On April 21, 2020, the U.S. Securities and Exchange Commission proposed a long-anticipated framework for valuation of fund investments.¹ Proposed Rule 2a-5 under the Investment Company Act of 1940 would establish requirements for good faith determinations of fair value and would address both the board’s and the adviser’s role and responsibilities relating to valuation.

The proposal, including the SEC’s guidance in the Release, seeks to modernize and formalize the framework for fair valuation determinations in light of the modern fund industry’s investments and practices. The proposed rule would create a risk-based valuation regime focused on process, testing and oversight. Determining fair value in good faith would require periodically assessing risks, establishing and applying appropriate methodologies, testing those methodologies, and evaluating pricing services, as applicable. Fund boards would be permitted to assign their fair valuation responsibilities to fund advisers, subject to a number of reporting and oversight conditions.

Fair Value Determination

Under proposed Rule 2a-5, determining fair valuation in good faith would require:

• Periodically assessing material risks associated with determining fair value of fund investments (“valuation risks”);
• Establishing and applying fair valuation methodologies, taking into account the fund’s valuation risks;
• Testing fair valuation methodologies;
• Evaluating pricing services, if used;
• Adopting and implementing written policies and procedures reasonably designed to achieve compliance with the four preceding requirements; and
• Maintaining relevant records.

Establishing and applying fair valuation methodologies would specifically require: (i) selecting and consistently applying methodologies for determining and calculating fair value;² (ii) periodically reviewing the appropriateness and accuracy of the methodologies selected and making necessary adjustments; (iii) monitoring for circumstances necessitating the use of fair value; and (iv) establishing criteria for determining when market quotations are no longer reliable. The SEC noted that “for a fair value methodology to be appropriate under the proposed rule, it must be determined in accordance with U.S. GAAP,” and guidance in the Release represents an attempt by the SEC to more closely align the 1940 Act valuation framework with the GAAP valuation guidance (ASC Topic 820) used for financial reporting.³

“Readily Available Market Quotations”

The SEC noted in the Release that when market quotations are no longer reliable, they are not “readily available,”⁴ so the proposed reliability criteria described above in sub-item (iv) would facilitate the proposed monitoring requirement described in sub-item (iii). Separately, proposed Rule 2a-5 would provide that a market quotation is “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.” The SEC explained that “a quote would be considered unreliable under proposed rule 2a-5(c) in the same circumstances where it would require adjustment under U.S. GAAP or where U.S. GAAP would require consideration of additional inputs in determining the value of the security.”⁵ The SEC also noted that evaluated prices, by themselves, are not readily available market quotations, and “indications of interest” and “accommodation quotes” similarly would not be readily available market quotations for purposes of proposed Rule 2a-5.

Board (and Adviser) Responsibilities Concerning Fair Valuation

Proposed Rule 2a-5 would expressly place fair valuation responsibilities on a fund’s board, but would permit the board to assign those responsibilities to an investment adviser of the fund (which could include one or more sub-advisers), which the board would continue to oversee. In the Release, the SEC articulates high-level expectations regarding the nature, scope and tone of board oversight: “[b]oards should approach their oversight of fair value ... with a skeptical and objective view”; “effective oversight cannot be a passive activity”; “[t]he board should view oversight as an iterative process and seek to identify potential issues and opportunities to improve the fund’s fair value processes.”⁶ The Release also would place the identification, monitoring and management of the adviser’s and other service providers’ conflicts of interest at the center of the board’s oversight role.

An investment adviser assigned fair valuation responsibilities by a fund’s board would carry out those responsibilities in accordance with the fair valuation determination requirements set forth above and subject to the following additional conditions:

• At least quarterly, the adviser would be required to provide in writing an assessment of the adequacy and effectiveness of the investment adviser’s process for determining fair value;
• The adviser would be required to promptly (and in any case no later than three business days after the adviser becomes aware of the matter)⁷ report to the board in writing on matters associated with the adviser’s process that materially affect, or could have materially affected, the fair value of portfolio investments;
• The adviser also would be required to specify the titles of persons responsible for determining fair value (including specifying particular functions for which such persons are responsible) and to reasonably segregate the fair value determination process from portfolio management;⁸ and
• The fund would be required to maintain certain additional records.

The adviser’s quarterly reports to the board would be required to include, at a minimum, a summary or description of: (i) the assessment and management of material valuation risks, including material conflicts of interest; (ii) any material changes to or material deviations from established fair valuation methodologies; (iii) the results of the testing of fair valuation methodologies; (iv) the adequacy of resources allocated to the fair value process, including material changes to roles or functions of those responsible; (v) any material changes to the adviser’s process for selecting and overseeing pricing services and related material events (e.g., changes in service providers used or price overrides);⁹ and (vi) any other materials requested by the board. As a practical matter, the breadth and depth of the required information could place more, and more specific, responsibilities on a fund’s board than does the current framework.

Key Dates and Timing

The SEC proposed a one-year transition period for proposed Rule 2a-5. If adopted, proposed Rule 2a-5 would become effective one year following Federal Register publication of the final rule.

Comments on the SEC’s proposal are due on or before July 21, 2020.

An upcoming Dechert OnPoint will provide further analysis of this proposal.

Footnotes

1) See Good Faith Determinations of Fair Value, Rel. No. IC-33845 (April 21, 2020) (Release). Unless otherwise specified, the term “fund” as used herein refers to a registered investment company or business development company.

2) The SEC stated that the proposed rule would require that valuation methodologies be consistently applied within the asset classes for which they are relevant. However, the SEC also noted that there are circumstances when it would be appropriate to adjust or change these methodologies for a particular investment. See Release at II.A.2.

3) Release at II.C. ASC Topic 820 (FASB Accounting Standard Codification Topic 820) “defines the term ‘fair value’ for purposes of the accounting standards and establishes a framework for the recognition, measurement, and disclosure of fair value under” U.S. GAAP. Release at I. As part of the proposal, the SEC would rescind two releases (Accounting Series Release 113, issued in 1969, and Accounting Series Release 118, issued in 1970) in which the SEC provided accounting guidance on fund valuation matters. The SEC noted its belief that, since that guidance was issued, “developments in the [Financial Accounting Standards Board] accounting standards have modernized the approach to accounting topics addressed in” these releases. Release at II.D.

4) As set forth in the 1940 Act’s definition of “value” and noted in the Release, fair valuation is required where market quotations are not “readily available.” See 1940 Act Section 2(a)(41); Release at II.A.2 and II.C.

5) Release at II.C.

6) Release at II.B.1.

7) The SEC recognized that determining and verifying whether an event has or could materially affect fair value can, in some cases, take time. The SEC provided that “if an adviser needs some reasonable amount of time after becoming aware of the matter to verify and determine its materiality, that verification period would not be counted as part of the ‘prompt’ trigger period.” This process should be completed within three business days, including the day the adviser became aware of the event. See Release at II.B.2.b.

8) The SEC noted that the proposed requirement of reasonable segregation of functions would be distinct from a more prescriptive requirement, and would “allow funds to structure their fair value determination process and portfolio management functions in ways that are tailored to each fund’s facts and circumstances.” The SEC acknowledged the “important perspective and insight regarding the value of fund holdings that portfolio management personnel can provide” and, accordingly, did not propose to exclude portfolio management from providing input to the fair valuation process. See Release at II.B.3.

9) Notably, the SEC proposed to require that all price overrides be reported. The SEC specifically requested comment as to whether (and if so, how) it should limit this reporting requirement to certain price overrides.