On December 30, 2019, the SEC proposed amendments to certain independence requirements with the goal of further aligning the auditor’s independence analysis with Rule 2-01’s “reasonable investor” concept.  The concept asks us to consider whether a reasonable investor with knowledge of all the relevant facts and circumstances would conclude that the auditor is capable of exercising objective and impartial judgment?

For those involved with the audit function in the investment company industry, particularly audits of mutual funds, exchange-traded funds, private funds and interval funds, the following facets of the amendment are of specific interest:

The Definition of Investment Company Complex Is Amended

• Unregistered funds should now be included as part of the investment company complex.

BBD Note – There are certain concepts guiding these proposed changes— notably that the existing rules are more onerous than they need be. The perfect example is the current definition of the Investment Company Complex “ICC” and the idea that any entity in that definition should be considered an affiliate for purposes of analyzing independence.

 Under the current Rule, an auditor might assess the affiliates of an unregistered fund consistent with an operating company, rather than considering the independence analysis consistent with an investment company. This update further conforms the consideration of independence for an unregistered fund with that of a registered fund.

• The amendments will include only sister companies, advisors, or sponsors that are material to the controlling entity in the Investment Company Complex

BBD Note – The materiality evaluation to be used is consistent with the definition of “affiliate” in Reg S-X Rule 2-01, which considers entities where significant influence exists between those entities and the audit client.

This is likely the most significant proposed change.  However, while the concepts of the materiality evaluation do already exist, there will no doubt be much time spent by auditors and others researching the interrelationships of various investment company complexes to properly support their conclusion on whether or not one entity is material to another entity– neither of which are the client or potential client.

You may recall that the SEC had also issued amendments that were effective October 2019 and relevant specifically to the Loan Rule. See BBD’s blog post “SEC Updates the Loan Rule.”

Further Modifications to the Loan Rule Through These Rule 2-01 Amendments

• Student loans relating to a “covered person’s” educational expenses obtained while the individual was not a “covered person” will not be considered as a violation of the Loan Rule.

BBD Note – The specific limitations to student loans of the individual and also those obtained while not a covered member are aimed at the potential materiality of the loan to the covered member. The concept here is that the auditor obtained a loan for education.  That loan is likely aging at this point, of less value, and not obtained at a point when there is a conflict.

• Violations of the loan rule now exclude “consumer loans” such as retail installment loans, cell phone installment plans, and home improvement loans with a balance less than $10,000

BBD Note – Limited amounts of debt can reasonably be expected to be incurred and not likely to raise threats to the auditor’s objectivity or impartiality

In June of 2016, the SEC issued a No-Action Letter to Fidelity Management & Research Company relating to a potential independence issue of its auditors and relating specifically to the Loan Rule. There were updates to Rule 2-01 effective in October 2019, and now further updates are being proposed. Clearly the SEC sees room for improvement.  Did these most recent modifications do the trick?