The Securities and Exchange Commission passed amendments to ease its auditor independence rules, making the environment for GPs operating with their auditors easier.
Auditor independence rules generally don’t take up a significant chunk of a managers’ time but are of significance when firms opt into taking companies public or otherwise have to provide audited financial statements.
Jonathan Tuttle, partner at Debevoise & Plimpton, said: “The main issue that this was designed to address is something that’s been called the ‘up- and-over-rule.’”
The rule takes into scope all entities controlled by or under common control with the entity under audit. That means all of an audited portfolio company’s subsidiaries and third-party providers downstream, as well upstream to the fund and management company and back down to all of their subsidiaries.
Per Chilstrom, partner at Clifford Chance, said: “If [a manager has] a PE fund that owns multiple portfolio companies, and one of those companies is looking to do an IPO, under the current rules, [they] have to evaluate the auditor that you select for purposes of that IPO, and make sure that that auditor isn’t doing anything else for any of your other portfolio companies.”
For big firms with complex webs of companies and operational mandates, this could conceivably force managers to assess every portfolio company and third-party provider in a firm’s structure.
The rule is meant to retain audit integrity by keeping firms from benefiting from overly close relationships with their clients. Some view accounting firms that supply consulting and audit services to the same client as having a conflict of interest, but not if they only provide various audit services to the same client.
The recent amendments to the rule are in place to “avoid some of those ‘independence-impairing’ relationships that no one would have reasonably assumed were impaired,” said Tuttle.
If an auditor’s independence was deemed impaired, the accounting or audit firm would have to perform a “full facts and circumstances analysis” and consult with the SEC, Tuttle explained. Then all parties would have to agree on these facts and circumstances.
“Even though there may have been a prohibited relationship [in a given auditor-client transaction], but that prohibited relationship didn’t actually impair the independence of the audit firm on the particular entity, [then] that was just a costly and uncertain added transaction cost for everyone.”
Now, the Commission will only flag conflicts of interest when the auditor relationship is “material” to its parent, which would then end the progression of the “up-and-over-rule,” thus focusing the analysis in question with its immediate parent or subsidiaries.
Question of ‘materiality’
The Commission’s new focus on “materiality” is not clearly defined and will require closer analysis of other relationships “material” to an auditor.
In the adopting release, the SEC didn’t articulate anything to help analyze the concept of materiality in this specific context, Chilstrom said. But there are other references to materiality in other contexts within this rule change, as well as “other references to materiality in the accounting standards that auditors use,” he added.
“[The Commission’s] view is that as a result of all those other different contextual references to materiality, auditors will be able to, given their experience with using materiality in other contexts, determine what is material in this context,” Chilstrom said.
The Big Four accounting firms, who helped push for these amendments with SEC staff, have likely already made arguments to the SEC about how materiality should be interpreted.
“I think there will be precedents [discovered] for the auditor to build upon in terms of how they think about materiality,” Chilstrom said.