[Federal Register Volume 85, Number 10 (Wednesday, January 15, 2020)]
[Proposed Rules]
[Pages 2332-2354]
[FR Doc No: 2019-28476]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 210

[Release No. 33-10738; 34-87864; FR-86; IA-5422; IC-33737; File No. S7-
26-19]
RIN 3235-AM63

Amendments to Rule 2-01, Qualifications of Accountants

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: We are proposing amendments to update certain auditor
independence requirements as a result of recent feedback received from
the public and our experience administering these requirements since
their initial adoption nearly two decades ago. The proposed amendments
would more effectively focus the independence analysis on those
relationships or services that are more likely to pose threats to an
auditor's objectivity and impartiality.

DATES: Comments should be received on or before March 16, 2020.

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_ADDRESS>Please include
File Number S7-26-19 on the subject line.

Paper Comments

     Send paper comments to Vanessa A. Countryman, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.

All submissions should refer to File Number S7-26-19. 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 of submission. The Commission will post all comments on the
Commission's website (http://www.sec.gov/rules/proposed.shtml).
Comments also are 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 publicly available.
    We or the SEC staff (the ``staff'') may add studies, memoranda or
other substantive items 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 our website. To ensure direct electronic
receipt of such notifications, sign up through the ``Stay Connected''
option at www.sec.gov to receive notification by email.

FOR FURTHER INFORMATION CONTACT: Duc Dang, Senior Special Counsel, or
Giles T. Cohen, Acting Chief Counsel, Office of the Chief Accountant,
at<PHONE_NUMBER>; Alexis Cunningham, Assistant Chief Accountant, or
Daniel Rooney, Assistant 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 17 CFR 210.
2-01 (``Rule 2-01'') of 17 CFR 210.01 et seq. (``Regulation S-X).\1\
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    \1\ Hereinafter, all references to Rule 2-01 and any paragraphs
included within the rule are referring to Rule 2-01 of Regulation S-
X.
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Table of Contents

I. Introduction
II. Proposed Amendments
    A. Proposed Amendments to Definitions
    1. Proposed Amendments to Affiliate of the Audit Client and the
Investment Company Complex
    2. Proposed Amendment to Audit and Professional Engagement
Period
    B. Proposed Amendments to Loans or Debtor-Creditor Relationships
    1. Proposed Amendment to Except Student Loans
    2. Proposed Amendment to Clarify the Reference to ``a Mortgage
Loan''
    3. Proposed Amendment to Revise the Credit Card Rule to Refer to
``Consumer Loans''
    C. Proposed Amendment to the Business Relationships Rule
    1. Proposed Amendment to the Reference to ``Substantial
Stockholder''
    2. Additional Guidance on the Reference to ``Audit Client'' when
Referring to Persons Associated with the Audit Client in a Decision-
Making Capacity, including the Beneficial Owner with Significant
Influence
    D. Proposed Amendments for Inadvertent Violations for Mergers
and Acquisitions
    E. Proposed Amendments for Miscellaneous Updates
    1. Proposed Amendments to Update the Reference to Concurring
Partner Within Rule 2-01
    2. Proposed Amendment to Preliminary Note to Rule 2-01
    3. Proposed Amendment to Delete Outdated Transition and
Grandfathering Provision
III. Economic Analysis
    A. Introduction
    B. Baseline and Affected Parties
    C. Potential Costs and Benefits
    1. Overall Potential Benefits and Costs
    2. Benefits and Costs of Specific Proposed Amendments
    D. Effects on Efficiency, Competition and Capital Formation
    E. Alternatives
    F. Request for Comment
IV. Paperwork Reduction Act
V. 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
VI. Small Business Regulatory Enforcement Fairness Act
VII. Statutory Basis

I. Introduction

    The Commission has long recognized that an audit by an objective,
impartial, and skilled professional contributes to both investor
protection and investor confidence.\2\ If investors do not perceive
that the auditor is independent from the audit client, they will derive
less confidence from the auditor's report and the audited financial
statements. As such, the Commission's auditor independence rule, as set
forth in Rule 2-01, requires auditors \3\ to be independent of their
audit clients both ``in fact and in appearance.'' \4\
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    \2\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)] (``2000 Adopting Release'').
    \3\ We use the terms ``accountants'' and ``auditors''
interchangeably in this release.
    \4\ See Preliminary Note 1 to Rule 2-01 and Rule 2-01(b). 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.'').
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    In 2000, the Commission adopted a comprehensive framework of rules
governing auditor independence, laying out governing principles and
describing certain specific financial, employment, business, and non-
audit service relationships that would cause an auditor not to be
independent of its audit client. The 2000 amendments set forth the
standard for analysis to determine whether an auditor is

independent. Under this analysis, pursuant to Rule 2-01(b), the
``Commission will not recognize an accountant as independent, with
respect to an audit client, if the accountant is not, or 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.'' Rule 2-01(b) further states that the
``Commission will consider all relevant circumstances, including all
relationships between the accountant and the audit client,'' in
determining whether an auditor is independent. Rule 2-01(c) then sets
forth a nonexclusive list of particular circumstances that the
Commission considers to be inconsistent with the independence standard
in Rule 2-01(b), including certain financial, employment, business, and
non-audit service relationships between an accountant and its audit
client.\5\
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    \5\ See Rule 2-01(c); see also 2000 Adopting Release, 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, and relationships where
auditors provide certain non-audit services between auditors and
audit clients . . .'').
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    Except for revisions made in connection with amendments required by
the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley Act'') \6\ and the
recent amendments related to certain debtor-creditor relationships,\7\
many of the provisions from the 2000 Adopting Release have remained
unchanged since adoption. We seek to maintain the relevance of our
auditor independence requirements, and evaluate their effectiveness in
light of current market conditions and industry practices. As such, in
connection with the recent proposal to address certain debtor-creditor
relationships, we also solicited comment on other potential updates to
the auditor independence rules.\8\ After considering the feedback
received from the public and our experience administering these rules
since their initial adoption nearly two decades ago, we are proposing
additional amendments to our auditor independence rules to more
effectively focus the independence analysis on those relationships or
services that we believe are most likely to threaten an auditor's
objectivity and impartiality.
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    \6\ Strengthening the Commission's Requirements Regarding
Auditor Independence, Release No. 33-8183 (Jan. 28, 2003) [68 FR
6005 (Feb. 5, 2003)].
    \7\ Auditor Independence With Respect to Certain Loans or
Debtor-Creditor Relationships, Release 33-10648 (June 18, 2019) [84
FR 32040 (July 5, 2019)] (``Loan Provision Adopting Release''). In
this release, references to the ``Loan Provision'' are referring to
Rule 2-01(c)(1)(ii)(A).
    \8\ See Auditor Independence with Respect to Certain Loans or
Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018)
[83 FR 20753 (May 8, 2018)] (``Loan Provision Proposing Release'').
The comment letters received in response to the Proposing Release
are available at https://www.sec.gov/comments/s7-10-18/s71018.htm.
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    We welcome feedback and encourage interested parties to submit
comments on any or all aspects of the proposed rule amendments. When
commenting, it would be most helpful if you include the reasoning
behind your position or recommendation.

II. Proposed Amendments

A. Proposed Amendments to Definitions

1. Proposed Amendments to Affiliate of the Audit Client and the
Investment Company Complex
    ``Rule 2-01 is designed to ensure that auditors are qualified and
independent of their audit clients both in fact and in appearance.''
\9\ The term ``audit client'' \10\ is defined as ``the entity whose
financial statements or other information is being audited, reviewed or
attested'' \11\ and any ``affiliates of the audit client.'' \12\ The
definition of ``affiliate of the audit client'' includes, in part,
``[a]n 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''
and ``[e]ach entity in the investment company complex when the audit
client is an entity that is part of an investment company complex.''
\13\ Rule 2-01(f)(14) defines an investment company complex (``ICC'')
to include, in part, ``[a]ny entity controlled by or controlling an
investment adviser or sponsor . . . or any entity under common control
with an investment adviser or sponsor . . . 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.''
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    \9\ Preliminary note 1 to Rule 2-01.
    \10\ Rule 2-01(f)(6).
    \11\ For the purposes of our discussion in this release, we
refer to this part of the definition as the ``entity under audit.''
    \12\ See Rule 2-01(f)(6). For the purpose of Rule 2-01(c)(1)(i),
entities covered by Rule 2-01(f)(4)(ii) or (iii) are not considered
affiliates of the audit client.
    \13\ Rule 2-01(f)(4)(i) and (iv).
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    As noted above, the first paragraph of the definition of affiliate
of the audit client includes ``an entity that has control over the
audit client . . . or which is under common control with the audit
client, including the audit client's parents and subsidiaries'' \14\
(emphasis added). As such, entities under common control with the audit
client (``sister entities'') are considered affiliates and fall within
the definition of the ``audit client'' set forth in Rule 2-01(f)(6).
Additionally, pursuant to Rule 2-01(f)(4)(iv), each entity in an ICC is
considered an affiliate when the audit client is part of the ICC.
Consequently, in complex organizational structures, such as large ICCs,
the requirement to identify and monitor for potential independence-
impairing relationships and services currently applies to affiliated
entities, including sister entities, regardless of whether the sister
entities are material to the controlling entity.
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    \14\ Rule 2-01(f)(4)(i).
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    In our experience administering the independence rules, we have
observed some challenges in the practical application of the ``common
control'' component of the definition of affiliate of the audit client.
We also have observed a number of situations where a prohibited service
or relationship with a sister entity did not result in a corresponding
threat to an auditor's objectivity and impartiality. Additionally,
several commenters have suggested that we revisit the scope of the
current application of the independence rules to entities under
``common control.'' \15\ In the private equity and investment company
context, where there potentially is a significant volume of
acquisitions and dispositions of unrelated portfolio companies,\16\ the
definition of affiliate of the audit client may result in an expansive
and constantly changing list of entities that are considered to be
affiliates of the audit client. Such changes in portfolio companies can
create compliance challenges for audit firms performing independence
analyses by requiring them to monitor their various relationships and
services with affiliates of the audit client, even if many of those
relationships and services likely would not threaten the auditor's
objectivity and impartiality.
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    \15\ See e.g., letters from PricewaterhouseCoopers LLP (June 29,
2018) (``PwC''), Center for Audit Quality (July 3, 2018) (``CAQ''),
BDO USA, LLP (July 9, 2018) (``BDO''), Ernst & Young LLP (July 9,
2018) (``EY''), American Institute of Certified Public Accountants
(July 9, 2018) (``AICPA''), and American Investment Council (July 9,
2018) (``AIC'').
    \16\ In this release, we are using the term ``portfolio
company'' to refer to an operating company that has among its
investors, investment companies or unregistered funds in private
equity structures.
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    Furthermore, individual portfolio companies are often audited by
different auditors, even when they are within the

