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  • Doug Chia

SEC Proposes Auditor Independence Rule Amendments

The SEC ended 2019 with two items relevant to public company audit committees: (1) a Statement on Role of Audit Committees in Financial Reporting and Key Reminders Regarding Oversight Responsibilities; and (2) Proposed Amendments to Rule 2-01 (Qualifications of Accountants) of Regulation S-X.


The first is a fairly anodyne summary of what every audit committee should think about every year -- tone at the top, auditor independence, management's use of non-GAAP measures, etc. Audit committees should consider using this helpful document as a checklist for its annual self-evaluation, and corporate secretaries and CFOs should add it to the orientation materials for new audit committee members.


The second is more significant, as it could meaningfully impact the independence analysis for hiring and retaining audit firms. I direct you to few other sites that have posted summaries better that I could write, so I can focus on my own observations: Weil, Cooley, Society for Corporate Governance.


The SEC says these proposed amendments are designed to make auditor independence analysis simpler and less burdensome and allow auditors and companies to focus their analysis on issues that could really impair independence as opposed to "foot faults" that may technically blow an audit firm's independence, but would really have no impact on their ability to make independent judgments when doing the work. It makes sense for the SEC to go back and make adjustments to rules based on what they've seen after period of time since they were implemented (in this case 16+ years). I actually wish they would do it more. Clearly, over the years, they've seen some fact patterns that have resulted in weird or even silly outcomes, and they give some mind-bending examples in their press release and Proposing Release, including a hypo involving an audit partner who is still paying off his student loans from college.


Whenever you have bright-line rules for things like independence or related persons, you're going to see some outcomes that make people throw up their hands and say, "C'mon, you gotta be kidding me!" It drives directors and executives nuts when annoying lawyers (like me) ask them every year to write down where all their kids, step-kids, step-parents, mothers and fathers in-law, sons and daughters in-law, and brothers and sisters in-law work and how much they make. In most cases, they probably don't know and don't care. Instead, they are forced to have some awkward conversations with family members they may otherwise never talk to or whom they haven't spoken to since Nana's funeral ten years ago. So, I'm all for freeing up time to focus on factors that could actually impair a person or firm's ability to do their work in a truly objective and independent fashion, rather than getting headaches confirming that no hyper-technicalities exist.


The SEC says these proposed amendments also "would increase the number of qualified audit firms an issuer could choose from" (quoting Chairman Clayton). Is that really the case? With all due respect, I'm not ready to presume this will happen. The theory is that once the proposed rules are adopted, companies will be able to look at firms they were not able to consider before to be their independent auditors. But, it would also make it easier for companies to keep their current independent auditors because they no longer have to fret if they come across one of the old trip-wires. I think we've all seen that most companies want to stick with the audit firms they have rather than go through the pain and expense of switching audit firms if they're not forced to. Companies and audit firms have been resistant to proposals to require companies to switch audit firms every few years or even rotate audit partners from the same firm every so often. While SEC's "more options to choose from" tune sounds good, I think "I'm Sticking With You" on the B-side will actually get more play. Not as much flipping means not as many opportunities for new engagements.


Also consider that the proposed rules may end up eliminating some choices as a result of industry consolidation. These rule changes may make it easier for the bigger fish to gobble up smaller ones that it didn't want to before because of too many independence entanglements. Remember that not too long ago we referred to the "Big Eight" audit firms. Now we're down to the "Big Four." Those four could get even bigger, resulting in fewer choices for issuers.


As is to be predicted, we're already seeing some characterize these proposed amendments as "relaxing," "easing," or "loosening" the rules for auditors. My guess is the comment letters from investors and investor advocacy groups will follow this line of thinking, and they won't be happy. Just like popular opinion in Corporate Governanceland is "more disclosure is always better," the conventional wisdom is that more independence is always better. This proposal may be going in the other way. That'll be good if it gets rid of nonsensical restrictions and creates more competition, but I'm not sure the latter is going to happen, despite what the SEC says with such degree of certainty.