On December 3, 2020, the U.S. Securities and Exchange Commission adopted a long-anticipated rule for the fair valuation of fund investments.1 Rule 2a-5 under the Investment Company Act of 1940 (final rule) establishes requirements for good faith determinations of fair value, and addresses both the board’s and the “valuation designee’s” role and responsibilities relating to fair valuation.
The SEC declined to reframe Rule 2a-5 as a safe harbor, as some commenters had suggested. Instead, Rule 2a-5 “establishes the requirements the board must meet to fulfill its continuing statutory obligations.”2 The SEC did, however, make several changes to the rule as proposed (proposed rule), in response to industry comments on the prescriptiveness of the proposal.3 The following provides a brief overview of Rule 2a-5 and certain of these changes. A subsequent Dechert OnPoint will address these matters in more detail.
“Readily Available Market Quotations”
Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder require valuation of a portfolio security for which market quotations are not readily available at fair value as determined in good faith by the board of directors.
Rule 2a-5 provides 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 commented:
This definition is consistent with the definition of a level 1 input in the fair value hierarchy outlined in U.S. GAAP. Thus, under the final definition, a security will be considered to have readily available market quotations if its value is determined solely by reference to these level 1 inputs. Fair value, as defined in the [1940] Act and further defined in [R]ule 2a-5, therefore must be used in all other circumstances. ... [W]e do not believe that securities valued with level 2 inputs are consistent with the definition of readily available market quotations.4
The SEC stated further that the “definition of readily available market quotations that we are adopting will apply in all contexts under the 1940 Act and the rules thereunder, including [R]ule 17a-7,” and that “certain securities that had been previously viewed as having readily available market quotations and being available to cross trade under [R]ule 17a-7 may not meet our new definition and thus would not be available for such trades.” The SEC acknowledged that many cross trades are undertaken in reliance on certain SEC staff no-action letters and noted that the “staff is reviewing these letters to determine whether these letters, or portions thereof, should be withdrawn.”5 In addition, the SEC noted that its current rulemaking agenda includes consideration of potential updates to Rule 17a-7. These developments, which could have far-reaching implications for investment companies and the debt markets, should be considered closely.
Fair Value Determination
Under Rule 2a-5, determining fair value in good faith requires:
- Periodically assessing material risks associated with determining fair value of fund investments (valuation risks), including material conflicts of interest, and managing valuation risks;
- Establishing and applying fair valuation methodologies, taking into account the fund’s valuation risks, which involves:
- Selecting and applying in a consistent manner6 appropriate methodologies for determining and calculating fair value, provided that a selected methodology may be changed if a different methodology is equally or more representative of the fair value of fund investments, including specifying key inputs and assumptions specific to each asset class or portfolio holding;7
- Periodically reviewing the appropriateness and accuracy of the methodologies selected and making necessary adjustments; and
- Monitoring for circumstances necessitating the use of fair value.
- Testing the appropriateness and accuracy of fair valuation methodologies selected, including identifying testing methods and minimum frequency for their use; and
- Overseeing pricing services, if used, including establishing the processes for:
- Approving, monitoring and evaluating each pricing service; and
- Initiating price challenges, as appropriate.8
The SEC reiterated its position expressed in the rule proposal that, in order to be an appropriate fair valuation methodology under Rule 2a-5, the methodology must be “consistent with the principles of the valuation approaches laid out in ASC Topic 820,” and accordingly, “if a valuation methodology was used that is not consistent with the principles of the valuation approaches laid out in ASC Topic 820, we would presume that use of such a methodology would be misleading or inaccurate.”9
The SEC noted 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” Rule 2a-5.10 In addition, rather than requiring the maintenance of specific records as part of Rule 2a-5, the SEC opted instead to adopt a separate rule – Rule 31a-4 – to contain recordkeeping requirements associated with Rule 2a-5.11
In response to concerns raised by commenters that a technical failure could result in a statutory violation, the SEC “underscore[d] that the objective of the final rule is to ensure that a fund’s assets are properly valued” and stated that “[a] violation of the final rule does not necessarily mean that the actual values ascribed to particular fund investments were in fact inappropriate, or, for example, that the fund has violated [R]ule 22c-1.”12 In addition, by moving the recordkeeping requirements to a separate rule, the SEC addressed concerns that a recordkeeping failure alone could be deemed a failure to determine fair value in good faith.
