On December 3, 2020, the Securities and Exchange Commission (SEC) adopted new rule 2a-5 ("Rule 2a-5") under the Investment Company Act of 1940, as amended ("1940 Act") addressing valuation practices and the board of directors’ role in fair valuing securities of a registered investment company or business development company (each, a “fund”).[1] Additionally, a companion rule, new rule 31a-4 under the 1940 Act ("Rule 31a-4") was adopted to address the recordkeeping requirements relating to fair value determinations.

Summary

Rule 2a-5 sets forth certain requirements that must be followed by funds and their boards when determining the fair value of securities for purposes of Section 2(a)(41) of the 1940 Act. Such requirements include establishing policies and procedures to: assess and manage material risks associated with fair value determinations; selecting, applying and testing fair value methodologies; and overseeing and evaluating the work of any pricing services used. Under Rule 2a-5, a fund’s board may designate to certain parties (the "valuation designee") the responsibility to perform certain fair value functions, including performing the actual day-to-day fair value determinations. The activities of the valuation designee will be subject to board oversight and the valuation designee has certain reporting requirements to the board. Under Rule 2a-5, the board will no longer be required to approve or ratify specific fair value determinations. While the board will remain responsible for the fair valuation of fund securities under the 1940 Act; Rule 2a-5 provides that the board can fulfill this statutory obligation through its active oversight of the valuation designee’s performance and compliance with other requirements of Rule 2a-5.

Rule 2a-5 also defines when market quotations are determined to be readily available under Section 2(a)(41) of the 1940 Act. This new definition will apply to all sections and rules under the 1940 Act, which may impact the ability of certain funds, particularly fixed-income funds, to continue to utilize Rule 17a-7 under the 1940 Act. The SEC is also rescinding previously issued fair valuation guidance, including guidance on the board of directors’ role in fair valuation determinations, effective as of the mandatory compliance date.

The various aspects of Rule 2a-5 and Rule 31a-4 are discussed in more detail below.

Compliance Dates

Rules 2a-5 and 31a-4 are effective 60 days after publication in the Federal Register (which has not occurred as of the date of this client alert). The mandatory compliance date is 18 months from the effective date.[2] A fund may voluntarily comply with the Rules after the effective date but if it chooses to do so, such fund may not rely on any of the prior SEC guidance or staff letters regarding fair valuation that are to be withdrawn.

Definition of Readily Available Market Quotations

Section 2(a)(41) of the 1940 Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations are "readily available." When a market quotation for a specific portfolio security is unreliable or otherwise not readily available, Section 2(a)(41) requires the fund to use the fair value of that security, as determined in good faith by the fund’s board.

Under Rule 2a-5, a market quotation is “readily available” only when the quotation is a quoted price (unadjusted) in active markets for identical instruments that the fund can access at the measurement date, provided that even such a quotation is not considered to be "readily available" if it is not reliable. The Adopting Release notes that this definition is consistent with the definition of a level 1 input in the fair valued hierarchy outlined in U.S. GAAP. Therefore, in all other circumstances, market values are not considered to be "readily available" and fair value must be used. Importantly, therefore, the Adopting Release notes that evaluated prices - whether or not provided by third-party pricing services – are not by themselves readily available market quotations. In addition, broker-dealer "accommodation quotes" are not readily available market quotations.

The Adopting Release notes that a quotation would be considered unreliable if it would require adjustment under U.S. GAAP or consideration of additional inputs in order to determine the value of the security, such as may be needed for a security that principally trades on a closed foreign market when an event occurs prior to the fund calculating its net asset value ("NAV") that would likely result in a change in its price.

Rule 17a-7 Cross Trades

The Adopting Release notes that for a fund to engage in a Rule 17a-7 cross trade, the security must have a readily available market quotation and also must be able to satisfy the other requirements of the Rule. Therefore, for certain types of fixed income securities that may not qualify as level 1 securities under U.S. GAAP, funds may no longer be able to engage in cross trades due to the definition of readily available market quotation in Rule 2a-5. The Adopting Release notes that the SEC staff is currently reviewing certain SEC no-action letters that address Rule 17a-7 and may determine to withdraw them. Additionally, the SEC staff is considering potential revisions to Rule 17a-7.