same ICC or private equity structure. Where the portfolio companies are
otherwise unrelated, multiple audit firms may need to be independent of
each of the entities currently deemed affiliates of the audit client.
As a result, the shared responsibility of the audit client and
respective audit firm to monitor the relationships and services against
this often expansive and constantly changing list of affiliates as part
of their independence analysis throughout the audit and professional
engagement period could result in substantial compliance costs. Such
compliance costs from independence monitoring arise even where the
relationships being monitored are not likely to threaten the auditor's
objectivity and impartiality, as discussed further below.
    In addition to impacting monitoring and compliance efforts, the
current application of the common control prong in Rule 2-01(f)(4)(i)
to an auditor's relationships and services with sister entities also
may have competitive effects on the market for audit and non-audit
services. Where a potential audit client is in the market for an
auditor, the number of qualified audit firms may be reduced because
certain audit firms may have relationships with or provide services to
sister entities that are impermissible under the current auditor
independence rules regardless of the impact to the objectivity or
impartiality of the audit firm. This potential reduction in the number
of qualified audit firms may constrain the audit client's choice as to
its preferred auditor and thereby also may have an impact on audit
quality. For example, those responsible for selecting an auditor may
believe a certain audit firm is the best fit from an audit quality
perspective to audit one of the portfolio companies, but the audit firm
would not be considered independent if it is providing a prohibited
service to a sister entity, even where such sister entity is not
material to the controlling entity.
    To address these challenges and more effectively focus the
definition of affiliate of the audit client on those relationships and
services that are most likely to threaten auditor objectivity and
impartiality, we propose amending both paragraphs (f)(4) (i.e., the
affiliate of the audit client definition) and (f)(14) (i.e., the ICC
definition) of Rule 2-01 to include materiality qualifiers in the
respective common control provisions and to distinguish how the
definition applies when an accountant is auditing a portfolio company,
an investment company, or an investment adviser or sponsor.
    Although the proposed amendments in this section will impact an
auditor's analysis under Rule 2-01(c) by changing the population of
entities that are included in the definition of audit client, the
proposed amendments do not alter the application of the general
standard in Rule 2-01(b). Because the Commission is not able to
ascertain all the permutations of relationships or services that would
impair an auditor's objectivity and impartiality, the Commission
focused ``the legal standard [in Rule 2-01(b)] by including the
explicit reference to `all relevant facts and circumstances.' '' \17\
As noted in the 2000 Adopting Release, ``[c]ircumstances that are not
specifically set forth in our rule are measured by the general standard
set forth in Rule 2-01(b).'' As such, notwithstanding the potential
exclusion from the term audit client of entities that are currently
considered affiliates of the audit client but would no longer be deemed
affiliates under the proposed amendments, relationships and services
between an auditor and such entities are still subject to the general
standard. For example, the audit firm, or those charged with governance
of the entity under audit, may identify independence concerns in fact
or in appearance, individually or in the aggregate, upon considering
the nature, extent, relative importance and other aspects of the
services or relationships between the auditor, the controlling entity,
and such sister entities that are not material to the controlling
entity.
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    \17\ 2000 Adopting Release at 65 FR 76031.
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a. Proposed Amendments for Common Control and the Affiliate of the
Audit Client
    We are proposing to amend Rule 2-01(f)(4)(i) to include a
materiality requirement with respect to operating companies under
common control.\18\ With respect to the application of the affiliate of
the audit client definition to operating companies, including portfolio
companies, we propose amending Rule 2-01(f)(4)(i) to focus the
independence analysis on sister entities that are material to the
controlling entity. Specifically, proposed Rule 2-01(f)(4)(i)(B) would
qualify the definition with ``unless the entity is not material to the
controlling entity.''
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    \18\ Proposed Rule 2-01(f)(4)(i)(B). In the 2000 Adopting
Release, the Commission stated that ``entities, if not part of an
[ICC], will be considered affiliates of the audit client if they
satisfy the criteria of one of the three paragraphs of Rule 2-
01(f)(4).'' 2000 Adopting Release at 65 FR 76059. The proposed
amendments do not alter the scope of application for the affiliate
of the audit client definition. For the purpose of this release, we
use the term ``operating company'' to refer to entities that are not
investment companies, investment advisers, or sponsors.
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    To demonstrate the application of proposed Rule 2-01(f)(4)(i)(B) to
operating companies, consider the following organizational structure: A
parent company (Parent Company A) has control over three operating
companies, including Operating Company B. If an accountant is serving
as Operating Company B's auditor, it would need to consider whether
either of the other two sister entities are material to Parent Company
A to determine whether one or both of the sister entities are
affiliates of the audit client.
    As noted below, we believe it is appropriate to identify the
affiliates of the audit client for a portfolio company under audit
under proposed Rule 2-01(f)(4)(i) rather than under proposed Rule 2-
01(f)(14). Portfolio companies are a type of operating company and,
also as discussed below, often the portfolio companies are unrelated
even though they are controlled by the same entity in the private
equity structure or ICC.
    To demonstrate the application of the proposed Rule 2-01(f)(4)(i)
to portfolio companies, consider the situation where the accountant is
serving as the auditor for Portfolio Company C, which is controlled by
Unregistered Fund D. Even though Portfolio Company C is controlled by
an entity within proposed Rule 2-01(f)(14) (discussed further below),
Portfolio Company C's auditor would still look to proposed Rule 2-
01(f)(4)(i)(A) through (D) and not proposed paragraph (f)(14) to
determine which entities are affiliates of Portfolio Company C. That is
because the portfolio company is the entity under audit and, as such,
it does not fall within the definition of ICC set forth in proposed
Rule 2-01(f)(14).
    Based on the SEC staff's consultation experience, audit firms
providing services to or having relationships with sister entities not
material to the controlling entity do not typically present issues with
respect to the audit firm's objectivity or impartiality. As such, we
believe it is appropriate to exclude sister entities that are not
material to the controlling entity from being considered affiliates of
the audit client because an auditor's relationships and services with
such entities do not typically pose a threat to the auditor's
objectivity and impartiality.
    We recognize that adding an evaluation of materiality as proposed
may result in additional work to be done by audit firms with ongoing
monitoring responsibilities for the purposes of compliance with the

independence rules. However, the affiliate of the audit client
definition already has a materiality evaluation, which is familiar to
auditors and their audit clients. In particular, materiality is applied
currently in the existing affiliate of the audit client definition in
Rule 2-01(f)(4)(ii) and (iii).\19\ Also, a materiality evaluation as it
relates to sister entities is consistent, in part, with the definition
of ``affiliate'' used by the American Institute of Certified Public
Accountants (``AICPA'') in its ethics and independence rules, which are
the independence rules typically applied when domestic companies are
not subject to SEC and Public Company Accounting Oversight Board
(``PCAOB'') independence requirements.\20\ Auditors therefore have
experience in applying a materiality standard when identifying
affiliates, whether applying the independence rules of the SEC or
AICPA.
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    \19\ Rule 2-01(f)(4)(ii) includes as an affiliate of the audit
client ``an entity over which the audit client has significant
influence, unless the entity is not material to the audit client.''
Rule 2-01(f)(4)(iii) includes as an affiliate of the audit client
``an entity that has significant influence over the audit client,
unless the audit client is not material to the entity.''
    \20\ See AICPA Professional Code of Conduct available at https://pub.aicpa.org/codeofconduct/ethicsresources/et-cod.pdf. We
acknowledge that the proposed amendment may not result in the same
number of sister entities being deemed material to the controlling
entity under our rules and the AICPA rules. For example, in defining
control the AICPA uses the accounting standards adopted by the
Financial Accounting Standards Board, whereas our rules define
control in Rule 1-02(g) of Regulation S-X. Also, the AICPA affiliate
definition pertaining to common control deems a sister entity as an
affiliate if both the entity under audit and the sister entity are
material to the entity that controls both. The proposed amendment
only focuses on the materiality of the sister entity to the
controlling entity because we believe requiring materiality between
the entity under audit and the controlling entity may exclude, from
the proposed definition, sister entities whose relationships with or
services from an auditor would impair the auditor's objectivity and
impartiality.
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    We note that a determination under the proposed amendments that
sister entities are not material to the controlling entity, by itself,
does not conclude the independence analysis under Rule 2-01. This is
because, as explained above, auditors and audit clients must consider
``all relevant facts and circumstances'' when assessing independence
pursuant to the general standard in Rule 2-01(b).
    We believe focusing on sister entities that are material to the
controlling entity would relieve some of the compliance burden
associated with making independence determinations, as there should be
fewer entities considered affiliates. For the relationships and
services that might nevertheless impact the auditor's independence
under the general standard in Rule 2-01(b), we would expect those
relationships and services individually or in the aggregate would be
easily known by the auditor and the audit client because such services
and relationships are most likely to threaten an auditor's objectivity
and impartiality due to the nature, extent, relative importance or
other aspects of the service or relationship. We also believe the
proposed amendments could increase choice and competition for audit and
non-audit services.
Request for Comment
    1. Should we add the materiality requirement, as proposed, so that
only sister entities that are material to the controlling entity are
deemed to be an affiliate of the audit client? Alternatively, should we
retain the current common control provision in the affiliate of the
audit client definition?
    2. Does the proposed amendment sufficiently focus the common
control prong of the definition of affiliate of the audit client on
those relationships and services that are most likely to threaten
auditor objectivity and impartiality? Should we focus on the
materiality of sister entities to the controlling entity, as proposed?
If not, are there other amendments that would better focus on
relationships and services that are more likely to threaten auditor
objectivity and impartiality? For example, should we focus on whether
sister entities are material to the entity under audit, in addition to
whether they are material to the controlling entity? Should we consider
aggregating sister entities in the materiality assessment rather than
the assessment being done on an individual basis? Or is aggregation of
multiple sister entities sufficiently covered by the general standard
under Rule 2-01(b)?
    3. Would auditors and audit clients face challenges in applying the
materiality concept in this context? Would auditors face particular
challenges assessing materiality in connection with private portfolio
companies? If so, what are those challenges and how could they be
addressed?
    4. Would focusing only on sister entities that are material to the
controlling entity increase the risk that auditors will be performing
audits when they are not objective and impartial? If so, is the
overarching consideration of all relevant facts and circumstances, as
required by Rule 2-01(b), sufficient to mitigate this risk? Would
focusing on sister entities that are material to the controlling entity
increase the risk of appearance issues?
    5. Are there other types of affiliates that should be excluded from
the definition because the services and relationships with such
entities rarely threaten an auditor's objectivity and impartiality?
b. Proposed Amendments to the Investment Company Complex
    We are also proposing to clarify that with respect to an entity
under audit that is an investment company or an investment adviser or
sponsor, the auditor and the audit client should look solely to
proposed Rule 2-01(f)(14) (i.e., the ICC definition) to identify
affiliates of the audit client.\21\ The proposed amendments would
explicitly direct auditors of an investment company or an investment
adviser or sponsor to include all entities within the proposed ICC
definition as affiliates of the audit client instead of conducting an
analysis based on the prongs in proposed Rule 2-01(f)(4)(i). As such,
we are proposing amendments to the ICC definition in Rule 2-01(f)(14)
to focus the definition from the perspective of the entity under audit
and align certain portions of the ICC definition with the amendments
discussed in the preceding section.
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    \21\ Proposed Rule 2-01(f)(4)(ii).
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    Consistent with the discussion in the preceding section, while the
proposed amendments to the ICC definition may alter the composition of
entities that are deemed affiliates of the audit client principally due
to materiality being added for sister entities, the overarching general
standard in Rule 2-01(b) continues to apply.
i. Entity Under Audit and Unregistered Funds
    We propose to clarify that auditors of investment companies,
including unregistered funds,\22\ or investment advisers or sponsors
must assess whether other entities are affiliates of

