SEC Proposes New Rule on Funds’ Valuation Practices

On April 21, 2020, the Securities and Exchange Commission (SEC) issued a proposal (the proposing release) to adopt Rule 2a-5 (the proposed rule) under the Investment Company Act of 1940, as amended (the Act), addressing good faith determinations of fair value by registered investment companies and business development companies (collectively, funds). The proposed rule reflects an effort to provide a clear and specific structure to define compliant determinations of fair value — a structure that explicitly allows fund boards of directors (boards) to assign fair value determinations of any or all fund investments to the fund’s adviser or sub-advisers.

Background

Section 2(a)(41) of the Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations are readily available and to otherwise use the fair value of that security as determined in good faith by the board. The SEC last comprehensively addressed valuation under the Act through the 1969 Accounting Series Release 113 and the 1970 Accounting Series Release 118 (together, the ASRs) and provided valuation guidance for money market funds in adopting final money market rules in 2014. The ASRs provided guidance on certain accounting and auditing matters as well as the role of the board in fair value determinations. Under the ASRs, the board was required to, among other things, (i) choose the methods used to arrive at fair value and continuously review the appropriateness of such methods, (ii) consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available, and (iii) carefully review the fair value findings.

The SEC has previously taken the position that a board may not delegate the determination of fair value to anyone else. However, the proposing release emphasizes that determining fair value now requires greater resources and expertise than when the SEC issued the ASRs. The proposing release points to changes in markets and fund investment practices as well as significant regulatory developments that have altered the framework in which funds, boards, fund service providers and auditors perform functions related to fair value determinations. The proposing release further cites the growing complexity of valuation and board oversight of funds in light of recent regulatory developments in fund fair value practices, as well as the increased need for expertise on the part of fund advisers in the fair value determination process.

Overview of the Proposed Rule

The proposed rule covers the board’s role in assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining records.

