Overview

On April 21, 2020, the Securities and Exchange Commission (SEC) announced the proposal of new Rule 2a-5 (the Proposed Rule) under the Investment Company Act of 1940, as amended (the 1940 Act), that would establish a framework for fund valuation practices and clarify how the board of directors of a fund can satisfy their valuation obligations under the 1940 Act. The Proposed Rule applies to all registered investment companies and business development companies (together, Funds). 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 Proposed Rule would impact the valuation process in two primary ways: (1) by permitting a Fund’s board of directors to assign the determination of fair value to the Fund’s investment adviser or sub-adviser, subject to certain conditions, including continued oversight, and (2) by creating a framework for the determination of the fair value of a Fund’s investment to create a standard baseline practice across all Funds, whether it is an investment adviser or the board making the fair value determination.

Valuing a Fund’s Investments

The 1940 Act requires the board of directors of a Fund to value the Fund’s portfolio investments using the market value of their portfolio securities when market quotations for those securities are “readily available.” The Proposed Rule 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, the board of directors of a Fund determines the fair value in good faith. The Proposed Rule not only confirms that the board can make this valuation determination itself, but the Proposed Rule also permits the board of directors of a Fund to assign the determination of fair value to one or more of the Fund’s investment advisers or sub-advisers.¹ Consequently, a multi-manager Fund could assign the role of determining fair value to different advisers for the different investments those advisers manage. When a board of directors assigns the determinations to multiple advisers, the Fund’s policies and procedures, as discussed below, should address the added complexities in order to be reasonably designed to avoid violating the federal securities laws.

In conjunction with the Proposed Rule, the SEC is proposing to rescind the ASRs and various letters from the SEC staff, which provide guidance on the role of the Fund’s board of directors in determining fair value.²

Assigning Valuation Responsibilities to an Investment Adviser

The Proposed Rule requires that, if the board of directors chooses to delegate this responsibility, it comply with the following conditions:

Board Oversight of the Adviser

• The Proposed Rule would require the board of directors to oversee the adviser with a skeptical and objective view, considering:
  • The Fund’s valuation risks, including conflicts;
  • The appropriateness of the process; and
  • The skill and resources devoted to it in an active and iterative manner.
• The Proposed Rule would require reports from the adviser. The board of directors should consider the type, content and frequency of the reports they receive, and seek follow-up information and take reasonable steps to see identified matters are addressed when appropriate.

Periodic and Prompt Reporting by the Adviser to the Board of Directors

Under the Proposed Rule, the adviser would be required to provide written reports to the board of directors of the Fund. The reports are intended to supplement, not replace, the board’s oversight.

• These reports should:
  • Contain tailored information with sufficient context;
  • Familiarize directors with the adviser’s process and explain how this process addresses the requirements of the Proposed Rule; and
  • May take the form of narrative summaries, graphical representations, statistical analyses, dashboards or exceptions-based reporting, among other methods.
• Periodic Reporting: The adviser would need to provide the Fund’s board of directors a written assessment of the adequacy and effectiveness of the adviser’s process at least quarterly. The periodic reports would be required to, at a minimum, summarize:
  • Material valuation risks;
  • Material changes to, or material deviations from, methodologies;
  • Testing results;
  • Resources;
  • Pricing services;
  • Any other materials requested by the board related to the adviser’s valuation process.
• Prompt Board Reporting: The adviser would need to notify the board of directors of certain issues, as they arise, that may require immediate attention, in less than three business days after the adviser becomes aware of the matter.
  • The adviser would need to promptly report to the board, in writing, 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, including a significant deficiency or a material weakness in the design or implementation of the adviser’s fair value determination process or material changes in the Fund’s valuation risks.

Clear Delineation and Delegation of Duties among the Adviser’s Personnel

• The adviser would be required to:
  • Specify the titles of the persons responsible for determining the fair value of the assigned investments, including those persons’ particular functions; and
  • Reasonably segregate the process of making fair value determinations from the portfolio management of the Fund.
• The Fund and the Fund’s board of directors should seek to provide independent voices and administration of the process as a check on any potential conflicts.
• The Proposed Rule would require reasonable segregation of functions, rather than taking a more prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific personnel. The requirement is not intended as a communications “firewall,” but rather a flexible approach considering each Fund and adviser’s individual facts and circumstances.

