On April 21, 2020, the U.S. Securities and Exchange Commission (“SEC”) proposed new Rule 2a-5 (the “Proposed Rule”) under the Investment Company Act of 1940 (the “Investment Company Act”) to address valuation practices of registered investment companies (“Funds”). According to the SEC, the Proposed Rule is necessary due to major technological and regulatory changes since the last time the SEC proposed comprehensive valuation rules, a half-century ago. 

Investment Company Act § 2(a)(41) generally defines the “value” of assets held by Funds to mean market value, if market quotations are readily available, or “fair value,” as determined in good faith by a Fund’s board of directors, if market quotations are not readily available. As proposed, Rule 2a-5 would establish requirements for Fund boards to satisfy their valuation responsibilities. Among other things, since Fund boards do not play a day-to-day role in valuing Fund investments, the Proposed Rule would permit Fund boards to assign the responsibility for fair value determinations to a Fund’s investment adviser, subject to certain oversight requirements.[1] The Proposed Rule also would define when a market quotation is “readily available.”

Summary

The SEC has not comprehensively addressed Investment Company Act valuation issues since 1970. Since then, major technological changes have altered market and investment practices. These include advances in communications technology, which have greatly enhanced the availability of pricing information and data that inform value determinations, and the widespread adoption of third-party pricing services, particularly for thinly traded or complex assets. There have also been significant regulatory changes since the 1970s, including the enactment of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), which requires audits of public companies, and the SEC’s adoption of compliance rules that require Funds and registered investment advisers to adopt and implement written compliance policies and procedures to reasonably prevent violations of the federal securities laws. Finally, in 2009, the Financial Accounting Standards Board (“FASB”) codified ASC Topic 820, which defined “fair value” for purposes of the accounting standards for public filers (including Funds), and established a framework for recognition, measurement and disclosure of fair value under U.S. generally accepted accounting standards (“GAAP”).

To address these changes, the Proposed Rule would impose specific requirements on a Fund’s board valuation processes, including: assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating pricing services; and adopting and implementing policies and procedures, including recordkeeping requirements. Additionally, the Proposed Rule would permit a Fund’s board to assign fair value determinations to the Fund’s investment adviser, subject to board oversight. The Proposed Rule would also define when market quotations are readily available under the Investment Company Act, thereby providing clarity on when fair value determinations would be required. Finally, the SEC notes its intent to rescind prior staff guidance that is inconsistent with the Proposed Rule.

Proposed Rule 2a-5

The Proposed Rule has the following four key components:

1. Fair Value Determinations in Good Faith

Paragraph (a) of the Proposed Rule would impose six requirements on a Fund’s board or its investment adviser :

• Periodically assessing any material valuation risks, including the investment adviser’s conflicts of interest, and managing any identified risks;
• Establishing and applying fair value methodologies by:
• Selecting and consistently applying an appropriate methodology or methodologies for determining (and calculating) the fair value of the Fund’s investments;
• Periodically reviewing the appropriateness and accuracy of the methodologies selected and making any necessary adjustments;
• Monitoring for circumstances that may necessitate the use of fair value; and
• Establishing criteria for determining when market quotations are no longer reliable;
• Testing the appropriateness and accuracy of the Fund’s methodologies, including by identifying the testing methods to be used and the minimum frequency with which such testing methods are used;
• Overseeing any pricing service providers, including the approval, monitoring, and evaluation of each such provider, and the criteria for initiating price challenges;
• Adopting and implementing written policies and procedures that are reasonably designed to achieve compliance with the requirements above; and
• Maintaining appropriate documentation to support fair value determinations as well as a copy of the policies and procedures mentioned above, each for five years.

