[Federal Register Volume 83, Number 89 (Tuesday, May 8, 2018)]
[Proposed Rules]
[Pages 20753-20773]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-09721]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 210

[Release No. 33-10491; 34-83157; IC-33091; IA-4904; FILE NO. S7-10-18]
RIN 3235-AM01


Auditor Independence With Respect to Certain Loans or Debtor-
Creditor Relationships

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing to amend its auditor independence rules to refocus the 
analysis that must be conducted to determine whether an auditor is 
independent when the auditor has a lending relationship with certain 
shareholders of an audit client at any time during an audit or 
professional engagement period. The proposed amendments would focus the 
analysis solely on beneficial ownership rather than on both record and 
beneficial ownership; replace the existing 10 percent bright-line 
shareholder ownership test with a ``significant influence'' test; add a 
``known through reasonable inquiry'' standard with respect to 
identifying beneficial owners of the audit client's equity securities; 
and amend the definition of ``audit client'' for a fund under audit to 
exclude funds that otherwise would be considered affiliates of the 
audit client. The Commission is also requesting comment on certain 
other potential amendments to its auditor independence rules.

DATES: Comments should be received on or before July 9, 2018.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an email to [email protected]. Please include 
File Number S7-10-18 on the subject line.

Paper Comments

     Send paper comments to Brent J. Fields, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090.

All submissions should refer to File Number S7-10-18. This file number 
should be included on the subject line if email is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
website (http://www.sec.gov/rules/proposed.shtml). Comments are also 
available for website viewing and printing in the Commission's Public 
Reference Room, 100 F Street NE, Washington, DC 20549, on official 
business days between the hours of 10:00 a.m. and 3:00 p.m. All 
comments received will be posted without change. Persons submitting 
comments are cautioned that we do not redact or edit personal 
identifying information from comment submissions. You should submit 
only information that you wish to make available

[[Page 20754]]

publicly. Studies, memoranda, or other substantive items may be added 
by the Commission or staff to the comment file during this rulemaking. 
A notification of the inclusion in the comment file of any such 
materials will be made available on the Commission's website. To ensure 
direct electronic receipt of such notifications, sign up through the 
``Stay Connected'' option at www.sec.gov to receive notifications by 
email.

FOR FURTHER INFORMATION CONTACT: Giles T. Cohen, Deputy Chief Counsel, 
or Peggy Kim, Senior Special Counsel, Office of the Chief Accountant, 
at (202) 551-5300; Alison Staloch, Chief Accountant, Chief Accountant's 
Office, Division of Investment Management, at (202) 551-6918; or Joel 
Cavanaugh, Senior Counsel, Investment Company Regulation Office, 
Division of Investment Management, at (202) 551-6792, U.S. Securities 
and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION: We are proposing amendments to Rule 2-01 of 
Regulation S-X.\1\
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    \1\ 17 CFR 210.2-01.
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Table of Contents

I. Background
    A. The Loan Provision of Regulation S-X
    B. Application of the Current Loan Provision
II. Proposed Amendments
    A. Overview of the Proposed Amendments
    B. Focus the Analysis Solely on Beneficial Ownership
    C. Significant Influence Test
    D. Reasonable Inquiry Compliance Threshold
    E. Excluding Other Funds That Would Be Considered Affiliates of 
the Audit Client
III. Request for Comment
    A. Materiality
    B. Accounting Firms' ``Covered Persons'' and Immediate Family 
Members
    C. Evaluation of Compliance
    D. Secondary Market Purchases of Debt
    E. Other Changes to the Commission's Auditor Independence Rules
IV. Paperwork Reduction Act
V. Economic Analysis
    A. General Economic Considerations
    B. Baseline
    C. Anticipated Benefits and Costs, and Unintended Consequences
    1. Anticipated Benefits
    2. Anticipated Costs and Potential Unintended Consequences
    D. Effects on Efficiency, Competition and Capital Formation
    E. Alternatives
    F. Request for Comment
VI. Initial Regulatory Flexibility Act Analysis
    A. Reasons for and Objectives of the Proposed Action
    B. Legal Basis
    C. Small Entities Subject to the Proposed Rules
    D. Projected Reporting, Recordkeeping and Other Compliance 
Requirements
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. Solicitation of Comment
VII. Small Business Regulatory Enforcement Fairness Act
VIII. Statutory Basis

I. Background

A. The Loan Provision of Regulation S-X

    We are proposing to amend certain provisions of our auditor 
independence rules. The Commission has long considered auditor 
independence to be essential to reliable financial reporting and 
critical to the effective functioning of the U.S. capital markets.\2\ 
Independent auditors have an important public trust.\3\ Many Commission 
regulations require entities to file or furnish financial statements 
that have been audited by an independent auditor; such entities include 
operating companies, registered investment companies, registered 
investment advisers, pooled investment vehicles,\4\ and registered 
broker-dealers.\5\
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    \2\ See generally Proposed Rule: Revision of the Commission's 
Auditor Independence Requirements, Release No. 33-7870 (June 30, 
2000) (``2000 Proposing Release''), available at https://www.sec.gov/rules/proposed/34-42994.htm.
    \3\ The U.S. Supreme Court in describing the independent 
auditor's responsibility, stated that the accountant's ``public 
watchdog'' function ``demands that the accountant maintain total 
independence from the client at all times and requires complete 
fidelity to the public trust.'' United States v. Arthur Young, 465 
U.S. 805, 818 (1984).
    \4\ In this Release, we use the term ``pooled investment 
vehicle'' to refer to a limited partnership, limited liability 
company, or another type of pooled investment vehicle for which the 
pooled investment vehicle's investment adviser relies on paragraph 
(b)(4) of Rule 206(4)-2 (the ``Custody Rule'') under the Advisers 
Act. In general, paragraph (b)(4) of the Custody Rule provides 
conditions under which an investment adviser is not required to 
comply with provisions of the Custody Rule relating to the delivery 
of certain notices and account statements and is deemed to have 
complied with the surprise examination requirements of the rule with 
respect to an account that is a limited partnership, limited 
liability company or other pooled investment vehicle that is subject 
to audit (as defined in Rule 1-02(d) of Regulation S-X). In order to 
rely on this ``audit exception,'' the audit must be performed by an 
independent public accountant that: (i) Meets the standards in Rule 
2-01(b) and (c) of Regulation S-X; and (ii) is registered with, and 
subject to regular inspection as of the commencement of the 
professional engagement period, and as of each calendar year-end, by 
the Public Company Accounting Oversight Board (``PCAOB'') in 
accordance with its rules. Many advisers to private funds rely on 
the audit exception. A ``private fund'' is an issuer that would be 
an investment company, as defined in Section 3 of the Investment 
Company Act, but for Section 3(c)(1) or 3(c)(7) of that Act. See 
Section 202(a)(29) of the Investment Advisers Act.
    \5\ For example, Items 25 and 26 of Schedule A to the Securities 
Act of 1933 (``Securities Act'') [15 U.S.C. 77aa(25) and (26)] and 
Section 17(e) of the Securities Exchange Act of 1934 (``Exchange 
Act'') [15 U.S.C. 78q] expressly require that financial statements 
be certified by independent public or certified accountants. In 
addition, Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange 
Act [15 U.S.C. 78l and 78m], Sections 8(b)(5) and 30(e) and (g) of 
the Investment Company Act of 1940 (``Investment Company Act'') [15 
U.S.C. 80a-8 and 80a-29], and Section 203(c)(1)(D) of the Investment 
Advisers Act of 1940 (``Advisers Act'') [15 U.S.C. 80b-3(c)(1)] 
authorize the Commission to require the filing of financial 
statements that have been audited by independent accountants. 
Paragraph (f)(1) of Rule 17a-5 under the Exchange Act [17 CFR 
240.17a-5(f)(1)] requires that for audits under paragraph (d) of 
Rule 17a-5 of broker-dealers registered with the Commission, an 
independent public accountant must be independent in accordance with 
Rule 2-01 of Regulation S-X. See also id. (discussing Rule 206(4)-2 
under the Advisers Act).
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    The Commission's auditor independence standard is set forth in Rule 
2-01 of Regulation S-X, which requires auditors \6\ to be independent 
of their audit clients both ``in fact and in appearance.'' \7\ Rule 2-
01(b) provides that the Commission will not recognize an accountant as 
independent with respect to an audit client if the accountant is not 
(or if a reasonable investor with knowledge of all relevant facts and 
circumstances would conclude that the accountant is not) capable of 
exercising objective and impartial judgment on all issues encompassed 
within the accountant's engagement.\8\
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    \6\ Rule 2-01 refers to ``accountants'' rather than 
``auditors.'' We use these terms interchangeably in this Release.
    \7\ See Preliminary Note 1 to Rule 2-01 and Rule 2-01(b) of 
Regulation S-X. See also United States v. Arthur Young & Co., 465 
U.S. 805, 819 n.15 (1984) (``It is therefore not enough that 
financial statements be accurate; the public must also perceive them 
as being accurate. Public faith in the reliability of a 
corporation's financial statements depends upon the public 
perception of the outside auditor as an independent 
professional.'').
    \8\ See Rule 2-01(b) of Regulation S-X.
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    Rule 2-01(c) sets forth a nonexclusive list of circumstances that 
the Commission considers to be inconsistent with the independence 
standard in Rule 2-01(b), including certain direct financial 
relationships between an accountant and audit client and other 
circumstances where the accountant has a financial interest in the 
audit client.\9\ In particular, the restriction on debtor-creditor 
relationships in Rule 2-01(c)(1)(ii)(A) (the ``Loan Provision'') 
generally provides that an accountant is not

[[Page 20755]]

independent when (a) the accounting firm, (b) any covered person \10\ 
in the accounting firm (e.g., the audit engagement team and those in 
the chain of command), or (c) any of the covered person's immediate 
family members has any loan (including any margin loan) to or from (x) 
an audit client, or (y) an audit client's officers, directors, or (z) 
record or beneficial owners of more than 10 percent of the audit 
client's equity securities.\11\ We note that simply because a lender to 
an auditor holds 10 percent or less of an audit client's equity 
securities does not, in itself, establish that the auditor is 
independent under Rule 2-01 of Regulation S-X. The general standard 
under Rule 2-01(b) and the remainder of Rule 2-01(c) still apply to 
auditors and their audit clients regardless of the applicability of the 
Loan Provision.
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    \9\ See Rule 2-01(c) of Regulation S-X; see also Revision of the 
Commission's Auditor Independence Requirements, Release No. 33-7919 
(Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)] (``2000 Adopting 
Release'')  available at https://www.sec.gov/rules/final/33-7919.htm, at 65 FR 76009 (``The amendments [to Rule 2-01 adopted in 
2000] identify certain relationships that render an accountant not 
independent of an audit client under the standard in Rule 2-01(b). 
The relationships addressed include, among others, financial, 
employment, and business relationships between auditors and audit 
clients . . . .'').
    \10\ See Rule 2-01(f)(11) of Regulation S-X.
    \11\ See 2000 Adopting Release, supra footnote 9, at 65 FR 
76035.
[GRAPHIC] [TIFF OMITTED] TP08MY18.006

    Thus, in the above illustration, pursuant to the Loan Provision, a 
lending relationship between any entity in the left hand column and any 
entity in the right-hand column impairs independence, unless an 
exception applies.
    When the Commission proposed the Loan Provision, it noted that a 
debtor-creditor relationship between an auditor and its audit client 
reasonably could be viewed as ``creating a self-interest that competes 
with the auditor's obligation to serve only investors' interests.'' 
\12\ The Commission's concern about a competing self-interest extended 
beyond loans directly between the auditor and its audit client to loans 
between the auditor and those shareholders of the audit client who have 
a ``special and influential role'' with the audit client.\13\ As a 
proxy for identifying a ``special and influential role,'' the 
Commission adopted a bright-line test for loans to or from a record or 
beneficial owner of more than 10 percent of an audit client's equity 
securities.\14\
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    \12\ See 2000 Proposing Release, supra footnote 2, at 65 FR 
76034-76035.
    \13\ See 2000 Adopting Release, supra footnote 9, at 65 FR 
76035.
    \14\ The Commission proposed that the Loan Provision include a 
five-percent equity ownership threshold, but raised the threshold to 
10 percent when it adopted the Loan Provision. See 2000 Adopting 
Release, supra footnote 9, at 65 FR 76035. As the basis for its use 
of a 10 percent threshold, the Commission pointed to similar 10 
percent ownership thresholds elsewhere in the federal securities 
laws, including Rule 1-02(r) of Regulation S-X (defining ``principal 
holder of equity securities''), Rule 1-02(s) of Regulation S-X 
(defining ``promoter''), and Section 16 of the Exchange Act 
(requiring reporting to the Commission of beneficial ownership 
information by directors, officers and beneficial owners of more 
than 10 percent of any class of equity securities of an issuer). Id.
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    Under Rule 2-01(f)(6) of Regulation S-X, the term ``audit client'' 
is defined to include any affiliate of the entity whose financial 
statements are being audited.\15\ Rule 2-01(f)(4) provides that 
``affiliates of the audit client'' include entities that control, are 
controlled by, or are under common control with the audit client. As a 
result, generally, an accounting firm is not independent under the Loan 
Provision if it has a lending relationship with an entity having record 
or beneficial ownership of more than 10 percent of the equity 
securities of either (a) the firm's audit client; or (b) any entity 
that is a controlling parent company of the audit client, a controlled 
subsidiary of the audit client, or an entity under common control with 
the audit client.
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    \15\ See Rule 2-01(f)(6) of Regulation S-X.
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    In addition, the term ``affiliate of the audit client'' includes 
each entity in an investment company complex (``ICC'') of which the 
audit client is a part.\16\ Accordingly, in the ICC context, an 
accounting firm is considered not independent under the Loan Provision 
if it has a lending relationship with an entity having record or 
beneficial ownership of more than 10 percent of any entity within the 
ICC, regardless of

[[Page 20756]]

which entities in the ICC are audited by the accounting firm.
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    \16\ See Rule 2-01(f)(4)(iv) of Regulation S-X (defining 
``affiliate of the audit client''). ``Investment company complex'' 
is defined in Rule 2-01(f)(14) of Regulation S-X to include: ``(A) 
An investment company and its investment adviser or sponsor; (B) Any 
entity controlled by or controlling an investment adviser or sponsor 
in paragraph (f)(14)(i)(A) of this section, or any entity under 
common control with an investment adviser or sponsor in paragraph 
(f)(14)(i)(A) of this section if the entity: (1) Is an investment 
adviser or sponsor; or (2) Is engaged in the business of providing 
administrative, custodian, underwriting, or transfer agent services 
to any investment company, investment adviser, or sponsor; and (C) 
Any investment company or entity that would be an investment company 
but for the exclusions provided by section 3(c) of the [1940 Act] 
that has an investment adviser or sponsor included in this 
definition by either paragraph (f)(14)(i)(A) or (f)(14)(i)(B) of 
this section.''
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B. Application of the Current Loan Provision

