On April 21, 2020, the U.S. Securities and Exchange Commission (SEC) proposed a new framework for valuation practices under the Investment Company Act of 1940 (Investment Company Act) for registered open-end funds and closed-end funds, including business development companies (BDCs).1
Proposed Rule 2a-5 (Proposed Rule), which would replace decades-old guidance and interpretations, is designed to modernize the regulatory framework of registered fund valuation practices. It would clarify how fund boards can satisfy their valuation obligations in light of recent market developments, including an increase in the variety of asset classes held by funds and an increase in both the volume and types of data used in valuation determinations.
Proposed Rule 2a-5 is a major step forward that was decades in the making. The role of fund directors in determining fair values of portfolio holdings has been an evolving issue since 1940. The Proposed Rule recognizes the reality that fund directors are not in the best position to fairly value individual portfolio holdings. The Proposed Rule would create a principles-based standard that eliminates the need for directors and counsel to dig through rules, guidance, interpretations and no-action letters spread out over at least 50 years. It is now up to advisers, funds and their directors to evaluate whether the Proposed Rule is workable, the costs and resources required to comply and how the SEC can fine-tune it to protect fund shareholders and fund directors alike.
In the proposing release, the SEC stated that the Proposed Rule reflects the increased role that accounting and auditing developments play in setting fair value practices for funds as well as the growing complexity of valuation and the interplay of certain compliance rules under the Investment Company Act and the Investment Advisers Act of 1940 in facilitating board oversight of funds.2
Proposed Rule 2a-5 would establish clear requirements for a fund board in determining fair value in good faith with respect to the fund’s investments, which reflect the SEC’s understanding of current fair value practices. In determining the fair value of portfolio securities, the Proposed Rule would require fund boards to, among other things,
- assess and manage material risks associated with fair value determinations
- select, apply and test fair value methodologies
- oversee and evaluate any pricing services used
- adopt and implement valuation policies and procedures
- maintain certain records
Proposed Rule 2a-5 also would permit a fund’s board to “assign” the fair value determinations to an investment adviser of the fund, which would then carry out these functions for some or all of the fund’s investments. This assignment would be subject to board oversight and certain reporting, recordkeeping and other requirements designed to facilitate the board’s ability to oversee the adviser’s fair value determinations.
Proposed Rule 2a-5 would apply to all registered investment companies and BDCs, regardless of their classification or subclassification or their investment objectives or strategies.3 In the case of unit investment trusts (UITs), which do not have boards of directors or advisers, a UIT’s trustee would conduct fair value determinations under the Proposed Rule.
Rule 2a-5(a): Requirements for Determining Fair Value
The Investment Company Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations for those securities are “readily available” and, when a market quotation is not readily available, as determined in good faith by the fund’s board.4 The SEC has addressed valuation under the Investment Company Act on numerous occasions, and there have been a number of regulatory developments in other contexts that affected the regulatory framework of investment company fair value determinations.5 Proposed Rule 2a-5 is a response to these regulatory developments and, as described by the SEC staff, is intended to establish a “minimum, consistent framework for fair value and standard of baseline practice across funds.”6
Under Proposed Rule 2a-5(a), the following functions must be performed to determine in good faith the fair value of a fund’s investments:7
Determining Valuation Risks. Proposed Rule 2a-5 would require a periodic assessment of any material risks, including material conflicts of interest,8 associated with the determination of the fair value of a fund’s investments. The SEC said it believes that these assessments are “an important element for determining fair value in good faith, because ineffectively managed valuation risks can make it more likely that a board or an adviser may incorrectly value an investment.”9
