SEC considers amending auditor independence rules

Complexity and consolidation may have created a global market environment in which truly independent auditors are impossible to find.

That’s the conundrum that is quietly under examination at the Securities and Exchange Commission, and it may lead to some new slack in auditor independence rules.

SEC Chief Accountant Wes Bricker is considering recommending an amendment to the detailed independence rules that prohibit auditors from having loans tied to audit clients. The thicket of rules that are under examination is contained in Regulation S-X, which governs the content of financial statements and establishes the qualifications of accountants to audit them.

The SEC established the current body of auditor independence rules in 2001, around the time that Enron was collapsing into bankruptcy and Sarbanes-Oxley was taking shape. Independence rules are seen as critical to assuring auditors can be objective and impartial as they consider the numerous risks, estimates, and assumptions that underlie financial statements.

Auditor independence rules are predicated on the belief or assumption that an auditor couldn’t be considered independent of an entity if the auditor has a financial relationship with the entity, like a hefty investment account or a large loan. The specific provision now in question speaks to lending relationships an auditor might have with an audit client.

The rule says an auditor is not considered independent when the firm, any “covered person” in the firm, or any of his or her immediate family members “has any loan to or from an audit client, or an audit client’s officers, directors, or record or beneficial owners of more than 10 percent of the audit client’s equity securities.” A covered person generally includes partners, principals, shareholders, and employees of an audit firm who are on the audit engagement team or in the supervisory chain of command over the team. It could also include individuals who provide even nominal support to the engagement team.

In 2016, Fidelity Management & Research Co. found itself in a pickle over that specific provision of auditor independence rules and appealed to the SEC for relief. Fidelity, a privately held entity that sponsors certain registered investment companies and exchange-traded funds, explained its predicament in a “no-action” request to the SEC. That’s a letter to the SEC staff where a company describes what it understands to be a potential violation of securities law and asks the SEC to forego enforcement action.

“The way the rules are written, it’s an absolute. It’s a cliff-type of foul. There’s no mitigation, no accommodation.”
Richard Morris, Partner, Herrick Feinstein

Fidelity told the SEC it learned from an audit committee of one of its Fidelity Funds that its audit firm discovered and disclosed a concern around independence. The firm reported it could not provide assurance that it was independent under the loan rule provision of auditor independence rules. Fidelity told the SEC the audit firm believed it was still capable of delivering objective, impartial judgments, and Fidelity believed that to be true as well, despite the technical lapse.

Normally, the discovery of a breach in auditor independence would suggest the company should determine which historic financial statements had been potentially compromised and get fresh audits from truly independent auditors. Instead, Fidelity explains, it asked for the SEC’s forgiveness because it believed it would be impossible to find auditors who would be independent under the strict application of the loan rule.

Fidelity boasts 26 million individual customers across dozens of registered funds. As of September 2017, the firm says it held $6.5 trillion in customer assets and $2.4 trillion in global assets under management. Shares of Fidelity entities may be held by a wide range of institutions and individuals, and shares of certain Fidelity entities are held by financial institutions or other entities, Fidelity explained to the SEC.

Sometimes, some of those institutions may also be lenders to public accounting firms that are registered with the Public Company Accounting Oversight Board to provide audit services to listed entities. And they may hold more than 10 percent of a Fidelity entity’s equity securities, although they often do not have voting rights, Fidelity said.

Absent relief from the SEC on this technical violation that Fidelity believes has not led to any actual lapse in objectivity or impartiality by auditors, “it may not be possible for many Fidelity entities to engage a registered public accounting firm that could reasonably provide assurances of ongoing compliance with the loan provision despite the firm’s efforts,” Fidelity wrote.

Entities the size of Fidelity rarely regard any firm other than a Big 4 firm to have the depth and breadth of resources and expertise necessary to audit such an expansive organization. Given the prohibition under independence rules for auditors to provide consulting and tax services to audit clients, an organization the size of Fidelity may have only one firm, two at best, to which it could turn if it needed to change audit firms for some reason.