• Fair Value Determinations. Funds would be required under the proposed rule to perform the following functions, either through the board or through an adviser:
  • Valuation risks — A fund would be required to periodically assess any material risks associated with determining the fair value of the fund’s investments (including material conflicts of interest) and managing the identified risks. The proposed rule does not specify particular valuation risks to be addressed or prescribe the frequency of review, but instead notes that these factors would be based on the facts and circumstances of a particular fund’s investments.
  • Fair value methodologies — A fund would be required to select an appropriate methodology and apply it in a consistent manner when determining fair value. The proposed rule would require the party (whether the board or the adviser) making valuation decisions to specify (1) the key inputs and assumptions specific to each asset class or portfolio holding and (2) the methodologies that will apply to new types of investments in which the fund intends to invest. The selected methodologies would have to be periodically reviewed, and the board or adviser would have to monitor for circumstances under which a fair value determination is needed.
  • Testing of fair value methodologies — The board or adviser would be required to test the appropriateness and accuracy of the methodologies used to calculate fair value. The proposed rule would require the identification of (1) the testing methods to be used and (2) the minimum frequency of the testing, based on the facts and circumstances of each fund.
  • Pricing services — For funds that use pricing services, the proposed rule would require the board or adviser to establish a process for the approval, monitoring and evaluation of each pricing service provider. Specifically, the board or adviser would have to establish criteria (e.g., objective thresholds) under which a pricing service’s basis for its pricing information may be challenged.
  • Fair value policies and procedures — The proposed rule would require the fund or the adviser, depending on how valuation responsibilities are assigned, to develop written policies and procedures for the fair value of the fund’s investments. These policies and procedures would have to be reasonably designed to achieve compliance with the proposed rule.
    • In practice, where the board determines the fair value of the investments, the board-approved fair value policies and procedures would be adopted and implemented by the fund. Where fair value is assigned to the adviser by the board, the fair value policies and procedures would be adopted and implemented by the adviser and subject to board oversight under rule 38a-1.
  • Recordkeeping — The proposed rule would require that a fund maintain certain records sufficient for a third party to verify the fair value determination.
• Performance of Fair Value Determinations.
  • Board oversight — Where the board assigns day-to-day fair value determinations to an adviser, the proposed rule would require the board to satisfy its statutory obligation with respect to the determinations by actively overseeing the adviser, taking into account the fund’s particular type and level of valuation risks, including risks with respect to conflicts of interest.
    • While fair valuation responsibility for a portion of a fund overseen by a sub-adviser may be assigned to that sub-adviser, the fund’s policies and procedures adopted under rule 38a-1 would need to address the added complexity of oversight in such an arrangement.
  • Board reporting — Where valuation determinations are assigned to an adviser, the adviser would be required to provide relevant and tailored reports to the board that include such information as may be reasonably necessary for the board to be familiar with and to evaluate the adviser’s process.
    • Quarterly reports: Advisers would have to provide the board a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the assigned portfolio of investments, at least quarterly. The periodic reports would have to include, at a minimum, a summary or description of:
      • material valuation risks (including conflicts of interest)
      • material changes to or material deviations from established fair value methodologies
      • testing results for fair value methodologies
      • adequacy of resources allocated to fair value determinations
      • material changes to the process for overseeing pricing services
      • any other information requested by the board
    • The proposing release suggests a number of other items that may assist boards in their oversight of the adviser, including among other things summaries of adviser price challenges, calibrations and back-testing data, stale price reports, the adviser’s due diligence on pricing services, reports on outlying price changes, narrative summaries or reports on pricing errors, and trends in the portion of the fund’s portfolio that were fair valued or valued using broker quotes.
    • Prompt board reporting: Under the proposed rule, advisers would be required to report in writing promptly (no later than three business days after the adviser becomes aware) to the board on matters associated with the adviser’s process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments.
  • Adviser Responsibilities — Advisers assigned fair value determinations would be required to reasonably segregate the process of making fair value determinations from the portfolio management of the fund. An adviser’s fair value policies and procedures would also have to specify the individuals and the functions they cover in the valuation process, or, if the adviser uses a valuation committee, the composition of the committee.
  • Records of assignment — A fund would be required to maintain records related to the fair value determinations assigned to an adviser for at least five years that include (1) copies of the reports and other information provided to the board and (2) a specified list of the investments or investment types whose fair value determinations have been assigned to the adviser.
• Readily Available Market Quotations. The proposed rule would provide that a market quotation is readily available for purposes of section 2(a)(41) of the Act with respect to an investment only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. Other than in these circumstances, a fund would be required to use fair value in accordance with U.S. generally accepted accounting principles.

The proposing release states that the ASRs, certain existing staff no-action letters and other staff guidance in connection with the role of the board in good faith determinations of fair value would be rescinded. Funds would be granted a one-year transition period to come into compliance with Rule 2a-5 after it is adopted.

The proposing release includes numerous questions for public comment on the proposed rule and how it relates to funds’ fair value practices. The public comment period will remain open until July 21, 2020.

Practice Points

The proposed rule may not fundamentally change the fair value process at the board level, particularly with larger fund groups that already have a well-developed fair value process. In all probability, most fund boards will decide to take advantage of the proposed rule and assign their fair value responsibilities to the adviser, who in most cases is already fair valuing fund securities under board supervision. If a board assigns these responsibilities, the proposed rule would require the adviser to adopt fairly specific fair value policies and procedures. Areas of focus for adviser policies would include, among others, testing of the pricing methodologies used, the basis for challenging pricing services’ prices, segregation of portfolio management personnel from the fair value process, quarterly assessments provided to the board regarding the adequacy and effectiveness of the adviser’s pricing policies and procedures, and prompt board reporting with regard to material issues regarding the adviser’s fair value process. The proposed rule, however, would still require the board to engage in “active oversight” of the adviser with regard to the fair value process. Accordingly, even if the board assigns its responsibilities to the adviser, it will still find itself performing a significant level of oversight over the fair value process under the proposed rule.