The SEC provided a list of potential valuation risks that funds should assess, among them
- the types of investments held or intended to be held by the fund
- potential market or sector shocks or dislocations
- the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the adviser
- the proportion of the fund’s investments that are fair valued as determined in good faith, and their contribution to the fund’s returns
- any reliance on service providers that have more limited expertise in relevant asset classes, the use of fair value methodologies that rely on inputs from third-party service providers and the extent to which third-party service providers rely on their own service providers (so-called fourth-party risks)
- the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly
Fair Value Methodologies. Under Proposed Rule 2a-5, a good faith fair value determination would require selecting and applying in a consistent manner an appropriate methodology or methodologies. Among other things, this requirement would include specifying
- the key inputs and assumptions specific to each asset class or portfolio holdings
- the methodologies that will apply to new types of investments in which a fund intends to invest
To be appropriate under the Proposed Rule, any methodology must be consistent generally with ASC 820 and, specifically, the market approach, income approach and cost approach referred to therein. Further, any methodology would also have to reflect a range of potential fair values, as the SEC believes “that for any particular investment there may be a range of appropriate values that could reasonably be considered to be fair value, and whether a specific value should be considered fair value will depend on the facts and circumstances of the particular investment.”10
While the Proposed Rule would require that a fund apply a valuation methodology in a consistent manner, the Proposed Rule would not preclude the board or adviser from changing the methodology of an investment in certain circumstances. The Proposed Rule would also require funds to review periodically the selected methodologies for appropriateness and accuracy and to adjust them when appropriate.
Funds must establish the fair value of portfolio securities when market quotations are not readily available. Accordingly, as a component of determining appropriate fair value methodologies, the Proposed Rule would require a fund to establish a methodology or criteria for determining when market quotations are no longer reliable and not readily available.
Testing Fair Value Methods. Rule 2a-5 would require a fund to test the appropriateness and accuracy of the methodologies used to calculate fair value. Although the Proposed Rule does not specify the nature and frequency of such tests (which the SEC believes depend on the circumstances of each fund),11 the Proposed Rule would require the fund to identify
- the testing method to be used
- the minimum frequency of testing
Pricing Services. The Proposed Rule would require oversight and evaluation of pricing services, which typically provide funds with information on evaluated prices, matrix prices, price opinions, or similar pricing estimates, or information to help in determining the fair value of fund investments. Under the Proposed Rule, the board or adviser would be required to establish a process for the approval, monitoring, and evaluation of each pricing service provider. Factors for the board or adviser to consider would include, among other things,
- the qualifications, experience and history of the pricing service
- the valuation methods or techniques, inputs and assumptions used by the pricing service for different classes of holdings and how they are affected as market conditions change
- the pricing service’s process for considering price “challenges,” including how the pricing service incorporates information received from pricing challenges into its pricing information
- the pricing service’s potential conflicts of interest and the steps it takes to mitigate such conflicts
- the testing processes used by the pricing service
Fair Value Policies and Procedures. The Proposed Rule would require written policies and procedures “reasonably designed to achieve compliance with the requirements of” the Proposed Rule. Under the Proposed Rule, when the board determines the fair value of investments, the fund would adopt and implement the board-approved fair value policies and procedures. When the board assigns fair value determinations to the adviser (as discussed below), the adviser would implement and adopt the fair value policies and procedures, subject to board oversight under, and in compliance with, Rule 38a-1 under the Investment Company Act.
