Overview

On December 3, 2020, the Securities and Exchange Commission (the SEC) adopted new rule 2a-5 (Rule 2a-5) under the Investment Company Act of 1940, as amended (the 1940 Act), which establishes a framework for fund valuation practices and clarifies how the board of directors (the Board) of a fund can satisfy its valuation obligations under the 1940 Act. The SEC also adopted new rule 31a-4 (Rule 31a-4, and together with Rule 2a-5, the Final Rules), which provides certain recordkeeping requirements associated with fair value determinations. The Final Rules were initially proposed in April 2020 (the Proposed Rule) and, as described below, the SEC adopted the Final Rules with certain modifications to the Proposed Rule.¹ The Final Rules apply to all registered investment companies and business development companies (together, Funds).² This is the first time the SEC is comprehensively addressing valuation under the 1940 Act since the release of Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118 and, together with ASR 113, the ASRs) in 1969 and 1970, respectively.

The Final Rules impact the valuation process in two primary ways: (i) by permitting a Fund’s Board to designate³ the determination of fair value to the Fund’s investment adviser⁴ or, if the Fund is internally managed, to an officer or officers of the Fund⁵ (the Valuation Designee), subject to certain conditions, including continued Board oversight, and (ii) by creating a framework for the determination of the fair value of a Fund’s investment in order to establish a standard baseline valuation practice across all Funds, whether it is a Valuation Designee or the Board making the fair value determination.

Valuing a fund’s investments

The 1940 Act requires the Board to value the Fund’s portfolio investments using the market value of their portfolio securities and other assets when market quotations for those securities are “readily available.” Rule 2a-5 defines a market quotation as “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.”

When market quotations are not readily available for any of a Fund’s portfolio investments, the 1940 Act requires the Board to determine the fair value of such investments in good faith. Rule 2a-5 not only confirms that the Board, or a designated committee thereof composed of a majority of directors who are not interested persons of the Fund (as defined in Section 2(a)(19) of the 1940 Act), can make this valuation determination itself, but also permits the Board to designate the determination of fair value to a Valuation Designee as long as certain requirements are met.

In conjunction with Rule 2a-5, the SEC will also rescind or withdraw the ASRs and certain additional SEC guidance, staff letters and other staff guidance addressing a Board’s determination of fair value and other matters.⁶

Designating valuation responsibilities to a Valuation Designee

Rule 2a-5 requires that, if the Board chooses to delegate its valuation responsibility to a Valuation Designee, the Board complies with the following conditions:

Board oversight of the Valuation Designee

Rule 2a-5 will require the Board to oversee the Valuation Designee with a skeptical and objective view in an active and iterative manner, considering: (1) the Fund’s valuation risks, including conflicts; (2) the appropriateness of the fair value determination process; and (3) the skill and resources devoted to such process.

The Valuation Designee must also provide both periodic and prompt reports to the Board, as described in the following subsection. The Board should consider the type, content and frequency of the reports it receives, seek follow-up information, and take reasonable steps to see that identified issues are addressed when appropriate.

Periodic and prompt reporting by the Valuation Designee to the Board

Rule 2a-5 will require the Valuation Designee to report to the Board regarding its performance of the valuation responsibility, including via certain periodic reports and prompt notification and reporting.

• Periodic Reporting: Rule 2a-5 will require the Valuation Designee to make both quarterly and annual written reports to the Board:
  • Quarterly Reports. The Valuation Designee must provide to the Board at least quarterly, in writing:
    • 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 a Fund’s investments; and
    • a summary or description of material fair value matters that occurred in the prior quarter, including any material changes (1) in the assessment and management of valuation risks, (2) to, or material deviations from, the fair value methodologies, and (3) 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.
  • Annual Reports. The Valuation Designee must provide at least annually, in writing, 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, this annual report must include (1) a summary of the results of the testing of fair value methodologies required under the Final Rules and (2) 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 Board Notification and Reporting: The Valuation Designee will need to provide written notification, including timely follow-on reports as appropriate, of the occurrence of matters that materially affect the fair value of the designated portfolio of investments (Material Matters) 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 in this instance include, as examples, a significant deficiency or material weakness in the design or effectiveness of the Valuation Designee’s fair value determination process or of material errors in the calculation of the Fund’s net asset value.

Clear delineation and delegation of duties among the valuation Designee’s personnel

The Valuation Designee will be required to specify the titles of the persons responsible for determining the fair value of the designated investments, including those persons’ particular functions. The Valuation Designee must also reasonably segregate fair value determinations from the portfolio management of the Fund such that the portfolio managers may not determine, or effectively determine by exerting substantial influence on, the fair values ascribed to portfolio investments.

Establishing a valuation framework

Whether completed by the Board itself, or designated to a Valuation Designee, the Final Rules establish the following “required functions” that must be performed to determine, in good faith, the fair value of a Fund’s investments. The SEC has stated that it believes these required functions are essential for creating a consistent valuation framework across Funds.

Valuation risks

Boards or the Valuation Designee will be required to periodically assess any material risks associated with the determination of the fair value of a Fund’s investments. The Final Rules provide a non-exhaustive list of risks to be considered, including:

• The types of investments held or intended to be held by a Fund;
• 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;
• The extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the Valuation Designee;
• The proportion of a Fund’s investments that are fair valued as determined in good faith by the Board or Valuation Designee, and their contribution to a 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 (so-called 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.