    The Commission has become aware that, in certain circumstances, the 
existing Loan Provision may not be functioning as it was intended, 
under current market conditions. It also presents significant practical 
challenges.\17\ Registered investment companies, pooled investment 
vehicles, and registered investment advisers have articulated concerns 
about the Loan Provision in both public disclosures \18\ and, together 
with their auditors, in extensive consultations with Commission 
staff.\19\ It has become clear that there are certain fact patterns 
where an auditor's objectivity and impartiality is not impaired despite 
a failure to comply with the requirements of the Loan Provision. \20\
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    \17\ The audit committees of registered investment companies may 
be focused on this issue because, under the Sarbanes-Oxley Act of 
2002 (``Sarbanes-Oxley Act''), audit committees are responsible for 
the selection, compensation and oversight of such funds' independent 
auditors. See Rule 10A-3 under the Exchange Act [17 CFR 240.10A-3]. 
In addition, for audits conducted pursuant to PCAOB standards, the 
auditor is required to notify the audit committee of matters that 
may reasonably bear upon the independence of the auditor. See PCAOB 
Rule 3526.
    \18\ Several funds and investment advisers have noted concerns 
regarding the Loan Provision in their public filings with the 
Commission. See, e.g., AIM Investment Securities Funds (Invesco 
Investment Securities Funds) Form N-CSR filed on May 12, 2016; 
Invesco Mortgage Capital Inc. Form 10-Q filed on May 10, 2016; 
iShares Trust Form N-CSR filed on June 6, 2016; Delaware Investments 
Colorado Municipal Income Fund, Inc. Form N-CSR filed on June 6, 
2016; Goldman Sachs Trust Form N-CSR filed on June 6, 2016; Advent 
International Corp. Form ADV filed on March 30, 2016; NB 
Alternatives Advisers LLC Form ADV filed on June 29, 2016; Indaba 
Capital Management, L.P. Form ADV filed on March 30, 2016; and MFS 
Government Markets Income Trust Schedule 14A filed on August 31, 
2016.
    \19\ Staff in the Office of the Chief Accountant (OCA staff) 
regularly engage in consultations with issuers regarding accounting, 
financial reporting, and auditing concerns or questions, including 
application of the auditor independence rules.
    \20\ Challenges associated with the Loan Provision have also 
arisen with issuers other than funds, although not to the same 
extent. For example, a foreign private issuer (``FPI'') and its 
external auditor encountered compliance issues with the Loan 
Provision as a result of the FPI's use of a depositary bank to hold 
its American Depositary Shares. In that case, the depositary bank 
was the record holder, but not the beneficial owner, of more than 10 
percent of the underlying equity shares of the FPI while also having 
a lending relationship with the auditor. See, e.g., JMU Ltd. Form 
20-F, filed on May 26, 2017.
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    One challenge associated with the Loan Provision is that it applies 
to both ``record'' and ``beneficial'' owners of the audit client's 
equity securities. However, publicly traded shares, as well as certain 
fund shares, often are registered in the name of a relatively small 
number of financial intermediaries \21\ as ``record'' owners for the 
benefit of their clients or customers. Certain of these financial 
intermediaries may also be lenders to public accounting firms or be 
affiliated with financial institutions that may be lenders to public 
accounting firms.\22\ As a result, audit clients may have financial 
intermediaries that own, on a ``record'' basis, more than 10 percent of 
the issuer's shares and are also lenders to public accounting firms, 
covered persons of accounting firms, and their immediate family 
members, or are affiliated with companies that are lenders to public 
accounting firms (see Figure 2 below for illustration). However, these 
financial intermediaries are not ``beneficial'' owners. They also may 
not have control over whether they are ``record'' owners of more than 
10 percent of the issuer's shares.
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    \21\ See infra footnote 23.
    \22\ We note that the Loan Provision can be implicated by 
lending relationships between an auditing firm and those that 
control the record or beneficial owner of more than 10 percent of 
the shares of an audit client (i.e., entities that are under common 
control with or controlled by the record or beneficial owner are not 
as such implicated by the Loan Provision).
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    For example, open-end funds, such as mutual funds, may face 
significant challenges, because the record ownership percentages of 
open-end funds may fluctuate greatly within a given period for reasons 
completely out of the control or knowledge of a lender who is also a 
fund shareholder of record. To be more specific, as a result of 
underlying customer activity in an omnibus account (such as when 
beneficial owners purchase or redeem their shares in an open-end fund) 
or as a result of the activity of other record or beneficial owners, 
the record ownership of a lender that is a financial intermediary 
holding fund shares for customers may exceed, or conversely fall below, 
the 10 percent threshold within a given period without any affirmative 
action on the part of the financial intermediary.\23\ In this scenario, 
the financial intermediary's holdings might constitute less than 10 
percent of a mutual fund and, as a result of subsequent redemptions by 
beneficial owners through other non-affiliated financial 
intermediaries, the same investment could then constitute more than 10 
percent of the mutual fund. However, regardless of their diligence in 
monitoring compliance, the financial intermediary, the fund, or the 
auditor may not know that the 10 percent threshold had been exceeded 
until after the fact.
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    \23\ Financial intermediaries such as broker-dealers, banks, 
trusts, insurance companies and retirement plan third-party 
administrators perform the recordkeeping of open-end fund positions 
and provide services to customers, including beneficial owners and 
other intermediaries and, in most cases, aggregate their customer 
records into a single or a few ``omnibus'' accounts registered in 
the intermediary's name on the fund transfer agent's recordkeeping 
system. Shares of other types of registered investment companies, 
such as closed-end funds, also are frequently held by broker-dealers 
and other financial intermediaries as record owners on behalf of 
their customers, who are not required and may be unwilling to 
provide, information about the underlying beneficial owners to 
accounting firms, and particularly accounting firms that do not 
audit the fund. In addition, a financial intermediary may act as an 
authorized participant or market maker to an exchange-traded fund 
(``ETF'') and be the holder of record or beneficial owner of more 
than 10 percent of an ETF.
    An open-end fund, or open-end company, is a management company 
that is offering for sale or has outstanding any redeemable 
securities of which it is the issuer. A closed-end fund, or closed-
end company, is any management company other than an open-end 
company. See Section 5 of the Investment Company Act [15 U.S.C. 80a-
5]. ETFs registered with the Commission are organized either as 
open-end management companies or unit investment trusts. See Section 
4 of the Investment Company Act [15 U.S.C. 80a-4] (defining the 
terms ``management company'' and ``unit investment trust''). 
References to ``funds'' in this Release include ETFs, unless 
specifically noted.
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    Another practical challenge is that the auditor independence rules' 
broad definition of the term ``audit client'' gives rise to results 
that are out of step with the purpose of the rule and that can have 
adverse effects when applied in the specific context of the Loan 
Provision. As described above, the Loan Provision applies not only to 
an entity that the audit firm is auditing but also to those entities 
that are ``affiliated'' with the audit client.\24\ The auditor 
independence rules broadly define an ``affiliate of the audit client'' 
to include, among other things, both (a) an entity that is under common 
control with the audit client; and (b) each entity in an ICC when the 
audit client is part of that ICC.\25\
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    \24\ See Rule 2-01(f)(6) of Regulation S-X.
    \25\ See Rule 2-01(f)(4) of Regulation S-X, in which an 
``affiliate of the audit client'' is defined to include the 
following:
    (i) An entity that has control over the audit client, or over 
which the audit client has control, or which is under common control 
with the audit client, including the audit client's parents and 
subsidiaries;
    (ii) An entity over which the audit client has significant 
influence, unless the entity is not material to the audit client;
    (iii) An entity that has significant influence over the audit 
client, unless the audit client is not material to the entity; and
    (iv) Each entity in the investment company complex when the 
audit client is an entity that is part of an investment company 
complex.
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    Open-end funds are often part of large and varied ICCs, and 
multiple accounting firms may be retained to perform audits of various 
entities within the ICC. If an accounting firm is not independent under 
the Loan Provision with respect to only one of a given ICC's funds, no 
fund or other entity in the ICC can engage or retain that accounting 
firm as an independent auditor consistent with Rule 2-01 of Regulation 
S-X. An auditor to one fund in an ICC thus must seek information 
regarding the record and beneficial owners of the equity securities of 
all of the other funds (and other entities) in the ICC and such owner's 
affiliates (see Figure 3 below for illustration). Other funds in the 
ICC that are not audited by the requesting auditor are not required to 
provide this information, and may only provide it, if at all, after 
negotiation and the establishment of information-sharing protocols, all 
of which can require substantial time and expense incurred by auditors 
and funds. Even where funds not audited by this auditor do provide 
information regarding the owners of their equity securities, the fact 
that fund shares often are held in omnibus accounts registered in the 
name of financial intermediaries creates further challenges in 
identifying the shares' beneficial owners to determine if they are 
lenders to the auditing firm that own more than 10 percent of the 
fund's equity securities.\26\
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    \26\ In some cases, financial intermediaries such as broker-
dealers or banks hold fund shares on behalf of other financial 
intermediaries, such as retirement plan administrators or other 
broker-dealers, creating multiple layers of intermediaries between 
the fund and the beneficial owners of its shares. See also, e.g., 
Mutual Fund Redemption Fees, Release No. IC-27504 (Sept. 27, 2006) 
[71 CFR 58257 (Oct. 3, 2006)] at 58258 (discussing application of 
Rule 22c-2 under the Investment Company Act to ``chains of 
intermediaries'').
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    Further, not only loans to accounting firms but also loans to 
certain ``covered persons'' at such firms and their immediate family 
members may implicate the Loan Provision.\27\ As a result, certain 
lending relationships with members of the audit engagement team, 
individuals generally in the supervisory reporting chain for the audit, 
certain accounting firm employees in the same primary office as the 
lead engagement partner, and other accounting firm employees--or with 
immediate family members of any of those persons--could be found to 
impair the audit firm's independence.\28\
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    \27\ See Rule 2-01(c)(1)(ii) of Regulation S-X.
    \28\ See Rule 2-01(f)(11) of Regulation S-X (definition of 
``covered persons'').

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    The Commission understands that accounting firms use loans to help 
finance their core business operations. Accounting firms frequently 
obtain financing to pay for their labor and out-of-pocket expenses 
before they receive payments from audit clients for those services. 
Accounting firms also use financing to fund current operations and 
provide capital to fund ongoing investments in their audit 
methodologies and technology. Accounting firms borrow from commercial 
banks or through private placement debt issuances, typically purchased 
by large financial institutions, both of which give rise to debtor-
creditor relationships.\29\ For creditor diversification purposes, 
credit facilities provided or arranged by commercial banks are often 
syndicated among multiple financial institutions, thereby expanding the 
number of lenders to an accounting firm. As a result, accounting firms 
typically have a wide array of lending arrangements. These arrangements 
facilitate firms' provision of audit services to investors and other 
market participants, but also multiply the number of lenders that may 
also be record or beneficial owners of securities in audit clients and 
that must be analyzed under the Loan Provision.
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    \29\ The Commission further understands that insurance companies 
may purchase accounting firms' private placement notes. Insurance 
companies may also act as sponsors of insurance products, and may be 
record owners, on behalf of contract holders, of certain investment 
companies' equity securities.
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    The current market conditions that have enabled these accounting 
firms' financing methods appear to have resulted in various scenarios 
in which the Loan Provision deems an accounting firm's independence to 
be impaired, notwithstanding that the relevant facts and circumstances 
regarding the relationships between the auditor and the audit client 
suggest that in most cases the auditor's objectivity and impartiality 
do not appear to be affected as a practical matter. Nevertheless, 
auditors and audit committees may feel obligated to devote substantial 
resources to evaluating potential instances of noncompliance with the 
existing Loan Provision, which could distract auditors' and audit 
committees' attention from matters that may be more likely to bear on 
the auditor's objectivity and impartiality.\30\ Audit committees' 
receipt of a high volume of communications of such relationships may 
dilute the impact of communications that identify issues that may 
actually raise concerns about an auditor's independence.\31\
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    \30\ Auditors are required to communicate any relationships, 
including lending relationships, with the audit client that may 
reasonably be thought to bear on independence to the audit committee 
at least annually. See, e.g., PCAOB Rule 3526 (requiring a 
registered public accounting firm, at least annually with respect to 
each of its audit clients, to: (1) Describe, in writing, to the 
audit committee of the audit client, all relationships between the 
registered public accounting firm or any affiliates of the firm and 
the audit client or persons in financial reporting oversight roles 
at the audit client that, as of the date of the communication, may 
reasonably be thought to bear on independence; (2) discuss with the 
audit committee of the audit client the potential effects of the 
relationships described in subsection (b)(1) on the independence of 
the registered public accounting firm; (3) affirm to the audit 
committee of the audit client, in writing, that, as of the date of 
the communication, the registered public accounting firm is 
independent in compliance with Rule 3520; and (4) document the 
substance of its discussion with the audit committee of the audit 
client.
    \31\ In this Release, we use the term ``audit committee,'' when 
referring to funds, generally to refer to audit committees 
established by a fund's board of directors or trustees or, where no 
formal audit committee exists as may be the case for certain private 
funds, for example, those responsible for the governance of the 
fund.
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    Similarly, numerous violations of the independence rules that no 
reasonable person would view as implicating an auditor's objectivity 
and impartiality could desensitize market participants to other, more 
significant violations of the

