(Article from Registered Funds Alert, September 2016)
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Under the 1940 Act, registered funds (including ETFs) are required to provide financial statements, which must be audited by an independent accounting firm, to their shareholders on an annual basis and file them with the SEC. The SEC has set forth strict requirements identifying what conditions must be met for an accounting firm to be considered “independent.” The requirements are intended to ensure that accounting firms are qualified and independent of their audit clients both in fact and in appearance. Specifically, under Rule 2-01(c)(1)(ii)(A) of Regulation S-X, an accountant is not independent when:
“ [t]he accounting firm, any covered person in the firm, or any of his or her immediate family members has . . . [a]ny loan (including any margin loan) to or from an audit client, or an audit client’s officers, directors, or record or beneficial owners of more than ten percent of the audit client’s equity securities. ”
This is commonly referred to as the “Loan Rule.”
For over a decade, the four major accounting firms, among others, have generally interpreted the Loan Rule as not being applicable in the registered fund context. Accordingly, an accounting firm would be independent with respect to a registered fund, even when a large shareholder of the fund, such as a financial institution, has lent money to the accounting firm. However, in May 2016, it was revealed that the SEC’s Office of Chief Accountant and the Chief Accountant of the SEC Division of Investment Management indicated to certain accounting firms that they may be misinterpreting the Loan Rule. A change in the interpretation of the rule could have far reaching consequences for the fund industry. For example, the financial statements of many funds (who have been operating under the long standing interpretation of the Loan Rule) could be deemed deficient, given that the accounting firms would no longer be considered independent, and funds would be required to obtain a new (independent) audit and refile their financial statements.
In June 2016, however, the SEC granted temporary no-action relief addressing this issue. The relief allows fund complexes to continue to use financial statements audited by accounting firms that may not comply with the Loan Rule so long as certain conditions are satisfied.
First, the accounting firm must have complied with PCAOB Rule 3526(b)(1) and (2) (“Rule 3526(b)”), which requires the firm to describe to a client’s audit committee on at least an annual basis all relationships between the accounting firm (or any of its affiliates) and the audit client or persons in financial reporting oversight roles at the audit client that may impact the accounting firm’s independence and to discuss the potential effects of those relationships. The accounting firm must also confirm in writing that it meets applicable independence requirements. To the extent that Rule 3526(b) does not apply to an audited fund, the accounting firm must provide substantially equivalent communications.
Second, the SEC only granted relief for potential independence issues arising out of certain lending relationships:
(i) the financial institution that has lent money to the accounting firm holds more than ten percent of the shares of an audited fund (or an entity within the same fund complex);
(ii) an insurance company that has lent money to the accounting firm holds more than ten percent of the shares of an audited fund (or an entity within the same fund complex) in separate accounts that it maintains on behalf of its insurance contract holders; or
(iii) an institution that has lent money to the accounting firm and acts as an authorized participant or market maker to an audited fund (or an entity within the same fund complex) and holds of record or beneficially more than ten percent of the shares of the audited fund.
Finally, notwithstanding such non-compliance, the accounting firm must conclude that it is objective and impartial with respect to the issues encompassed within its engagement.
In relying on the relief, a fund is required to make reasonable inquiry regarding a lending relationship and its potential impact on an accounting firm’s independence prior to submitting certain proxy proposals to fund shareholders, including (i) the election of trustees, (ii) the appointment of an independent accounting firm or (iii) any other proposal that similarly could impact the independence and impartiality of the independent accounting firm. The no-action letter includes an expectation that funds will adopt policies and procedures to provide for such an inquiry, which may require contacting institutions that owns a significant stake in a fund and has a lending relationship with the accounting firm. In this regard, the no-action letter notes that the initial request for relief included a representation that if a fund discovers that a lending institution owning more than 10% of a fund’s outstanding shares actually exercises discretionary voting authority with respect to those shares, the fund would not be able to rely on the relief.
Notably, the SEC’s no-action letter is explicit that the relief is temporary and expires in December 2017. The temporary nature of the relief suggests the Commission may consider modifying the Loan Rule prior to the relief’s expiration. We will continue to monitor this issue and provide any significant updates in future Alerts.