However, the Final Rules intentionally do not identify specific risks (other than material conflicts of interest) or state how frequent risk assessments should be, as different risks and frequencies may be appropriate for different Funds or investments.

Fair value methodologies

Boards or the Valuation Designee will be required to select and apply an appropriate methodology or methodologies for determining the fair value of investments. This will require specifying the key inputs and assumptions specific to each asset class or portfolio holding. Rule 2a-5 provides that the selected methodologies for Fund investments may be changed if different methodologies are equally or more representative of the fair value of the investments. Importantly, Rule 2a-5 will require that the appropriate party maintain records supporting any such change in methodology. Unlike the Proposed Rule, Rule 2a-5 will not require the specification of methodologies that will apply to new types of investments that the Fund does not currently hold but in which it intends to invest in the future.

Furthermore, Rule 2a-5 will require the methodologies to be consistently applied to their associated asset classes. However, Rule 2a-5 clarifies that this requirement is not meant to limit Funds from using an appropriate methodology to fair value an investment, even if other investments within the same “asset class” are fair valued using a different appropriate methodology. Applying a methodology consistently is not meant to lock in place a rigid pre-established methodology, but instead is intended to address the risks associated with changing methodologies in order to achieve a specific outcome.

Rule 2a-5 will require the Board or Valuation Designee to periodically review the selected methodologies for appropriateness and accuracy, and to change or adjust them as necessary. The results of back-testing or calibration, or a change in circumstances specific to an investment, could necessitate adjustments. The Board or Valuation Designee, as applicable, must also monitor for circumstances that may necessitate the use of fair value as determined in good faith.

Financial Accounting Standards Board ASC Topic 820 (ASC Topic 820) refers to: (1) valuation approaches, including the market approach, income approach and cost approach, and (2) valuation techniques and methods to measure fair value. For the methodology to be appropriate under Rule 2a-5 and in accordance with current accounting standards, the methodology must be consistent with ASC Topic 820, and thus derived from one of these approaches.

Testing of fair value methodologies

Rule 2a-5 will require Funds to test the appropriateness and accuracy of the methodologies used to calculate fair value, and to identify the testing method to be used and frequency of this testing.

Pricing services

If a Fund chooses to use a pricing service to obtain valuation information, Rule 2a-5 will require the Fund to establish a process for approving, monitoring and evaluating each pricing service provider, as well as establishing a process[7] for challenging the pricing service’s determination where materially different from the Fund’s view of the fair value.

The Board or Valuation Designee should generally consider:

• 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;
• The quality of the pricing information provided by the service and the extent to which the service determines its pricing information as close as possible to the time as of which the Fund calculates its net asset value;
• 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 actual and potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and
• The testing processes used by the pricing service.

Fair value policies and procedures

Rule 2a-5, unlike the Proposed Rule, does not separately require the Fund to adopt written policies and procedures reasonably designed to achieve compliance with the requirements of Rule 2a-5. The SEC instead stated that Rule 38a-1 under the 1940 Act by its terms, will require the adoption and implementation of written policies and procedures reasonably designed to prevent violations of the requirements of the Final Rules. Accordingly, Rule 2a-5 does not include a separate policies and procedures requirement.

Recordkeeping under Rule 31a-4

Rule 31a-4 will require Funds or their advisers to maintain appropriate documentation to support fair value determinations. In addition, Rule 31a-4 provides that, in cases where the Board has designated a Valuation Designee, 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 generally be required to be maintained for six years, the first two in an easily accessible place.⁸

Rule 31a-4 will require Funds or their advisers to maintain appropriate documentation to support fair value determinations, rather than requiring a Fund or adviser to keep records of the specific methodologies applied and assumptions and inputs that form the basis of the fair value determination in all cases.

Moreover, Funds will be required to maintain these records unless the Board has designated the performance of fair value determinations to the Fund’s investment adviser. In that case, the investment adviser will maintain the records.

Next steps

The Final Rules will become effective on March 8, 2021 (60 days after publication in the Federal Register), and will have a compliance date of September 8, 2022 (18 months following the effective date) to provide sufficient time for Funds and Valuation Designees to prepare to come into compliance with the rules. A Fund may voluntarily comply with the Final Rules after the effective date, and in advance of the compliance date. However, any Fund that elects to rely on the Final Rules prior to the compliance date may rely only on the Final Rules and may not also consider SEC and staff letters and other guidance that will be withdrawn or rescinded on the compliance date in determining fair value in good faith for purposes of section 2(a)(41) of the Act and rule 2a-4 thereunder.

While many of the requirements of the Final Rules likely align with Funds’ current valuation policies and procedures, Boards, Funds and their proposed Valuation Designees should review their current valuation policies and procedures, as well as the related sections of their compliance manuals, to determine what adjustments or changes will be required to implement the review, testing, recordkeeping, reporting and other requirements of the Final Rules. As part of this review, Boards should consider:

• What changes to our valuation process are needed to comply with the Final Rules;
• What are the credentials of our prospective Valuation Designee;
• Are any changes to our valuation methods needed, and how should we disclose these changes;
• How will the Final Rules impact our reporting;
• How are we backtesting our valuation process; and,
• How do the Final Rules impact our records retention policies?

SEC Press Release: SEC Modernizes Framework for Fund Valuation Practices

Final Rule: Good Faith Determinations of Fair Value

ASR 113 (Oct. 21, 1969): ASR 113

ASR 118 (Dec. 23, 1970): ASR 118

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