[[Page 20759]]

independence rules. Respect for the seriousness of these obligations is 
better fostered through limiting violations to those instances in which 
the auditor's independence would be impaired in fact or in appearance.
    Moreover, searching for, identifying, and assessing noncompliance 
or potential non-compliance with the Loan Provision and reporting these 
instances to audit committees also may generate significant costs for 
entities and their advisers and auditors, which costs are ultimately 
borne by shareholders. These costs are unlikely to entail corresponding 
benefits to the extent that the Loan Provision's breadth identifies and 
requires analysis of circumstances that are unlikely to bear on the 
auditor's independence.
    In addition, the compliance challenges associated with the Loan 
Provision can have broader disruptive effects, particularly for 
funds.\32\ For example, in order for a registered open-end fund to make 
a continuous offering of its securities, it must maintain a current 
prospectus by periodically filing post-effective amendments to its 
registration statement that contain updated financial information 
audited by an independent public accountant in accordance with 
Regulation S-X.\33\ In addition, the federal securities laws require 
that investment companies registered under the Investment Company Act 
transmit annually to shareholders and file with the Commission 
financial statements audited by an independent registered public 
accounting firm.\34\ Accordingly, noncompliance with the auditor 
independence rules in some cases can result in affected funds not being 
able to sell shares, investors not being able to rely on affected 
financial statements, or funds (and, indirectly, but importantly, their 
investors) having to incur the costs of re-audits.
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    \32\ Registered investment advisers that have custody of client 
funds or securities also face compliance challenges from the Loan 
Provision. These advisers generally are required under the Custody 
Rule to obtain a surprise examination conducted by an independent 
public accountant or, for pooled investment vehicles, may be deemed 
to comply with the requirement by distributing financial statements 
audited by an independent public accountant to the pooled investment 
vehicle's investors. An auditor's inability, or potential inability, 
to comply with the Loan Provision raises questions concerning an 
adviser's ability to satisfy the requirements of the Custody Rule.
    \33\ See generally Section 10(a)(3) of the Securities Act [15 
U.S.C. 77j(a)(3)] and Item 27 of Form N-1A.
    \34\ See Rules 30e-1 and 30b2-1 under the Investment Company 
Act.
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    In order to provide time for the Commission to address these 
challenges, and recognizing that funds and their advisers were most 
acutely affected by the Loan Provision, the Commission staff issued a 
no-action letter to Fidelity Management & Research Company regarding 
the application of the Loan Provision (``Fidelity No-Action 
Letter'').\35\ In the Fidelity No-Action Letter, the staff stated that 
it would not recommend enforcement action to the Commission, even 
though certain Fidelity entities identified in the letter used audit 
firms that were not in compliance with the Loan Provision, subject to 
certain conditions specified in the letter (e.g., that notwithstanding 
such non-compliance, the audit firm had concluded that it is objective 
and impartial with respect to the issues encompassed within the 
engagement).\36\ Staff continue to receive inquiries from registrants 
and accounting firms regarding the application of the Loan Provision, 
or clarification of the Fidelity No-Action Letter, and requests for 
consultation regarding issues not covered in the Fidelity No-Action 
Letter.
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    \35\ See No-Action Letter from the Division of Investment 
Management to Fidelity Management & Research Company (June 20, 2016) 
(``June 20, 2016 Letter''), available at https://www.sec.gov/divisions/investment/noaction/2016/fidelity-management-research-company-062016.htm. The June 20, 2016 Letter provided temporary no-
action relief, and was to expire 18 months from the issuance date. 
On September 22, 2017, the staff extended the June 20, 2016 Letter 
until the effective date of any amendments to the Loan Provision 
adopted by the Commission that are designed to address the concerns 
expressed in the June 20, 2016 Letter. See No-Action Letter from the 
Division of Investment Management to Fidelity Management & Research 
Company (Sept. 22, 2017) (``September 22, 2017 Letter''), available 
at https://www.sec.gov/divisions/investment/noaction/2017/fidelity-management-research-092217-regsx-rule-2-01.htm.
    \36\ The June 20, 2016 Letter described the following 
circumstances, each of which could have potential implications under 
the Loan Provision: (i) ``An institution that has a lending 
relationship with an Audit Firm holds of record, for the benefit of 
its clients or customers (for example, as an omnibus account holder 
or custodian), more than 10 percent of the shares of a Fidelity 
Entity;'' (ii) ``An insurance company that has a lending 
relationship with an Audit Firm holds more than 10 percent of the 
shares of a Fidelity Fund in separate accounts that it maintains on 
behalf of its insurance contract holders;'' and (iii) ``An 
institution that has a lending relationship with an Audit Firm and 
acts as an authorized participant or market maker to a Fidelity ETF 
and holds of record or beneficially more than 10 percent of the 
shares of a Fidelity ETF.''
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II. Proposed Amendments

A. Overview of the Proposed Amendments

    Given the dynamics identified above, we are proposing amendments to 
Rule 2-01 of Regulation S-X that would result in a rule that we believe 
would effectively identify those debtor-creditor relationships that 
could impair an auditor's objectivity and impartiality, yet would not 
include certain extended relationships that are unlikely to present 
threats to objectivity or impartiality.\37\ Specifically, we are 
proposing amendments that would:
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    \37\ See Rule 2-01(b) of Regulation S-X.
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     Focus the analysis solely on beneficial ownership;
     replace the existing 10 percent bright-line shareholder 
ownership test with a ``significant influence'' test;
     add a ``known through reasonable inquiry'' standard with 
respect to identifying beneficial owners of the audit client's equity 
securities; and
     amend the definition of ``audit client'' for a fund under 
audit to exclude from the provision funds that otherwise would be 
considered ``affiliates of the audit client.''
    The proposed amendments are designed to better focus the Loan 
Provision on those relationships that, whether in fact or in 
appearance, could threaten an auditor's ability to exercise objective 
and impartial judgment. We also are soliciting input on other potential 
changes to the Loan Provision or Rule 2-01 of Regulation S-X that may 
be appropriate.
    Given that compliance challenges associated with applying the Loan 
Provision have arisen with entities other than funds, the proposed 
amendments would apply broadly to entities beyond the investment 
management industry, including operating companies and registered 
broker-dealers.

B. Focus the Analysis Solely on Beneficial Ownership

    Where a lender to an auditor holds more than 10 percent of the 
equity securities of that auditor's audit client either as a beneficial 
owner or as a record owner, the Commission's rules indicate that the 
auditor is not independent of the audit client. The record owner 
exceeding 10 percent may be a broker-dealer, custodian, or an 
intermediary omnibus account holder for its customers. Thus, as noted 
in Section I.B., the existing Loan Provision applies where a lender 
holds the audit client's equity securities of record, even though the 
lender may be unable to influence an audit client through its holdings 
of the audit client's equity securities, and may have no economic 
incentive to do so.\38\
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    \38\ The financial gain of beneficial owners is tied to the 
performance of their investment and as such, beneficial owners may 
have stronger incentives to influence the auditor's report. Record 
owners, on the other hand, likely do not benefit directly from the 
performance of securities of which they are record owners, and as 
such, they may have low incentives to affect the report of the 
auditor. For example, record holders' discretion to vote the shares 
on behalf of their beneficial owners is typically limited. See the 
New York Stock Exchange (NYSE) Rule 452. The NYSE allows brokers to 
vote on certain items on behalf of their clients, if the broker has 
received no voting instructions from those clients within 10 days of 
the annual meeting. Brokers are only allowed to cast these 
discretionary votes on ``routine'' matters, which are generally 
uncontested and do not include a merger, consolidation, or any 
matter which may affect substantially the rights or privileges of 
such stock. Rule 452 lists the types of matters that brokers may not 
vote without customer instructions, which include executive 
compensation or uncontested elections of directors (other than 
uncontested director elections of companies registered under the 
Investment Company Act of 1940).

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[[Page 20760]]

    Under the proposed amendments, the Loan Provision would apply only 
to beneficial owners of the audit client's equity securities and not to 
those who merely maintain the audit client's equity securities as a 
holder of record on behalf of their beneficial owners.\39\ We believe 
that tailoring the Loan Provision to focus only on the beneficial 
ownership of the audit client's equity securities would more 
effectively identify shareholders ``having a special and influential 
role with the issuer'' and therefore better capture those debtor-
creditor relationships that may impair an auditor's independence.\40\
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    \39\ An equity holder who acquired such ownership by buying a 
certificated share would be both a record owner and a beneficial 
owner and thus would continue to be analyzed under the Loan 
Provision.
    \40\ See 2000 Adopting Release, supra footnote 9.
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C. Significant Influence Test

    Furthermore, we believe that the current bright-line 10 percent 
test may be both over- and under-inclusive as a means of identifying 
those debtor-creditor relationships that actually impair the auditor's 
objectivity and impartiality. For example, the existing Loan Provision 
applies even in situations where the lender may be unable to influence 
the audit client through its holdings.\41\ In such circumstances, the 
lender's ownership of an audit client's equity securities alone would 
not threaten an audit firm's objectivity and impartiality. Conversely, 
the existing Loan Provision does not apply if the auditor's lender owns 
10 percent or less of the audit client's equity securities, despite the 
fact that such an owner could exert significant influence over the 
audit client through contractual or other means.\42\ A holder of 10 
percent or less of an audit client's equity securities could, for 
example, have the contractual right to remove or replace a pooled 
investment vehicle's investment adviser. Although other portions of 
Rule 2-01 of Regulation S-X apply, the Loan Provision's existing 10 
percent bright-line test by itself would not capture this debtor-
creditor relationship even though the relationship potentially raises 
questions about an auditor's objectivity and impartiality.\43\
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    \41\ Cf. Accounting Standards Codification (``ASC'') 323, infra 
footnote 49 (providing examples where a holder may not have 
significant influence).
    \42\ Cf. ASC 323, infra footnote 49 (providing examples where a 
holder may have significant influence).
    \43\ See supra Section I.A for a discussion of the general 
standard under Rule 2-01(b) of Regulation S-X.
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    We therefore propose to replace the existing 10 percent bright-line 
test in the Loan Provision with a ``significant influence'' test 
similar to that referenced in other parts of the Commission's auditor 
independence rules.\44\ Specifically, the proposed amendment would 
provide that an accountant would not be 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 beneficial 
owners (known through reasonable inquiry) of the audit client's equity 
securities where such beneficial owner has significant influence over 
the audit client.\45\
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    \44\ See Rule 2-01(c)(1)(i)(E)(1)(i), (E)(1)(ii), (E)(2), 
(E)(3), (f)(4)(ii) and (f)(4)(iii) of Regulation S-X.
    \45\ See proposed Rule 2-01(c)(1)(ii)(A) (replacing the phrase 
``record or beneficial owners of more than ten percent of the audit 
client's equity securities'' with ``beneficial owners (known through 
reasonable inquiry) of the audit client's equity securities, where 
such beneficial owner has significant influence over the audit 
client''). Under the proposed amendments, the rule would continue to 
have exceptions for four types of loans: (1) Automobile loans and 
leases collateralized by the automobile; (2) loans fully 
collateralized by the cash surrender value of an insurance policy; 
(3) loans fully collateralized by cash deposits at the same 
financial institution; and (4) 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. We 
discuss the proposed ``known through reasonable inquiry'' standard 
below. See infra section II.D.
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    We believe the proposed significant influence test would more 
effectively identify shareholders ``having a special and influential 
role with the issuer'' and therefore would better capture those debtor-
creditor relationships that may impair an auditor's independence.\46\ 
This test focuses on a lender shareholder's ability to influence the 
policies and management of an audit client, based on a totality of the 
facts and circumstances. While this analysis would include a 
consideration of the lender's beneficial ownership level in an audit 
client's equity securities, a bright-line percentage ownership of an 
audit client's securities alone would no longer determine an auditor's 
independence with respect to an audit client.
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    \46\ See 2000 Adopting Release, supra footnote 9, at 65 FR 76035 
(describing the 10 percent bright-line test as identifying 
shareholders ``having a special and influential role with the 
issuer'' that ``would be considered to be in a position to influence 
the policies and management of that client.'').
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    Specifically, under the ``significant influence'' test we are 
proposing today, an audit firm, together with its audit client, would 
be required to assess whether a lender (that is also a beneficial owner 
of the audit client's equity securities) has the ability to exert 
significant influence over the audit client's operating and financial 
policies.\47\ Although not specifically defined, the term ``significant 
influence'' appears in other parts of Rule 2-01 of Regulation S-X,\48\ 
and we intend to use the term ``significant influence'' in the proposed 
amendment to refer to the principles in the Financial Accounting 
Standards Board's (``FASB's'') ASC Topic 323, Investments--Equity 
Method and Joint Ventures.\49\ The concept of ``significant influence'' 
has been part of the Commission's auditor independence rules since 2000 
and has been part of the accounting standards since 1971.\50\ Given its 
use in other parts of the Commission's independence rules,\51\ the 
concept of ``significant influence'' is one with which audit firms and 
their clients are already required to be familiar. While audit firms 
and audit committees of operating companies already should be familiar 
with application of the ``significant influence'' concept, this concept 
is not as routinely applied today in the investment fund context for 
financial reporting purposes.\52\ Nonetheless, the concept of 
significant

[[Page 20761]]

influence is applicable to funds under existing auditor independence 
rules.\53\
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    \47\ See ASC 323, infra footnote 49. See also infra Section II.C 
for a discussion of an audit client's operating and financial 
policies in the fund context.
    \48\ See Rule 2-01(c)(1)(i)(E)(``investments in audit clients'') 
and Rule 2-01(f)(4) of Regulation S-X (``affiliate of the audit 
client'' definition).
    \49\ See ASC 323 Investments--Equity Method and Joint Ventures 
(``ASC 323''). See 2000 Adopting Release, supra footnote 9, at 65 FR 
76034, note 284 (referring to Accounting Principles Board Opinion 
No. 18, ``The Equity Method of Accounting for Investments in Common 
Stock'' (Mar. 1971), which was codified at ASC 323).
    \50\ See Accounting Principles Board (APB) Opinion No. 18 (March 
1971) (``The Board concludes that the equity method of accounting 
for an investment in common stock should also be followed by an 
investor whose investment in voting stock gives it the ability to 
exercise significant influence over operating and financial policies 
of an investee even though the investor holds 50% or less of the 
voting stock.'').
    \51\ See supra footnote 44.
    \52\ See ASC 946. Financial Services--Investment Companies.
    \53\ See Rule 2-01(c)(1)(i)(E)(1)(i), (E)(1)(ii), (E)(2), and 
(E)(3) of Regulation S-X.
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    Under the proposed test, the ability to exercise significant 
influence over the operating and financial policies of an audit client 
would be based on the facts and circumstances, and under the existing 
accounting framework, could be indicated in several ways, including:
     Representation on the board of directors;
     Participation in policy-making processes;
     Material intra-entity transactions;
     Interchange of managerial personnel; or
     Technological dependency.\54\
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    \54\ See ASC 323, supra footnote 49.
---------------------------------------------------------------------------

    The lender's beneficial ownership of an audit client's equity 
securities also would be considered in determining whether a lender has 
significant influence over an audit client's operating and financial 
policies.\55\ Unlike the existing Loan Provision, however, the 
significant influence test would not set a bright-line threshold above 
which a lender is assumed to be in a position to influence the policies 
and management of that client. Instead, the proposed significant 
influence test would be consistent with ASC 323 by establishing a 
rebuttable presumption that a lender beneficially owning 20 percent or 
more of an audit client's voting securities is presumed to have the 
ability to exercise significant influence over the audit client, absent 
predominant evidence to the contrary.\56\ Conversely, and consistent 
with ASC 323, under the proposed significant influence test, if the 
ownership percentage were less than 20 percent, there would be a 
rebuttable presumption that the lender does not have significant 
influence over the audit client, unless it could be demonstrated that 
the lender has the ability to exert significant influence over the 
audit client.\57\ Thus, significant influence could exist in 
circumstances where ownership is less than 20 percent.
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    \55\ The extent of a lender's ownership interest would be 
considered in relation to the concentration of other shareholders, 
but substantial or majority ownership of an audit client's voting 
stock by another shareholder would not necessarily preclude the 
ability to exercise significant influence by the lender. See id.
    \56\ ASC 323 contains a presumption that in the absence of 
predominant evidence to the contrary, an investor of 20% or more of 
the voting stock has the ability to exercise significant influence 
over the investee. See ASC 323-10-15-8. See also 2000 Adopting 
Release, supra footnote 9, at 65 FR 76034, note 497 and accompanying 
text.
    \57\ Under ASC 323, an investment of less than 20% of the voting 
stock shall lead to the presumption that an investor does not have 
the ability to exercise significant influence over the investee 
unless such ability can be demonstrated. See ASC 323-10-15-8.
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    ASC 323 lists several indicators that, as applied to the proposed 
significant influence test, would suggest a shareholder that owns 20 
percent or more of the audit client's voting securities nonetheless may 
be unable to exercise significant influence over the operating and 
financial policies of the audit client, including the following:
     Opposition by the audit client, such as litigation or 
complaints to governmental regulatory authorities, challenging the 
shareholder's ability to exercise significant influence;
     An agreement (such as a standstill agreement) under which 
the shareholder surrenders significant rights as a shareholder;
     Majority ownership of the audit client is concentrated 
among a small group of shareholders who operate the audit client 
without regard to the views of the shareholder;
     The shareholder needs or wants more financial information 
than is available to other shareholders, tries to obtain that 
information, and fails; \58\ and
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    \58\ We recognize that there may be reasons other than a lack of 
influence--such as concerns under Regulation FD or the antifraud 
provisions of the federal securities laws generally--that might 
result in an issuer declining to provide financial information to a 
shareholder.
---------------------------------------------------------------------------

