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SEC updates auditor independence rules: impact for Registered Investment Advisors

Authored by Justin Heckler

On Oct. 16, 2020, the U.S. Securities and Exchange Commission (SEC) announced it has adopted final amendments to auditor independence requirements in Rule 2-01 of Regulation S-X.

Overview of Rule 2-01 of Regulation S-X

Rule 2-01 of SEC Regulation S-X is designed to ensure that auditors are qualified and independent of their audit clients. These rules set forth the independence requirements for the issuance of audit, attestation and review reports filed with the SEC.

Registered Investment Advisors (RIA) are required to comply with these SEC independence rules if the RIA uses the audit in satisfying Rule 206(4)-2 (the Custody Rule). For RIAs, Rule 2-01 applies not only to the entity under audit or examination, but also to each of the entity’s affiliates and to entities within an investment company complex (ICC).

RIAs and their audit firms are required to continually identify and monitor for potential independence-impairing relationships. In general, these relationships include, but are not limited to: the audited entity (or fund), the general partner of the entity, the RIA, any affiliated entities that control the general partner and RIA, other entities advised by the RIA, other entities in which the general partner holds an interest, portfolio investee companies controlled by the entity and portfolio companies over which the entity has significant control.

When evaluating and monitoring independence, the nature and extent of these relationships for RIAs can be challenging, given: 1) the potentially significant number of affiliated entities within an ICC; and 2) the wide range of services that can be provided to them.

Purpose of amendments to Rule 2-01

The SEC acknowledged the challenges RIAs and audit firms can face when identifying and monitoring potential independence-impairing relationships and services. They further acknowledged that certain relationships and services between RIAs and audit firms have previously caused technical independence violations without necessarily impairing an auditor’s objectivity and impartiality.

The amendments aim to reduce the amount of non-substantive rule breaches and to better focus auditor independence rules on relationships and services that are more likely to impact the objectivity and impartiality of auditors.

Key highlights for RIAs

To address the challenges for RIAs noted above, the SEC has amended the definitions of “affiliate of the audit client” in Rule 2-01(f)(4) and “ICC” in Rule 2-01(f)(14). Additionally, amendments were made to Rule 2-01(f)(4)(i) to address certain affiliate relationships.

  • Amendment to Rule 2-01(f)(4) – This amendment seeks to further clarify the definition of “affiliate of the audit client.” The amendment specifies that if an entity under audit is an investment company or RIA, “the auditor and audit client should look to Rule 2-01(f)(14) (i.e., the ICC definition) to identify affiliates of the audit client.”
  • Amendment to Rule 2-01(f)(4)(i) – This amendment moves towards including a materiality qualifier when evaluating auditor independence for operating and portfolio companies under common control of an entity under audit. Under this amendment, it is now appropriate to exclude entities within an ICC that are not material to the entity under audit. The SEC noted that if an entity within an ICC is not material to the entity under audit, then the relationships and services with such entity would not pose a threat to the auditor’s independence.
  • Amendment to Rule 2-01(f)(14) – This amendment moves to provide additional clarity of the definition of ICC by incorporating the term “entity under audit.” The intent is for auditors and their clients to focus their independence analysis from the perspective of the entity under audit, rather than evaluating the ICC in its entirety. Additionally, the amendment includes a revision to explicitly define the term “investment company” to include unregistered investment funds.

There certainly remains significant challenges for RIAs and audit firms in evaluating and monitoring their independence; however, these amendments seek to provide further clarity and to allow additional flexibility during this process. Auditors and clients should continue to have effective two-way communication as they navigate through SEC independence requirements.

The amendments will be effective 180 days after the date of publication and voluntary early compliance is permitted.

For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.

The information above was obtained from the SEC website, in particular press release 2020-261 and 17 CFR Part 210 [Release No. 33-10876; 34-90210; FR-88; IA-5613; IC-34052; File No. S7-26-19] RIN 3235-AM63.

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