[Federal Register Volume 83, Number 89 (Tuesday, May 8, 2018)]
[Proposed Rules]
[Pages 20753-20773]
[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

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<PHONE_NUMBER>; Alison Staloch, Chief Accountant, Chief Accountant's
Office, Division of Investment Management, at<PHONE_NUMBER>; or Joel
Cavanaugh, Senior Counsel, Investment Company Regulation Office,
Division of Investment Management, at<PHONE_NUMBER>, 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

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.
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    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

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).
[GRAPHIC] [TIFF OMITTED] TP08MY18.007

    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

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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    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.'').
---------------------------------------------------------------------------

    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

influence is applicable to funds under existing auditor independence
rules.\53\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

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

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

``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

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

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

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

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.
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    \89\ See supra footnote 64.
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    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.
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    \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.
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    \91\ See supra footnote 11.
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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

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