the audit client by focusing solely on proposed Rule 2-01(f)(14).
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    \22\ We use the term ``unregistered fund'' in this release to
refer to entities that are not considered investment companies
pursuant to the exclusions in Section 3(c) of Investment Company Act
of 1940. Registered investment advisers acting as qualified
custodians that have custody of client funds or securities generally
are required by 17 CFR 275.206(4)-2 (Rule 206(4)-2 (the ``Custody
Rule'') under the Investment Advisers Act of 1940 (the ``Investment
Advisers Act'')) to obtain a surprise examination conducted by an
independent public accountant that is registered with, and subject
to regular inspection by, the PCAOB or, for pooled investment
vehicles, may be deemed to comply with the requirement by
distributing financial statements audited by an independent public
accountant that is registered with, and subject to regular
inspection by, the PCAOB to the pooled investment vehicle's
investors.
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    Unlike the current ICC definition, the proposed amendments would
reference the entity under audit in proposed paragraph (f)(14)(i)(A) as
the starting point for the analysis of which entities are to be
considered part of an ICC. As a result, when the entity under audit is
an investment company, an investment adviser or a sponsor, the auditor
would focus solely on proposed Rule 2-01(f)(14) to determine what other
entities are part of the ICC and, therefore, affiliates of the audit
client. We also are proposing to include within the meaning of the term
investment company, for the purposes of the ICC definition, entities
``that would be an investment company but for the exclusions provided
by section 3(c) of the Investment Company Act.'' \23\ As such, proposed
paragraph (f)(14)(iv) would cover registered investment companies,
business development companies, and entities that would be investment
companies but for the exclusions provided by section 3(c) of the
Investment Company Act, such as private funds that rely on section
3(c)(1) or 3(c)(7). If an auditor is auditing only these entities, it
would look solely to proposed Rule 2-01(f)(14) to determine which
entities are affiliates of the audit client. This would more
effectively focus the independence analysis for unregistered funds
under audit and align with the analysis to be undertaken for registered
investment companies.
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    \23\ See proposed Rule 2-01(f)(14)(iv). This is in contrast to
current Rule 2-01(f)(14)(i)(C) which includes an unregistered fund
only if it has an investment adviser or sponsor already included
within the definition of investment company complex. Revision of the
Commission's Auditor Independence Requirements, Release No. 33-7870
(June 30, 2000) [65 FR 43147, 43181 (July 12, 2000)].
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    If an auditor audits both a portfolio company and an investment
company or an investment adviser or sponsor, then the auditor would
have to apply both proposed Rules 2-01(f)(4)(i) and (f)(14) to identify
the entities that are affiliates of the audit client and where it would
need to monitor for prohibited relationships and services. To
demonstrate this using the example from the preceding section, where
the accountant is serving as the auditor of both Unregistered Fund D
and Portfolio Company C, which is controlled by Unregistered Fund D,
the auditor would apply both proposed Rules 2-01(f)(4)(i) and (f)(14)
in connection with its independence analysis. Specifically, the auditor
of Portfolio Company C would conduct its analysis under proposed Rule
2-01(f)(4)(i), while the same auditor, with respect to its audit of
Unregistered Fund D, would conduct its analysis under proposed Rule 2-
01(f)(14) to determine the affiliate status of entities within the same
ICC as Unregistered Fund D. However, if an auditor audits only an
investment company or investment adviser or sponsor, as defined by
proposed Rule 2-01(f)(14), then it would look solely to proposed Rule
2-01(f)(14) to determine the affiliates it would have to monitor for
prohibited relationships and services.
Request for Comment
    6. Should the proposed ICC definition specifically reference the
entity under audit and explicitly define investment companies, for the
purpose of proposed paragraph (f)(14), to include unregistered funds,
as proposed?
    7. Is it appropriate to direct auditors of an investment adviser,
sponsor, or investment company to the investment company complex
definition, as we propose to amend it, to determine the entities that
will be considered affiliates of the audit client? Why or why not?
Would that lead to more consistent independence analyses by auditors of
these entities?
ii. Common Control With Any Investment Company, Investment Adviser or
Sponsor
    Under the current ICC definition, any entity under common control
with an investment adviser or sponsor of an investment company \24\
audit client that is also an investment adviser or sponsor (``sister
investment adviser or sponsor'') is considered part of the ICC, and
thereby an affiliate of the audit client.\25\ Additionally, the current
ICC definition includes not just the investment companies that share an
investment adviser or sponsor with an investment company audit client,
it also includes any investment company advised by a sister investment
adviser or has a sister sponsor.\26\
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    \24\ As noted in the preceding section, since proposed Rule 2-
01(f)(14)(iv) defines investment company to include entities that
would be considered investment companies but for the exclusions
provided by Section 3(c) of the Investment Company Act of 1940, when
we use the term investment company in this release to discuss the
proposed amendments, the term also includes such entities.
    \25\ Rule 2-01(f)(14)(i)(B)(1).
    \26\ Rule 2-01(f)(14)(i)(C).
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    To demonstrate the application of the current definition of ICC,
consider the following example: An investment company, Investment
Company A, is the entity under audit. Investment Company A is advised
by Investment Adviser B. Investment Adviser B is under common control
with Investment Adviser C and Investment Adviser D. Under current Rule
2-01(f)(14)(i)(B)(1), Investment Adviser C and Investment Adviser D are
considered sister investment advisers and, therefore, are affiliates of
the audit client Investment Company A. Moreover, every investment
company advised by Investment Adviser C and Investment Adviser D falls
within the definition of ICC and, therefore, is also an affiliate of
the audit client Investment Company A because of the application of
current Rule 2-01(f)(14)(i)(C). In this instance, the auditor could not
have any prohibited services or relationships with any of the sister
investment advisers or any of the investment companies they advise.
    We are proposing to align the common control prong of the proposed
ICC definition (proposed Rule 2-01(f)(14)(i)(D)) with the proposed
common control prong for operating companies (proposed Rule 2-
01(f)(4)(i)(B)), for the same reasons we discuss in Section II.A.1.a.
As a result, proposed paragraph (f)(14)(i)(D)(1) of the ICC definition
includes only sister investment companies, advisers, and sponsors that
are material to the controlling entity. If the sister investment
company, adviser, or sponsor is not material to the controlling entity,
the general standard under Rule 2-01(b) would still apply, as discussed
above.
    Under the current ICC definition, an investment company seeking an
auditor to audit its financial statements is precluded from considering
any accountant with services or relationships prohibited by Rule 2-
01(c) with sister investment advisers, sponsors, or any of the
investment companies they advise or sponsor. As such, an investment
company's choices among qualified auditors may be limited. The
inclusion of a materiality qualifier in proposed paragraph
(f)(14)(i)(D)(1) may broaden the pool of prospective accountants the
potential investment company audit client can evaluate and consider to
engage as its auditor while being unlikely to increase the potential
threat to an auditor's objectivity and impartiality. Proposed paragraph
(f)(14)(i)(D) is not meant to change the population of controlling
entities an auditor should consider when assessing common control under
the current Rule 2-01(f)(14)(i)(B), but rather to be consistent with
the common control provision in proposed Rule 2-01(f)(4)(i)(B), with
the primary change being the inclusion of a materiality qualifier.
Because of the changes to the ICC definition discussed in the preceding
section, which direct auditors

and the audit client to look solely to proposed Rule 2-01(f)(14) to
identify affiliates of the audit client with respect to an entity under
audit that is an investment company or an investment adviser or
sponsor, the proposed amendment discussed in this section simply aligns
with the change in proposed Rule 2-01(f)(4)(i)(B).
    Additionally, current Rule 2-01(f)(14)(i)(B) does not include
investment companies whereas proposed paragraph (f)(14)(i)(D)(1) does
include investment companies in the assessment of sister entities. We
are introducing the reference to investment companies in the proposed
ICC common control provision because, under current Rule 2-
01(f)(14)(i)(C), any investment company advised or sponsored by a
sister investment adviser is already included as an affiliate,
regardless of materiality. With the addition of the materiality
requirement in proposed paragraph (f)(14)(i)(D)(1), we did not want to
exclude investment companies that are material to the controlling
entity from the ICC when such investment companies' investment advisers
or sponsors are not material to the controlling entity. This is
intended to ensure that a controlling entity's investment directly in
an investment company is considered in the affiliate analysis in the
event that the adviser to that investment company is deemed not
material to the controlling entity. We do not believe that this would
expand the scope of entities determined to be affiliates based on the
current application of Rule 2-01(f)(14)(i)(B) and (C).
    Furthermore, we proposed to add a reference to proposed paragraph
(f)(14)(i)(C) within proposed paragraph (f)(14)(i)(D) to align with the
concept of parent and subsidiaries found in proposed paragraph
(f)(4)(i)(B). This is intended to ensure that entities downstream and
upstream to the entity under audit are considered in the analysis for
common control.
Request for Comment
    8. Should we include a materiality qualifier in Rule 2-
01(f)(14)(i)(D), as proposed, so that only sister investment companies
or investment advisers or sponsors that are material to the controlling
entity are included in the proposed definition of ICC and, as a result,
are deemed to be an affiliate of the audit client? Should we focus on
whether sister investment companies, advisers, or sponsors are material
to the investment company, adviser, or sponsor under audit, in addition
to whether they are material to the controlling entity? Should we
consider aggregating sister entities in the materiality assessment
rather than the assessment being done on an individual basis? Or is
aggregation of multiple sister entities sufficiently covered by the
general standard under Rule 2-01(b)?
    9. Does the proposed amendment sufficiently focus the common
control prong of the ICC definition on those relationships and services
that are most likely to threaten auditor objectivity and impartiality?
Should the analysis focus on the materiality of sister entities to the
controlling entity, as proposed?
    10. Would auditors and audit clients face challenges in applying
the materiality concept in this context? Would auditors face particular
challenges assessing materiality in connection with unregistered funds?
If so, what are the challenges and how could they be addressed?
    11. Would focusing only on sister entities that are material to the
controlling entity increase the risk that auditors will be performing
audits when they are not objective and impartial? If so, is the
overarching consideration of all relevant facts and circumstances, as
required by Rule 2-01(b), sufficient to mitigate this risk? Would
focusing on sister entities that are material to the controlling entity
increase the risk of appearance issues?
    12. Is it appropriate for auditors to assess whether or not sister
investment companies are material to the controlling entity even when a
sister fund's investment adviser may not be material to the controlling
entity? Should we include a reference to paragraph (f)(14)(i)(C) within
paragraph (f)(14)(i)(D), as proposed?
iii. Investment Companies That Share an Investment Adviser or Sponsor
Included Within the ICC Definition
    Under current paragraph (f)(14)(i)(C) of the ICC definition, an
auditor of an investment company has to monitor for prohibited services
and relationships with sister investment companies that have the same
investment adviser or sponsor or have an investment adviser or sponsor
that is under common control, regardless of whether the sister
investment companies are material to such investment adviser or
sponsor. The proposed amendments would not change the analysis of
sister investment companies that have an investment adviser or sponsor
included within the ICC definition. This is because proposed paragraph
(f)(14)(i)(F) would include within the ICC definition any investment
company that has any investment adviser or sponsor that is an affiliate
of the audit client pursuant to proposed paragraphs (f)(14)(i)(A)
through (D).
    For example, proposed paragraph (f)(14)(i)(B) includes the
investment adviser or sponsor of an investment company under audit. As
the language in neither proposed paragraph (f)(14)(i)(B) nor proposed
paragraph (F) includes a materiality requirement, under proposed
paragraph (f)(14)(i)(F), an auditor would need to consider as part of
its independence analysis, sister investment companies that have the
same investment adviser or sponsor as the investment company under
audit, regardless of whether such sister investment companies are
material to the shared investment adviser or sponsor. Consistent with
current paragraph (f)(14)(i)(C), we continue to believe that the nature
of the relationship between an investment adviser or sponsor and the
investment companies it advises is such that once an investment adviser
or sponsor is included within the proposed ICC definition, the
investment companies it advises should be included as well.
Request for Comment
    13. Should paragraph (f)(14)(i)(F) be adopted as proposed? Should
we instead include a materiality qualifier for sister investment
companies in proposed paragraph (f)(14)(i)(F)?
iv. Significant Influence Within the ICC Definition
    As discussed above, the proposed ICC definition would clarify that
when the entity under audit is an investment company or an investment
adviser or sponsor, the auditor should look to the proposed ICC
definition in proposed Rule 2-01(f)(14) to determine which entities are
considered affiliates of the audit client. As such, we propose
including in the proposed ICC definition a significant influence prong
to align, in part, with the current significant influence analysis
applicable to operating companies in the definition of affiliate of the
audit client in Rule 2-01(f)(4)(ii) and (iii).\27\ Given that
``significant influence'' is used in other parts of the Commission's
independence rules, including within the affiliate definition, the
concept of ``significant influence'' is one with which audit firms and
their clients are already required to be familiar.\28\
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    \27\ The proposed amendments to the affiliate of the audit
client definition include conforming amendments to list these two
prongs as proposed Rule 2-01(f)(4)(i)(C) and (D).
    \28\ The Loan Provision Adopting Release clarified what
constitutes significant influence in an investment company context
and that analysis would apply here as well. See Section II.C.3 of
the Loan Provision Adopting Release.

