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On April 21, the Securities and Exchange Commission (SEC) voted to propose a new rule, <a href="https://www.sec.gov/rules/proposed/2020/ic-33845.pdf" target="_blank" rel="noopener">Rule 2a-5 (Proposed Rule)</a>, which would establish a framework for fund fair valuation practices for the purposes of Section 2(a)(41) of the Investment Company Act of 1940 (1940 Act). The Proposed Rule is designed to establish requirements for satisfying a board’s obligations under the 1940 Act to determine fair value in good faith.

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Additionally, the Proposed Rule would permit a board to assign the determination of fair value to a fund’s adviser (or sub-adviser), subject to oversight requirements and conditions including specific reporting by the adviser, clear specification of responsibilities and additional recordkeeping.

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The Proposed Rule would require boards to assess and manage material risks associated with fair value determinations; select, apply and test fair value methodologies; oversee and evaluate any pricing services used; adopt and implement policies and procedures; and maintain certain records.

The Proposed Rule allows a board to make fair value determinations or delegate, with appropriate oversight, the responsibility to establish and apply fair value methodologies to a fund’s adviser. In allowing the delegation to a fund’s adviser, the SEC recognizes that compliance with the 1940 Act does not require a board to perform each specific task and, more importantly, fair valuations require significant resources and specialized expertise that may make it impracticable for a board to perform without assistance. The Proposed Rule would also require that boards and advisers adopt fair value policies and procedures designed to comply with the Proposed Rule and maintain documentation to support fair value determinations as well as copies of policies and procedures for at least five years.

Rather than create a new framework for the delegation of responsibility to a fund’s adviser, the Proposed Rule seeks to create a modern framework that is consistent with Accounting Series Releases (ASR) 113 and 118. Under the Proposed Rule, a board’s oversight process should:

To facilitate effective oversight of an adviser, the Proposed Rule would require an adviser, at least quarterly, to provide the board a written assessment of the adequacy and effectiveness of its process for determining the fair value of the assigned portfolio of investments. Specifically, the written assessment should include a summary or description of:

Under the Proposed Rule, an adviser would be required to promptly, in no less than three days, report to a 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.

The Proposed Rule’s requirements apply only to securities for which market quotations are not readily available. Under the Proposed Rule, a market quotation is readily available when it is a quoted price (unadjusted) in active markets for identical investments that a fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. In defining whether market quotations are readily available and reliable, the SEC relied upon current industry practice by including concepts from Accounting Standards Codification 820 and U.S. GAAP.

The SEC identified several types and sources of valuation risks that a board should consider when determining fair value, including:

Selecting, Applying and Testing Fair Value Methodologies

Under the Proposed Rule, the SEC would require a board to specify the key inputs and assumptions specific to each asset class or investment to be considered for fair valuing an asset, and the methodologies that will apply to the new types of investments in which the fund intends to invest when funds are selecting and applying fair value methodologies. A fund or an adviser would be required to consider the applicability of the chosen methodologies for investments that the fund intends to hold in the future. Moreover, the selected methodologies are also to be reviewed periodically for appropriateness and accuracy, which includes identifying the testing methods used and the minimum frequency of testing.

Overseeing and Evaluating Pricing Services

Boards would be required to establish processes to oversee and evaluate pricing service providers, and they should consider the following when evaluating pricing service providers:

Under the Proposed Rule, the SEC would rescind ASR 113 and 118 and several staff letters and guidance including:

The Proposed Rule would provide greater clarity by establishing a more definitive framework for the fair value process. Rather than breaking new ground, it takes into account current industry practices while also introducing more specific policy, reporting and recordkeeping requirements. If adopted, the Proposed Rule would have a one-year transition period to allow fund boards and advisers to determine fair value responsibilities and establish the appropriate policies and procedures to comply with the final rule.

Andrew J. Davalla 614.469.3353 <a href="mailto:Andrew.Davalla@ThompsonHine.com">Andrew.Davalla@ThompsonHine.com</a>

Brian Doyle-Wenger 614.469.3294 <a href="mailto:Brian.Doyle-Wenger@ThompsonHine.com">Brian.Doyle-Wenger@ThompsonHine.com</a>

Tashia Love 614.469.3284 <a href="mailto:Latashia.Love@ThompsonHine.com">Latashia.Love@ThompsonHine.com</a>

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel.

This document may be considered attorney advertising in some jurisdictions.

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SEC Proposes Rule to Establish Framework for Fund Valuation Practices

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