Newsflash: SEC Staff Issues No-Action Relief on Auditor Independence and the “Loan Provision”

The U.S. Securities and Exchange Commission’s Division of Investment Management (the “SEC Staff”) last night issued a no-action letter (the “Relief”) to Fidelity Management and Research Company that provides guidance to registered investment companies and their investment advisers as they continue to evaluate the independence of their audit firms in light of recent uncertainty about the application of Rule 2-01(c)(1)(ii)(A) under Regulation S-X – the so-called “Loan Provision.”¹ 

The Relief indicates that the SEC Staff would not recommend enforcement action if a registered fund or other entity in the fund’s “investment company complex,” as that term is defined in Regulation S-X,² continues to fulfill its regulatory requirements under the federal securities laws using audit services provided by an audit firm that has a relationship with lending financial institutions that cause the audit firm not to be in compliance with the Loan Provision in certain circumstances, subject to conditions intended to ensure that the audit firm remains objective and impartial. 

While the Relief is addressed to certain Fidelity entities, it articulates the SEC Staff’s position with regard to any registered investment company or other entities in the investment company complex that share the same facts outlined in Fidelity’s no-action request. The Relief applies to a variety of situations impacting open-end funds (including exchange-traded funds (“ETFs”) and variable products funds), closed-end funds and other entities in their investment company complexes. 

In essence, the Loan Provision provides that an audit firm will not be considered independent from an audit client under Regulation S-X if the audit firm or certain personnel of the audit firm has taken a loan from a person that owns, beneficially or of record, more than 10% of the equity securities of the audit client. “Audit client” is defined to include affiliates of the audit client, which, for a registered investment company, includes all entities within the “investment company complex,” regardless of whether the audit firm actually provides audit services to those other entities. While the Loan Provision applies broadly to many different types of entities, it is particularly significant for the investment company industry due to how securities issued by investment companies are sold and held, resulting in many non-compliance situations where the lender would have no opportunity to influence either an audit firm or a fund. 

The Relief is in response to recent developments that raised significant concerns throughout the investment company industry, as audit firms and others had begun to inform fund audit committees that they had identified many instances where their independence under the Loan Provision could have been put in doubt, despite the audit firms’ assurances that they remained objective and impartial with respect to their audits. The Relief allows registered investment companies to move forward with their securities filings and to continue to retain their audit firms in many of these cases. 

The Relief specifically addresses situations where an audit firm or certain of its personnel has an outstanding loan from, or the audit firm has issued debt held by, an institution that: 

• holds of record for the benefit of its customers or clients greater than 10% of the shares of an entity within an investment company complex that is audited by the audit firm; 
• holds greater than 10% of the shares of such an entity through a separate account that it maintains on behalf of its insurance contract holders; or 
• acts as an authorized participant or market maker to an ETF and holds more than 10% of the shares of the ETF. 

The Relief also addresses other situations where a lender to an audit firm owns beneficially greater than 10% of the shares of a fund or other entity in the investment company complex, but has taken steps to limit the lender’s discretion to vote (e.g., where the shares are held in an irrevocable trust without discretion as to the voting of shares, the lending institution has agreed to mirror vote the shares, pass-through the vote to an unaffiliated third-party entity, or otherwise relinquished its right to vote the shares). 

The SEC Staff acknowledged Fidelity’s analysis that the concerns underlying the Loan Provision are generally not implicated where the record or beneficial owner of shares of an audit client is not able to exercise undue influence over the audit client and the objectivity and impartiality of the audit is not impaired. Accordingly, the Relief generally does not extend to situations where a lending institution in fact exercises discretionary voting authority with respect to matters that could influence the objectivity and impartiality of the audit firm. However, the Relief does extend to situations where the lending institution to an audit firm exercises discretionary voting authority over more than 10% of the shares of an entity in the investment company complex that the audit firm does not audit. 

For an audit client to rely on the Relief, the following conditions must be met: 

1. the client’s auditor has complied with PCAOB Rule 3526(b)(1) and (2) (or, with respect to a private fund or other entity to which Rule 3526 does not apply, has provided substantially equivalent communications);³ 
2. the non-compliance of the auditor is with respect to the specific types of lending relationships discussed in the Relief; and 
3. notwithstanding such non-compliance, the auditor has concluded that it is objective and impartial with respect to the issues encompassed within its audit engagement. 

The Relief also provides insight about two aspects of the Loan Provision that have been the subject of much discussion in the investment company industry: 

• First, the SEC Staff noted that, for purposes of determining the scope of the Loan Provision, the relevant institutions are those that directly own or control the owner of the shares, and not entities under common control or controlled by the owner. Accordingly, the Loan Provision is not implicated when an affiliate of a lending institution owns shares of an entity in the investment company complex, unless the affiliate controls the lending institution. 
• Second, the Relief offers guidance about when the SEC Staff expects an entity in an investment company complex to assess compliance with the Loan Provision. Specifically, the Relief states that an entity in an investment company complex should make a “reasonable inquiry” to determine whether any 10% owners in fact exercise discretionary voting authority at the time a matter is put before shareholders (i.e., as of the record date) that could influence the objectivity of the audit firm, including the election of trustees or directors or the appointment of an independent auditor.⁴ 

The Relief states that the no-action assurances are temporary and will expire 18 months from issuance unless renewed by the SEC Staff, which may signal that the SEC Staff anticipates a more comprehensive solution to the Loan Provision issue in the future. 

Footnotes 

_{1) Fidelity Management & Research Company, et al., SEC No-Action Letter (June 20, 2016). We expect that the SEC Staff will post the no-action letter here, but as of the time of this publication, it has not yet done so.
2) An investment company’s “investment company complex” is defined in Rule 2-01(f)(14) to include, among other things: (1) the company’s investment adviser; (2) any affiliates of the investment adviser that are investment advisers or provide administrative, custodian, underwriting or transfer agent services to registered funds; and (3) any other investment companies advised by the investment adviser.
3) These provisions of PCAOB Rule 3526 require an auditor, at least once annually, to provide the audit committees of its audit clients with a written communication describing any relationships between the audit firm and the client that may reasonably be thought to bear on the audit firm’s independence, and to discuss with each audit committee the potential effects of such relationships on the audit firm’s independence.
4) The SEC Staff indicated that it expects entities in an investment company complex will implement policies and procedures that are appropriate for their organizations for conducting such reasonable inquiry. As an example of such procedures, the SEC Staff stated that if an entity solicits investor approval concerning a matter that could influence its audit firm’s objectivity and impartiality, the entity could review applicable ownership records and contact applicable owners to enquire as to whether an institution in a lending relationship with the audit firm owns of record or beneficially more than 10% of the entity’s shares.}