---------------------------------------------------------------------------

    Again, because of the changes to the ICC definition discussed
above, which direct auditors and the audit client to look solely to
proposed Rule 2-01(f)(14) to identify affiliates of the audit client
with respect to an entity under audit that is an investment company or
an investment adviser or sponsor, the proposed amendment discussed in
this section simply aligns with the significant influence prongs in the
current definition of affiliate of the audit client.
    Additionally, we are also proposing a conforming amendment to the
definition of the term audit client in Rule 2-01(f)(6) to include a
reference to proposed Rule 2-01(f)(14)(i)(E) to be consistent with the
existing references in such definition to the significant influence
prongs of the affiliate of the audit client definition. Currently Rule
2-01(f)(6), for the purposes of considering investment relationship
prohibitions under current Rule 2-01(c)(1)(i), excludes from the audit
client definition entities that are deemed affiliates solely because of
the significant influence prongs in current paragraphs (f)(4)(ii) and
(iii). This conforming amendment would add a reference to proposed Rule
2-01(f)(14)(i)(E) to those exclusions.
Request for Comment
    14. Should we incorporate a significant influence prong into the
ICC definition, as proposed?
    15. Should we also adopt the proposed conforming amendment to Rule
2-01(f)(6) to include the reference to proposed paragraph
(f)(14)(i)(E)?
2. Proposed Amendment To Audit and Professional Engagement Period
    Currently, paragraphs (c)(1) through (5) of Rule 2-01 enumerate
certain circumstances that, if they occur during the ``audit and
professional engagement period,'' are inconsistent with the general
independence standard of Rule 2-01(b).\29\ Under the current rule, the
term ``audit and professional engagement period'' is defined
differently for domestic issuers and foreign private issuers (``FPIs'')
\30\ with respect to situations in which a company first files, or is
required to file, a registration statement or report with the
Commission. Specifically, Rule 2-01(f)(5)(i) and (ii) defines the audit
and professional engagement period as including both the ``period
covered by any financial statements being audited or reviewed'' and the
``period of the engagement to audit or review the . . . financial
statements or to prepare a report filed with the Commission. . . .''
However, paragraph (iii) of the definition narrows the audit and
professional engagement period to just the ``first day of the last
fiscal year before the foreign private issuer first filed, or was
required to file, a registration statement or report with the
Commission, provided there has been full compliance with home country
independence standards in all prior periods covered by any registration
statement or report filed with the Commission'' (emphasis added).
---------------------------------------------------------------------------

    \29\ See Preliminary Note 2 and paragraphs (c)(1), (2), (3),
(4), and (5) to Rule 2-01.
    \30\ 17 CFR 240.3b-4(c). A foreign private issuer is any foreign
issuer other than a foreign government, except for an issuer that
(1) has more than 50% of its outstanding voting securities held of
record by U.S. residents; and (2) any of the following: (i) A
majority of its executive officers or directors are citizens or
residents of the United States; (ii) more than 50% of its assets are
located in the United States; or (iii) its business is principally
administered in the United States. See 17 CFR 240.3b-4(c).
---------------------------------------------------------------------------

    The narrower definition applicable to FPIs creates a disparate
application of the auditor independence rules between domestic issuers
and FPIs when, for example, both types of audit clients are engaging in
an IPO. The auditor of a domestic issuer engaging in an IPO has to be
independent in accordance with Rule 2-01 during all periods included in
the issuer's registration statement filed with the Commission. For
example, if the registration statement includes three years of
financial statements, then the auditor of a domestic issuer engaging in
an IPO would have to look back three years and assess independence
under Rule 2-01 during all such prior years. Conversely, the auditor of
an FPI engaging in an IPO has to be independent in accordance with Rule
2-01 only during the immediately preceding fiscal year. Even if the
registration statement for the FPI includes three years of financial
statements, the auditor and the FPI would, for purposes of Rule 2-01,
look back and assess independence only during the most recently
completed fiscal year provided the FPI has been in full compliance with
its home country independence standards in all prior periods covered by
any registration statement or report filed with the Commission.
    As a consequence, a domestic private company may need to delay its
IPO or engage a new auditor in order to comply with the auditor
independence rules, which would put it at a potential economic
disadvantage when compared to an FPI. Several commenters specifically
suggested that the definition of ``audit and professional engagement
period'' be amended so that domestic issuers would be subject to the
same audit and professional engagement period as FPIs when they are
first filing, or are required to file, a registration statement or
report with the Commission.\31\ Commenters also suggested that
shortening the look-back period may encourage capital formation for
domestic issuers contemplating an IPO (e.g., for those issuers that may
have to delay an IPO to comply with Rule 2-01), or at least put them on
the same footing as FPIs.\32\
---------------------------------------------------------------------------

    \31\ See e.g., letters from PwC, CAQ, BDO, AICPA, and AIC.
    \32\ See e.g., letters from CAQ, AICPA, and AIC.
---------------------------------------------------------------------------

    In addition, the staff has observed, from its independence
consultation experience related to potential filings of initial
registration statements, that often one factor, among many, in the
auditor's objectivity and impartiality analysis is how far back in time
the prohibited service or relationship ended. If the prohibited service
or relationship ended in the early years of the financial statements
included in the initial registration statement, that fact may lend
support to a conclusion that the auditor is objective and impartial
under Rule 2-01 at the time the IPO is consummated.
    In light of this feedback and our experience, we are proposing to
amend Rule 2-01(f)(5)(iii) so that the one year look back provision for
issuers filing or required to file a registration statement or report
with the Commission for the first time (``first-time filers'') will
apply to all such filers.\33\ As proposed, an auditor for a first time
filer that is either a domestic issuer or an FPI would apply Rule 2-01
for the most recently completed fiscal year included in its first
filing provided there has been full compliance with applicable
independence standards in all prior periods covered by any registration
statement or report filed with the Commission. We believe that the
proposed requirement to comply with applicable independence standards
in all prior periods sufficiently mitigates the risk associated with
shortening the look back provision for domestic first-time filers.
Also, as it relates to relationships and services in prior years that
would not be included in the look back period as a result of the
proposed amendment, such relationships and services should still be
considered under the general standard of Rule 2-01(b). Similar to the
discussion in Section II.A.1, for the relationships and services to be
evaluated under Rule 2-01(b), individually and in the aggregate,

we would expect those relationships and services would be easily known
by the auditor as such services and relationships might be thought to
reasonably bear on an auditor's independence due to the nature, extent,
relative importance, or other aspects of the service or relationship.
---------------------------------------------------------------------------

    \33\ The proposed amendments would not impact the compliance
analysis related to the partner rotation provisions in Rule 2-
01(c)(6).
---------------------------------------------------------------------------

Request for Comment
    16. We are proposing to amend rule 2-01(f)(5) to shorten the look-
back period for all first-time filers to the most recently completed
fiscal year, which would result in treating all first-time filers
(including domestic issuers and FPIs) similarly for purposes of our
independence requirements under Rule 2-01. Should we amend Rule 2-
01(f)(5) as proposed? Alternatively, should we consider instead
lengthening the lookback period for FPIs to all periods in which the
financial statements are being audited or reviewed to harmonize the
lookback periods?

B. Proposed Amendments to Loans or Debtor-Creditor Relationships

    Currently, under Rule 2-01(c)(1)(ii)(A) (the ``Loan Provision''),
an accountant is not independent if the accounting firm, any covered
person in the firm, or any of his or her immediate family members has
any loans (including any margin loan) to or from an audit client, or
certain other entities or persons related to the audit client.\34\ The
Commission originally adopted this provision because certain creditor
or debtor relationships ``reasonably may be viewed as creating a self-
interest that competes with the auditor's obligation to serve only
investors' interest.'' \35\ Recognizing that not all creditor or debtor
relationships threaten an auditor's objectivity and impartiality, the
Commission included in Rule 2-01(c)(1)(ii)(A) a list of loans that are
excepted from the prohibition. Under the current rule, the following
loans from a financial institution under its normal lending procedures,
terms, and requirements are excepted from the prohibition:
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    \34\ In the Loan Provision Adopting Release, the Commission
amended this rule to replace ``record or beneficial owners of more
than ten percent of the audit client's equity securities'' with
beneficial owners known through reasonable inquiry that have
``significant influence over the audit client.'' The Commission also
added new paragraphs (2)(i) and (ii) to Rule 2-01(c)(1)(ii)(A) to
address how the amended rule applies to a fund that is an audit
client.
    \35\ Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7870 (June 30, 2000) [65 FR 43147 (July
12, 2000)].
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     Automobile loans and leases collateralized by the
automobile;
     Loans fully collateralized by the cash surrender value of
an insurance policy;
     Loans fully collateralized by cash deposits at the same
financial institution; and
     A mortgage loan collateralized by the borrower's primary
residence provided the loan was not obtained while the covered person
in the firm was a covered person.
    Additionally, Rule 2-01(c)(1)(ii)(E) (the ``Credit Card Rule'')
provides that an accountant is not independent if the accounting firm,
any covered person in the firm, or any of his or her immediate family
members has any aggregated outstanding credit card balance owed to a
lender that is an audit client that is not reduced to $10,000 or less
on a current basis taking into consideration the payment due date and
any available grace period.
    In response to the requests for comment in the Loan Provision
Proposing Release, we received feedback suggesting other potential
exceptions to the Loan Provision.\36\
---------------------------------------------------------------------------

    \36\ See e.g., letters from Grant Thornton LLP (July 9, 2018)
(``Grant Thornton''), BDO, EY, RSM US LLP (July 9, 2018) (``RSM''),
Financial Executives International (July 9, 2018) (``FEI''), MFS
Funds Board Audit Committee (July 6, 2018) (``MFS Funds''), T. Rowe
Price (July 9, 2018), and the Securities Industry and Financial
Markets Association, Asset Management Group (July 9, 2018)
(``SIFMA'').
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1. Proposed Amendment To Except Student Loans
    In the Loan Provision Proposing Release, we asked whether student
loans should be excepted from the Loan Provision and received feedback
supporting such exception.\37\ In arriving at the proposed amendments,
we considered the different characteristics associated with student
loans, such as whether the student loan was obtained specifically for
accounting and auditing education, obtained by the covered persons when
they were pursuing their undergraduate education, or obtained by the
covered persons for their immediate family members.
---------------------------------------------------------------------------

    \37\ See e.g., letters from Grant Thornton, BDO, EY, RSM, and
FEI.
---------------------------------------------------------------------------