Responsibilities Concerning Fair Valuation
Rule 2a-5 expressly places fair valuation responsibilities on a fund’s board, but permits the board to designate13 a “valuation designee,” which the board would continue to oversee, to perform fair valuation determinations relating to any or all fund investments. In the Release, the SEC articulated high-level expectations regarding the nature, scope and tone of board oversight, reiterating statements made in the Proposing Release: “[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.”14
Under Rule 2a-5, the valuation designee may be the fund’s investment adviser (other than a sub-adviser) or an officer of an internally-managed fund. In the Release, the SEC expressly declined to allow a board to designate a valuation designee other than the fund’s adviser or officers (in the case of an internally-managed fund), because the SEC believes that “it is critical for the entity actually performing the fair value determinations to owe a fiduciary duty to the fund and be subject to direct board oversight whenever possible.”15 Nevertheless, the Release provides guidance as to how a valuation designee may engage other third-parties – such as pricing services, fund administrators, sub-advisers, accountants or counsel – to assist with certain functions of the fair value determination process (other than making such determinations). The Release notes that a board or valuation designee remains responsible for fair value determinations notwithstanding the input or assistance of such other parties, and that fair value determination responsibilities may not be designated or assigned to those parties.
A valuation designee must carry out its responsibilities in accordance with the fair valuation determination requirements set forth above and subject to the following additional conditions:
Quarterly, Annual and Prompt Reporting
- At least quarterly, the valuation designee is required to provide, in writing: (i) 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 (ii) a summary or description of material fair value matters that occurred during the prior quarter;
- At least annually, the valuation designee is required to provide a written assessment of the adequacy and effectiveness of its process for determining the fair value of the designated portfolio investments;16 and
- The valuation designee is required to promptly (within a time period determined by the board and, in any case, no later than five business days after the valuation designee becomes aware of the material matter17) report to the board in writing on the occurrence of matters that materially affect the fair value of the designated portfolio of investments.
In addition to any reports or materials requested by the board, the valuation designee’s quarterly reports to the board are required to include, at a minimum, a summary or description of: (i) any material changes in the assessment and management of material valuation risks, including any material changes in material conflicts of interest of the valuation designee or any other service provider; (ii) any material changes to or material deviations from established fair valuation methodologies; and (iii) any material changes to the valuation designee’s process for selecting and overseeing pricing services and related material events related to the valuation designee’s oversight of pricing services.
The reporting requirements reflect changes made by the SEC in response to comments about the prescriptiveness of the proposed rule’s reporting requirements. The Release notes that the changes are “designed to enhance flexibility of reporting to better match boards’ needs and to minimize the chance that boards receive reporting that is too detailed or repetitive to facilitate appropriate oversight.”18
Segregation of Fair Value Determination Responsibilities
Rule 2a-5 requires a valuation designee to: (i) specify the titles of persons responsible for determining fair value (including specifying particular functions for which such persons are responsible); and (ii) reasonably segregate fair value determinations from portfolio management, such that fund portfolio manager(s) may not determine, or effectively determine by exerting substantial influence on, the fair values assigned to portfolio investments. The Release explains that this requirement is designed to “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 exclude portfolio management from providing input into the fair valuation process. However, the Release clarifies that “a fund should limit the extent of influence portfolio managers may have on administration of the fair value process” and that “[i]f portfolio managers provide a significant amount of input on the fair value of an investment, the segregation process should be appropriately rigorous and robust to mitigate any potential conflicts of interest.”19
Recordkeeping Requirements
The fund (or investment adviser designated to perform fair value determinations) also is required to maintain certain additional records pursuant to new Rule 31a-4 under the 1940 Act.
Prior SEC Guidance
As proposed, the SEC is rescinding in their entirety Accounting Series Release 113 (issued in 1969) and Accounting Series Release 118 (issued in 1970), which provided accounting guidance on fund valuation matters. Additionally, the SEC noted that certain prior SEC guidance regarding pricing service oversight20 has been superseded by guidance in the Release and that prior guidance in the 2014 Money Market Fund Release regarding valuation of thinly traded securities is being rescinded and restated. The SEC further provided a list of SEC guidance, staff letters and staff guidance being withdrawn, noting that “[t]o the extent any staff guidance is inconsistent or conflicts with the requirements of the rules, even if not specifically identified [in the Release’s list], that guidance is superseded.”21
Key Dates and Timing
Rule 2a-5 will be effective 60 days after publication in the Federal Register. The SEC adopted an 18-month transition period beginning from the effective date for both Rule 2a-5 and the associated new recordkeeping requirements.
Footnotes
1) See Good Faith Determinations of Fair Value, Rel. No. IC-34128 (Dec. 3, 2020) (Release). Unless otherwise specified, the term “fund” as used herein refers to a registered investment company or business development company.
2) Release at n.18.
3) See Good Faith Determinations of Fair Value, Rel. No. IC-33845 (April 21, 2020) (Proposing Release).