2. Assignment of Fair Value Determinations

Paragraph (b) of the Proposed Rule authorizes a Fund’s board to assign responsibility for making fair value determinations of any or all Fund investments to the Fund’s investment adviser, provided that the board oversees the adviser.  According to the SEC, board oversight should not be passive, but should be an “iterative process” designed to identify potential issues and opportunities to improve the Fund’s valuation processes. If responsibility for valuation is assigned to an investment adviser, the adviser would be required to:

• provide a quarterly assessment of the adequacy and effectiveness of its process for determining fair value to the Fund’s board;
• report any matter that could materially affect the fair value of the Fund’s portfolio to the board within three business days; and
• specify the titles of the persons responsible for determining fair value, including the particular functions for which they are responsible, and reasonably segregate the process of making fair value determinations from the Fund’s portfolio management. 

The Fund would be required to maintain copies of the adviser’s reports and assessments, as well as a list of the investments or investment types whose fair value determination has been assigned to the adviser, for five years.

3. Readily Available Market Quotations

Neither the Investment Company Act nor related SEC rules currently define when market quotations are “readily available.” The Proposed Rule would close this regulatory gap by providing 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 Proposed Rule’s definition of “readily available” is designed to bring the SEC’s standard more in line with ASC 820 and U.S. GAAP. GAAP requires Funds to maximize the use of observable inputs and minimize the use of unobservable inputs. Under GAAP, when otherwise relevant observable inputs become unreliable, Funds must consider additional inputs to determine the value of securities. Under the Proposed Rule’s definition of “readily available,” a quote would not be readily available if, under GAAP, the quote would be unreliable and would require consideration of additional inputs to determine the value of a security. In short, the Proposed Rule would require a Fund to fair value a security in the circumstances that GAAP would require additional inputs, thereby bringing the two regulatory regimes in sync.

4. Rescission of Prior SEC Guidance and Staff No-Action Letters

If adopted as proposed, Rule 2a-5 would contradict certain previous SEC guidance addressing a board’s role in fund valuation. In particular, the Proposed Rule would be inconsistent with certain provisions of Accounting Series Release (“ASR”) No. 113 and ASR No. 118, which address accounting topics related to a Fund’s purchase of restricted securities. These ASRs advised Fund boards to choose the methods used to determine fair value and continuously review the appropriateness of such methods. However, FASB’s subsequent adoption of modern accounting standards introduced authoritative accounting guidance that did not exist when the SEC issued ASR 113 and ASR 118. Additionally, the SEC said that the guidance in ASR 113 and ASR 118 is similar to requirements of GAAP with respect to recognition, measurement, and disclosure of Fund investments. Accordingly, the SEC’s staff guidance is not necessary. Moreover, in light of the Sarbanes-Oxley Act giving the Public Company Accounting Oversight Board the authority to establish professional auditing standards, the ASR 118 requirement that an independent accountant verify all readily available market quotations is no longer necessary. Thus, the SEC would rescind ASR 113 and ASR 118 subsequent to adopting the Proposed Rule.

In addition to rescinding accounting guidance, the SEC would also rescind certain staff no-action letters and guidance addressing Fund fair value determinations that are inconsistent with the Proposed Rule. Finally, if it adopts the Proposed Rule, the SEC proposes a one-year transition period to provide Funds and their advisers time to prepare to comply with the Proposed Rule.

Conclusion

The Proposed Rule seeks to update Investment Company Act valuation practices to account for massive technological and regulatory changes that have occurred in the past half-century. It does this by establishing requirements for Fund boards to satisfy their obligation to determine, in good faith, the fair value of investments where there is no readily available market quotation and by defining when a market quotation is readily available. The Proposed Rule also recognizes the role investment advisers play in Fund valuation by allowing Fund boards to assign fair value determinations to a Fund’s investment adviser.

Comments on the Proposed Rule are due July 31, 2020. We anticipate that there will be a robust discussion in Fund board rooms and among investment advisers and pricing services over the next several months, regarding whether the Proposed Rule accurately addresses the complexity of the securities valuation process and whether the principles set forth in the Proposed Rule are flexible enough to withstand the next half-century of market and regulatory developments in this area.

[1] In the case of unit investment trusts (“UITs”), which do not have boards of directors or investment advisers, a UIT’s trustee would have responsibility for conducting fair valuation under the proposed rule.

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