The staff of the SEC’s Division of Investment Management has provided temporary relief to the fund industry in connection with audit firm independence and Regulation S-X Rule 2-01(c)(1)(ii)(A) known as the “Loan Rule.” The no-action letter, issued on June 20, 2016, to Fidelity Management & Research Company, was in response to recent concerns raised by the SEC that under the Loan Rule certain lending relationships among shareholders and audit firms could impair auditor independence.
The “Loan Rule” and Auditor Independence
Registered investment companies and other investment vehicles regularly engage independent public accountants (“audit firms”) registered with the Public Company Accounting Oversight Board (PCAOB) to audit their financial statements and for other purposes as required by various securities laws. The “Loan Rule” provides that an audit firm is not independent if the firm, any covered person in the firm or any of their immediate family members have a loan to or from an audit client or the record or beneficial owners of more than 10 percent of the audit client’s equity securities. Under Regulation S-X, “audit client” refers to both the audit client and its “affiliates,” which include, among other entities, any entity that is controlling, controlled by or under common control with the audit client or is part of the same “investment company complex” as the audit client.
The Fidelity No-Action Letter Provisions
The Fidelity no-action letter provides that the staff of the SEC’s Division of Investment Management would not recommend enforcement action against the applicants for continuing to satisfy regulatory requirements under federal securities laws by using an audit firm that is not in compliance with the Loan Rule so long as: (i) the audit firm has provided, on at least an annual basis, the client’s audit committee with written disclosure regarding relationships between the audit firm and the client that may bear on the audit firm’s independence and discussed with the audit committee the potential impact of those relationships on audit independence; (ii) independence concerns are limited to the lending relationships described in the no-action letter; and (iii) notwithstanding the lending relationship the audit firm has concluded that it is objective and impartial with respect to its engagement.
The relief applies to the following situations in which an entity has a lending relationship with an audit firm:
- Institutions that hold of record, for the benefit of clients (e.g., an omnibus intermediary), more than 10 percent of the shares of an entity in an investment company complex;
- An insurance company that holds more than 10 percent of the shares of a registered investment company or exchange traded fund (ETF) on behalf of insurance contract holders; and
- An institution that acts as an authorized participant or market maker to an ETF and holds of record or beneficially more than 10 percent of the shares of the ETF.
Note that beneficial ownership is not covered in the first two instances above.
The no-action letter also provides relief where the lending institution implicated by the Loan Rule has taken steps to limit its discretion in voting its shares of the affected audit client. Such steps may include “mirror voting” (i.e., voting its shares in the same proportion as all other shares were voted), holding the shares in an irrevocable voting trust under which the institution has no voting discretion, agreeing to pass through the vote to an unaffiliated third party or otherwise relinquishing the right to vote.
The no-action letter further notes that the relief was based on a representation by the audit firm that the lending institution “is not able to impact the impartiality of the audit firm or assert any influence over the . . . Fund whose shares the institution owned or its investment adviser, under the circumstances.” Also important is that those responsible for oversight of the funds have not reached a different conclusion about the audit firm’s independence.
The no-action letter imposes more stringent requirements in connection with certain shareholder votes. That is, if shareholders are voting on the election of directors, the appointment of auditors or other unspecified matters that could influence the objectivity and impartiality of an audit firm, the fund must make “reasonable inquiry” as of the record date of the shareholder meeting regarding the Loan Rule. The SEC notes that this inquiry could include review of available ownership records and contacting applicable owners to inquire about their lending relationships with the audit firm. If that inquiry results in a finding that an institution with a lending relationship with the audit firm is exercising discretionary voting authority with respect to 10 percent or more of the fund’s shares, the no-action relief cannot be relied upon. The no-action letter points out, however, that this inquiry would not be necessary where a lending institution holds more than 10 percent of a fund (“Fund A”) in advance of a shareholder vote and is implicated by the Loan Rule solely because it has a lending relationship with an audit firm that is not Fund A’s audit firm, but is the audit firm of another fund in the same investment company complex (“Fund B”). In that instance, Fund B’s audit firm would not be able to impact the impartiality of Fund A’s audit.
Closed end funds have shareholder votes more frequently than open end funds and therefore may be more impacted by the “reasonable inquiry” requirements discussed above.
The relief provided by the SEC expires in 18 months (December 20, 2017), indicating that the staff is continuing to look for a more permanent solution. The letter specifically states that the SEC may or may not renew the relief at that time.
By its terms the no-action relief does not impose any additional requirements on auditors, audit committees and fund operations unless a shareholder vote is held. Existing PCAOB rules impose ongoing requirements on audit firms to annually communicate with clients on independence matters.
Audit committees may consider discussing these matters with their auditors at upcoming audit committee meetings or sooner, especially if a shareholder vote is anticipated in the near future. Funds may also need to develop written policies and procedures reasonably designed to ensure that a reasonable inquiry is made with respect to audit firm lending relationships in connection with a shareholder vote. We note that there are no disclosure requirements in the letter with regard to reliance on the no-action letter.
Should you have any questions about the issues raised by the no-action letter, please contact the Drinker Biddle Investment Management Group lawyer with whom you regularly work or one of the authors listed below.
 See, e.g., Section 30(e) of the Investment Company Act of 1940, as amended (the “1940 Act”), and Rule 30e-1 thereunder (requiring registered investment companies to provide their shareholders with financial statements audited by an independent public accountant each year); Form N-1A (requiring open-end registered investment companies to include or incorporate by reference their audited financial statements in their registration statements); Regulation S-X (setting forth requirements for financial statements and auditor independence); Rule 206(4)-2 of the Investment Advisers Act of 1940, as amended (requiring, subject to certain exceptions, registered investment advisers to submit client funds and securities over which they have custody to verification by an independent public accountant).
 Rule 2-01(f)(14) of Regulation S-X provides that an “investment company complex” includes (A) investment companies and their investment advisers or sponsors; (B) entities controlling, controlled by or under common control with such investment advisers or sponsors, provided that such entities are investment advisers or sponsors or provide administrative, custodian, underwriting or transfer agent services to any investment company, investment adviser or sponsor; or (C) any entity that would be an investment company but for Section 3(c) of the 1940 Act that has an investment adviser or sponsor included in (A) or (B) of this definition.