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Auditor Independence No-Action Relief Extended

Posted in Fund Regulation

In a letter dated September 22, 2017, the SEC staff agreed to extend previous relief that enables registered fund groups to fulfill regulatory requirements under Regulation S-X if the accounting firm auditing the funds’ financial statements is not in compliance with Rule 2-01(c)(1)(ii)(A) of Regulation S-X (the “Loan Provision”).

Rule 3520 adopted by the Public Company Accounting Oversight Board (PCAOB) requires an auditing firm and its associated persons to be independent of their audit clients.  Under the PCAOB’s rules, audit firms are required to provide prospective clients with a written description of the relationships existing between the auditor and its clients.  Auditors make similar representations to existing clients annually.

The SEC takes the position that an accounting firm is not independent of its audit clients if it has a “lending relationship with any entities having a record or beneficial ownership of more than ten percent of any entity within the investment company complex of an audit client.”  Since certain financial institutions may hold more than 10 percent of the outstanding shares of a fund for the benefit of their underlying clients, and such financial institutions may from time to time have lending relationships with an audit firm or its associated persons, compliance with the Loan Provision of Regulation S-X is difficult to monitor and enforce.  In June 2016, therefore, the SEC staff agreed that it would not object to a fund group using financial statements that were audited by an accounting firm that failed to comply with the Loan Provision as long as the audit firm’s judgment remained “objective and impartial.”

The original no-action relief was temporary and set to expire 18 months after its issuance, or in December 2017.  Fund groups and audit firms who have been relying on the prior no-action relief will be relieved that the staff has determined to extend the previous relief.  Unlike the prior relief, there is no specific term for this relief, although it will be withdrawn if the PCAOB makes changes to the Loan Provision that address the SEC staff’s concerns.

For the time being, fund groups can continue to rely on their auditor’s independence as long as it continues to represent that it is objective and impartial with respect to the issues encompassed in its engagement.  In this regard, as noted by the SEC staff, since investors rely on audited financial statements in making their investment decisions, fund audit committees should still take care in reviewing any relationships between the funds’ auditor and the funds to ensure that the auditors meet the “independent and impartial” standard.