     The shareholder tries and fails to obtain representation 
on the audit client's board of directors.\59\
---------------------------------------------------------------------------

    \59\ See ASC 323-10-15-10.
---------------------------------------------------------------------------

    In the fund context, we believe that the operating and financial 
policies relevant to the significant influence test would include the 
fund's investment policies and day-to-day portfolio management 
processes, including those governing the selection, purchase and sale, 
and valuation of investments, and the distribution of income and 
capital gains (collectively ``portfolio management processes''). An 
audit firm could analyze whether significant influence over the fund's 
portfolio management processes exists based on an initial evaluation of 
the fund's governance structure and governing documents, the manner in 
which its shares are held or distributed, and any contractual 
arrangements, among any other relevant factors.
    We believe that it would be appropriate to consider the nature of 
the services provided by the fund's investment adviser(s) pursuant to 
the terms of an advisory contract with the fund as part of this 
analysis. In circumstances where the terms of the advisory agreement 
grant the adviser significant discretion with respect to the fund's 
portfolio management processes and the shareholder does not have the 
ability to influence those portfolio management processes, significant 
influence generally would not exist. The ability to vote on the 
approval of a fund's advisory contract or a fund's fundamental policies 
on a pro rata basis with all holders of the fund alone generally should 
not lead to the determination that a shareholder has significant 
influence. On the other hand, if a shareholder in a private fund, for 
example, has a side letter agreement outside of the standard 
partnership agreement that allows for participation in portfolio 
management processes (including participation on a fund advisory 
committee), then the shareholder would likely have significant 
influence.
    In circumstances where significant influence could exist, the audit 
firm would then evaluate whether an entity that is a beneficial owner 
of shares of a fund audit client has the ability to exercise 
significant influence over the fund and has a debtor-creditor 
relationship with the audit firm, any covered person in the firm, or 
any of his or her immediate family members.\60\ If the auditor 
determines that significant influence does not exist based on the facts 
and circumstances at the time of the auditor's initial evaluation, we 
believe that the auditor should monitor the Loan Provision on an 
ongoing basis which could be done, for example, by reevaluating its 
determination when there is a material change in the fund's governance 
structure and governing documents, publicly available information about 
beneficial owners, or other information that may implicate the ability 
of a beneficial owner to exert significant influence of which the audit 
client or auditor becomes aware.
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    \60\ See infra Part II.D for a discussion of the proposed 
``known through reasonable inquiry'' standard.
---------------------------------------------------------------------------

    We believe that moving to a ``significant influence'' test would be 
advantageous. First, the ``significant influence'' test, which applies 
qualitative factors to broadly capture influence over an audit client, 
would be more effective in identifying lender shareholders that 
threaten an auditor's impartiality and independence than the current 10 
percent bright-line test.
    Second, the concept of ``significant influence'' already exists in 
the auditor independence rules and in ASC 323. For example, Rule 2-
01(c)(1)(i)(E) of Regulation S-X, which generally governs investments 
in entities that invest in audit clients and investments in entities in 
which audit clients invest, requires the auditor to assess whether

[[Page 20762]]

investments are material and whether the investment results in the 
ability to exercise significant influence over that entity.\61\ 
Similarly, the ``affiliate of the audit client'' definition in the 
auditor independence rules requires that a determination be made as to 
whether there are entities over which the audit client has significant 
influence (unless the entity is not material to the audit client) or 
any entities that have significant influence over the audit client 
(unless the audit client is not material to the entity).\62\ The 
parties that would be tasked with implementing a ``significant 
influence'' test in the Loan Provision--accounting firms, issuers and 
their audit committees--thus are already required to be familiar with 
this concept under the auditor independence rules. We believe that 
these entities likely would be able to leverage any existing practices, 
processes and controls for determining significant influence to comply 
with the proposed changes to the Loan Provision.
---------------------------------------------------------------------------

    \61\ See 2000 Adopting Release, supra footnote 9, at 65 FR 
76034. Rule 2-01(c)(1)(i)(E) of Regulation S-X contains several 
provisions that use a materiality qualifier. For example, an 
accountant would not be independent if it ``[h]as any material 
investment in an entity over which an audit client has the ability 
to exercise significant influence. . . .'' See Rule 2-
01(c)(1)(i)(E)(2) of Regulation S-X. Rule 2-01(c)(1)(i)(E) of 
Regulation S-X also contains a significant influence provision 
without a materiality qualifier, in which an accountant would not be 
independent of its audit client when the accountant ``[h]as the 
ability to exercise significant influence over an entity that has 
the ability to exercise significant influence over an audit 
client.'' See Rule 2-01(c)(1)(i)(E)(3) of Regulation S-X.
    \62\ See Rule 2-01(f)(4) of Regulation S-X.
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D. Reasonable Inquiry Compliance Threshold

    As described above, another challenge in the application of the 
current Loan Provision involves the difficulty in accessing information 
regarding the ownership percentage of an audit client for the purposes 
of the current 10 percent bright-line test. For example, the shares of 
closed-end funds are commonly held of record by broker-dealers, which 
may be reluctant to share information about the underlying beneficial 
owners. In addition, also as indicated above, institutions may be the 
holder of record of shares in an audit client merely as custodian or as 
an omnibus account holder, adding a layer, and in some cases multiple 
layers, of complexity to obtaining information about the underlying 
beneficial ownership. Moreover, a beneficial owner may object to 
disclosure of its name, address, and securities position to the issuer, 
so that issuers may be unable to obtain the beneficial ownership 
information for these owners.\63\
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    \63\ Pursuant to Rule 14a-13(b) under the Exchange Act, an 
issuer may obtain from broker-dealers and banks a list of the names, 
addresses and securities positions of only the beneficial owners who 
either have consented or have not objected to having such 
information provided to issuers. See 17 CFR 240.14a-13(b).
---------------------------------------------------------------------------

    We therefore propose to amend the Loan Provision to address the 
concerns about accessibility to records or other information about 
beneficial ownership by adding a ``known through reasonable inquiry'' 
standard with respect to the identification of such owners. Under this 
proposed amendment, an audit firm, in coordination with its audit 
client, would be required to analyze beneficial owners of the audit 
client's equity securities who are known through reasonable inquiry. We 
believe that if an auditor does not know after reasonable inquiry that 
one of its lenders is also a beneficial owner of the audit client's 
equity securities, including because that lender invests in the audit 
client indirectly through one or more financial intermediaries, the 
auditor's objectivity and impartiality is unlikely to be impacted by 
its debtor-creditor relationship with the lender. This ``known through 
reasonable inquiry'' standard is generally consistent with regulations 
implementing the Investment Company Act, the Securities Act and the 
Exchange Act,\64\ and therefore is a concept that already should be 
familiar to those charged with compliance with the provision.
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    \64\ See, e.g., Rule 3b-4 under the Exchange Act (stating, with 
respect to the definition of foreign private issuer, that ``[i]f, 
after reasonable inquiry, you are unable to obtain information about 
the amount of shares represented by accounts of customers resident 
in the United States, you may assume, for purposes of this 
definition, that the customers are residents of the jurisdiction in 
which the nominee has its principal place of business.); Rule 144(g) 
under the Securities Act (noting, with respect to ``brokers' 
transactions'' that ``[t]he term brokers' transactions in section 
4(4) of the [Securities] Act shall for the purposes of this rule be 
deemed to include transactions by a broker in which such broker: . . 
. (4) After reasonable inquiry is not aware of circumstances 
indicating that the person for whose account the securities are sold 
is an underwriter with respect to the securities or that the 
transaction is a part of a distribution of securities of the 
issuer''); Rule 502(d) under the Securities Act (stating, with 
respect to limits on resales under Regulation D, that ``[t]he issuer 
shall exercise reasonable care to assure that the purchasers of the 
securities are not underwriters within the meaning of section 
2(a)(11) of the [Securities] Act, which reasonable care may be 
demonstrated by the following: (1) Reasonable inquiry to determine 
if the purchaser is acquiring the securities for himself or for 
other persons''). Registered investment companies also are subject 
to a similar requirement to disclose certain known beneficial 
owners. See Item 18 of Form N-1A (``State the name, address, and 
percentage of ownership of each person who owns of record or is 
known by the Fund to own beneficially 5% or more of any Class of the 
Fund's outstanding equity securities.''); and Item 19 of Form N-2 
(``State the name, address, and percentage of ownership of each 
person who owns of record or is known by the Registrant to own of 
record or beneficially five percent or more of any class of the 
Registrant's outstanding equity securities.'').
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E. Excluding Other Funds That Would Be Considered Affiliates of the 
Audit Client

    The current definition of ``audit client'' in Rule 2-01 of 
Regulation S-X includes all ``affiliates of the audit client,'' which 
broadly encompasses, among others, each entity in an ICC of which the 
audit client is a part. In the fund context, this expansive definition 
of ``audit client'' could result in non-compliance with the Loan 
Provision as to a broad range of entities, even where an auditor does 
not audit that entity.\65\ Yet, in the investment management context, 
investors in a fund typically do not possess the ability to influence 
the policies or management of another fund in the same fund complex. 
Although an investor in one fund in a series company can vote on 
matters put to shareholders of the company as a whole, rather than only 
to shareholders of one particular series, even an investor with a 
substantial investment in one series would be unlikely to have a 
controlling percentage of voting power of the company as a whole.
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    \65\ For example, under the current Loan Provision, an audit 
firm (``Audit Firm B'') could be deemed not to be independent as to 
an audit client under the following facts: Audit Firm A audits an 
investment company (``Fund A'') for purposes of the Custody Rule. A 
global bank (``Bank'') has a greater than 10 percent interest in 
Fund A. Bank is a lender to a separate Audit Firm B, but has no 
lending relationship with Audit Firm A. Audit Firm B audits another 
investment company (``Fund B'') that is part of the same ICC as Fund 
A because it is advised by the same registered investment adviser as 
Fund A. Under these facts, Audit Firm B would not be independent 
under the existing Loan Provision because the entire ICC would be 
tainted as a result of Bank's investment relationship with Fund A.
---------------------------------------------------------------------------

    Moreover, for the purposes of the Loan Provision, the inclusion of 
certain entities in the ICC as a result of the definition of ``audit 
client'' is in tension with the Commission's original goal to 
facilitate compliance with the Loan Provision without decreasing its 
effectiveness.\66\ Indeed, auditors often have little transparency into 
the investors of other funds in an ICC (unless they also audit those 
funds), and

[[Page 20763]]

therefore, are likely to have little ability to collect such beneficial 
ownership information.
---------------------------------------------------------------------------

    \66\ See 2000 Adopting Release, supra footnote 9, at 76035 (The 
Commission, in adopting an ownership threshold of 10 percent, rather 
than the five percent proposed, stated that ``[w]e have made this 
change because we believe that doing so will not make the rule 
significantly less effective, and may significantly increase the 
ease with which one can obtain the information necessary to assure 
compliance with this rule.'').
---------------------------------------------------------------------------

    As a result, we propose, for purposes of the Loan Provision, to 
exclude from the definition of audit client, for a fund under audit, 
any other fund that otherwise would be considered an affiliate of the 
audit client.\67\ Thus, for example, if an auditor were auditing Fund 
ABC, a series in Trust XYZ, the audit client for purposes of the Loan 
Provision would exclude all other series in Trust XYZ and any other 
fund that otherwise would be considered an affiliate of the audit 
client. The proposed amendment would, without implicating an auditor's 
objectivity and impartiality, address the compliance challenges 
associated with the application of the Loan Provision where the audit 
client is part of an ICC, such as when an accountant is an auditor of 
only one fund within an ICC, and the auditor must be independent of 
every other fund (and other entity) within the ICC, regardless of 
whether the auditor audits that fund.
---------------------------------------------------------------------------

    \67\ See proposed Rule 2-01(c)(1)(ii)(A)(2) of Regulation S-X: 
``For purposes of paragraph (c)(1)(ii)(A) of this section, the term 
audit client for a fund under audit excludes any other fund that 
otherwise would be considered an affiliate of the audit client. The 
term fund means an investment company or an entity that would be an 
investment company but for the exclusions provided by section 3(c) 
of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)).''
---------------------------------------------------------------------------

III. Request for Comment

    We request and encourage any interested person to submit comments 
on any aspect of our proposed amendments, other matters that might have 
an effect on the proposed amendments, and any suggestions for 
additional changes to other parts of Rule 2-01 of Regulation S-X. We 
note that comments are of greatest assistance where accompanied by 
supporting data and analysis of the issues addressed in those comments.
    We also specifically seek comment on the following changes to the 
Loan Provision:

1. Focus the Analysis Solely on Beneficial Ownership

    [cir] Should the Loan Provision be analyzed by reference to 
beneficial owners rather than record owners? Why or why not?
    [cir] Would eliminating the requirement to analyze record owners 
under the Loan Provision ease compliance challenges described above 
under Section 1.B.? Is there any further guidance the Commission should 
provide, or should the Commission consider alternatives?
    [cir] Would eliminating the requirement to analyze record owners 
under the Loan Provision raise other concerns about the independence of 
auditors? If so, what concerns would it raise and why?
    [cir] If the Commission merely amended the Loan Provision to 
provide for evaluation of the beneficial owner, rather than record 
owner, would other proposed amendments be necessary or appropriate? Why 
or why not?