Good Faith Determination of Fair Value under Rule 2a-5

Under Rule 2a-5, the fund’s board of directors may either: (i) determine fair value as set forth in Rule 2a-5 or (ii) designate a valuation designee to perform the fair value determinations. The valuation designee can be the fund’s investment adviser (but not its portfolio manager) or, for internally managed funds, an officer of the fund.[3] The valuation designee may not be a sub-adviser to a fund, nor may it be any other party, such as an administrator. However, as discussed below, the valuation designee may seek the assistance of others in performing its functions.

For purposes of this Client Alert, we have assumed that a fund's board will assign the fair value determinations to a valuation designee. If a fund's board decides to determine fair value itself, such board would be responsible for carrying out the functions discussed below.

Valuation Risks

Under Rule 2a-5, the valuation designee must make periodic assessments of any material risks associated with the determination of an investment’s fair value, including material conflicts of interest, and develop a mechanism for managing those identified valuation risks. The Adopting Release notes that a fund’s specific valuation risks depend on the facts and circumstances of the fund’s investments. Nonetheless, the Adopting Release provides the following non-exhaustive list of sources and types of valuation risks.

• the types of investments held or intended to be held by the fund[4] and the characteristics of those investments;[5]
• potential market or sector shocks or dislocations and other types of disruptions that may affect a valuation designee’s or a third-party’s ability to operate;[6]
• the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the valuation designee;
• the proportion of the fund’s investments that are fair valued, and their contribution to the fund’s returns;
• 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 (also known as “fourth party” risks); and
• the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.

The valuation designee must determine which of the sources and types of valuation risk are relevant to the fund’s investments, as well as identify other risks not set forth in the Adopting Release. Additionally, the valuation designee must determine if certain sources of valuation risk should be weighed more heavily than others.

Rule 2a-5 does not specify the frequency for the required re-assessment of a fund’s valuation risks and the Adopting Release notes that determining the frequency of such assessment should take into account changes in fund investments, significant changes in a fund’s investment strategy or policies, market events, and other relevant factors. A fund's board and the valuation designee should work together to establish the frequency of the periodic assessment of material valuation risks.

Fair Value Methodologies

Rule 2a-5 requires the valuation designee to establish and apply fair value methodologies. To satisfy this requirement, the valuation designee must: (i) select and apply appropriate fair value methodologies; (ii) periodically review the appropriateness and accuracy of the methodologies selected and make any necessary changes or adjustments thereto; and (iii) monitor for circumstances that may necessitate the use of fair value. Each aspect of this requirement is discussed in detail below.

• Select and apply appropriate fair value methodologies
  • Rule 2a-5 requires the valuation designee to select and apply in a consistent manner an appropriate methodology or methodologies for determining (including calculating) the fair value of fund investments.[7] The valuation designee may select different methodologies for different securities within the same asset class or may use the same methodology for all securities within an asset class.
  • The valuation designee must specify the key inputs and assumptions specific to each asset class or portfolio holding. Rule 2a-5 allows for selected methodologies to be changed if different methodologies are equally or more representative of the fair value of the investment. Methodologies that will apply to new types of investment in which the fund may subsequently invest need not be specified prior to an actual such investment.[8]
• Periodically review the appropriateness and accuracy of the methodologies selected and make any necessary changes or adjustments thereto
  • Rule 2a-5 requires the valuation designee to periodically review the selected methodologies for appropriateness and accuracy, and to make adjustments if necessary. The Adopting Release notes that adjustments to a fund’s fair value methodology could be appropriate as a result of back-testing, calibration, or a change in circumstances specific to an investment.[9] The valuation designee should generally seek to account for such incidences and consider specifying alternative sources. It is further noted that an adjustment to a methodology could include a change to a new methodology.
• Monitor for circumstances that may necessitate the use of fair value
  • Rule 2a-5 requires the valuation designee to monitor for circumstances that may necessitate the use of fair value. For example, if a fund has investments that trade in foreign markets, the valuation designee should identify and monitor for the kinds of significant events that, if they occurred after the market closed in the relevant jurisdiction but before the fund prices its shares, would materially affect the value of the security and therefore may suggest that market quotations are not readily available.

Testing of Fair Value Methodologies

Rule 2a-5 requires the testing of the appropriateness and accuracy of the fair value methodologies used by a fund. The valuation designee will have to identify the testing methods to be used and the minimum frequency that they will be performed, but Rule 2a-5 does not require particular testing methods or a specific minimum frequency of such testing. As with the assessment of a fund’s valuation risks, the Adopting Release notes that the specific tests to be performed and the frequency with which they are performed depend on the facts and circumstances of the fund. The Adopting Release notes that back-testing and calibration can help identify trends in certain circumstances and potentially help identify issues with methodologies provided by service providers, including poor performance or potential conflicts of interest. As an example, the Adopting Release notes that if a fair value methodology consistently over-values or under-values one or more fund investments as compared to observed transactions, then the valuation designee would need to investigate reasons for the differences.