- documentation to support12 fair value determinations (such as information regarding specific methodologies and assumptions) for at least five years from the time the determination was made, the first two years in an easily accessible place
- a copy of required policies and procedures in effect within the past five years
Rule 2a-5(b): Assignment of Fair Value Determinations
The Proposed Rule reflects a recognition by the SEC that a fund board need not itself perform each of the specific tasks required to calculate fair value in order to satisfy its obligations under Section 2(a)(41).13 The SEC acknowledged the reality that in many cases it may be impracticable for fund directors themselves to fair value every portfolio security without help. In this regard, the SEC believes that Rule 2a-5 would provide a “consistent, modern approach” to allocating responsibility for fair valuing portfolio securities.14 The Proposed Rule, therefore, permits a fund’s board to assign fair value determinations relating to any or all fund investments to one or more investment advisers of the fund.15
Board Oversight: Taking a “Skeptical and Objective View.” When a fund board assigns fair value determinations to an adviser, Proposed Rule 2a-5 would require the board to satisfy its fiduciary obligations through oversight of the adviser. The SEC called for boards to take a “skeptical and objective view”16 that takes into account the fund’s particular valuation risks (including with respect to conflicts), the appropriateness of the fair value determination process and the skill and resources devoted to it. As described by the SEC staff, “oversight cannot be a passive activity.” Among other things, fund directors should
- ask questions and seek relevant information
- request follow up information when appropriate
- use the appropriate level of scrutiny based on the fund’s valuation risk17
- seek to identify potential conflicts of interest, monitor such conflicts and take reasonable steps to manage such conflicts in order to serve as a meaningful check on the conflicts of interest of the adviser and other service providers involved in the determination of fair value
- probe the appropriateness of the adviser’s fair value processes, such as periodically reviewing the financial resources, technology, staff and expertise of the adviser, and the reasonableness of the adviser’s reliance on other fund service providers, with respect to valuation
The SEC also reminded fund boards of their fundamental obligation to identify potential conflicts of interest of the adviser and other service providers involved in fair value determinations. Conflicts could arise, for example, when an adviser has an incentive to improperly value fund assets to increase fees, improve or smooth out performance returns or avoid violating the fund’s investment policies and restrictions.
Board Reporting. In an effort to streamline and ensure that boards receive “relevant and tailored information”18 from the adviser, the Proposed Rule would require that an adviser provide a board with at least quarterly reports with respect to valuation that include “such information as may be reasonably necessary for the board to evaluate the matters covered in the [fair valuation] reports.”19 Fund boards can “reasonably rely” on the reports that advisers and other service providers send them. The SEC staff emphasized, however, that these reports “are intended to supplement, not replace” director oversight of the valuation process.20
At a minimum, the Proposed Rule would require quarterly reports to include a summary or description of the following:
- assessment and management of material valuation risk, including any material conflicts of interest
- any material changes to, or material deviations from, methodologies
- the results of any testing of fair value methodologies
- adequacy of resources allocated to the process for determining the fair value of the fund’s assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value
- any material changes to the adviser’s process for overseeing pricing services, including any material events such as changes of service providers used or price overrides
In addition to periodic, quarterly reporting, the Proposed Rule would require the adviser to promptly report to the board in writing on matters that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments. An adviser is required to deliver such reports promptly but in no event later than three business days after the adviser becomes aware of the matter.21
Specification of Functions. The Proposed Rule would require an adviser to specify the titles of the persons responsible for determining the fair value of assigned investments.22 In addition, the fair value policies and procedures also would have to identify the specific personnel with duties associated with price challenges, including those with authority to override a price, and the roles and responsibilities of such persons, and establish a process for the review of price overrides.
In part to address the potential for conflicts of interest, the Proposed Rule would require the adviser to reasonably segregate the process of making fair value determinations from the portfolio management of the fund. However, recognizing that a fund’s portfolio manager may be the most knowledgeable person at an investment adviser regarding a fund’s portfolio holdings, the Proposed Rule would require a “reasonable segregation” of functions. This does not mean, however, that portfolio management functions are necessarily subject to a communications “firewall.”23 Accordingly, this segregation requirement would not prevent portfolio managers from providing inputs that are used in the fair value determination process.
Records of Assignment. Under the Proposed Rule, a fund must keep records of fair value determinations assigned to the adviser. Specifically, the fund would be required to keep
- copies of the reports and other information provided to the board required by the Proposed Rule
- a specified list of the investments or types of investments whose fair value determinations have been assigned to the adviser pursuant to the Proposed Rule
Such documents must be kept for at least five years after the end of the fiscal year in which the foregoing documents were provided to the board, the first two years in an easily accessible place.
