On Friday, the SEC announced amendments to the auditor independence requirements set forth in Rule 2-01 of Regulation S-X. Here’s the 130-page adopting release. The amendments are intended to update the independence rules to address recurring fact patterns that triggered technical independence rule violations without necessarily impairing the auditor’s objectivity and impartiality.
Among other things, the amendments address independence issues that arise when sister companies with a common PE fund owner have engaged an audit firm to provide non-audit services that could impair the independence of the audit firm with respect to another sibling company. The amendments also shorten the look-back period for auditor independence from three years to one year for first time filers, which will provide increased flexibility for IPO companies to address potential disqualifying relationships with their audit firms.
The SEC’s press release summarizes the changes implemented by the amendments & provides a couple of examples of how they will work. According to the release, the amendments will:
– Amend the definitions of “affiliate of the audit client,” in Rule 2-01(f)(4), and “investment company complex,” in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control;
– Amend the definition of “audit and professional engagement period,” specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements;
– Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships;
– Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence;
– Replace the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions; and
– Make certain other miscellaneous updates.
I’ll give you three guesses how the SEC’s vote on this went down – and the first two don’t count. Anyway, here’s Chair Clayton’s statement on the adoption of the amendments, and here’s the customary dissenting statement from Commissioners Lee and Crenshaw. The dissenters expressed concern with the increased discretion provided to audit firms when assessing their own independence and the lack of any mechanism to provide visibility into how auditors are exercising this discretion. We’ll be posting memos in our “Auditor Independence” Practice Area.
Enforcement: SEC Provides $20MM Reminder That You’d Better Know What You Know. . .
In addition to the SEC’s amendment of Rule 2-01 of S-X, there was also some interesting news on the enforcement front last Friday. The SEC announced a settled enforcement proceeding against Andeavor LLC arising out of alleged internal controls violations that resulted in the company engaging in a stock buyback while it was engaged in preliminary merger negotiations with a potential buyer.
According to the SEC’s order, the company’s CEO directed its CFO to initiate a $250 million stock buyback two days before the CEO was scheduled to meet with his counterpart at Marathon to resume confidential discussions about Marathon’s potential acquisition of Andeavor at a significant premium. The next day, Andeavor’s law department approved a Rule 10b5-1 plan to repurchase $250 million of stock. It made that authorization after concluding that these discussions did not constitute MNPI.
According to the order, that conclusion was “based on a deficient understanding of all relevant facts and circumstances regarding the two companies’ discussions.” As this excerpt from the order notes, the SEC contended that this deficient understanding was the result of a breakdown in internal accounting controls:
This lack of understanding was the result of Andeavor’s insufficient internal accounting controls. Andeavor used an abbreviated and informal process to evaluate the materiality of the acquisition discussions that did not allow for a proper analysis of the probability that Andeavor would be acquired. Andeavor’s informal process did not require conferring with persons reasonably likely to have potentially material information regarding significant corporate developments prior to approval of share repurchases.
In particular, nobody involved in the process discussed with the CEO the prospects that the two companies would reach a deal, which the SEC said resulted in a miscalculation of its probability (remember, we’re in Basic v. Levinson territory here). The company ultimately consented to a C&D against violations of the book & records provisions of the Exchange Act and a $20 million penalty.
The trouble with contingency cases is that there’s a huge potential for hindsight when you know how things ended up, and this case is no exception. The parties ultimately did agree on a deal at a valuation of $150 per share in April 2018 – compared to an average price of $97 paid for shares acquired in the buyback during February & March of the same year. That’s not exactly an ideal fact pattern for defending a position that the preliminary merger negotiations weren’t material.
A key takeaway from this proceeding seems to be that one of the key functions of internal controls – whether you’re talking about disclosure controls & procedures or ICFR – is to enable companies to “know what they know.” That’s even more important when dealing with contingency disclosure. Companies that want to defend claims that are brought with the benefit of hindsight need to demonstrate that their control procedures were robust & well-functioning at the time a critical judgment call was made.
Virtual Meetings: P&G Gets It Right
Soundboard Governance’s Doug Chia has attended a slew of virtual annual meetings this year, and he says that Procter & Gamble’s recent meeting was among the best he’s seen. Check out his recent blog for the details.
Doug will also be participating in our webcast next Thursday, October 29th – “Virtual Annual Meetings: What To Do Now” – along with CII’s Amy Borrus, Dorothy Flynn of Broadridge, Independent Inspector of Election Carl Hagberg and Bristol-Myers Squibb’s Kate Kelly. Don’t miss it!
– John Jenkins