The U.S. Securities and Exchange Commission (SEC) recently announced its proposal of new Rule 2a-5 (the “Proposed Rule”) under the Investment Company Act of 1940 (1940 Act) to establish a framework for fund valuation practices. The Proposed Rule would apply to all registered investment companies and Business Development Companies regardless of their classification, investment objective, or strategy. Funds would have one year from the date a final rule is adopted to comply with the rule. The Proposed Rule can be found here and the SEC is accepting public comments until July 21, 2020. Below is a summary of the Proposed Rule and the changes to fund valuation practices.

Background

Section 2(a)(42) of the 1940 Act and Rule 2a-4 thereunder, requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations for those securities are “readily available.” When a market quotation for a portfolio security is not readily available, funds are required to value their portfolio investments by using the fair value of that security, as determined in good faith by the fund’s board.

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. In the ASRs, the SEC expressed the view that, while fund boards need not perform the fair value calculation, it is the board’s responsibility to choose and review the appropriateness of the fair valuation methodology implemented by a fund.

For 50 years, funds have developed their fair valuation practices, policies, and procedures based on no-action letters, SEC staff statements, and commentary in SEC releases. The Proposed Rule would be the first rule that establishes a comprehensive regulatory framework for fair valuing investments in good faith for which there are no readily available market quotations. The release accompanying the Proposed Rule (the “Release”) stated that the ASRs, certain staff letters and other staff guidance that funds have historically relied upon, would be rescinded or withdrawn in connection with the potential adoption of the Proposed Rule.

In addition, significant regulatory developments have altered how boards, investment advisers, auditors, and other market participants address valuation under the federal securities laws. The Release describes three important developments that the SEC believes support adoption of Rule 2a-5 and its approach to fair valuation. One was the adoption in 2002 of the Sarbanes-Oxley Act, which established the Public Company Accounting Oversight Board. The second was the SEC’s 2003 compliance rules under the 1940 Act. The third was adoption by the Financial Accounting Standards Board of ASC Topic 820 in 2006 and 2009, which defined the term “fair value” for purposes of financial report accounting standards. The Release explains that these developments have altered the framework in which funds, boards, advisors, and other service providers, perform fair valuation responsibilities. The Release indicates that certain of the Proposed Rule’s requirements are based on SEC staff reviews of current fund valuation policies and procedures that have been adapted to these historical developments.

In summary, the Proposed Rule would: (i) provide requirements for determining fair value in good faith, (ii) allow a fund’s board of directors to assign the fair value determination to an investment adviser, (iii) and define when market quotations are “readily available.”

Determining Fair Value

The Proposed Rule sets out the required functions for making a good faith determination of the fair value of a fund’s investments, pursuant to Section 2(a)(41) of the Investment Company Act and Rule 2a-4 thereunder, each of which is designed to provide funds with a consistent framework and standard of practice. Determining fair valuation in good faith would require the following functions to be performed:

• Assessing periodically any material risks associated with determining fair value of fund investments (“valuation risks”);
• Selecting and applying a consistent methodology for determining fair value of fund investments, including specifying key inputs and assumptions made;
• Testing the appropriateness and accuracy of fair valuation methodologies;
• Overseeing and evaluating pricing services, if applicable;
• Adopting and implementing written policies and procedures to achieve compliance; and
• Maintaining relevant records.

Assigning Fair Value Determination

The Proposed Rule permits a fund’s board to assign fair value determination relating to any or all fund investments to one or more investment advisers of the fund. Previously, the SEC insisted that only a fund board could adopt and modify the fund’s fair value policies and procedures. The Proposed Rule explains that if a board chooses to assign fair valuation determination to a fund’s investment adviser, the adviser “would carry out all of the functions required by the Proposed Rule,” including the adoption and implementation of fair value policies and procedures. The Release recognizes that this is a substantial change from current industry practice whereby advisers merely “assist the board in developing the fund’s fair value methodologies.”

If a fund’s board assigns fair value determination to an adviser, the Proposed Rule would require the board to oversee the adviser with a “skeptical and objective view” that takes into account the fund’s particular valuation risks, the appropriateness of the fair value determination process and the skill and resources devoted to it. Fund directors should:

• Ask questions and seek relevant information;
• Seek to identify potential issues and opportunities to improve the fund’s fair value processes;
• Use appropriate level of scrutiny based on the fund’s valuation risk; and
• Seek to identify potential conflicts of interest, and monitor and manage such conflicts.

To ensure a fund’s board has sufficient information to properly oversee the adviser, the adviser would be required to report to the board with respect to matters related to the adviser’s fair value process. The adviser would be required, at least quarterly, to provide the fund’s board with a written assessment of the adequacy and effectiveness of the adviser’s process for determining the investment’s fair value. The adviser’s report must include a summary of material valuation risks, material changes to or material deviations from methodologies, testing results, pricing vendor services, and any other requested materials. Additionally, the adviser would be responsible for promptly — no later than three business days — reporting to the board on matters associated with the adviser’s process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments.

Readily Available Market Quotations

The Release acknowledges that neither the 1940 Act nor the rules thereunder define when market quotations are “readily available” for the purpose of determining whether a fund’s investments should be valued based on market value or on fair value. Paragraph (c) of the Proposed Rule would treat a market quotation as “readily available” only when that quotation (i) is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date and (ii) the quotation is reliable. Also, consistent with industry practice, the Release clarifies that “indications of interest” and “accommodation quotes” would not qualify.