Bryan Chegwidden is a partner and David Geffen is a senior attorney at Ropes & Gray.

The Securities and Exchange Commission staff recently granted no-action relief to the Fidelity funds, whose auditor's independence was called into question by the "loan rule." Other fund boards are likely to face the same problem.

Earlier this year, several funds disclosed that their auditor was in talks with the SEC about the loan rule, which can be interpreted to mean that a fund's auditor is not independent if the auditor has a loan from a record or beneficial owner of more than 10% of the fund's equity securities.

In June, the SEC staff provided temporary no-action relief to the Fidelity funds. It stated that the staff would not recommend enforcement action against any fund whose auditor has one or more of three specific types of lending relationships, which it identified in the letter. The relief applies to all mutual funds in a similar circumstance and expires in December 2017.

The no-action letter imposed certain conditions. For example, the auditor must provide the audit committee with a written report regarding the auditor's independence. The report must include all relationships – including those with lenders – that may affect its independence. The auditor must discuss with the committee whether the reported relationships could affect its independence. The auditor also must conclude that it remains objective and impartial. In addition, if a meeting is scheduled for shareholders to elect directors or appoint an independent audit firm, the fund must make "reasonable inquiry" into whether the auditor's lender can exercise voting authority with respect to more than 10% of the fund's shares. If so, the no-action letter's relief may not be available.

There are a number of concrete steps boards should consider when confronted with a potential issue under the loan rule:

Understand the scope of the problem. The SEC's auditor independence rules, which include the loan rule, provide that, if an auditor is not independent with respect to one fund within a fund family, the auditor is not independent with respect to every fund within the fund family. Therefore, fund complexes with multiple boards should make sure that there is proper communication and coordination across the fund complex.
Require the auditor to describe in writing the extent and nature of its lending relationships and to document the reasons why it believes it is objective and impartial. This can include the auditor's ability to rely on other lenders or the relatively small amount of financing obtained from a particular lender. This should be more than a check-the-box exercise. The auditor should provide detailed information to satisfy any questions that the board has, and the board should be comfortable with the auditor's conclusion.
Approve policies and procedures that clearly assign responsibility for conducting the reasonable inquiry prior to a shareholders' meeting. Such policies and procedures could outline which of the fund's service providers are responsible for making the reasonable inquiry.
Be vigilant. Lending relationships are not static, and neither is share ownership – the two variables principally in play when determining whether an issue exists under the loan rule. A fund or fund complex that may not have the issue today may discover it does down the road. A periodic review of these matters may be appropriate to eliminate the possibility of a last-minute surprise.
Have a backup plan in place. This could include understanding the steps, timing and costs required to change auditors, if necessary. This may also include prior identification, vetting and approval of a replacement audit firm.
Watch the clock. The relief expires in December 2017. Although it is possible that the relief could be extended or a more permanent resolution found, there is no guarantee that either will happen. Bear in mind that the timing of the relief's expiration may impact different funds differently. For example, audits for funds with Oct. 31 or Nov. 30 fiscal year ends will be underway in December, potentially requiring swift implementation of a backup plan if the relief is not extended.

Every fund must distribute an annual report to its shareholders that is certified by an independent auditor, and that annual report must be incorporated into the fund's registration statement filed with the SEC. The recent problems under the loan rule and the resulting no-action letter underscore the value of an audit committee's regular dialogue with the fund's auditor. It is important to look for issues that could jeopardize the auditor's independence.

Six Steps Boards Can Take to Address Auditor Independence Issues

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