Overview of SEC Auditor Independence Rules for Private Funds
The complexity and rate of change for compliance requirements for financial service entities have increased dramatically since the 2008 financial crisis. The U.S. Securities and Exchange Commission (“SEC”) has greatly expanded regulatory scope to include many private fund managers and added new reporting, record- keeping and inspection requirements. These changes also have greatly increased the complexity of the regulatory framework for advisors. How funds are structured and how management uses and distributes audited financial statements may affect regulatory compliance. While using various holding companies for acquisitions may be beneficial for tax or legal purposes, the presence of controlling interests in these structures may impose regulatory requirements that did not previously exist.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) requires all private fund managers with more than $150 million in assets to file as a Registered Investment Adviser (“RIA”) with the SEC under the Investment Advisers Act. RIAs with custody of client assets are subject to the Custody Rule under Section 206(4) of the Investment Advisors Act of 1940 (“Advisers Act”) and Advisers Act Rule 206(4)-2.
Advisors to pooled investment vehicles which generally include private investment funds and/or private equity funds can comply with the Custody Rule if, among other things, the pooled investment vehicle is audited at least annually by a PCAOB-registered independent public accountant that is subject to regular inspection by the PCAOB. This does not mean the financial statement audits have to be conducted in accordance with PCAOB audit standards resulting in the issuance of a PCAOB-based audit opinion. However, it does mean auditors of pooled investment funds are subject to the more stringent auditor independence guidelines issued by the PCAOB and the SEC under Rule 2-01 of Regulation S-X (“Rule 2-01”), which require auditors maintain strict independence from SEC audit clients.
Independence for these audit clients also means audit firms are prohibited from performing non-audit services for the funds and many of their portfolio companies. This relationship creates what is known as an Investment Company Complex (“ICC”).1 Entities within the ICC include the advisor, the funds controlled by the advisor and the corresponding portfolio controlled by the fund. Any entity within the ICC is required to be under SEC independence standards from the audit firm performing the fund audit. Rule 2-01(c)(4) of Regulation S-X sets forth a non-exhaustive list of non-audit services which cannot be provided by the audit firm to its audit clients and be considered independent.
Recent Regulatory Updates
In October 2020, the SEC adopted amendments to certain auditor independence requirements in Rule 2-01 which governs independence requirements for the aforementioned RIAs (“Amendments”). The amendments modernize the rules and “more effectively focus the analysis on relationships and services that may pose threats to an auditor’s objectivity and impartiality.” The Final Rule and the adopting press release provide helpful examples to inform the application of the Amendments.2
By adopting the Amendments, the SEC seeks to increase investor protection by focusing the auditor independence rules (and thereby the attention of audit clients, audit committees and auditors) on relationships and services that are more likely to jeopardize the objectivity and impartiality of auditors, while avoiding potentially time- consuming audit committee review of technical rule violations and similar non-substantive matters. The Amendments are particularly helpful for private equity firms and investment companies with numerous portfolio
companies and investments. Below are a few, but not all, of the changes that impact private fund clients:
- Address potential independence issues arising when portfolio companies with a common investment advisor, or investment companies within the same investment company complex, have engaged an audit firm to provide audit and non-audit services that could impair the independence of the audit firm;
- Shorten the IPO look-back period for domestic first-time filers in assessing compliance with the independence requirements; and
- Introduce a transition framework to address inadvertent independence violations that only arise as a result of mergers or acquisitions.
Independence Issues Involving Affiliated Sister Entities
The Amendments amend the definitions of “affiliate of the audit client,” in Rule 2-01(f)(4), and “investment company complex,” in Rule 2-01(f)(14), to incorporate a dual materiality threshold such that a sister entity will be included as an affiliate of the audit client if the sister and the entity under audit are each material to the controlling entity. If either the sister entity or the entity under audit is not material to the controlling entity, then the sister entity will not be deemed to be an affiliate of the audit client. As a result, the Amendments will address and resolve certain auditor independence issues that private equity funds, investment companies and their affiliates currently face as a result of relationships and services that do not ultimately jeopardize the objectivity and impartiality of the audit firm.