4) Release at II.D. The SEC stated further that investments “in a mutual fund or similar structure that has a readily determinable fair value per share that is determined and published and is the basis for current transactions, such as a daily NAV for mutual fund shares” are considered to have readily available market quotations under Rule 2a-5. However, “securities that are valued using NAV as a practical expedient, like certain private funds ... generally do not have readily available market quotations under the final definition.”
5) As examples of such no-action letters, the SEC identified United Municipal Bond Fund, SEC Staff No-Action Letter (Jan. 27, 1995) and Federated Municipal Funds, SEC Staff No-Action Letter (Nov. 20, 2006).
6) The Release specifically indicates that the requirement to apply methodologies “in a consistent manner” is not intended to limit the use of an appropriate methodology for a particular investment “even if other investments within the same ‘asset class’ are fair valued using a different appropriate methodology.” Release at II.A.
7) Unlike the proposed rule, the final rule does not require specifying which methodologies apply to new types of fund investments in which a fund intends to invest.
8) The SEC noted that the requirement in the final rule to establish the process for initiating price challenges is distinct from the requirement in the proposed rule to establish criteria for the circumstances under which price challenges would be initiated. The SEC acknowledged that “there can be a range of circumstances under which a price challenge may be warranted, some of which cannot be distilled into specific criteria in advance,” and stated that a process for initiating price challenges “generally should outline the circumstances under which a price challenge should be initiated.” Release at II.A.
9) Release at II.A. ASC Topic 820 (FASB Accounting Standards 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. Proposing Release at I.
10) Release at II.A. Unlike the proposed rule, the final rule does not include its own, separate provision requiring funds to adopt written policies and procedures for compliance with the rule. The SEC noted that “the requirements of [R]ule 2a-5 and guidance in this release will supersede the [Rule 38a-1 adopting release’s] discussion of policies and procedures for the pricing of portfolio securities and fund shares,” and that fair value policies and procedures for compliance with Rule 2a-5 (as well as new Rule 31a-4, discussed below) “must be approved by the board pursuant to [R]ule 38a-1 and may not be considered material amendments to existing fair value policies and procedures.”
11) Rule 31a-4 requires funds to maintain appropriate documentation to support fair value determinations made pursuant to Rule 2a-5 rather than records of the specific methodologies applied and assumptions and inputs forming the basis of the fair value determination in all cases, as had been proposed. See Release at II.C.
12) Release at II; see also Commissioner Hester M. Peirce, Statement on Good Faith Determinations of Fair Value under the Investment Company Act of 1940 Final Rule, (Dec. 3, 2020) (“The decision not to craft the rule as a non-exclusive safe harbor should not be read to mean that the purpose of this rule is to trip people up on technicalities; its objective is to ensure that funds’ assets are properly valued, not to create a basis for enforcement actions rooted in inconsequential departures from the rule’s requirements.”).
13) The Release indicates that the use of the term “designate” rather than “assign” when describing the relationship between a board and valuation designee is intended to indicate that the “the valuation designee performs the fair value determinations for the fund on the board’s behalf subject to appropriate oversight by the fund’s board,” and to clarify that the board has not “completely delegated the entire valuation function and related obligations.” Release at II.B.
14) Id. The SEC declined to confirm that boards must exercise oversight of fair valuation “consistent solely with the business judgment rule,” stating its belief that the guidance it is providing “should be more useful to directors than the more generalized principles of the business judgment rule, as this new guidance specifically relates to directors’ oversight responsibilities under [S]ection 2(a)(41) of the [1940] Act and the final rule.”
15) Id. Specifically, the Release states that the SEC “believe[s] that having fiduciary obligations to the fund will help ensure that the party performing fair value determinations acts in the fund’s best interest and, as appropriate, eliminates, mitigates, or discloses conflict.” The Release also notes that the SEC views as important that the valuation designee “have a direct relationship with the fund’s board and have comprehensive and direct knowledge of the fund.”
16) Under Rule 2a-5, this would include, at a minimum, providing: (i) a summary of the results of the testing of fair value methodologies required under Rule 2a-5(a)(3); and (ii) an assessment of the adequacy of resources allocated to the process for determining the fair value of designated investments.
17) Under Rule 2a-5, the term “material matter” includes a significant deficiency or material weakness in the design or effectiveness of the valuation designee’s fair value determination process, or material errors in the calculation of NAV. The board also could request, and if so, the valuation designee would be required to provide, such additional timely follow-on reporting as the board may determine.
18) Release at II.B.
19) Id.
20) See Money Market Fund Reform; Amendments to Form PF, Rel. No. IC-31166 (July 23, 2014) (2014 Money Market Fund Release).
21) Release at II.F.