    We propose to add student loans obtained from a financial
institution under its normal lending procedures, terms, and
requirements for a covered person's educational expenses provided the
loan was obtained by the individual prior to becoming a covered person
in the firm as defined under Rule 2-01(f)(11). The limitation on the
student loan exclusion (i.e., not obtained while a covered person in
the firm) is consistent with the current provision in Rule 2-
01(c)(1)(ii)(A)(1)(iv) limiting the mortgage exclusion to mortgage
loans ``not obtained while the covered person in the firm was a covered
person,'' and provides a familiar principle for compliance purposes.
    Moreover, we believe obtaining a student loan as a covered person
poses a higher risk to the auditor's objectivity and impartiality
because loans obtained while a covered person are likely more recent
and thus may have a larger balance than loans obtained when such person
was not a covered person. Additionally, a covered person obtaining a
student loan from an audit client creates, at a minimum, an
independence appearance issue that is not present when a non-covered
person obtained a similar student loan from such audit client. In
addition, the proposed exception would not encompass student loans
obtained for a covered person's immediate family members. We are
concerned that the amount of student loan borrowings could be
significant when considering student loans obtained for multiple
immediate family members and thus could impact an auditor's objectivity
and impartiality. We are therefore limiting the exclusion to student
loans obtained for the covered person's educational expenses.
Considered together, we believe these proposed limitations
appropriately balance the benefits of the proposed exception with its
potential impact on the auditor's objectivity and impartiality.
Request for Comment
    17. We are proposing to except student loans obtained for a covered
person's educational expenses that were not obtained while the covered
person in the firm was a covered person. Should we adopt this new
exception as proposed? Should we limit the proposed exception to
student loans not obtained while the covered person in the firm was a
covered person and to student loans obtained only for the individual's
educational expenses (i.e., not the loans of immediate family members),
as proposed?
    18. Should all student loans be excepted from the application of
the Loan Provision? Should the proposed exception include any other
limitations, such as being limited only to the covered person's
accounting and auditing educational expenses? Alternatively, should we
expand the proposed exception to student loans of immediate family
members? If we expand the exception to student loans of immediate
family members, should we adopt a dollar limit on the aggregate amount
of student loans that may be excepted? Is the overarching

consideration of all relevant facts and circumstances related to the
auditor's objectivity and impartiality, as required by Rule 2-01(b),
sufficient to mitigate against any potential risk that student loans
obtained for multiple immediate family members could be significant?
    19. Should the proposed student loan exception include a limit on
the amount that may be outstanding? If so, what is the appropriate
amount?
2. Proposed Amendment To Clarify the Reference to ``a Mortgage Loan''
    We are proposing to clarify that the reference to ``a mortgage
loan'' in Rule 2-01(c)(1)(ii)(A)(1)(iv) was not intended to exclude
just one outstanding mortgage loan on a borrower's primary residence.
As currently drafted, the reference to ``a mortgage loan'' may be read
to suggest that only a single loan would qualify for the exception.
Over the years, the SEC staff has received questions about how the
exclusion applies to second mortgages, home improvement loans, equity
lines of credit, and similar mortgage obligations collateralized by a
primary residence.\38\ To provide further clarity on this point, we are
proposing to revise Rule 2-01(c)(1)(ii)(A)(1)(iv) to refer to
``mortgage loans'' instead of ``a mortgage loan.''
---------------------------------------------------------------------------

    \38\ See Section B. Question 1 Office of the Chief Accountant:
Application of the Commission's Rules on Auditor Independence
Frequently Asked Questions (June 27, 2019) (originally issued August
13, 2003) (indicating the staff's view that the rationale for a
mortgage on a primary residence also applies to second mortgages,
home improvement loans, equity lines of credit and similar mortgage
obligations collateralized by a primary residence obtained from a
financial institution under its normal lending procedures, terms and
requirements and while not a covered person in the firm).
---------------------------------------------------------------------------

    Further, where the borrower becomes a covered person only because
of a change in the ownership in the loan, and provided there is no
modification in the original terms or conditions of the loan or
obligation after the borrower becomes, or in contemplation of the
borrower becoming, a covered person, the loan would be included within
this exception.\39\
---------------------------------------------------------------------------

    \39\ Id.
---------------------------------------------------------------------------

Request for Comment
    20. Should we revise Rule 2-01(c)(1)(ii)(A)(1)(iv) to refer to
``mortgage loans'' instead of ``mortgage loan,'' as proposed?
3. Proposed Amendment To Revise the Credit Card Rule To Refer to
``Consumer Loans''
    We received feedback from commenters on the Loan Provision
Proposing Release that certain de minimis financings and immaterial
loans may not threaten an auditor's objectivity and impartiality.\40\
We agree that a limited amount of debt that is routinely incurred for
personal consumption, even if the audit client is the lending entity,
would typically not impair an auditor's objectivity and impartiality.
As such, we propose revising Rule 2-01(c)(1)(ii)(E) to replace the
reference to ``credit cards'' with ``consumer loans'' and revise the
provision to reference any consumer loan balance owed to a lender that
is an audit client that is not reduced to $10,000 or less on a current
basis taking into consideration the payment due date and available
grace period. Consistent with the payment terms in current Rule 2-
01(c)(1)(ii)(E), in assessing the current basis of a consumer loan
balance, the borrower would consider the payment due date, plus any
available grace period, which is typically monthly for credit cards.
For example, if a covered person has an outstanding consumer loan
balance above $10,000 with an audit client, such covered person would
have to reduce the balance to $10,000 or less by the monthly due date,
plus any available grace period, in order to comply with the proposed
amendment. The proposed amendment would expand the current Credit Card
Rule to encompass the types of consumer financing borrowers routinely
obtain for personal consumption, such as retail installment loans, cell
phone installment plans, and home improvement loans that are not
secured by a mortgage on a primary residence. We expect the types of
consumer loans contemplated by the proposed amendment would typically
have a payment due date consistent with credit cards (e.g., monthly).
---------------------------------------------------------------------------

    \40\ See e.g., letters from Grant Thornton, Investment Company
Institute and Independent Directors Council (July 9, 2018) (``ICI/
IDC''), MFS Funds, T. Rowe Price, SIFMA, and Federated Investors,
Inc. (July 10, 2018) (``Federated'').
---------------------------------------------------------------------------

Request for Comment
    21. We propose amending Rule 2-01(c)(1)(ii)(E) to replace ``credit
cards'' with ``consumer loans'' and revise the provision to reference
any consumer loan balance owed to a lender that is an audit client that
is not reduced to $10,000 or less on a current basis taking into
consideration the payment due date and available grace period. Should
we amend Rule 2-01(c)(1)(ii)(E), as proposed?
    22. Is the outstanding balance limit of $10,000 appropriate? If
not, what would be a more appropriate limit?
    23. Is further guidance needed regarding how ``current basis''
applies for different types of consumer loans? If so, what additional
guidance should we provide?
    24. Is further guidance needed regarding the types of loans that
would be considered ``consumer loans'' under the proposed amendment? If
so, what additional guidance should we provide?

C. Proposed Amendment to the Business Relationships Rule

    1. Proposed Amendment to the Reference to ``Substantial
Stockholder''
    Currently, Rule 2-01(c)(3) (the ``Business Relationships Rule'')
prohibits, at any point during the audit and professional engagement
period, the accounting firm or any covered person from having ``any
direct or material indirect business relationship with an audit client,
or with persons associated with the audit client in a decision-making
capacity, such as an audit client's officers, directors, or substantial
stockholders. . . .'' (emphasis added). In response to the Loan
Provision Proposing Release, commenters suggested aligning this rule
with the then proposed amendments to the Loan Provision by replacing
the reference to substantial stockholders with a significant influence
analysis.\41\
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    \41\ See e.g., letters from Deloitte LLP (June 29, 2018)
(``Deloitte''), PwC, KPMG LLP (July 3, 2018) (``KPMG''), Crowe LLP
(July 3, 2018) (``Crowe''), CAQ, Professor Joseph A. Grundfest,
Stanford Law School (July 9, 2018) (``Grundfest''), Grant Thornton,
EY, U.S. Chamber of Commerce, Center for Capital Markets
Competitiveness (July 9, 2018) (``CCMC''), FEI, and AIC.
---------------------------------------------------------------------------

    We agree that referring to ``beneficial owners (known through
reasonable inquiry) of the audit client's equity securities where such
beneficial owner has significant influence over the audit client''
instead of ``substantial stockholders'' would improve the rule by
making it more clear and less complex. In this regard, we note that
``substantial stockholder'' is not currently defined in Regulation S-X,
whereas the concept of significant influence is used in the Loan
Provision \42\ and other aspects of the independence rules.\43\ As
such, we recommend proposing to replace the term ``substantial
stockholders'' in the Business Relationships Rule with the phrase
``beneficial owners (known

through reasonable inquiry) of the audit client's equity securities
where such beneficial owner has significant influence over the audit
client.''
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    \42\ Consistent with the recently adopted amendments discussed
in the Loan Provision Adopting Release, the use of ``significant
influence'' in these proposed amendments is intended to refer to the
principles in the Financial Accounting Standards Board's
(``FASB's'') ASC Topic 323, Investments--Equity Method and Joint
Ventures. See Section II.C.3 of the Loan Provision Adopting Release.
Similarly, as it relates to the application of significant influence
to investment companies, please refer to Section II.C.3 of the Loan
Provision Adopting Release.
    \43\ See e.g., Rule 2-01(f)(ii) and (iii).
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2. Additional Guidance on the Reference to ``Audit Client'' When
Referring to Persons Associated With the Audit Client in a Decision-
Making Capacity, Including the Beneficial Owner With Significant
Influence
    The current Business Relationships Rule prohibits business
relationships, in part, with persons associated with the audit client
in a decision-making capacity, such as an audit client's officers,
directors, or substantial stockholders.\44\ A commenter suggested that
for this part of the Business Relationships Rule, the focus should be
on those business relationships with persons in a decision-making
capacity that are associated with the entity whose financial statements
or other information is being audited, as opposed to the ``audit
client'' more broadly which, by definition, includes affiliates of the
audit client.\45\ In other words, the commenter suggested the focus
should be on those business relationships with persons in a decision-
making capacity that are associated with the entity under audit.\46\
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    \44\ Rule 2-01(c)(3).
    \45\ See letter from AIC (July 26, 2019).
    \46\ As discussed in Section II.A.1, we refer to the entity
whose financial statements or other information is being audited,
reviewed, or attested, as the entity under audit.
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    We agree that the focus should be on those business relationships
with persons in a decision-making capacity as it relates to the entity
under audit. In fact, our staff consultation experience regarding this
portion of the Business Relationships Rule generally focuses on the
persons associated with an affiliate of the audit client only where
such persons would be able to exert decision-making capacity over the
entity under audit. As such, as it relates to the proposed amendment
discussed in the preceding section, regardless of whether the
beneficial owner owns equity securities of an audit client, including
an affiliate of the audit client, the independence analysis should
focus on whether the beneficial owner has significant influence over
the entity under audit, since business relationships with persons with
such influence could be reasonably expected to impact an auditor's
objectivity and impartiality.\47\
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    \47\ This guidance is limited to the analysis related to
associated persons in a decision-making capacity of an audit client.
This guidance does not change the analysis when evaluating ``any
direct or material indirect business relationships with an audit
client.'' Under the current and proposed rule, an auditor is still
prohibited from having any direct or material indirect business
relationships with an audit client, which includes any affiliates of
the audit client.
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    We are also providing this clarification based on recent staff
experience with consultations concerning implementation of the recently
amended Loan Provision. As noted in the preceding section, in June 2019
we adopted similar language for the Loan Provision to that being
proposed as a replacement for ``substantial stockholders'' in this
release (i.e., ``beneficial owners (known through reasonable inquiry)
of the audit client's equity securities where such beneficial owner has
significant influence over the audit client.'').\48\ Staff
consultations since the adoption of the amended Loan Provision are
consistent with our past experience that, with regard to lending
relationships with beneficial owners of equity securities of the audit
client, including affiliates, the focus is on significant influence as
it relates to the entity under audit when considering if the auditor's
objectivity and impartiality is impaired.
---------------------------------------------------------------------------

    \48\ See supra note 7.
---------------------------------------------------------------------------

    As a result, the guidance in the second paragraph of this section
also applies to the audit client references in the Loan Provision
referring to ``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,'' as we believe that a threat to an auditor's
objectivity and impartiality is more likely when the beneficial owner
of the equity securities of the audit client, including affiliates, has
significant influence over the entity under audit.
    In summary, when an auditor is evaluating lending or business
relationships with officers, directors, or beneficial owners with
significant influence over an affiliate of the entity under audit
pursuant to the Loan Provision or the current or proposed Business
Relationships Rule, the auditor should focus on whether the significant
influence exists at the entity under audit.
Request for Comment
    25. Should we replace the reference to ``substantial stockholders''
in the Business Relationships Rule with the concept of beneficial
owners with significant influence, as proposed? Would the proposed
amendment make the rule more clear and reduce complexity, given that
``substantial stockholder'' is not currently defined in Regulation S-X?
Alternatively, should substantial stockholder be defined? If so, how
should we define it?
    26. Would the proposed amendment result in more or fewer instances
of business relationships that are prohibited by Rule 2-01(c)(3)? Does
the concept of beneficial owners with significant influence, as
proposed, more appropriately identify relationships that are likely to
impair an auditor's objectivity and impartiality than the current rule?
    27. We understand that it is more common today for companies to
enter into multi-company arrangements in delivering products or
services and that audit firms may contribute to such multi-company
arrangements, such as through intellectual property or access to data
using common technology platforms. Do these arrangements present
instances where an auditor's objectivity and impartiality would not be
impaired even after considering the proposed amendments discussed in
this release? If so, what further amendments should be considered to
appropriately focus on relationships where it is more likely an
auditor's objectivity and impartiality would be impaired?
    28. Is the guidance related to ``persons associated with the audit
client in a decision-making capacity'' and its application to the
amended Loan Provision appropriate? Is further guidance needed to
assist auditors and their clients in applying the recently amended Loan
Provision and the proposed amendments? If so, what additional guidance
is needed? Should we codify this guidance in our rules?

