In June 2019, the SEC issued amendments to Rule 2-01 of Regulation S-X (“the Loan Rule”). The amendments now more effectively identify whether independence may be impaired with respect to an audit client when the audit firm or its covered members have a lending relationship with certain shareholders of that audit client.
These amendments are effective October 3, 2019 and consist of four main provisions:
The loan provision now applies to lenders who are beneficial owners of the audit client’s equity securities rather than lenders who hold record ownership of the audit client’s equity securities without the ability to influence the voting or disposal of those securities. This new provision may exclude certain financial intermediaries who are record owners but hold the shares for the benefit of other parties.
The new amendment replaces the 10% beneficial owner test with a test for significant influence. The audit firm, together with the audit client, can assess whether a particular lender has significant influence over the audit client. While “significant influence” is not defined in this amendment, there are references to this term in other parts of Rule 2-01, for example a rebuttable presumption of significant influence once beneficial ownership meets or exceeds 20% of the audit client’s equity’s voting securities. Significant influence could be deemed to include involvement in the portfolio management process.
The Reasonable Inquiry Threshold
The rule adoption includes a “known through reasonable inquiry” standard with respect to identifying beneficial owners of an audit client. The standard suggests that auditors, in conjunction with their audit clients, could look to the client’s governing documents, filings with the SEC and other client information to identify beneficial ownership.
Definition of an Audit Client
The new amendment excludes “sister” funds from the definition of an audit client for a fund under audit. It is believed that investors in one fund would not have the ability to influence the policies of other “sister” funds. Prior to this change, the definition of the audit client included all affiliates, which included other entities in the same investment complex.
BBD has consistently had procedures in place to monitor our firm and personal lending relationships with our audit clients to ensure our compliance with the independence rules. We are happy to discuss our procedures with our clients and their audit committees.