Keeping Additional Records Relevant to the Assignment to the Adviser

Funds would be required to keep:

• Copies of the reports and other information provided to the board of directors required by the Proposed Rule; and
• A specified list of the investments or investment types whose fair value determinations have been assigned to the adviser pursuant to the requirements of the Proposed Rule.³

Establishing a Valuation Framework

Whether done by the Fund’s board of directors itself, or delegated to an adviser, the Proposed Rule would establish the following “required functions” that must be performed to determine, in good faith, the fair value of the 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

A Fund would be required to periodically assess any material risks associated with the determination of the fair value of the Fund’s investments. The Proposed Rule provides a non-exhaustive list of risks to be considered, including:

• The types of investments held or intended to be held by the Fund;
• Potential market or sector shocks or dislocations;
• The extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the adviser;
• The proportion of the Fund’s investments that are fair valued as determined in good faith, 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 (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 Proposed Rule intentionally does not identify specific risks (other than material conflicts of interest) or state how frequent assessment should be, as different risks and frequencies may be appropriate for different Funds or investments.

Fair Value Methodologies

Funds would be required to select and apply an appropriate methodology or methodologies for determining the fair value of investments. This would require specifying (1) the key inputs and assumptions specific to each asset class or portfolio holding, and (2) the methodologies that will apply to new types of investments in which the Fund intends to invest. The Fund’s board of directors or adviser would have to consider the applicability of the selected methodology to types of the Fund’s investments in which it intends to invest in the future, but does not currently hold.

The Proposed Rule also would require the board of directors or adviser to periodically review the selected methodologies for appropriateness and accuracy, and to adjust them as necessary. The results of back-testing or calibration, or a change in circumstances specific to an investment could necessitate adjustments. While the Proposed Rule requires the methodologies be consistently applied to their associated asset classes, it also allows for circumstances in which adjustments would result in a measurement that is equally or more representative of fair value. Importantly, the Proposed Rule would require the appropriate party maintain records supporting any such methodology change.

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 the Proposed Rule 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

The Proposed Rule would 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, the Proposed Rule would require the Fund to establish a process for approving, monitoring and evaluating each pricing service provider, as well as establishing criteria for challenging the pricing service’s determination where materially different from the Fund’s view of the fair value.

The board of directors or adviser 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 as market conditions change;
• The pricing service’s process for considering price “challenges,” including how the pricing service incorporates information received from pricing 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.

Fair Value Policies and Procedures

The Proposed Rule would require written policies and procedures addressing the determination of the fair value of the Fund’s investments. These policies and procedures must be reasonably designed to: (1) periodically assess any material risks associated with the determination of the fair value, including material conflicts of interest, and manage those identified valuation risks; (2) select and apply in a consistent manner methodologies for determining and calculating the fair value; (3) test the appropriateness and accuracy of the fair value methodologies that have been selected, and (4) select and oversee pricing service providers, if used.

Under the Proposed Rule, where the Fund’s board of directors determines the fair value of investments, the board-approved fair value policies and procedures would be adopted and implemented by the Fund. Where the board of directors assigns fair value determinations to the adviser, the fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight.

Under the current regulatory regime, Rule 38a-1 requires a Fund to adopt certain compliance policies and procedures with respect to fair value. Rule 38a-1 would continue to encompass a Fund’s compliance obligations under the Proposed Rule and would require a Fund’s board to oversee compliance with the Proposed Rule. To the extent that adviser policies and procedures under the Proposed Rule would otherwise be duplicative of Fund valuation policies under Rule 38a-1, a Fund could adopt the policies and procedures of the adviser in fulfilling its Rule 38a-1 obligations.

Recordkeeping

Funds would be required to maintain certain records so as to allow a third-party to verify the fair value determination. These records include sufficient supporting documentation and the fair value policies and procedures described in the preceding section.

For supporting documentation, the board of directors or adviser would be required to maintain appropriate documentation to support fair value determinations, including (1) information regarding the methodologies applied, (2) the assumptions and inputs considered, or (3) any adjustments in methodologies, for at least five years from the time the determination was made, the first two years in an easily accessible place.

The board of directors or adviser would also be required to maintain a copy of the required policies and procedures that are in effect, or that were in effect at any time within the past five years, in an easily accessible place.

Next Steps

The SEC will accept comments from all interested parties on the Proposed Rule until July 21, 2020. Funds and their advisers should consider whether the Proposed Rule’s framework adequately addresses their day-to-day valuation functions. In connection with their consideration of the Proposed Rule, Funds and their advisers should be prepared to review and update their valuation policies and procedures, as well as the related sections of their compliance manuals, and implement the review, testing, recordkeeping, reporting and other requirements of the Proposed Rule.

SEC Press Release: SEC Proposes to Modernize Framework for Fund Valuation Practices

Proposed 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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