Pricing Services

Under Rule 2a-5, if pricing services are used to help determine the fair value of fund investments, then the valuation designee must have a process for the approval, monitoring and evaluation of each pricing service used. In carrying out this function, the valuation designee should generally take into consideration factors such as:

• 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 (if at all) as market conditions change. In this regard, the fair value policies and procedures should address whether the pricing service is relying on inputs or assumptions provided by the valuation designee or its affiliates;
• the quality of the pricing information provided by the service and the extent to which the pricing service determines its pricing information as close as possible to the time as of which the fund calculates it NAV;
• the pricing service’s process for considering price challenges, including how the pricing service incorporates information received from price challenges into its pricing information;
• the pricing service’s potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and
• the testing processes used by the pricing service.

Rule 2a-5 also requires the valuation designee to establish a process for initiating price challenges, with such process generally identifying the circumstances under which a price challenge may be initiated.

Fair Value Policies and Procedures

Rule 2a-5 does not contain a separate requirement for a fund to adopt written policies and procedures reasonably designed to achieve compliance with the requirements of Rule 2-5 (“fair value policies and procedures”) as such policies are already required to be included in the fund’s Rule 38a-1 compliance program, which is itself subject to board oversight. The valuation designee is required to adopt and implement the fair value policies and procedures, which must be initially approved by the board.

Performance of Fair Value Determinations

The valuation designee is required to make certain reports to the board, identify individuals and specify their responsibilities regarding fair valuation determinations, and reasonably segregate portfolio management from fair valuation determinations.

Designation: A fund’s investment adviser, but not its investment sub-adviser, may serve as the valuation designee, or, in the case of an internally-managed fund, officers of the fund. To the extent that other parties provide services that are essential to the fair valuation process, the valuation designee can seek their assistance, as discussed below. Also, as discussed below, the portfolio manager of a fund may not serve as the valuation designee.

Guidance on Valuation Designee Obtaining Assistance of Others: The valuation designee may obtain assistance from others in fulfilling its fair valuation duties, including, for example, the fund’s portfolio manager, pricing services, fund administrators, investment sub-advisers, accountants or counsel. The Adopting Release notes that while these parties may perform services such as back-testing and calculations, the valuation designee must continue to perform its duties under Rule 2a-5 and other applicable rules under the 1940 Act as such valuation designee remains responsible for any fair value determinations.

Specification of Functions: Rule 2a-5 requires the valuation designee to specify the titles of the persons responsible for determining the fair value of the designated investments, including by specifying the particular functions for which the persons identified are responsible. The specific personnel with duties associated with price challenges should be identified, including those with authority to override a price, along with the roles and responsibilities of such persons, and the valuation designee is required to establish a process for the review of price overrides. If it is determined to use a valuation committee to assist in fair value determinations, the fair value policies and procedures should describe the composition and role of the committee, or reference any related committee governance documents as appropriate.

The valuation designee will be required to reasonably segregate the fair value determination process from the portfolio management of the fund such that the portfolio manager may not determine, or effectively determine by exerting substantial influence on, the fair values ascribed to portfolio investments. The Adopting Release notes that there are unique insights that portfolio management may have regarding the value of fund holdings and, therefore, Rule 2a-5 will not prohibit portfolio managers from participating in the fair value determination process. The Adopting Release notes that this requirement may present challenges for smaller advisers and internally managed funds due to their smaller number of personnel, but that funds are able to tailor the way in which they segregate the fair value determination process and portfolio management, including based on the size and resources of that fund. In such case, the valuation designee could, as part of its reasonable segregation process, seek to provide independent voices as a check on any potential conflicts of interest to the extent appropriate.