2. ``Significant Influence'' Test

    [cir] Should we amend the Loan Provision to replace the 10 percent 
bright-line test with a ``significant influence'' test? Why or why not?
    [cir] Would the proposed reference to ASC's 323's provisions for 
``significant influence'' effectively identify those lending 
relationships that may compromise auditor independence?
    [cir] Would amending the Loan Provision to replace the 10 percent 
bright-line test with a ``significant influence'' test, along with the 
other proposed amendments, address the compliance challenges that we 
identify above?
    [cir] Application of ``significant influence'' for financial 
reporting purposes and evaluation of auditor independence may not 
necessarily be congruent. Accordingly, does ASC 323--Investments--
Equity Method and Joint Ventures, provide an appropriate framework for 
analyzing ``significant influence'' in the context of the Loan 
Provision? Why or why not?
    [cir] Are there challenges associated with implementing the 
``significant influence'' test that we should consider? Will accounting 
firms' and audit clients' relative experience with application of the 
``significant influence'' test, given its use in other contexts, 
mitigate any such challenges? To what extent do audit clients lack 
experience with application of the significant influence test, and what 
costs would such audit clients bear in learning to apply the test? Will 
funds, which may have relatively less experience than operating 
companies with the significant influence test, face any particular 
challenges in applying the test?
    [cir] Is the proposed ``significant influence'' test sufficiently 
clear? Are there specific circumstances for which we should provide 
additional guidance? For example, we discuss above the application of 
the significant influence test in the fund context. Is the guidance 
sufficiently clear? Would the application of the significant influence 
test as applied to funds be effective in addressing the compliance 
challenges generated by the current Loan Provision while also 
identifying debtor-creditor relationships that may bear on an auditor's 
independence with respect to a fund client? Why or why not? Is there 
further guidance that we should provide or other approaches that we 
should consider?
    [cir] Should the ``significant influence'' test (or specific 
elements) be codified in our rules? Why or why not?
    [cir] Authorized participants (``APs'') for ETFs deposit or receive 
basket assets in exchange for creation units of the fund. We believe 
that the deposit or receipt of basket assets by an AP that is also a 
lender to the auditor alone would not constitute significant influence 
over an ETF audit client. Should we provide additional guidance about 
the proposed ``significant influence'' test with respect to APs? 
Similarly, should we provide additional guidance about the proposed 
``significant influence'' test with respect to a market maker that is 
also a lender to the auditor and that engages an AP on an agency basis 
to create or redeem creation units of the ETF on its behalf?
    [cir] ASC 323 includes a rebuttable presumption of 20 percent. For 
purposes of the Loan Provision and the proposed significant influence 
test, should the rebuttable presumption be lower or higher than 20 
percent? Would a lower threshold (e.g., 10 percent) be more likely to 
capture relevant independence-impairing relationships, or to result in 
additional false positives that the proposed rule seeks to avoid? Would 
setting our threshold differently than ASC 323 diminish the benefits 
that we seek to achieve by using an existing standard--e.g., by 
requiring the reperformance of certain analyses at a greater degree of 
sensitivity? How much more complex would it be to apply a threshold 
other than 20 percent? Are there further relevant facts about a lower 
or higher threshold that we should consider?
    [cir] Would the proposed amendment raise any new concerns regarding 
auditor independence (e.g., are there circumstances related to lending 
relationships in which an auditor's independence should be considered 
impaired that would not be identified under the proposed ``significant 
influence'' test)? Conversely, would the proposed ``significant 
influence'' test result in an auditor's independence being considered 
impaired in circumstances under which the auditor should otherwise be 
considered independent?
    [cir] Should we consider alternatives to this test? If so, what 
tests should we consider, and what would be the anticipated costs and 
benefits? For example, should the modifier

[[Page 20764]]

``significant'' be removed, such that the test hinges on whether a 
lender shareholder has influence over an audit client? Why or why not? 
What is the difference between ``influence'' and ``significant 
influence'' in the auditor independent context and how does that 
difference inform the test?
    [cir] Should the nature of the services provided by the investment 
adviser be part of the significant influence test as proposed? Why or 
why not?

3. ``Known Through Reasonable Inquiry''

    [cir] Should the Loan Provision include a ``known through 
reasonable inquiry'' standard? Why or why not? What alternatives should 
we consider?
    [cir] Would the proposed ``known through reasonable inquiry'' 
standard with respect to identifying beneficial owners help to address 
compliance challenges associated with the Loan Provision?
    [cir] Are there specific circumstances for which we should provide 
additional guidance about the proposed ``known through reasonable 
inquiry'' standard?
    [cir] Does the ``known through reasonable inquiry'' standard raise 
any new concerns regarding auditor independence (e.g., are there 
circumstances related to lending relationships in which an auditor's 
independence should be considered impaired that would not be identified 
under the proposed amendment and the use of ``known through reasonable 
inquiry'' standard)?
    [cir] Alternatively, should we amend the Loan Provision to apply 
the significant influence test to ``known beneficial owners'' of an 
audit client's equity securities, without also including a reasonable 
inquiry standard, consistent with the way beneficial owners are treated 
elsewhere in Regulation S-X (that is, when assessing compliance with 
the Loan Provision, the determination would encompass assessing whether 
the known beneficial owners have significant influence over the audit 
client)? \68\
---------------------------------------------------------------------------

    \68\ Under Rule 1-02(r) of Regulation S-X, ``principal holder of 
equity securities,'' when used in respect of a registrant or other 
person named in a particular statement or report, is defined to 
mean: ``a holder of record or a known beneficial owner of more than 
10 percent of any class of equity securities of the registrant or 
other person, respectively, as of the date of the related balance 
sheet filed.'' (emphasis added). This approach also would be 
consistent with the disclosure requirements for registered funds, 
which require a fund to disclose information about known beneficial 
owners of five percent or more of the fund's securities. See Item 18 
of Form N-1A (``State the name, address, and percentage of ownership 
of each person who owns of record or is known by the Fund to own 
beneficially 5% or more of any Class of the Fund's outstanding 
equity securities.''); and Item 19 of Form N-2 (``State the name, 
address, and percentage of ownership of each person who owns of 
record or is known by the Registrant to own of record or 
beneficially five percent or more of any class of the Registrant's 
outstanding equity securities.'').
---------------------------------------------------------------------------

4. Proposed Amendment To Exclude From ``Audit Client'' Other Funds That 
Would Be Considered an ``Affiliate of the Audit Client''

    [cir] Should affiliates of an audit client be excluded from the 
definition of ``audit client'' as it relates to the Loan Provision? Why 
or why not?
    [cir] Would the proposed amendment to exclude from the term ``audit 
client'' for a fund under audit any other fund that otherwise would be 
considered an ``affiliate of the audit client'' address compliance 
challenges associated with the Loan Provision while still effectively 
identifying lending relationships that may impair auditor independence?
    [cir] Would the proposed amendment appropriately exclude funds of 
an ``investment company complex'' (other than the fund under audit) 
that are currently within the Loan Provision's ambit?
    [cir] Alternatively, are there other changes we should consider to 
the Loan Provision to appropriately exclude certain affiliated funds?
    In addition to any comments regarding the proposed amendments, we 
also seek comment on the following potential changes to the Loan 
Provision and to other provisions in Rule 2-01 that we considered but 
determined not to propose at this time.
A. Materiality
    The proposed amendments to the Loan Provision do not consider 
whether the lender's investment in the equity securities of the audit 
client is material to the lender or to the audit client.\69\ We believe 
that adding a materiality qualifier to the proposed significant 
influence test is unnecessary to achieve our goal of effectively and 
appropriately identifying lending relationships that could pose threats 
to auditor independence. Nevertheless, we request comment on whether 
there should be a materiality qualifier as part of the Loan Provision.
---------------------------------------------------------------------------

    \69\ Certain other provisions of the existing auditor 
independence rules utilize a materiality qualifier. For example, an 
accountant is deemed not to be independent if the accountant has 
``any direct financial interest or material indirect financial 
interest in the accountant's audit client.'' See Rule 2-01(c)(1) of 
Regulation S-X. (emphasis added)
---------------------------------------------------------------------------

    [cir] For example, should we include a provision for assessing 
materiality in the Loan Provision such that an auditor's independence 
would only be impaired as a result of certain relationships where the 
lender to the auditing firm has beneficial ownership in the audit 
client's equity securities and that investment is material to the 
lender or to the audit client (and the lender has the ability to 
exercise significant influence over the audit client)? Would that 
approach more effectively identify lending relationships that are 
likely to threaten the auditor's objectivity and impartiality? Would 
focusing on the perspective of the lender, the audit client, or both be 
the most effective barometer of independence?
    [cir] If we were to add a materiality qualifier to the Loan 
Provision as described above, which qualitative and quantitative 
factors should be considered in making the materiality assessment? 
Would such a materiality assessment add unnecessary complexity to the 
significant influence analysis? Would a materiality qualifier tend to 
exclude most lending relationships from the Loan Provision? What 
guidance, if any, should the Commission provide?
B. Accounting Firms' ``Covered Persons'' and Immediate Family Members
    The Loan Provision is implicated with respect to loans both to and 
from an accounting firm, and also any ``covered person'' in the firm or 
any of his or her immediate family members.\70\ Some of the 
consultations the Commission staff have had with audit firms, funds, 
and operating companies involved lending relationships to or from 
covered persons or their immediate family members.
---------------------------------------------------------------------------

    \70\ See Rule 2-01(c)(1)(ii)(A) and (f)(11) of Regulation S-X.
---------------------------------------------------------------------------

    [cir] Should we amend the definition of ``covered person'' for 
purposes of the Loan Provision or elsewhere in the auditor independence 
rules, and if so, how should the definition of ``covered person'' be 
amended?
    [cir] In particular, taking into account the proposed ``significant 
influence'' test, should we, for example, remove or revise the part of 
the current definition that includes any partner, principal, or 
shareholder from an ``office'' of the accounting firm in which the lead 
audit engagement partner primarily practices in connection with the 
audit? Should all of these persons practicing out of an office from 
which an audit is conducted be included? Should immediate family 
members be removed from the definition? Why or why not?
    [cir] In addition, the Loan Provision provides that it does not 
apply to certain loans made by a financial institution under its normal 
lending procedures, terms, and requirements, such as automobile loans 
and leases

[[Page 20765]]

collateralized by the automobile. Should we consider expanding or 
otherwise modifying the specific types of loans that will not implicate 
the Loan Provision, given that the Loan Provision applies to covered 
persons of the accounting firm and their immediate family members? For 
example, should the Loan Provision address student loans or partner 
capital account loans? If so, how should it address them? For example, 
should it exclude them altogether or exclude them under certain 
conditions? If so, under what conditions?
C. Evaluation of Compliance
    Rule 2-01(c)(1) of Regulation S-X provides that an accountant is 
not independent if the accountant has an independence-impairing 
relationship specified in the rule at any point during the audit and 
professional engagement period. Some existing disclosure requirements 
require information about beneficial owners as of a specified date.\71\
---------------------------------------------------------------------------

    \71\ See e.g., Item 18 of Form N-1A and Item 19 of Form N-2.
---------------------------------------------------------------------------

    [cir] Should the rule provide that auditor independence may be 
assessed in reliance on such disclosures? Should we make any changes 
related to the frequency with which, the date as of which, or 
circumstances under which, an auditor must assess compliance with the 
Loan Provision or other provisions of Rule 2-01 of Regulation S-X? More 
specifically, should we permit the Loan Provision or other financial 
relationships to be assessed at specific dates during the audit and 
professional engagement period, or the beginnings or ends of specific 
periods, or under specified circumstances? If so, what would be 
appropriate dates, periods, or circumstances?
    We believe that if the auditor determines that significant 
influence over the fund's management processes could not exist,\72\ the 
auditor could monitor its independence on an ongoing basis by 
reevaluating its determination in response to a material change in the 
fund's governance structure and governing documents, publicly available 
information about beneficial owners, or other information which may 
implicate the ability of a beneficial owner to exert significant 
influence of which the audit client or auditor becomes aware.
---------------------------------------------------------------------------

    \72\ For funds, the auditor's initial determination would be 
based on an evaluation of a fund's governance structure and 
governing documents, the manner in which its shares are held or 
distributed, and any contractual arrangements, among any other 
relevant factors.
---------------------------------------------------------------------------

    [cir] Would this approach be sufficient for evaluating compliance 
with the Loan Provision? Why or why not?
D. Secondary Market Purchases of Debt
    The existing Loan Provision encompasses lending arrangements that 
may change depending upon secondary market purchases of syndicated or 
other debt. For example, audit firms may issue private placement notes 
for financing purposes, which could then be sold on the secondary 
market to new purchasers thereby creating new lending relationships 
between the audit firm and these new secondary market purchasers.
    [cir] Should such secondary market relationships be taken into 
account or excluded from the Loan Provision? Do secondary market 
relationships raise concerns about auditor independence?
E. Other Changes to the Commission's Auditor Independence Rules
    [cir] Should we make other changes to our auditor independence 
rules? If so, which rules and why?
    [cir] Would our proposed amendments have any unintended impact on 
other professional standards that may exist, such as the requirements 
of the PCAOB, professional societies, or state boards of accountancy?

IV. Paperwork Reduction Act

    The amendments we are proposing do not impose any new ``collections 
of information'' within the meaning of the Paperwork Reduction Act of 
1995 (``PRA''),\73\ nor do they create any new filing, reporting, 
recordkeeping, or disclosure requirements. Accordingly, we are not 
submitting the proposed amendments to the Office of Management and 
Budget for review in accordance with the PRA.\74\ We request comment on 
whether our conclusion that there are no collections of information is 
correct.
---------------------------------------------------------------------------

    \73\ 44 U.S.C. 3501 et. seq.
    \74\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------

V. Economic Analysis

    The Commission is proposing to amend the Loan Provision in Rule 2-
01 of Regulation S-X by: (1) Focusing the analysis solely on beneficial 
ownership; (2) replacing the existing 10 percent bright-line equity 
shareholder ownership test with a ``significant influence'' test; (3) 
adding a ``known through reasonable inquiry'' standard with respect to 
identifying beneficial owners of the audit client's equity securities; 
and (4) amending the definition of ``audit client'' for a fund under 
audit to exclude from the provision funds that otherwise would be 
considered affiliates of the audit client.
    Under existing rules, the bright-line test does not recognize an 
accountant as independent if the accounting 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. In terms of the scope of the ``audit 
client'' definition, the existing rule is generally broad, including as 
it relates to an audit client in an ICC.\75\ As discussed above, 
Commission staff has engaged in extensive consultations with audit 
firms, funds, and operating companies regarding the application of the 
Loan Provision. These consultations revealed that a number of entities 
face significant practical challenges to compliance with the Loan 
Provision. These discussions also revealed that in certain scenarios, 
in which the Loan Provision was implicated, the auditor's objectivity 
and impartiality in performing the required audit and interim reviews 
were not impaired.
---------------------------------------------------------------------------

    \75\ See supra footnote 16 and accompanying text.
---------------------------------------------------------------------------

    We are mindful of the costs imposed by and the benefits obtained 
from our rules and amendments.\76\ The following economic analysis 
seeks to identify and consider the likely benefits and costs that would 
result from the proposed amendments, including their effects on 
efficiency, competition, and capital formation. The discussion below 
elaborates on the likely economic effects of the proposed rules.
---------------------------------------------------------------------------