D. Proposed Amendments for Inadvertent Violations for Mergers and
Acquisitions

    We understand from the staff's independence consultation experience
that in certain instances an independence violation can arise as a
result of a corporate event, such as a merger or acquisition, where the
services or relationships that are the basis for the violation were not
prohibited by applicable independence standards before the consummation
of such corporate event.\49\ For example, an audit firm could have an
existing audit relationship with an issuer that acquires another
company for which the audit firm was not the auditor but provided
services or had relationships that would be prohibited under Rule 2-01.
Through no action of the audit firm, the acquisition would cause what
had been

permitted non-audit services or relationships to become prohibited non-
audit services or relationships in violation of the auditor
independence rules when the prohibited services or relationships
occurred within the audit or professional engagement period as defined
in Rule 2-01(f)(5). We also received comments in response to the Loan
Provision Proposing Release suggesting that a transition framework
should be available for inadvertent independence violations triggered
by corporate events, such as IPOs and mergers and acquisitions.\50\
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    \49\ In this section, we refer to these types of violations that
only arise due to a corporate event, such as mergers and
acquisitions, as ``inadvertent violations.''
    \50\ See e.g., letters from Deloitte, PwC, KPMG, Crowe, CAQ,
Grundfest, Grant Thornton, BDO, EY, CCMC, FEI, AICPA, and AIC.
---------------------------------------------------------------------------

    With respect to IPOs, we preliminarily believe the proposed
amendments discussed in Section II.A.2 could significantly mitigate the
challenges associated with these transactions because only one year of
previous compliance with Rule 2-01 would be required. In an IPO, the
auditor generally has an existing auditor-client relationship with the
audit client and the IPO is generally contemplated well in advance of
its consummation. As a result, focusing the independence analysis on
the most recent preceding fiscal year should significantly mitigate the
challenges associated with consummating an IPO under our rules.
    We believe that the root cause of auditor independence issues
arising from mergers and acquisitions, however, generally differs from
that arising from IPOs. In situations involving mergers and
acquisitions, a pre-existing auditor-client relationship between the
auditor and the merged company or the company being acquired is less
likely, as compared to an IPO, and the timing of the transaction is
generally shorter and more uncertain. As such, these transactions can
give rise to auditor independence violations that are inadvertent and
often difficult to contemplate in advance.\51\ The prospect of auditor
independence issues arising as a result of a corporate acquisition
transaction can have an adverse effect on the audit client, as it may
result in the termination of audit work midstream or termination of the
non-audit service that is in progress in a manner that is costly to the
audit client.\52\ Alternatively, it could result in a delay of a merger
or acquisition while the auditor and its audit client attempt to
resolve the potential independence matters to the possible detriment of
the audit client and investors.\53\ Accordingly, we believe it is
appropriate to provide, in a manner that preserves investor protection,
a transition framework for mergers and acquisitions to address
inadvertent violations related to such transactions so the auditor and
its audit client can transition out of prohibited services and
relationships in an orderly manner.
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    \51\ Given that these violations arise out of relationships or
services that were in place before the relationships or services
became prohibited as a result of being subject to our independence
requirements, the staff has generally not objected, as part of the
independence consultation process, to the auditor and the audit
client's determination that the auditor's objectivity and
impartiality were not impaired in these circumstances.
    \52\ See e.g., letters from Deloitte and Grundfest.
    \53\ Id.
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    As such, we are proposing amendments to Rule 2-01 to address the
challenges discussed above that may result from a merger or
acquisition. The proposed framework follows the consideration of the
audit firm's quality controls similar to Rule 2-01(d).\54\ Under the
proposed amendments, the auditor must:
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    \54\ The Commission adopted Rule 2-01(d) as a limited exception
to address a covered person's violations in certain circumstances
that would be attributed to an entire firm. The effect of Rule 2-
01(d) is that an accounting firm with ``appropriate quality controls
will not be deemed to lack independence when an accountant did not
know of the circumstances giving rise to the impairment and, upon
discovery, the impairment is quickly resolved.'' 2000 Adopting
Release, at 65 FR 76052.
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     Be in compliance with the applicable independence
standards related to the services or relationships when the services or
relationships originated and throughout the period in which the
applicable independence standards apply;
     Correct the independence violations arising from the
merger or acquisition as promptly as possible under relevant
circumstances associated with the merger or acquisition;
     Have in place a quality control system as described in
Rule 2-01(d)(3) that has the following features:
    [cir] Procedures and controls that monitor the audit client's
merger and acquisition activity to provide timely notice of a merger or
acquisition; and
    [cir] Procedures and controls that allow for prompt identification
of potential violations after initial notification of a potential
merger or acquisition that may trigger independence violations, but
before the transaction has occurred.
    Regarding the first provision, the auditor must be in compliance
with the independence standards applicable to the entities involved in
the merger or acquisition transaction from the origination of the
relationships or services in question and throughout the period prior
to the SEC and PCAOB independence standards applying as a result of
such transaction.
    With respect to correction of the independence violation as
promptly as possible, our expectation is that the violation, in most
instances, should and could be corrected before the effective date of
the merger or acquisition. However, we understand in some situations it
might not be possible for the audit client and the auditor to
transition the prohibited non-audit service or relationship in an
orderly manner without causing significant disruption to the audit
client. In those situations, we would expect the relationship or
service to be corrected as promptly as possible after the effective
date of the merger or acquisition. Whether a post-transaction
transition is considered ``as promptly as possible'' depends on all
relevant facts and circumstances used to support the delayed
correction. However, under the proposed transition framework, we expect
all corrective action would be taken no later than six months after the
effective date of the merger or acquisition that triggered the
independence violation. Audit firms and audit clients already manage to
this timeline as it is consistent with international ethical standards
for accountants.\55\
---------------------------------------------------------------------------

    \55\ See The International Code of Ethics for Professional
Accountants (including International Independence Standards, section
titled, ``Mergers and Acquisitions'' under, ``Part 4A-Independence
for Audit and Review Engagements'' available at https://www.ifac.org/system/files/publications/files/Final-Pronouncement-The-Restructured-Code_0.pdf.
---------------------------------------------------------------------------

Request for Comment
    29. Should we provide the transition framework to address
inadvertent independence violations arising from mergers and
acquisitions, as proposed? Should we expand the proposed framework to
encompass IPOs? If so, would this eliminate the need for the proposed
amendments in Section II.A.2? If we expand the proposed framework to
encompass IPOs, are there additional criteria we should include in the
quality control requirement? Are there other transactions that should
be covered by the proposed framework?
    30. Are the proposed criteria for the quality control requirement
sufficiently clear? If not, how could they be clarified?
    31. Are there other criteria that should be added to the quality
control requirement?
    32. Should certain prohibited services and relationships continue
to be an independence violation regardless of the transition framework
such as if the

service or relationship results in the auditor auditing its own work?
    33. The proposed framework requires any independence violations
resulting from a merger or acquisition to be corrected as promptly as
possible. What is a reasonable period of time after the consummation of
a merger or acquisition that would allow for an auditor to correct most
types of violations covered by the proposed framework? Should the
proposed amendments specify a maximum period of time for such
corrections?
    34. Should we exclude certain types of merger and acquisition
transactions from the proposed transition framework? If so, what
transactions should be excluded? For example, should the framework
exclude transactions that are in substance more like an IPO, such as
when the acquirer is a public shell company? In these situations, would
it be more appropriate to apply the proposed amendments related to the
look-back period for IPOs?

E. Proposed Amendments for Miscellaneous Updates

1. Proposed Amendments To Update the Reference to Concurring Partner
Within Rule 2-01
    On August 17, 2018, the Commission updated a number of rules as
part of its disclosure effectiveness initiative.\56\ Prior to the
adoption of these amendments, Rule 2-01(f)(7)(ii)(B) explained that the
``partner[s] performing a second level of review to provide additional
assurance . . .'' are considered ``concurring or reviewing partners.''
\57\ In its recent amendments, the Commission revised the language in
Rule 2-01(f)(7)(ii)(B) to be consistent with current auditing
standards. As a result, the rule no longer uses the term ``concurring
partner'' and instead uses the terms ``Engagement Quality Reviewer''
and ``Engagement Quality Control Reviewer'' to describe the ``partner
conducting a quality review.'' As such, we propose conforming
amendments throughout Rule 2-01 to replace references to ``concurring
partner'' with the term ``Engagement Quality Reviewer.''
---------------------------------------------------------------------------

    \56\ Disclosure Update and Simplification, Release No. 33-10532
(Aug. 17, 2018) [83 FR 50148 (Oct. 4, 2018)].
    \57\ See 2018 Annual Edition of the Code of Federal Regulations,
17 CFR 210.2-01, available at https://www.govinfo.gov/content/pkg/CFR-2018-title17-vol3/pdf/CFR-2018-title17-vol3-part210.pdf.
---------------------------------------------------------------------------

2. Proposed Amendment to Preliminary Note to Rule 2-01
    We propose a technical amendment to convert the current Preliminary
Note to Rule 2-01 into introductory text to Rule 2-01, as this is
consistent with current Federal Register practices. This proposed
amendment is in no way intended to affect the application of the
auditor independence rules.
3. Proposed Amendment To Delete Outdated Transition and Grandfathering
Provision
    Rule 2-01(e) was added as part of the 2003 amendments discussed in
Section I to address the existence of relationships and arrangements
that predated those amendments.\58\ Based on the passage of time, these
transition and grandfathering provisions are no longer necessary. We
propose deleting the current Rule 2-01(e) and reserving it for the
proposed amendments discussed in Section II.D.
---------------------------------------------------------------------------

    \58\ See supra note 6.
---------------------------------------------------------------------------

Request for Comment
    35. Should we make the miscellaneous updates described above? Are
there other conforming amendments we should make in light of these
updates?

