the “Loan Rule,” our firm has taken on many new clients in the mutual fund space as a result of conflicts and independence issues encountered by large firms. We have viewed these situations as an opportunity to impress upon these new clients the service we can provide to maintain those relationships, and we have had exceptional success in maintaining those clients.

The “Loan Rule” issue highlights one of the many advantages to working with boutique firms, beyond the experience of a more hands-on audit team. Given the smaller roster of clients and relationships and the relative simplicity of operations, compared to Big Four firms, it is much less likely that there will be conflicts of interest with audit clients. While a boutique firm may not be able to handle the largest mutual fund families, we view these scenarios as opportunities to show new clients that bigger is not always better!