    \76\ Section 2(b) of the Securities Act [15 U.S.C. 77b(b)], 
Section 3(f) of the Exchange Act [17 U.S.C. 78c(f)], Section 2(c) of 
the Investment Company Act [15 U.S.C. 80a-2(c)], and Section 202(c) 
of the Investment Advisers Act [15 U.S.C. 80b-2(c)] require the 
Commission, when engaging in rulemaking where it is required to 
consider or determine whether an action is necessary or appropriate 
in the public interest, to consider, in addition to the protection 
of investors, whether the action will promote efficiency, 
competition and capital formation. Additionally, Section 23(a)(2) of 
the Exchange Act [15 U.S.C. 78w(a)(2)] requires us, when adopting 
rules under the Exchange Act, to consider, among other things, the 
impact that any new rule would have on competition and not to adopt 
any rule that would impose a burden on competition that is not 
necessary or appropriate in furtherance of the Exchange Act.
---------------------------------------------------------------------------

A. General Economic Considerations

    Given that the actions of fund and operating company management are 
not usually observable, the information contained in mandated financial 
reports is important to investors, because it serves as a summary 
measure of outcomes of managerial actions and

[[Page 20766]]

decisions.\77\ However, financial reports are prepared by agents, and 
given the possibility that agents may have incentives to take actions 
that are not in the best interest of shareholders, agents may also have 
incentives to misreport such decisions and their outcomes. In order for 
the reported information to be useful to investors, it needs to be 
relevant and reliable. The independent audit of such information by 
impartial skilled professionals (i.e., auditors) is intended to create 
reliability in financial reports.\78\ Any potential conflicts of 
interest between companies or funds and their auditors may impair the 
objectivity and impartiality of the auditors in certifying the reported 
performance, thus lowering the credibility and usefulness of these 
disclosures to investors. Academic literature discusses and documents 
the importance of the role of auditors as an external governance 
mechanism for the firm.\79\ These studies generally find that better 
audit quality improves financial reporting by increasing the 
credibility of the financial reports.
---------------------------------------------------------------------------

    \77\ We use the terms agent and manager interchangeably.
    \78\ See M. Defond & J. Zhang, A Review of Archival Auditing 
Research, 58 J. Acct. & Econ. 275-326 (2014).
    \79\ See e.g., N. Tepalagul & L. Lin, Auditor Independence and 
Audit Quality: A Literature Review, 30 J. Acct. Audit. & Fin. 101-
121 (2015); M. Defond & J. Zhang, A Review of Archival Auditing 
Research, 58 J. Acct. & Econ. 275-326 (2014); Y. Chen, S. Sadique, 
B. Srinidhi, & M. Veeraraghavan, Does High[hyphen]Quality Auditing 
Mitigate or Encourage Private Information Collection?; and R. Ball, 
S. Jayaraman & L. Shivakumar, Audited Financial Reporting and 
Voluntary Disclosure as Complements: A Test of the Confirmation 
Hypothesis, J. Acct. & Econ. 53(1): 136-166 (2012).
---------------------------------------------------------------------------

    An accounting firm is not independent under the Loan Provision's 
existing bright-line shareholder ownership test if the firm has a 
lending relationship with an entity having record or beneficial 
ownership of more than 10 percent of the equity securities of either 
(a) the firm's audit client; or (b) any ``affiliate of the audit 
client,'' including, but not limited to, any entity that is a 
controlling parent company of the audit client, a controlled subsidiary 
of the audit client, or an entity under common control with the audit 
client. The magnitude of a party's investment in a company or fund is 
likely to be positively related with any incentive of that party to use 
leverage over the auditor with whom the party has a lending 
relationship, to obtain personal gain.
    The 10 percent bright-line test in the Loan Provision does not, 
however, distinguish between holders of record and beneficial owners 
even though beneficial owners are more likely to pose a risk to auditor 
independence than record owners given that the financial gain of 
beneficial owners is tied to the performance of their investment, and 
as such, beneficial owners may have strong incentives to influence the 
auditor's report. Record owners, on the other hand, may not benefit 
from the performance of securities of which they are record owners, and 
as such, they may have low incentives to influence the report of the 
auditor. Both the magnitude as well as the type of ownership are likely 
to be relevant factors in determining whether incentives exist for 
actions that could impair auditor independence. Beneficial ownership of 
more than 10 percent of a company's or fund's equity securities by a 
lender to the company's or fund's auditor is likely to pose a more 
significant risk to auditor independence than record ownership of more 
than 10 percent of the company's or fund's securities by the same 
lender.
    The current Loan Provision may in some cases over-identify and in 
other cases under-identify threats to auditor independence. The 
likelihood that the provision over-identifies threats to auditor 
independence will tend to be higher when the lender is not a beneficial 
owner of an audit client and does not have incentives to influence the 
auditor's report, but has record holdings that exceed the 10 percent 
ownership threshold. On the other hand, under-identification of the 
threat to auditor independence may occur when the lender is a 
beneficial owner--implying the existence of potential incentives to 
influence the auditor's report--and the investment is close to, but 
does not exceed, the 10 percent ownership threshold.\80\
---------------------------------------------------------------------------

    \80\ We are unable to estimate the extent to which the 10 
percent ownership threshold may over- or under-identify threats to 
independence because public data do not exist.
---------------------------------------------------------------------------

    We are not aware of academic studies that specifically examine the 
economic effects of the Loan Provision. The remainder of the economic 
analysis presents the baseline, anticipated benefits and costs from the 
proposed amendments, potential effects on efficiency, competition and 
capital formation, and alternatives to the proposed amendments.

B. Baseline

    The proposed amendments would change the Loan Provision compliance 
requirements for the universe of affected registrants. We believe the 
main affected parties would be audit clients, audit firms, and 
institutions engaging in financing transactions with audit firms and 
their partners and employees. Other parties that may be affected are 
covered persons and their immediate family members. Indirectly, the 
proposed amendment would affect audit clients' investors.
    We are not able to precisely estimate the number of current auditor 
engagements that would be immediately affected by the proposed 
amendments. Specifically, precise data on how audit firms finance their 
operations and how covered persons arrange their personal financing are 
not available to us and as such we are not able to identify pairs of 
auditors-institutions (lenders). Moreover, sufficiently detailed and 
complete data on fund ownership are not available to us, thus limiting 
our ability to estimate the prevalence/frequency of instances of 
significant fund ownership by institutions that are also lenders to 
fund auditors.
    Although data on fund ownership are not readily available, academic 
studies of operating companies have shown that for a selected sample of 
firms, the average blockholder (defined as beneficial owners of five 
percent or more of a company's stock) holds about 8.5percent of a 
company's voting stock.\81\ They also show that numerous banks and 
insurance companies are included in the list of blockholders. These 
findings suggest that the prevalence of instances of significant 
ownership by institutions that are also lenders to auditors could be 
high.
---------------------------------------------------------------------------

    \81\ See Y. Dou, O. Hope, W. Thomas & Y. Zou, Blockholder 
Heterogeneity and Financial Reporting Quality, working paper (2013).
---------------------------------------------------------------------------

    As mentioned above, the proposed amendments would impact audits for 
the universe of affected entities. The baseline analysis below focuses 
mainly on the investment management industry because that is where the 
most widespread issues with Loan Provision compliance have been 
identified to date; however, the proposed amendments would affect 
entities outside of this space.\82\
---------------------------------------------------------------------------

    \82\ According to the SEC's EDGAR database, during the period 
from January 1, 2017 to December 31, 2017, there were a total of 
7,585 entities that filed at least one Form 10-K, 20-F, or 40-F, or 
an amendment to one of these forms. This total does not include 
investment companies and business development companies.
---------------------------------------------------------------------------

    In Table 1, as of December 2017, there were around 12,000 fund 
series, with total net assets of $21 trillion, that file Form N-SAR 
with identified accounting firms.\83\ In addition, there were 23

[[Page 20767]]

accounting firms performing audits for these investment companies, 
though these auditing services were concentrated among the four largest 
accounting firms. Indeed, about 88 percent of the funds were audited by 
the four largest accounting firms, corresponding to 98percent of the 
aggregate fund asset value.\84\
---------------------------------------------------------------------------

    \83\ There are certain limitations regarding information 
reported on Form N-SAR and, as a result, this does not include 
information for all registered investment companies. If we were to 
incorporate private funds, the number would be significantly larger; 
the assets under management of private funds are also large.
    \84\ According to the 2017 PCAOB Annual Report, there were 535 
audit firms registered with the PCAOB that have issued audit reports 
for issuers (of which 338 are domestic audit firms, with the 
remaining 197 audit firms located outside the United States). The 
concentration in the provision of audit services for investment 
companies is indicative of the overall market as well. According to 
a report by Audit Analytics, the four largest accounting firms audit 
76% of accelerated and large accelerated filers, which account for 
97.9% of the market capitalization for public companies. See Who 
Audits Larger Public Companies-2016 Edition, available at http://www.auditanalytics.com/blog/who-audits-larger-public-companies-2016-edition.

   Table 1--Investment Company Auditors and Their Audited Fund Series
        [N-SARs filed for period dates: June 2017-December 2017]
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Total number of Fund Series.................................      11,666
Average number of Fund Series Per Auditor...................         507
Average Net Assets (in millions) Per Auditor................     907,813
Four Largest Audit Firms....................................  ..........
Total number of Fund Series.................................      10,177
Average number of Fund Series Per Auditor...................       2,544
Average Net Assets (in millions) Per Auditor................   5,137,472
% of Four Audit Firms by Series.............................          87
% of Four Audit Firms by Net Assets.........................          98
------------------------------------------------------------------------

    One key feature of the current rule is that the scope of the 
auditor independence rules, including the Loan Provision, extends 
beyond the audit client to encompass affiliates of the audit client. 
According to Morningstar Direct, as of December 31, 2017, 586 out of 
977 fund families \85\ (excluding closed-end funds) have more than one 
fund, 180 have at least 10 funds, 59 have more than 50 funds, and 38 
have more than 100 funds. According to the Investment Company 
Institute, also as of December 31, 2017, there were more than 11,188 
open-end funds and around 5,500 closed-end funds, with many funds 
belonging to the same fund family. Given that many fund complexes have 
several funds with some complexes having several hundreds of funds, if 
any auditor is deemed not in compliance with the Loan Provision with 
respect to one fund, under the current rule it cannot audit any of the 
hundreds of other funds within the same ICC.
---------------------------------------------------------------------------

    \85\ These fund statistics are based on information available 
from Morningstar Direct, and may not represent the universe of fund 
companies.
---------------------------------------------------------------------------

    In response to compliance challenges and as discussed above, 
Commission staff issued the Fidelity No-Action Letter to provide relief 
from the uncertainty surrounding compliance with the Loan Provision. 
The Fidelity No-Action Letter, however, did not resolve all compliance 
uncertainty, was limited in scope and provided staff-level relief to 
the requestor based on the specific facts and circumstances in the 
request, and did not amend the underlying rule. Staff continues to 
receive inquiries from registrants and accounting firms regarding the 
application of the Loan Provision, clarification of the application of 
the Fidelity No-Action Letter, and requests for consultation regarding 
issues not covered in the Fidelity No-Action Letter. As a result of the 
remaining compliance uncertainty, auditors and audit committees may 
spend a significant amount of time and effort to comply with the Loan 
Provision.

C. Anticipated Benefits and Costs, and Unintended Consequences

1. Anticipated Benefits
    Overall, we anticipate monitoring for non-compliance throughout the 
reporting period would be less burdensome for registrants under the 
proposed amendments. For example, based on the 10 percent bright-line 
test, an auditor may be in compliance at the beginning of the reporting 
period. However, the percentage of ownership may change during the 
reporting period, which may result in an auditor becoming non-
compliant, even though there may be no threat to the auditor's 
objectivity or impartiality. Further, a higher threshold (20 percent) 
for presumed significant influence, as well as a qualitative framework 
for assessing what constitutes significant influence, could better 
identify a lack of independence.
    There are also potential benefits associated with excluding record 
holders from the Loan Provision. Currently, the Loan Provision uses the 
magnitude of ownership by an auditor's lender as an indication of the 
likelihood of a threat to auditor independence regardless of the nature 
of ownership. From an economic standpoint, the nature of ownership also 
could determine whether incentives as well as the ability of the lender 
to use any leverage (due to the lending relationship) over the auditor 
exist that could affect the objectivity of the auditor. For example, a 
lender that is a record owner of the audit client's equity securities 
may be less likely to attempt to influence the auditor's report than a 
lender that is a beneficial owner of the audit client's equity 
securities. By taking into account the nature as well as the magnitude 
of ownership, the proposed amendments would focus on additional 
qualitative information to assess the relationship between the lender 
and the investee (e.g., a company or fund). Thus, we believe that, 
where there may be weak incentives by the lender to influence the 
audit, as when the lender is only a holder of record, the proposed 
amendments would exclude relationships that are not likely to be a risk 
to auditor independence. The proposed amendments would thus provide 
benefits to the extent that they would alleviate compliance and related 
burdens that auditors and funds would otherwise undertake to analyze 
debtor-creditor relationships that are not likely to threaten an 
auditor's objectivity and impartiality. Affected registrants also would 
be less likely to disqualify auditors in situations that do not pose a 
risk to auditor independence, thereby reducing auditor search costs for 
these entities.
    The potential expansion of the pool of eligible auditors also could 
result in better matching between the auditor and the client. For 
example, auditors tend to exhibit a degree of specialization in certain 
industries.\86\ If specialized auditors are considered not to be 
independent due to the Loan Provision, then an auditor without the 
relevant specialization may be selected by companies to perform the 
audit. Such an outcome could impact the quality of the audit, and as a 
consequence negatively impact the quality of financial reporting, and 
therefore the users of information contained in audited financial 
reports. In addition, this outcome also may lead to less specialized 
auditors expending more time to perform the audit service, thereby 
increasing audit fees for registrants. We anticipate that the proposed 
amendments likely would positively impact audit quality for scenarios 
such as the one described above. Relatedly, if the proposed amendments 
expand the pool of eligible auditors, we expect increased competition 
among auditors, which could reduce the cost of audit services