III. Economic Analysis

A. Introduction

    We are proposing to amend the auditor independence requirements in
Rule 2-01 by: (1) Amending the definition of an affiliate of an audit
client to address certain affiliate relationships in common control
scenarios and the definition of investment company complex; (2)
shortening the look-back period for domestic first time filers in
assessing compliance with the independence requirements; (3) adding
certain student loans and de minimis consumer loans to the categorical
exclusions from independence-impairing lending relationships; (4)
replacing the reference to ``substantial stockholders'' in the Business
Relationships Rule with the concept of beneficial owners with
significant influence; and (5) introducing a transition framework for
merger and acquisition transactions to consider whether an auditor's
independence is impaired, among other updates.
    We are sensitive to the costs and benefits of the proposed
amendments. The discussion below addresses the potential economic
effects of the proposed amendments, including the likely benefits and
costs, as well as the likely effects on efficiency, competition, and
capital formation.\59\
---------------------------------------------------------------------------

    \59\ 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. Further, Section 23(a)(2) of the
Exchange Act [17 U.S.C. 78w(a)(2)] requires the Commission, when
making rules under the Exchange Act, to consider the impact that the
rules would have on competition, and prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the Exchange Act.
---------------------------------------------------------------------------

    We note that, where possible, we have attempted to quantify the
benefits, costs, and effects on efficiency, competition, and capital
formation expected to result from the proposed amendments. In many
cases, however, we are unable to quantify the economic effects because
we lack information necessary to provide a reasonable estimate. For
example, we are unable to quantify, with precision, the costs to
auditors and audit clients of complying with the selected aspects of
the auditor independence rules and the potential compliance cost
savings and changes in audit quality that may arise from the proposed
amendments to Rule 2-01.
    The remainder of the economic analysis presents the baseline,
anticipated benefits and costs from the proposed amendments, potential
effects of the proposed amendments on efficiency, competition and
capital formation, and reasonable alternatives to the proposed
amendments.

B. Baseline and Affected Parties

    The proposed amendments would update the auditor independence
requirements, which would impact auditors, audit clients, and any other
entity that is currently or may become an affiliate of the audit
client. Other parties that may be affected by the proposed amendments
include ``covered persons'' of accounting firms and their immediate
family members. As discussed further below, the proposed amendments are
likely to affect investors indirectly.
    We are not able to estimate precisely the number of current audit
engagements that would be immediately affected by the proposed
amendments. We also do not have precise data on audit clients'
ownership and control structure. With respect to the proposed
amendments relating to treatment of student loans and consumer loans,
there is no data readily available to us relating to how ``covered
persons'' and their immediate family members arrange their financing.
Similarly there is no data readily available to quantify the number of
business relationships that audit firms have with beneficial owners of
an

audit client's equity securities where the beneficial owner has
significant influence over the audit client. As such, we are not able
to identify those auditor-client relationships that would be impacted
by the proposed amendments to the Business Relationships Rule. We
therefore are not able to quantify the effects of these aspects of the
proposed amendments.
    We have relied on information from PCAOB Forms 2 to approximate the
potential universe of auditors that may be impacted by the proposed
amendments.\60\ According to aggregated information from PCAOB Forms 2,
as of December 31, 2018, there were 1,862 audit firms registered with
the PCAOB (of which 984 are domestic audit firms, with the remaining
878 audit firms located outside the United States). According to a
report provided by Audit Analytics in 2018, the four largest accounting
firms audit about 75 percent of accelerated and large accelerated
filers \61\ and about 46 percent of all registrants.\62\
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    \60\ All registered accounting firms must file annual reports on
Form 2 with the PCAOB. To determine the number of audit firms
registered with the PCAOB, we aggregated the total number of
entities who filed a Form 2 with the PCAOB.
    \61\ Accelerated filers and large accelerated filers are defined
in Rule 12b-2 of the Exchange Act of 1934 [17 CFR 240.12b-2].
    \62\ See Who Audits Public Companies-2018 Edition, available at
https://blog.auditanalytics.com/who-audits-public-companies-2018-edition.
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    We estimate that approximately 6,919 issuers filing on domestic
forms \63\ and 393 FPIs filing on foreign forms would be affected by
the proposed amendments.\64\ Among the issuers that file on domestic
forms, approximately 29 percent are large accelerated filers, 19
percent are accelerated filers, 19 percent are non-accelerated filers,
and 33 percent are smaller reporting companies.\65\ In addition, we
estimate that approximately 21.3 percent of domestic issuers are
emerging growth companies.\66\
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    \63\ This number includes fewer than 25 foreign issuers that
file on domestic forms and approximately 100 business development
companies.
    \64\ The number of issuers that file on domestic forms is
estimated as the number of unique issuers, identified by Central
Index Key (CIK), that filed Forms 10-K and 10-Q, or an amendment
thereto, with the Commission during calendar year 2018. We believe
that these filers are representative of the issuers that would
primarily be affected by the proposed amendments. For purposes of
this economic analysis, these estimates do not include issuers that
filed only initial domestic Securities Act registration statements
during calendar year 2018, and no Exchange Act reports, in order to
avoid including entities, such as certain co-registrants of debt
securities, which may not have independent reporting obligations and
therefore would not be affected by the proposed amendments.
Nevertheless, the proposed amendments would affect any registrant
that files a Securities Act registration statement and assumes
Exchange Act reporting obligations. We believe that most registrants
that have filed a Securities Act registration statement, other than
the co-registrants described above, would be captured by this
estimate through their Form 10-K and Form 10-Q filings. The
estimates for the percentages of smaller reporting companies,
accelerated filers, large accelerated filers, and non-accelerated
filers are based on data obtained by Commission staff using a
computer program that analyzes SEC filings, with supplemental data
from Ives Group Audit Analytics.
    \65\ ``Smaller reporting company'' is defined in 17 CFR
229.10(f) as an issuer that is not an investment company, an asset-
backed issuer (as defined in 17 CFR 229.1101), or a majority-owned
subsidiary of a parent that is not a smaller reporting company and
that: (i) Had a public float of less than $250 million; or (ii) had
annual revenues of less than $100 million and either: (A) No public
float; or (B) a public float of less than $700 million.
    \66\ An ``emerging growth company'' is defined as an issuer that
had total annual gross revenues of less than $1.07 billion during
its most recently completed fiscal year. See 17 CFR 230.405 and 17
CFR 240.12b-2. See Rule 405; Rule 12b-2; 15 U.S.C. 77b(a)(19); 15
U.S.C. 78c(a)(80); and Inflation Adjustments and Other Technical
Amendments under Titles I and II of the JOBS Act, Release No. 33-
10332 (Mar. 31, 2017) [82 FR 17545 (Apr. 12, 2017)]. We based the
estimate of the percentage of emerging growth companies on whether a
registrant claimed emerging growth company status, as derived from
Ives Group Audit Analytics data.
---------------------------------------------------------------------------

    The proposed amendment related to the ``look-back'' period for
assessing independence compliance would impact future domestic first
time filers, but not future FPI first time filers. To assess the
effects of this amendment, we utilized historical data for domestic
IPOs. According to Thompson Reuters' Security Data Company (``SDC'')
database, there were approximately 421 domestic IPOs during the period
between June 30, 2016, and June 30, 2019.
    The proposed amendment related to a transition framework for merger
and acquisition transactions would impact issuers that might engage in
mergers and acquisitions at some point in time. To assess the overall
market activity for mergers and acquisitions, we examined mergers and
acquisitions data from SDC. During the period from January 1, 2016, to
December 31, 2018, there were 6,310 mergers and acquisitions entered
into by publicly listed U.S. firms.
    The proposed amendments to the ICC definition would potentially
affect registered investment companies and unregistered funds.\67\ We
estimate that there were 3,160 registered investment companies with an
``Active'' status as of December 2018. As of September 2019, there were
10,201 mutual funds (including money market funds) with $24,725 billion
in total net assets, 1,918 ETFs with $3,455 billion in total net
assets, 666 UITs (excluding ETFs) with $1,509 billion in total net
assets, 664 registered closed-end funds with $294 billion in total net
assets, and 13 variable annuity separate accounts registered as
management investment companies on Form N-3 with $224 billion in total
net assets.\68\ In addition, as of June 2019, there were 99 BDCs with
$63 billion in total net assets.\69\
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    \67\ Based on the current reporting requirements for
unregistered funds, we do not have data readily available regarding
unregistered funds that would allow us to quantify the number of
unregistered funds that would be affected by the proposed
amendments.
    \68\ Estimates of the number of registered investment companies
and their total net assets are based on a staff analysis of Form N-
CEN filings as of September 5, 2019. For open-end funds that have
mutual fund and ETF share classes, we count each type of share class
as a separate fund and use data from Morningstar to determine the
amount of total net assets reported on Form N-CEN attributable to
the ETF share class.
    \69\ Estimates of the number of BDCs and their net assets are
based on a staff analysis of Form 10-K and Form 10-Q filings as of
June 30, 2019. Our estimate includes BDCs that may be delinquent or
have filed extensions for their filings, and it excludes 6 wholly
owned subsidiaries of other BDCs.
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C. Potential Costs and Benefits

    In this section, we discuss the anticipated economic benefits and
costs of the proposed amendments. We first analyze the overall economic
effects of the proposed amendments. We then discuss the potential costs
and benefits of specific proposed amendments.
1. Overall Potential Benefits and Costs
    We anticipate the proposed amendments would benefit audit firms and
audit clients in several ways. First, the proposal is likely to reduce
compliance costs for both audit firms and their clients by updating
certain aspects of the auditor independence requirements that may be
unduly burdensome. The proposed amendments may reduce the emphasis in
our rules on relationships and services that are less likely to
threaten auditor objectivity and impartiality. As a result, the
proposed amendments likely would allow auditors and audit clients to
focus their resources and attention on those relationships and services
that are more likely to pose threats to auditor objectivity and
impartiality. In turn, compliance costs likely would decrease for both
auditors and audit clients.
    A reduction in compliance costs also may be realized because of the
potential larger pool of eligible auditors due to the proposed
amendments. With a larger pool of eligible auditors, audit clients
could potentially avoid costs associated with searching for an
independent auditor and related costs resulting from switching from one
audit firm to