Role of the Fund's Board

Guidance on Board Oversight

The Adopting Release provides specific guidance with respect to board oversight of fair value determinations. The Adopting Release notes that boards should approach their oversight with a "skeptical and objective view that takes account of 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. "Other items in the guidance on board oversight include:

• Appropriate oversight cannot be passive; the board should ask questions and seek relevant information.
• Oversight is an iterative[10] process and the board must seek to identify potential issues and opportunities to improve the fund’s fair valuation processes.
• The board should use the appropriate level of scrutiny based on the fund’s valuation risk, including the extent to which the fair value of the fund’s investments depends on subjective inputs. The Adopting Release notes that a board’s level of scrutiny should increase as the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures.
• The board should seek to identify potential conflicts of interest, monitor such conflicts, and take reasonable steps to manage such conflicts. With respect to monitoring potential conflicts of interest, the Adopting Release notes that a fund’s adviser may have incentives to improperly value fund assets in order to increase fees, improve or smooth reported returns, to comply with the fund’s investment policies and restrictions. Additionally, it is noted that pricing services or broker-dealers providing opinions on prices may have incentives or pressures to provide pricing estimates that are favorable to the valuation designee. Therefore, boards should ask questions relating to possible conflicts of interest of both the valuation designee and other service providers and ensure that it is comfortable any such potential conflicts are being appropriately managed.
• Boards should probe the appropriateness of the valuation designee’s fair value processes. Examples provided in the Adopting Release include review of the financial resources, technology, staff, and expertise of the valuation designee, and the reasonableness of the valuation designee’s reliance on other service providers, relating to valuation. The board should also consider the compliance capabilities of the valuation designee that support the fair valuation determinations, and the oversight and financial resources available for such determinations.
• With respect to board reporting, which is discussed further below, the board should consider the type, content and frequency of the reports it receives. The Adopting Release notes that while boards can reasonably rely on summaries and other materials provided by the valuation designee and other service providers in conducting its oversight responsibilities, the board must request and review such information as it considers necessary in order to be informed of the valuation designee’s process for determining the fair value of fund holdings. When receiving reports from the valuation designee, the board should request follow-up information when appropriate and take reasonable steps to see that matters identified are addressed. Additionally, the Adopting Release notes that if the board becomes aware of a material matters, whether identified by the board, the fund's Chief Compliance Officer, the valuation designee, or another party, the board has a duty to inquire about the matter and take reasonable steps to assure that it is addressed.

Board Reporting

Under Rule 2a-5, there are two types of required reporting to the board: periodic reporting and prompt reporting. The Adopting Release notes that the content of such required reports may take the form of narrative summaries, graphical representations, statistical analysis, dashboards, or exceptions-based reporting, among other methods. The board and the valuation designee should work together to determine the information and format that the board will find most useful in fulfilling its oversight role.

Periodic Reporting: Rule 2a-5 requires the valuation designee, at least quarterly, to provide the board, in writing with:

• Any reports or materials requested by the board related to the fair value of designated investments or the valuation designee’s process for fair valuing fund investments; and
• A summary or description of material fair value matters that occurred in the prior quarter. This summary or description must include:
  • Any material changes in the assessment and management of valuation risks, including any material changes in conflicts of interest of the valuation designee and any other service provider;
  • Any material changes to, or material deviations from, the fair value methodologies; and
  • Any material changes to the valuation designee’s process for selecting and overseeing pricing services, as well as any material events related to the valuation designee’s oversight of pricing services.

Rule 2a-5 requires the valuation designee, at least annually, to provide the board, in writing with:

• An assessment of the adequacy and effectiveness of the valuation designee’s process for determining the fair value of the designated portfolio of investments. At a minimum the report must include a summary of the results of the testing of fair value methodologies as required by Rule 2a-5 and an assessment of the adequacy of resources allocated to the process for determining the fair value of designated investments, including any material changes to the roles or functions of the persons responsible for determining fair value.

Prompt Reporting: Rule 2a-5 requires the valuation designee to provide a written notification to the board of the occurrence of matters that materially affect the fair value of the designated portfolio of investments within a time period determined by the board, but in no event later than five business days after the valuation designee becomes aware of the material matter.

• “material matters” for this purpose includes, for example, a significant deficiency or a material weakness in the design or implementation of the valuation designee’s fair value determination process or of material errors in the calculation of the fund’s NAV[11].

The valuation designee must provide timely follow-up reports on the material matter as the board may reasonably determine to request.

The Adopting Release provides guidance on what would be considered to be "material" in the context of Rule 2a-5, noting that it would be any matter about which the board would reasonably need to know in order to exercise appropriate oversight. Examples of material matters include:

• Significant deficiencies or material weakness in internal control over financial reporting related to fair value determinations that have been identified and generally would include those items that "could have materially affected" the fair value of the fund’s investments.
• A change to a pricing service affiliated with the valuation designee or material changes to or deviations from methodologies, including changes to critical inputs or assumptions.
• With respect to pricing services, material changes to the selection or oversight process, as well as a pattern of price challenges or overrides that raises concerns.