“Loan rule” provisions of auditor independence rules under study for possible amendment

An accountant is not independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has any loan (including any margin loan) to or from an audit client, or an audit client's officers, directors, or record or beneficial owners of more than 10 percent of the audit client's equity securities, except for the following loans obtained from a financial institution under its normal lending procedures, terms, and requirements:
automobile loans and leases collateralized by the automobile;
loans fully collateralized by the cash surrender value of an insurance policy;
loans fully collateralized by cash deposits at the same financial institution; and
a mortgage loan collateralized by the borrower’s primary residence provided the loan was not obtained while the covered person in the firm was a covered person.
Source: Regulation S-X

The SEC quickly answered Fidelity’s request with a promise to withhold enforcement action, but with an 18-month expiration on that promise while it explored how to navigate the conundrum. Then in the fall of 2017, SEC staff renewed the no-action pledge, attaching no expiration date. The SEC also opened a new rulemaking project.

The SEC has declined to discuss what action, if any, it plans to take. The Commission has not issued any written proposal, nor has it held or scheduled any public hearings. None of the Big 4 audit firms agreed to discuss the situation.

Clifford Alexander, a partner with law firm K&L Gates, says the rules are clear that auditors cannot own shares of a client, nor can they borrow money from clients, except for certain types of nominal loans. The issue now confounding Fidelity is what happens when Fidelity is simply a custodian of an entity where an auditor had a loan.

“Say the audit firm borrows money from a bank, and the bank has customers who own shares of a mutual fund, and that mutual fund is a client for the firm, but all the bank does is hold custody,” says Alexander. “The auditor doesn’t have economic ownership and doesn’t vote the shares. Auditing firms for years have thought the loan rule didn’t apply to that situation.”

It’s not clear how common Fidelity’s predicament might be, but it’s not the only company to report concerns. Invesco disclosed in a May 2016 filing that its audit firm, PwC, also reported concerns regarding compliance with the loan rule. Invesco reported that PwC said it was in discussions with the SEC staff regarding interpretation of the rule and application to its specific facts and circumstances.

The PCAOB also has seen enough instances to call it out. In a 2017 inspection brief summarizing concerns, the PCAOB wrote: “Inspections staff continued to identify deficiencies related to non-compliance with PCAOB rules and/or SEC rules and regulations related to auditor independence.” The board said auditors were misapplying rules in Regulation S-X to “conclude inappropriately” that a covered person’s lack of independence had not resulted in an impairment of independence for the firm.

In a separate similar brief, the PCAOB said inspections staff identified deficiencies in 2016 that indicated systems of quality control at certain firms “did not provide sufficient assurance that the firm’s personnel understood the independence requirements and that the firm and its personnel complied with independence requirements.” The PCAOB says it has seen numerous problems with independence beyond the loan rule, including insufficient communication to audit committees about potential independence problems, prohibited clauses in engagement letters seeking indemnification in the event of audit failures, and the performance of prohibited services.

Nancy Reimer, a partner at law firm LeClairRyan, says it has become increasingly difficult for companies and auditors to navigate auditor independence rules. “It has become really hard to find an audit firm that is completely independent,” she says. “Corporations are so large, and audit firms are so large. What are the chances that an auditor assigned to Fidelity is going to have some kind of distant relation to someone tied to Fidelity?”

That apparently puts the SEC in a position of trying to figure out how to amend the rules in a way that doesn’t add any risk or erode any confidence in audit opinions. “How can this be done in a way that will not lead to questioning of the validity of the audit report, so you still have that trust in the public markets that you can rely on the integrity of the financial statements?” says Reimer.

Richard Morris, a partner at law firm Herrick Feinstein, says one of the challenges with the current auditor independence rules is that it doesn’t provide for degrees of severity. “The way the rules are written, it’s an absolute,” he says. “It’s a cliff-type of foul. There’s no mitigation, no accommodation.” The evolution and globalization of both the auditing profession and the financial services sector have forced regulators to rethink the rigidity of the rules, he says.

Investor advocates like former SEC chief accountant Lynn Turner are not so convinced that the rules need to be amended. The SEC rules provide for inadvertent violations, he says, but they do not excuse situations where firms knew or should have known that they were violating the rules.

In Turner’s view, audit firms are likely looking for a way to address such violations without having to unravel audit reports or perhaps even disclose them as potential impairments to independence. “The SEC and PCAOB rules are very clear,” he says. “These rules are not new to anyone, and any professional knows they are serious and to be followed.”