[[Page 20768]]

to affected companies and, if such cost savings are passed through to 
investors, could result in a lower cost to investors. However, as 
discussed in Section V.B above, the audit industry is highly 
concentrated, and as a consequence, such a benefit may not be 
significant.\87\
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    \86\ See e.g., N. Dopuch & D. Simunic, Symposium, Competition in 
Auditing: An Assessment, Fourth Symposium on Auditing Research, p 
401-450 (1982); and R.W. Knechel, V. Naiker & G. Pachecho, Does 
Audit Industry Specialization Matter? Evidence from Market Reaction 
to Auditor Switches, 26 Audit. J. Prac. & Theory 19-45 (2007).
    \87\ The proposed amendments could result in some crowding-out 
effect, as the four largest audit firms may be deemed to be 
independent with more clients under the proposed amendments, 
crowding out small audit firms. We discuss this effect in more 
detail in Section V.D below. However, we believe that better 
matching between auditor specialization and their clients and the 
reduced unnecessary auditor turnovers could potentially prevent 
audit quality decline and in the long run may improve audit quality.
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    Another potential benefit of the proposed amendments is that the 
replacement of the bright-line test with the significant influence test 
could potentially identify risks to auditor independence that might not 
have been identified under the existing 10 percent bright-line test. 
For example, a beneficial owner that holds slightly less than 10 
percent of an audit client's equity securities is likely to have 
similar incentives and ability to influence the auditor's report than a 
beneficial owner that holds the same audit client's equity securities 
at slightly above the 10 percent threshold. The existing Loan Provision 
itself would differentially classify these two hypothetical situations, 
despite their similarity. To the extent that the proposed amendments 
are able to improve identification of potential risks to auditor 
independence through the use of qualitative criteria, then investors 
are likely to benefit from the proposed amendments. In the example 
above, under the proposed amendments, an audit firm would evaluate both 
beneficial owners to determine if they have significant influence, thus 
providing a consistent analysis under the Loan Provision for these 
economically similar fact patterns.
    In addition, there may be instances in which non-compliance with 
the Loan Provision may occur during the reporting year, after an 
auditor is selected by the registrant or fund. Particularly for 
companies in the investment management industry, an auditor may be 
deemed to comply with the Loan Provision using the bright-line test 
when the auditor is hired by the fund but, due to external factors, 
such as redemption of investments by other owners of the fund during 
the period, the lender's ownership level may increase and exceed 10 
percent. Such outcomes would be less likely under the proposed 
amendments, which take into account multiple qualitative factors in 
determining whether the Loan Provision is implicated during the 
period.\88\ We anticipate that the proposed amendments would likely 
mitigate changes in auditors' independence status and mitigate any 
negative consequences that can arise from uncertainty about compliance 
and the associated costs to the funds or companies involved and their 
investors.
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    \88\ The concept of significant influence, as described in ASC 
Topic 323, Investments--Equity Method and Joint Ventures, 
incorporates a rebuttable presumption of significant influence once 
beneficial ownership exceeds 20% of an audit client's securities. We 
discuss the effects of this provision in Section II.C above.
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    The proposed amendment to add a ``known through reasonable 
inquiry'' standard could potentially improve the practical application 
of the significant influence test. As described above, some of the 
challenges to compliance with the existing Loan Provision involve the 
lack of access to information about the ownership percentage of a fund 
that was also an audit client. If an auditor does not know that one of 
its lenders is also an investor in an audit client, including because 
that lender invests in the audit client indirectly through one or more 
financial intermediaries, the auditor's objectivity and impartiality 
may be less likely to be impacted by its debtor-creditor relationship 
with the lender. The proposed ``known through reasonable inquiry'' 
standard is generally consistent with regulations implementing the 
Investment Company Act, the Securities Act and the Exchange Act,\89\ 
and therefore is a concept that already should be familiar to those 
charged with compliance with the provision. The proposed standard is 
expected to reduce the compliance costs for audit firms as they could 
significantly reduce their search costs for information and data to 
determine beneficial ownership. Given that this would not be a new 
standard in the Commission's regulatory regime, we do not expect a 
significant adjustment to apply the ``known through reasonable 
inquiry'' standard for auditors and their audit clients.
---------------------------------------------------------------------------

    \89\ See supra footnote 64.
---------------------------------------------------------------------------

    The proposal to amend the definition of ``audit client'' to exclude 
any fund not under audit but that otherwise would be considered an 
``affiliate of the audit client'' could potentially lead to a larger 
pool of eligible auditors, potentially reducing the costs of switching 
auditors, and potentially creating better matches between auditors and 
clients. In addition, the larger set of potentially eligible auditors 
could lead to an increase in competition among auditors for clients, 
and improved matching between auditor specialization and client needs. 
Though the concentrated nature of the audit industry may not give rise 
to a significant increase in competition, the improved matching between 
specialized auditors and their clients should have a positive effect on 
audit quality.
    The proposed amendments could also have a positive impact on the 
cost of audit firms' financing. The proposed amendments may result in 
an expanded set of choices among existing sources of financing. This 
could lead to more efficient financing activities for audit firms, thus 
potentially lowering the cost of capital for audit firms.\90\ If 
financing costs for audit firms decrease as a result of the proposed 
amendments, then such savings may be passed on to the audit client in 
the form of lower audit fees. Investors also may benefit from reduced 
audit fees if the savings are passed on to investors. The Commission 
understands, however, that audit firms likely already receive favorable 
financing terms. Therefore, this effect may not be significant in 
practice.
---------------------------------------------------------------------------

    \90\ Studies on capital markets across countries suggest that 
better access to financing leads to more investment efficiency. See 
e.g., T. Rice & P. Strahan, Does Credit Competition Affect Small-
Firm Finance, 65 J. Fin. 861-889 (2010); R. Mclean, T. Zhang & M. 
Zhao, Why does the Law Matter? Investor Protection and its Effects 
on Investment, Finance, and Growth, 67 J. Fin. 313-350 (2012); and 
J. Wurgler, Financial Markets and the Allocation of Capital, 58 J. 
Fin. 187-214 (2000).
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    The replacement of the bright-line 10 percent test with the 
significant influence test also potentially allows more financing 
channels for the covered persons in accounting firms and their 
immediate family members.\91\ For example, the covered persons may not 
be able to borrow money from certain lenders due to potential non-
compliance with the existing Loan Provision. A larger set of financing 
channels may potentially lead to lower cost of capital for covered 
persons, increasing their opportunities for investment.
---------------------------------------------------------------------------

    \91\ See supra footnote 11.
---------------------------------------------------------------------------

2. Anticipated Costs and Potential Unintended Consequences
    The proposed significant influence test may increase the demands on 
the time of auditors and audit clients to familiarize themselves with 
the test and gather and assess the relevant information to apply the 
test. However, given that the significant influence test has been part 
of the Commission's auditor independence rules since 2000 and has 
existed in U.S. GAAP since 1971, we do not expect a significant 
learning curve in applying the test. We also do not expect significant 
compliance costs for auditors to implement the significant influence 
test

[[Page 20769]]

in the context of the Loan Provision given that they already are 
required to apply the concept in other parts of the auditor 
independence rules. We recognize that funds do not generally apply a 
significant influence test for financial reporting purposes. As such, 
despite the fact that they are required to apply the significant 
influence test to comply with the existing Commission independence 
rules, their overall familiarity in other contexts may be less. As a 
result, the proposed significant influence test may increase the 
demands on the time of funds and their auditors to gather and assess 
the relevant information and attendant costs.
    The replacement of the bright-line threshold test with the 
significant influence test and the ``known through reasonable inquiry'' 
standard would introduce more judgment in the determination of 
compliance with the Loan Provision. As discussed earlier, the 
significant influence test contains multiple qualitative elements to be 
considered in determining whether an investor has significant influence 
over the operating and financial policies of the investee. These 
elements include, but are not limited to, representation on the board 
of directors; participation in policy-making processes; material intra-
entity transactions; interchange of managerial personnel; and 
technological dependency. To the extent an auditor and audit client 
need to adjust their compliance activities to now focus on these new 
elements, there may be additional transition costs. The judgment 
involved in application of the significant influence test also could 
lead to potential risks regarding auditor independence. In particular, 
because the significant influence test relies on qualitative factors 
that necessarily involve judgment, there is a risk that the significant 
influence test could result in mistakenly classifying a non-independent 
auditor as independent under the Loan Provision. However, auditor 
reputational concerns may impose some discipline on the application of 
the significant influence test in determining compliance with the Loan 
Provision, thus mitigating this risk.

D. Effects on Efficiency, Competition and Capital Formation

    The Commission believes that the proposed amendments are likely to 
improve the practicality of the Loan Provision, enhance efficiency of 
implementation, and reduce compliance burdens. They also may facilitate 
capital formation.
    The proposed amendments may expand a particular audit client's 
choices by expanding the number of auditors that meet the auditor 
independence rules under the Loan Provision. As discussed earlier, the 
current bright-line test may be over-inclusive under certain 
circumstances. If more audit firms are eligible to undertake audit 
engagements without implicating the Loan Provision, then audit clients 
will have more options and as a result audit costs may decrease, 
although given the highly concentrated nature of the audit industry, 
this effect may not be significant. Moreover, the potential expansion 
of choice among eligible audit firms and the reduced threat of being 
required to switch auditors may lead to better matching between the 
audit client and the auditor. Improved matching between auditor 
specialties and audit clients could enable auditors to perform auditing 
services more efficiently, thus potentially reducing audit fees and 
increasing audit quality over the long term. Higher audit quality is 
linked to better financial reporting, which could result in a lower 
cost of capital. Reduced expenses and higher audit quality may decrease 
the overall cost of investing as well as the cost of capital, with 
potential positive effects on capital formation. However, due to the 
concentrated nature of the audit industry, we acknowledge that any such 
effects may not be significant.
    The replacement of the existing bright-line test with the 
significant influence test could more effectively capture those 
relationships that may pose a threat to an auditor's objectivity and 
impartiality. To the extent that the proposed amendments do so, the 
quality of financial reporting is likely to improve, and the amount of 
board attention to independence questions when impartiality is not at 
issue is likely to be reduced, thus allowing a fund board to focus on 
its role as an independent check on fund management. An operating 
company's board might focus on hiring the best management, choosing the 
most value-enhancing investment projects, and monitoring management to 
maximize shareholder value. This sharpened focus could potentially 
benefit shareholders. Furthermore, we expect that improved 
identification of threats to auditor independence would increase 
investor confidence about the quality and accuracy of the information 
reported. Reduced uncertainty about the quality and accuracy of 
financial reporting should attract capital, and thus facilitate capital 
formation.
    Under the proposed amendments, audit firms would potentially be 
able to draw upon a larger set of lenders. This potentially could lead 
to greater competition among the lending institutions, leading to lower 
borrowing costs for audit firms. Again, this could result in lower 
audit fees, lower fund fees, lower compliance expenses, and help 
facilitate capital formation, to the extent that lower borrowing costs 
for audit firms get passed on to their audit clients.
    The proposed amendments also may potentially lead to changes in the 
competitive structure of the audit industry. We expect more accounting 
firms to be eligible to provide auditing services and be in compliance 
with auditor independence under the proposed amendments. If the larger 
audit firms are the ones more likely to engage in significant financing 
transactions and are more likely to not be in compliance with the 
existing Loan Provision, then these firms are more likely to be 
positively affected by the proposed amendments. In particular, these 
firms may be able to compete for or retain a larger pool of audit 
clients. At the same time, the larger firms' potentially increased 
ability to compete for audit clients could potentially crowd out the 
auditing business of smaller audit firms. However, we estimate that 
four audit firms already perform 88 percent of audits in the registered 
investment company space.\92\ As a result, we do not expect any 
potential change in the competitive dynamics among auditors for 
registered investment companies to be significant.
---------------------------------------------------------------------------

    \92\ The market share of the four largest accounting firms in 
other industries is significantly high as well. According to the 
sample of 7,180 registrants covered by Audit Analytics in 2016, the 
four largest accounting firms' mean (median) market share across 
industries (based on two digit standard industry code) is 58% (57%). 
The upper quartile is as high as 78% with low quartile of the 
distribution being 45%.
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E. Alternatives

    The existing Loan Provision covers loans to and from the auditor by 
``record or beneficial owners of more than 10 percent of the audit 
client's equity securities.'' As discussed earlier, record owners are 
relatively less likely to have incentives to take actions that would 
threaten auditor independence than are beneficial owners. An 
alternative approach to the proposed amendments would be to maintain 
the 10 percent bright-line test, but to distinguish between types of 
ownership under the 10 percent bright-line test and tailor the rule 
accordingly. For example, record owners could be excluded from the 10 
percent bright-line test, to which beneficial owners would remain 
subject. The potential benefit of distinguishing

[[Page 20770]]

between types of ownership while retaining the 10 percent bright-line 
test is that applying a bright-line test would involve less judgment 
than the proposed significant influence test. Excluding record holders 
that may not have strong enough economic incentives or power to impair 
auditor independence could partially overcome the over-inclusiveness of 
the exiting rule. However, it still would not overcome the issues of 
over- or under-inconclusiveness with respect to beneficial owners.
    A second alternative would be to use the materiality of a stock 
holding to the lender in conjunction with the significant influence 
test as a proxy for incentives that could threaten auditor 
independence. Specifically, the significance of the holding to the 
lender could be assessed based on the magnitude of the stock holding to 
the lender (i.e., what percentage of the lender's assets are invested 
in the audit client's equity securities), after determining whether the 
lender has significant influence over the audit client. For example, 
two institutions that hold 15 percent of a fund may be committing 
materially different amounts of their capital to the specific 
investment. The incentives to influence the auditor's report are likely 
to be stronger for the lender that commits the relatively larger amount 
of capital to a specific investment. As such, the materiality of the 
investment to a lender with significant influence could be used as an 
indicator of incentives by the lender to attempt to influence the 
auditor's report. Materiality of a holding may better capture the 
incentives that could pose a threat to auditor independence. The 
potential cost to the auditors and audit clients could be that they 
need additional information and an additional layer of judgment in 
assessing their compliance with the Loan Provision. Also, given the 
size of most lenders, a materiality component might effectively exclude 
most, if not all, lending relationships that pose a threat to an 
auditor's objectivity and impartiality.
    A third potential approach would be to assess the materiality of 
the lending relationship between the auditor and the lending 
institution. The materiality of the lending relationship between the 
lender and the auditor, from both the lender's and the auditor's point 
of views, could act as an indicator of the leverage that the lender may 
have if it attempts to influence the auditor's report. However, again, 
given the size of most impacted audit firms and lenders, a materiality 
component might effectively exclude most, if not all, lending 
relationships that pose a threat to an auditor's objectivity and 
impartiality.

F. Request for Comment

    We request and encourage any interested person to submit comments 
regarding the proposed amendments and all aspects of our analysis of 
the potential effects of the amendments. Comments are particularly 
helpful to us if accompanied by quantified estimates or other detailed 
analysis and supporting data regarding the issues addressed in those 
comments. We also are interested in comments on the alternatives 
presented in this release as well as any additional alternatives to the 
proposed amendments that should be considered. To assist in our 
consideration of these costs and benefits, we specifically request 
comment on the following:
     The costs and benefits of the proposed amendment to 
eliminate the requirement that audit firms analyze record holders under 
the Loan Provision.
     The costs and benefits of the proposed significant 
influence test.
     The costs and benefits of the proposed addition of a 
``known through reasonable inquiry'' standard in applying the 
significant influence test.
     The costs and benefits of the proposed exclusion of the 
funds (other than the fund under audit) from being considered an 
affiliate of the audit client.
     The effect of the proposed amendments on the competitive 
structure of the audit industry.
     The effect of the proposed amendments on the quality of 
financial reporting.
     The effect of the proposed amendments on audit quality.
     The effect of the proposed amendments on capital 
formation.
     The effect of the proposed amendments on audit firms and 
their covered persons' financing.