The Adopting Release notes that if it is not immediately apparent to the valuation designee whether a valuation matter is material, the valuation designee should act promptly to determine the materiality. If a determination of materiality has not been made within 20 business days, the valuation designee must provide the board a written notification within the next five business days to inform them of the ongoing evaluation of the matter.

Recordkeeping

Rule 31a-4 sets out the recordkeeping requirements relating to fair value determinations made pursuant to Rule 2a-5. Rule 31a-4 will require funds or their advisers to maintain appropriate documentation to support fair value determinations. The reports and other information provided to the board must include a specified list of the investments or investment types for which the valuation designee has been designated. These records will be required to be maintained for at least six years from the time the determination was made, the first two years in an easily accessible place.[12]

The Adopting Release notes that the recordkeeping requirements were put into a separate rule: (i) to help centralize investment company recordkeeping requirements and (ii) to ensure a failure to keep the required records would not lead to a board being found to have not fair valued in good faith.

Rescission of Prior Commission Releases, Guidance and No-Action Letters

ASR 113 and ASR 118 are being rescinded in their entirety as the guidance contained therein is superseded or made redundant by Rule 2a-5 and requirements under current accounting and auditing standards.

Certain SEC guidance, staff letters and staff guidance addressing a board’s determination of fair value and other matters covered by Rule 2a-5 will be withdrawn or rescinded. Additionally, the SEC staff is rescinding and superseding certain guidance provided in the 2014 Money Market Fund Release (“MMF Release”) regarding the valuation of thinly traded securities and the use of pricing services. The SEC staff is not modifying the guidance contained in the MMF Release with respect to the use of amortized cost method, as it continues to believe that is relevant, adequate and appropriate.

[1] Release IC-34128, Good Faith Determinations of Fair Value (December 3, 2020) at https://www.sec.gov/rules/final/2020/ic-34128.pdf (Adopting Release).

[2]The new definition of readily available market quotation also has a compliance date of 18 months, after the effective date.

[3] For a unit investment trust (“UIT”), the valuation designee may be the UIT’s trustee or depositor.

[4] The Adopting Release notes that the valuation designee may not be able to identify all the types of investments the fund will hold or the specific valuation risks related to those investments, but that the risk assessment should generally take into account those investments that the fund would reasonably expect to purchase in the reasonably near future.

[5] Investment characteristics would include, among other items, the size of the investment relative to measures of market demand, such as daily trading volume.

[6] The Adopting Release notes that potential indicators could include a significant change in short-term volatility or market liquidity, significant changes in trading volume, and a sudden increase in trading suspensions. Examples of disruptions that may affect a valuation designee’s or a third-party’s ability to operate include a system failure or cyberattack.

[7] The Adopting Release states that it would not be sufficient, for example, to simply state that private equity investments are valued using a discounted cash flow model, or that options are valued using a Black-Scholes model, without providing additional detail on the specific qualitative and quantitative factors to be considered, the sources of the methodology’s inputs and assumptions, and a description of how the calculation is to be performed (which may, but does not have to, take the form of a formula).

[8] The Adopting Release states that an appropriate methodology must be consistent with those used to prepare the fund’s financial statements; so that if a methodology is not consistent with ASC Topic 820, that methodology should be presumed to be inaccurate.

[9] Changes in circumstances might include (i) the development of new markets; (ii) new information becoming available; (iii) information previously used is no longer being available; (iv) improvement in the valuation technique; and (v) changed market conditions.

[10] As the SEC staff noted in the Derivatives Rule Adopting Release, “iterative” is not intended to imply that the board is responsible for the day-to-day management of derivatives risk, but is intended to clarify that board oversight requires regular engagement with the derivatives risk management program rather than a one-time assessment.

[11] The Adopting Release notes that Rule 2a-5 does not establish a specific standard for what is a material error in the calculation of a fund’s NAV, but that the generally utilized threshold of $0.01 a share or 0.5% of NAV would not be an unreasonable standard.

[12] The recordkeeping requirements will not require detailed records relating to the specific methodologies and assumptions used by pricing services, but instead should consist of records relating to the valuation designee’s initial due diligence of each pricing service as well as records relating to the periodic monitoring and oversight of the pricing service