In relation to sister entities within the same investment company complex, the Amendments apply the dual materiality threshold with respect to sister investment advisers or sponsors with a common controlling entity, but the SEC has clarified that the dual materiality threshold will not apply to sister investment companies under the control of a shared investment adviser or sponsor. As a result, such entities should continue to be included as part of the investment company complex in evaluating the auditor’s independence, regardless of materiality.
IPO Look-Back Period
The Amendments also amend the definition of “audit and professional engagement period,” in Rule 2-01(f)(5)(iii), to shorten the look-back period for domestic first-time filers to one year, rather than covering all periods included in the issuer’s registration statement (which can be up to three years). The result of this amendment is that all first-time filers (i.e., domestic issuers and foreign private issuers) are treated similarly for purposes of the independence requirements under Rule 2-01. This is especially important for entities which may become public under a Special Purpose Acquisition Company or SPAC merger.
Transition Framework for Mergers and Acquisitions
The Amendments also introduce a transition framework to address inadvertent independence violations arising only as a result of a merger or acquisition under circumstances in which the services or relationships that are the basis for the violation would not have violated applicable independence standards prior to the corporate event. Under amended Rule 2-01(e), an auditor’s independence will not be impaired if an audit client engages in a merger or acquisition transaction resulting in a service or relationship that would otherwise be inconsistent with Rule 2-01 if:
- the auditor has been 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;
- the auditor addresses such services or relationships promptly under relevant circumstances as a result of the occurrence of the merger or acquisition; and
- the auditor has in place a quality control system as described in Rule 2-01(d)(3) that has the following features: (i) procedures and controls that monitor the audit client’s merger and acquisition activity to provide timely notice of a merger or acquisition; and (ii) procedures and controls that allow for prompt identification of potential violations after an initial notification of a potential merger or acquisition that may trigger independence violations, but before the effective date of the merger or acquisition.
What does this mean for PE Funds and Portfolio Companies?
If a private equity fund is subject to SEC independence rules, the auditor cannot provide prohibited services to any portfolio company that roll up into that fund’s financial
statements, assuming it is 1) controlled by the advisor and 2) material to the advisor.
When applying this definition, the following should be noted:
- Control is presumed if there is more than 50 percent ownership Control also may exist when there is less than 50 percent ownership interest if there are other conditions through which control could be exercised, e.g., board rights, veto rights, a contract, etc.
- Significant influence is presumed if there is 20 percent or more ownership interest but less than 50 percent ownership interest or if board rights or similar features are 20 percent or greater but less than 50 percent.
- An investment is deemed material if the investment in the investee is 5 percent or more of the private equity group’s total assets or fund that is subject to SEC If an investment is not yet material, consideration should be given to the likelihood that an affiliate may become material because of changes in the value of the investee.
This rule applies whether the portfolio companies are reported at fair value or are consolidated. It should be noted, however, that there is a “not subject to audit” exception which can be applied to certain brother/sister entities of a portfolio company which are deemed affiliates. For entities which meet the “not subject to audit” exception, audit firms are allowed to perform certain conditionally permissible services:
- Bookkeeping or other services related to the audit client’s accounting records or financial statements, g., preparing financial statements or tax provisions and providing valuation or tax provision templates;
- Financial information systems design and implementation;
- Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
The “not subject to audit” exception cannot be applied to the following categorically prohibited services:
- Management or human resources functions, g., executive searches
- Loaned staffing arrangements
- Litigation support
In the end, maintaining auditor independence in a private equity environment can be particularly challenging given the significant number of entities considered to be under common control and within the ICC. First and foremost, independence is a shared responsibility between the auditor and management. This requires a heightened level of communication between the auditor and the private equity fund management team regarding matters such as non-audit services. It is equally important there be heightened two-way communication between private equity fund management and its portfolio companies regarding these matters.
1. See, Appendix II for ICC definition from the SEC.
2. See SEC adopting release for the new rules at www.sec.gov/rules/final/2020/33-10876.pdf and the related Press Release entitled “SEC Updates Auditor Independence” at www.sec.gov/news/press-release/2020-261.