Readily Available Market Quotations
Section 2(a)(41) of the Investment Company Act provides that a fund must value a portfolio holding at its market value if that market value is readily available. When market quotations are not readily available, the fund must value the holding at fair value as determined by the board in good faith. The Proposed Rule provides guidance for determining when a market quotation is not readily available.
Under the Proposed Rule, a market quotation for a specific investment is considered readily available 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. A quote is considered unreliable where it would require adjustment under GAAP or where GAAP would require consideration of additional inputs.
Rescission of Prior SEC Guidance
In light of the evolution of market and fund investment practices since 1970, and the new regulatory framework for valuation practices that Proposed Rule 2a-5 proposes to establish, the SEC staff believes that ASR 113 and ASR 118 are no longer necessary. Accordingly, the SEC proposes to rescind ASR 113 and ASR 118 in their entirety as well as certain related staff letters and staff guidance.
Comments on the Proposed Rule should be submitted to the SEC on or before July 21, 2020.
1 “Good Faith Determinations of Fair Value,” Investment Company Act Release No. 33845 (April 21, 2020) (Release), available at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf.
2 Release at 14.
3 Proposed Rule 2a-5(e)(1).
4 Section 2(a)(41) of the Investment Company Act. See also Investment Company Act Rule 2a-4.
5 The SEC last comprehensively addressed valuation under the Investment Company Act in 1960 and 1970 in Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118). The SEC staff acknowledges in the Release that market and fund investments have evolved considerably since ASR 113 and ASR 118 were issued, referencing, in particular, the greater variety of securities and other instruments that did not exist in 1970, advances in communications and technology, greater volume of data and increasing reliance on third-party pricing services. As support for the Proposed Rule, the SEC staff also references the enactment of the Sarbanes-Oxley Act of 2002, the establishment of the Public Company Accounting Oversight Board, the SEC’s adoption in 2003 of compliance rules designed to enhance funds’ and advisers’ compliance with federal securities laws and the issuance and codification by the Financial Accounting Standards Board of ASC Topic 820 (ASC 820) (which defines “fair value” for purposes of accounting standards and establishes a framework for recognition, measurement and disclosure of fair value under U.S. generally accepted accounting principles (GAAP)). See Release at 13.
6 Release at 17.
7 It is worthwhile noting that as an alternative these prescribed functions, the SEC considered a “principles-based approach” to the Proposed Rule that could provide funds more flexibility to tailor their policies and procedures, reporting, and recordkeeping to their valuation needs. The SEC expressed concerns, however, that this approach could reduce certainty for funds with respect to fair value determinations.
8 Other than material conflicts of interest, Proposed Rule 2a-5 does not identify specific valuation risks to be addressed. Rather, an evaluation of specific valuation risks depends on the facts and circumstances of a fund’s investments.
9 Release at 17.
10 Release at 22.
11 Release at 23.
12 Documentation to support fair value determinations would be required to include documentation sufficient for a third party to verify the fair value determination.
13 Release at 9.
14 Release at 32.
15 A board may assign such determinations to an adviser or a subadviser. In the case of the latter, a subadviser could be assigned responsibility for fair valuing only those fund investments for which such subadviser is responsible. Where such assignments are made to multiple advisers, the fund’s policies and procedures would be required to address the added complexities of overseeing multiple assigned advisers.
16 Release at 34.
17 The SEC staff notes that this level of scrutiny depends on the nature of the fund and its investments. For example, the level of scrutiny is different if a fund invests in publicly traded foreign companies than if a fund invests in private early stage companies.
18 Release at 41.
19 As examples, the SEC notes that such reports could take the form of narrative summaries, graphical representations, statistical analyses, dashboards or exceptions-based reporting. See Release at 42.
20 Release at 45.
21 To the extent that an adviser is required to verify the materiality of a given event to determine whether prompt reporting is required, such verification period would not be counted as part of the “prompt” trigger period. See Release at 50.
22 If the adviser uses a valuation committee or similar body, the policies and procedures should describe the composition and role of the committee.
23 Release at 54.
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