VI. Initial Regulatory Flexibility Act Analysis

    The Regulatory Flexibility Act (``RFA'') \93\ requires the 
Commission, in promulgating rules under section 553 of the 
Administrative Procedure Act,\94\ to consider the impact of those rules 
on small entities. We have prepared this Initial Regulatory Flexibility 
Act Analysis (``IRFA'') in accordance with 5 U.S.C. 603. This IRFA 
relates to the proposed amendments to Rule 2-01 of Regulation S-X.
---------------------------------------------------------------------------

    \93\ 5 U.S.C. 601 et seq.
    \94\ 5 U.S.C. 553.
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Proposed Action

    As discussed above, the primary reason for, and objective of, the 
proposed amendments is to address certain significant compliance 
challenges for audit firms and their clients resulting from application 
of the Loan Provision that do not otherwise appear to affect the 
impartiality or objectivity of the auditor. Specifically, the proposed 
amendments would:
     Focus the analysis solely on beneficial ownership;
     replace the existing 10 percent bright-line shareholder 
ownership test with a ``significant influence'' test;
     add a ``known through reasonable inquiry'' standard with 
respect to identifying beneficial owners of the audit client's equity 
securities; and
     amend the definition of ``audit client'' for a fund under 
audit to exclude from the provision funds that otherwise would be 
considered affiliates of the audit client.
    The reasons for, and objectives of, the proposed rules are 
discussed in more detail in Sections I and II above.

B. Legal Basis

    We are proposing the amendments pursuant to Schedule A and Sections 
7, 8, 10, and 19 of the Securities Act, Sections 3, 10A, 12, 13, 14, 
17, and 23 of the Exchange Act, Sections 8, 30, 31, and 38 of the 
Investment Company Act, and Sections 203 and 211 of the Investment 
Advisers Act.

C. Small Entities Subject to the Proposed Rules

    The proposed amendments would affect small entities that file 
registration statements under the Securities Act, the Exchange Act, and 
the Investment Company Act and periodic reports, proxy and information 
statements, or other reports under the Exchange Act or the Investment 
Company Act, as well as smaller registered investment advisers and 
smaller accounting firms. The RFA defines ``small entity'' to mean 
``small business,'' ``small organization,'' or ``small governmental 
jurisdiction.'' \95\ The Commission's rules define ``small business'' 
and ``small organization'' for purposes of the Regulatory Flexibility 
Act for each of the types of entities regulated by the Commission. 
Securities Act Rule 157 \96\ and Exchange Act Rule 0-10(a) \97\ defines 
an issuer, other than

[[Page 20771]]

an investment company, to be a ``small business'' or ``small 
organization'' if it had total assets of $5 million or less on the last 
day of its most recent fiscal year. We estimate that there are 
approximately 1,163 issuers, other than registered investment 
companies, that may be subject to the proposed amendments.\98\ The 
proposed amendments would affect small entities that have a class of 
securities that are registered under Section 12 of the Exchange Act or 
that are required to file reports under Section 15(d) of the Exchange 
Act. In addition, the proposed amendments would affect small entities 
that file, or have filed, a registration statement that has not yet 
become effective under the Securities Act and that has not been 
withdrawn.
---------------------------------------------------------------------------

    \95\ 5 U.S.C. 601(6).
    \96\ 17 CFR 230.157.
    \97\ 17 CFR 240.0-10(a).
    \98\ This estimate is based on staff analysis of XBRL data 
submitted with EDGAR filings of Forms 10-K, 20-F and 40-F and 
amendments filed during the calendar year of January 1, 2017 to 
December 31, 2017.
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    An investment company is considered to be a ``small business'' for 
purposes of the RFA, if it, together with other investment companies in 
the same group of related investment companies, has net assets of $50 
million or less at the end of the most recent fiscal year.\99\ We 
believe that the proposed amendments would affect small entities that 
are investment companies. Commission staff estimates that, as of 
December 31, 2017, there were 54 open-end investment companies (within 
52 fund complexes) that would be considered small entities. This number 
includes open-end ETFs.\100\
---------------------------------------------------------------------------

    \99\ 17 CFR 270.0-10(a).
    \100\ This estimate is derived from an analysis of data obtained 
from Morningstar Direct as well as data reported on Form N-SAR filed 
with the Commission for the period ending June 30, 2017.
---------------------------------------------------------------------------

    For purposes of the RFA, an investment adviser is a small entity if 
it:
    (1) Has assets under management having a total value of less than 
$25 million;
    (2) did not have total assets of $5 million or more on the last day 
of the most recent fiscal year; and
    (3) does not control, is not controlled by, and is not under common 
control with another investment adviser that has assets under 
management of $25 million or more, or any person (other than a natural 
person) that had total assets of $5 million or more on the last day of 
its most recent fiscal year.\101\ We estimate that there are 
approximately 557 investment advisers that would be subject to the 
proposed amendments that may be considered small entities.\102\
---------------------------------------------------------------------------

    \101\ 17 CFR 275.0-7.
    \102\ This estimate is based on Commission-registered investment 
adviser responses to Form ADV, Part 1A, Items 5.F and 12.
---------------------------------------------------------------------------

    For purposes of the RFA, a broker-dealer is considered to be a 
``small business'' if its total capital (net worth plus subordinated 
liabilities) is less than $500,000 on the date in the prior fiscal year 
as of which its audited financial statements were prepared pursuant to 
Rule 17a-5(d) under the Exchange Act,\103\ or, if not required to file 
such statements, a broker-dealer with total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the last day of the 
preceding fiscal year (or in the time that it has been in business, if 
shorter); and that is not affiliated with any person (other than a 
natural person) that is not a small business or small 
organization.\104\ As of the year end of 2017, there are approximately 
1,042 small entity broker-dealers that may be subject to the proposed 
amendments.\105\
---------------------------------------------------------------------------

    \103\ 17 CFR 240.17a-5(d).
    \104\ 17 CFR 240.0-10(c).
    \105\ This estimate is based on the most recent information 
available, as provided in Form X-17A-5 Financial and Operational 
Combined Uniform Single Reports filed pursuant to Section 17 of the 
Exchange Act and Rule 17a-5 thereunder.
---------------------------------------------------------------------------

    Our rules do not define ``small business'' or ``small 
organization'' for purposes of accounting firms. The Small Business 
Administration (SBA) defines ``small business,'' for purposes of 
accounting firms, as those with under $20.5 million in annual 
revenues.\106\ We have limited data indicating revenues for accounting 
firms, and we cannot estimate the number of firms with less than $20.5 
million in annual revenue. We request comment on the number of 
accounting firms with revenue under $20.5 million.
---------------------------------------------------------------------------

    \106\ 13 CFR 121.201 and North American Industry Classification 
System (NAICS) code 541211. The SBA calculates ``annual receipts'' 
as all revenue. See 13 CFR 121.104.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping and Other Compliance Requirements

    The proposed amendments would not impose any reporting, 
recordkeeping, or disclosure requirements. The proposed amendments 
would impose new compliance requirements with respect to the Loan 
Provision.
    Although we are proposing to replace the 10 percent bright-line 
test with a ``significant influence'' test that requires the 
application of more judgment, we believe that the proposed amendments 
would not significantly increase costs for smaller entities, including 
smaller accounting firms. The concept of ``significant influence'' 
already exists in the auditor independence rules and in U.S. GAAP,\107\ 
and accounting firms, issuers and their audit committees are already 
required to apply the concept in these contexts and may have developed 
practices, processes or controls for complying with these 
provisions.\108\ We believe that these entities likely would be able to 
leverage any existing practices, processes or controls to comply with 
the proposed amendments.
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    \107\ See supra footnote 48; see also ASC 323, supra footnote 
49.
    \108\ Although the concept of ``significant influence'' is not 
as routinely applied today in the funds context for financial 
reporting purposes, nevertheless, the concept of significant 
influence is applicable to funds under existing auditor independence 
rules. See supra Section II.C.
---------------------------------------------------------------------------

    We also believe that the proposed ``known through reasonable 
inquiry'' standard would not significantly increase costs for smaller 
entities, including smaller accounting firms. The ``known through 
reasonable inquiry'' standard is generally consistent with regulations 
implementing the Investment Company Act, the Securities Act and the 
Exchange Act.\109\ Smaller entities, including smaller accounting 
firms, should therefore already be familiar with the concept.
---------------------------------------------------------------------------

    \109\ See supra footnote 64.
---------------------------------------------------------------------------

    In addition, we believe that the proposed amendments to exclude 
record owners and certain fund affiliates for purposes of the Loan 
Provision would reduce costs for smaller entities, including smaller 
accounting firms.
    Compliance with the proposed amendments would require the use of 
professional skills, including accounting and legal skills. The 
proposed amendments are discussed in detail in Section II above. We 
discuss the economic impact, including the estimated costs, of the 
proposed amendments in Section V (Economic Analysis) above.

E. Duplicative, Overlapping, or Conflicting Federal Rules

    We believe that the proposed amendment would not duplicate, overlap 
or conflict with other federal rules.

F. Significant Alternatives

    The RFA directs us to consider alternatives that would accomplish 
our stated objectives while minimizing any significant adverse impacts 
on small entities. In connection with the proposed amendments, we 
considered certain types of alternatives, including:
    (1) The establishment of differing compliance or reporting 
requirements or timetables that take into account the resources 
available to small entities;
    (2) The clarification, consolidation or simplification of 
compliance and reporting requirements under the rule for small 
entities;
    (3) The use of performance rather than design standards; and

[[Page 20772]]

    (4) An exemption from coverage of the rule, or any part of the 
rule, for small entities.
    In connection with our proposed amendments to Rule 2-01 of 
Regulation S-X, we do not think it feasible or appropriate to establish 
different compliance or reporting requirements or timetables for small 
entities. The proposed amendments are designed to address compliance 
challenges for both large and small issuers and audit firms. With 
respect to clarification, consolidation or simplification of compliance 
and reporting requirements for small entities, the proposed amendments 
do not contain any new reporting requirements. While the proposed 
amendments would create a new compliance requirement that focuses on 
``significant influence'' over the audit client to better identify 
those lending relationships that could impair an auditor's objectivity 
and impartiality, that standard is more qualitative in nature and its 
application would vary according to the circumstances. This more 
flexible standard would be applicable to all issuers, regardless of 
size.
    With respect to using performance rather than design standards, we 
note that our proposed amendments establishing a ``significant 
influence'' test and adding a ``known through reasonable inquiry'' 
standard are more akin to performance standards. Rather than prescribe 
the specific steps necessary to apply such standards, the proposed 
amendments recognize that ``significant influence'' and ``known through 
reasonable inquiry'' can be implemented in a variety of ways. We 
believe that the use of these standards would accommodate entities of 
various sizes while potentially avoiding overly burdensome methods that 
may be ill-suited or unnecessary, given the facts and circumstances.
    The proposed amendments are intended to address significant 
compliance challenges for audit firms and their clients, including 
those that are small entities. In this respect, exempting small 
entities from the proposed amendments would increase, rather than 
decrease, their regulatory burden relative to larger entities.

G. Solicitation of Comment

    We encourage the submission of comments with respect to any aspect 
of this Initial Regulatory Flexibility Analysis. In particular, we 
request comments regarding:
     The number of small entities that may be subject to the 
proposed amendments;
     The existence or nature of the potential impact of the 
proposed amendments on small entities discussed in the analysis;
     How to quantify the impact of the proposed amendments; and
     Alternatives that would accomplish our stated objectives 
while minimizing any significant adverse impact on small entities.
    Respondents are asked to describe the nature of any impact and 
provide empirical data supporting the extent of the impact. Such 
comments will be considered in the preparation of the Final Regulatory 
Flexibility Analysis, if the proposed amendments are adopted, and will 
be placed in the same public file as comments on the proposed 
amendments.

VII. Small Business Regulatory Enforcement Fairness Act

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996 (``SBREFA''),\110\ the Commission must advise the Office of 
Management and Budget as to whether a proposed regulation constitutes a 
``major'' rule. Under SBREFA, a rule is considered ``major'' when, if 
adopted, it results or is likely to result in:
---------------------------------------------------------------------------

    \110\ Public Law 104-121, Tit. II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

     An annual effect on the economy of $100 million or more 
(either in the form of an increase or a decrease);
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effects on competition, investment or 
innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review.
    We request comment on whether our proposed amendments would be a 
``major rule'' for purposes of SBREFA. We solicit comment and empirical 
data on:
     The potential effect on the U.S. economy on an annual 
basis;
     Any potential increase in costs or prices for consumers or 
individual industries; and
     Any potential effect on competition, investment or 
innovation.
    We request those submitting comments to provide empirical data and 
other factual support for their views to the extent possible.

VIII. Statutory Basis

    The amendment described in this release is being adopted under the 
authority set forth in Schedule A and Sections 7, 8, 10, and 19 of the 
Securities Act, Sections 3, 10A, 12, 13, 14, 17, and 23 of the Exchange 
Act, Sections 8, 30, 31, and 38 of the Investment Company Act, and 
Sections 203 and 211 of the Investment Advisers Act.

List of Subjects in 17 CFR Parts 210

    Accountants, Accounting, Banks, Banking, Employee benefit plans, 
Holding companies, Insurance companies, Investment companies, Oil and 
gas exploration, Reporting and recordkeeping requirements, Securities, 
Utilities.

    In accordance with the foregoing, the Commission proposes to amend 
title 17, chapter II of the Code of Federal Regulations as follows:

PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL 
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 
1934, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 
1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975

0
1. The authority citation for part 210 continues to read as follows:

    Authority:  15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 
77aa(25), 77aa(26), 77nn(25), 77nn(26), 78c, 78j-1, 78l, 78m, 78n, 
78o(d), 78q, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-20, 80a-29, 80a-30, 
80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, and sec. 102(c), 
Public Law 112-106, 126 Stat. 310 (2012), unless otherwise noted.

0
2. Amend Sec.  210.2-01 by revising paragraph (c)(1)(ii)(A) to read as 
follows:


Sec.  210.2-01   Qualifications of accountants.

* * * * *
    (c) * * *
    (1) * * *
    (ii) * * *
    (A) Loans/debtor-creditor relationship. (1) Any loan (including any 
margin loan) to or from an audit client, or an audit client's officers, 
directors, or beneficial owners (known through reasonable inquiry) of 
the audit client's equity securities where such beneficial owner has 
significant influence over the audit client, except for the following 
loans obtained from a financial institution under its normal lending 
procedures, terms, and requirements:
    (i) Automobile loans and leases collateralized by the automobile;
    (ii) Loans fully collateralized by the cash surrender value of an 
insurance policy;
    (iii) Loans fully collateralized by cash deposits at the same 
financial institution; and
    (iv) A mortgage loan collateralized by the borrower's primary 
residence

[[Page 20773]]

provided the loan was not obtained while the covered person in the firm 
was a covered person.
    (2) For purposes of paragraph (c)(1)(ii)(A) of this section:
    (i) The term audit client for a fund under audit excludes any other 
fund that otherwise would be considered an affiliate of the audit 
client;
    (ii) The term fund means an investment company or an entity that 
would be an investment company but for the exclusions provided by 
Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-
3(c)).
* * * * *

    By the Commission.

    Dated: May 2, 2018.
Brent J. Fields,
Secretary.
[FR Doc. 2018-09721 Filed 5-7-18; 8:45 am]
 BILLING CODE 8011-01-P