another. Larger pools of potentially qualified independent auditors may
promote competition among audit firms, which may lower audit fees.
Reduction in audit fees would lead to cash savings for audit clients,
who could utilize the savings to make further investments or return
excess savings to investors, all which may accrue to the benefit of
investors. However, this competition effect may be limited because the
audit industry is highly concentrated \70\ with the four largest audit
firms auditing about 46 percent of all registrants. More specifically,
the four largest audit firms audit about 75 percent of accelerated and
large accelerated filers.\71\
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    \70\ See United States Government Accountability Office. Audits
of Public Companies--Continued Concentration in Audit Market for
Large Public Companies Does Not Call for Immediate Action, available
at www.gao.gov/new.items/d08163.pdf (2008).
    \71\ See supra note 62.
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    The potential expansion of auditor choices as a result of the
proposed amendments could also allow audit clients to align audit
expertise better with the audit engagement, which may lead to an
improvement in audit quality and financial statement quality.\72\ For
example, audit clients in certain industries might have more
complicated or very specialized businesses, requiring auditors of those
clients to possess certain expertise or experience. If the pool of
potential independent auditors is restricted due to prohibitions under
current Rule 2-01 that are the subject of the proposed amendments, an
audit client might have to choose what it regards as a ``suboptimal''
audit firm, which may not provide the highest quality audit services.
Since audit quality is correlated with financial reporting quality,\73\
the improved financial reporting quality under the proposed amendments
also would benefit audit clients as the higher quality of financial
reporting could potentially reduce information asymmetry between
auditors and their investors, improve firms' liquidity and decrease
cost of capital.\74\ Investors would similarly benefit from any
resulting improvement in financial reporting quality.
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    \72\ See Mark Defond and Jieying Zhang, A Review of Archival
Auditing Research, 58 J. Acct. Econ. 275 (2014).
    \73\ See id.
    \74\ See Siew H. Teoh and T.J. Wong, Perceived Auditor Quality
and the Earnings Response Coefficient, 68 Acct. Rev. (1993) 346-366.
See also Jeffery A. Pittman and Steve Fortin, Auditor Choice and the
Cost of Debt Capital for Newly Public Firms, 37. J. Acct. Econ.
(2004). 113-136; Jere R. Francis and Bin Ke, Disclosure of Fees Paid
to Auditors and the Market Valuation of Earnings Surprises, 11 Rev.
Acct. Stud. (2006) 495-523; Chan Li, Yuan Xie, and Jian Zhou,
National Level, City Level Auditor Industry Specialization and Cost
of Debt, 24 Acct. Horizon. (2010) 395-417; and Jagan Krishnan, Chan
Li, and Qian Wang, Auditor Industry Expertise and Cost of Equity, 27
Acct. Horizon. (2013) 667-691.
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    Auditors also could benefit from the proposed amendments as they
may have a broader spectrum of audit clients and clients for non-audit
services. If the proposed amendments reduce certain burdensome
constraints on auditors in complying with the independence
requirements, auditors likely would incur fewer compliance costs. In
addition, the proposed amendments could potentially reduce auditor
turnover due to changes in audit clients' organizational structure
arising from certain merger and acquisition activities. The proposal
may also benefit auditors that provide non-auditing services, as those
audit firms, under the proposed amendments, would be permitted to
provide such services to an entity that is under common control with
the audit client, so long as that entity is not material to the
controlling entity.
    There also could be certain costs associated with the proposed
amendments. For example, if the proposed amendments increase the risk
of auditors' objectivity and impartiality being threatened by newly
permissible relationships and services, investors could have less
confidence in the quality of financial reporting, which could lead to
less efficient investment allocations and increased cost of capital.
Overall, however, we do not anticipate significant costs to investors
or other market participants associated with the proposal because the
proposed amendments address those relationships and services that are
less likely to threaten auditors' objectivity and impartiality.
2. Benefits and Costs of Specific Proposed Amendments
    We expect the proposed amendments would result in benefits and
costs to auditors, audit clients, and investors, and we discuss those
benefits and costs qualitatively, item by item, in this section.
a. Proposed Amendments to the Definition of an Affiliate of the Audit
Client and Investment Company Complex
i. Affiliate of the Audit Client
    Currently, the term affiliate of the audit client includes not only
``an entity that has control over the audit client or over which the
audit client has control,'' but also those ``under common control with
the audit client, including the audit client's parents and
subsidiaries'' \75\ (emphasis added). Under this definition, affiliates
of the audit client include all entities under common control with the
audit client, including those that are not material to the controlling
entity. The current inclusion of sister entities that are not material
to the controlling entity in the auditor independence analysis creates
practical challenges and imposes compliance costs on both auditors and
audit clients, especially those with complex organizational structures.
As it relates to entities under common control, the proposed amendment
includes as affiliates of the audit client only sister entities that
are material to the controlling entity for the auditor independence
analyses. Excluding sister entities that are not material to the
controlling entity likely would reduce compliance costs associated with
having to consider and potentially monitor independence impairing
relationships and services involving such entities.\76\ The proposed
amendment also would help avoid the costs that audit clients could
incur to switch auditors. Additionally, the proposed amendment could
reduce instances of lost revenues from non-audit services (e.g.,
management functions) that auditors must give up where an independence
impairing relationship or service exists with a sister entity that is
not material to the controlling entity. These cost savings could be
especially pronounced for entities with complex organizational
structures (e.g., private equity structures) that have an expansive and
constantly changing list of affiliates because the proposal may
significantly reduce the number of entities that fall within the
definition of affiliates of the audit client.
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    \75\ Rule 2-01(f)(4)(i).
    \76\ As noted in Section II.A above, notwithstanding the
proposed amendments, auditors and their clients would continue to be
required to consider ``all relevant facts and circumstances,''
consistent with the general independence standard in Rule 2-01(b).
Thus, audit firms and their clients may continue to incur some costs
to consider such entities as part of their independence analysis.
However, for those relationships and services that might
nevertheless impact the auditor's independence under the general
standard in Rule 2-01(b), we would expect those relationships and
services individually or in the aggregate would be easily known by
the auditor and the audit client because such services and
relationships might be thought to reasonably bear on an auditor's
independence due to the nature, extent, relative importance or other
aspects of the service or relationship. We note that a similar
qualification applies with respect to other aspects of the proposed
amendments that could have the potential benefit of reducing
compliance costs associated with considering and monitoring
independence impairing relationships and services.
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    According to the current definition of affiliate of the audit
client, an auditor

with desired expertise may be excluded from a firm's audit engagement
consideration because the auditor currently provides management
functions for the firm's sister entity that is not material to the
controlling entity. The exclusion of certain specialized auditors from
an audit engagement due to their prohibited relationships or services
with a sister entity that is not material to the sister entity under
the current rule might lead to the audit engagement not being matched
with the most qualified auditors. Such an outcome could compromise the
audit quality and decrease financial reporting quality, thereby
imposing compliance costs on audit clients and investors. In addition,
the lack of matching between auditor expertise and audit tasks might
result in inefficiency in the auditing processes, which likely
increases the costs of audit services (e.g., audit fees).
    The proposed amendment to the definition of affiliate of the audit
client may result in an expansion of the pool of qualified auditors.
With an expanded pool of eligible auditors, competition among auditors
might increase, thereby reducing audit fees for audit clients.\77\
However, the auditor market is highly concentrated, and such cost
savings are likely to be limited. The expanded pool of qualified
auditors also might improve matching between auditor expertise and
audit task, thereby improving audit efficiency and reducing audit
costs.\78\ Furthermore, the proposed amendment might positively
influence audit quality and financial reporting quality through
improved auditor-client alignment.\79\
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    \77\ See Paul K. Chaney, Debra C. Jeter, and Pamela E. Shaw,
Client-Auditor Realignment and Restrictions on Auditor Solicitation,
72 Acct. Rev. (1997) 433. See also Emilie R. Feldman, A Basic
Quantification of the Competitive Implications of the Demise of
Arthur Andersen, 29 R. Ind. Org. (2006) 193; Michael Ettredge, Chan
Li, and Susan Scholz. Audit Fees and Auditor Dismissals in the SOX
Era, 21 Acct Horizon (2011) 371; Wieteke Numan and Marleen
Willekens, An Empirical Test of Spatial Competition in the Audit
Market. 20 J. Acct Econ. 450 (2012); and Joseph Gerakos and Chad
Syverson, Competition in the Audit Market: Policy Implications, 53
J. Acct Res. 725 (2015).
    \78\ 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 smaller audit firms. However, we believe that better
matching between auditor specialization and their clients and the
reduction in unnecessary auditor turnovers could potentially prevent
any decline in audit quality and in the long run may improve audit
quality.
    \79\ See Chen-Lung Chin, and Hsin-Yi Chin, Reducing Restatements
with Increased Industry Expertise, 26 Cont. Acct. Res., (2009) 729;
Michael Ettredge, James Heintz, Chan Li, and Susan Scholz, Auditor
Realignments Accompanying Implementation of SOX 404 ICFR Reporting
Requirements, 25 Acct Horizon (2011) 17; and Jacob Z. Haislip, Gary
F Peters, and Vernon J Richardson, The Effect of Auditor IT
Expertise on Internal Controls, 20 Int. J. Acct. Inf. Sys. 1 (2016).
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    The proposed amendments are likely to benefit investors indirectly.
First, the potentially expanded auditor choices under the proposed
amendment might improve audit quality through better matching between
auditor expertise and audit engagement, thus potentially enhancing
financial reporting quality.\80\ Better financial reporting quality
would help investors make more efficient investment decisions, thereby
improving market efficiency. Second, the potential reduction in audit
fees from possible increased competition among auditors and improved
audit efficiency might generate cash savings to audit clients, which
might be passed to investors.
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    \80\ See supra note 72.
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    The proposed ``materiality test'' in the amended definition of
audit client might require more efforts from audit firms and audit
clients to familiarize themselves with and to apply the test. This
might potentially increase the compliance costs. However, given that
the materiality concept is already part of the Commission's auditor
independence rules,\81\ we do not expect a significant learning curve
in applying the test or significant incremental compliance costs for
auditors.
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    \81\ See e.g., Rule 2-01(f)(4)(ii) and (iii).
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ii. Investment Company Complex
    As discussed in Section II.A.1.b, above, the proposed amendments
(1) direct auditors of an investment company or an investment adviser
or sponsor to include all entities within the proposed ICC definition
as affiliates of the audit client; (2) focus the ICC definition from
the perspective of the entity under audit; (3) include within the
meaning of the term investment company, for the purposes of the ICC
definition, unregistered funds; (4) amend the common control prong of
the ICC definition to include only sister investment companies,
advisers, and sponsors that are material to the controlling entity; and
(5) include within the ICC definition entities where significant
influence exists between those entities and an audit client.
    The proposed amendments to the ICC definition would impact the
analysis used to identify entities that are considered affiliates of
registered investment companies, unregistered funds, and investment
advisers or sponsors that are under audit. The proposal would lead to
improved clarity in the ICC definition and, for the purpose of auditor
independence analysis, could facilitate audit firms, registered
investment companies, unregistered funds, and investment advisors or
sponsors in complying with the auditor independence requirements. The
improved clarity under the amended definition may result in compliance
cost savings, thus benefiting audit firms and audit clients.
    The economic implications of the materiality test under the amended
definition of investment company complex are largely similar to those
for operating companies as discussed above. For example, under the
current ICC definition, an investment company audit client may have a
rather restricted set of independence compliant auditors due to the
current common control provisions. The proposed amendments could
potentially reduce compliance costs for investment company audit
clients because the proposed ICC definition excludes from the affiliate
analysis sister entities that are not material to the controlling
entity.
    In addition, the auditors with certain relationships or providing
certain non-audit services to sister entities that are not material to
the controlling entity may become eligible to serve as an auditor to
the audit client under the proposed amendments. The potential expanded
pool of compliant auditors could help registered investment companies
and unregistered funds hire (and retain) auditors who have more
relevant industry expertise, which potentially could lead to better
financial reporting for investment companies. Better financial
reporting quality, in turn, would benefit investors in registered
investment companies and unregistered funds by allowing them to make
more informed investment decisions.
    With respect to the proposed amendments that include unregistered
funds within the meaning of the term investment company, for purposes
of the ICC definition,\82\ we believe the proposed amendments provide a
useful update to the ICC definition that was adopted in 2000.
Specifically, we believe the proposed amendments provide clarity for
unregistered funds, their investment advisers or sponsors, and their
auditors. In addition to this clarity, defining investment company to
include unregistered funds would promote consistency in the application
of Rule 2-01 to registered investment companies and unregistered funds
so that these two types of audit clients, which share some similar
characteristics, would not be subject to

disparate application of the independence rules.
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    \82\ See proposed Rule 2-01(f)(14)(iv).
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    We do not anticipate significant incremental costs associated with
the proposed amendments to the ICC definition for registered investment
companies, unregistered funds, investment advisers or sponsors, or
auditors as well as investment company investors. The proposed
amendments may require additional effort from audit firms and
registered investment companies, unregistered funds, and investment
advisers or sponsors that are under audit to become familiar with the
application of the proposed ICC definition. This may potentially lead
to an initial increase in compliance costs. However, the proposed
amendments would improve the clarity of the ICC definition and
therefore likely would decrease overall compliance costs after affected
parties adjust to the new definition. The proposed materiality test is
already part of the Commission's auditor independence rules \83\ and
also is aligned with the proposed common control prong of the affiliate
of the audit client definition.\84\ Therefore, we do not expect a
significant learning curve in applying the test or significant
incremental compliance costs for auditors or registered investment
companies, unregistered funds, and investment advisers or sponsors.
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    \83\ See e.g., Rule 2-01(f)(4)(ii) and (iii).
    \84\ See Proposed Rule 2-01(f)(4)(i)(B).
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    We do not expect any significant economic effects associated with
amending the definition of ICC to include the concept of ``significant
influence.'' As discussed in Section II.A.1.b.iv above, audit clients
and auditors are familiar with the concept as a result of the