SEC Proposes Rule to Establish Framework for Fund Valuation Practices

Investment Management Update

Date: May 12, 2020

Key Notes:

  • The SEC proposed a new rule to establish a framework for fund fair valuation practices.
  • The proposed rule would permit a fund’s board to assign fair value determinations to an adviser or sub-adviser, subject to board oversight.
  • It also would establish a more definitive regulatory framework for the fair valuation process.
  • Comments on the proposed rule are due by July 21.

On April 21, the Securities and Exchange Commission (SEC) voted to propose a new rule, Rule 2a-5 (Proposed Rule), 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.

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.

Fair Value Determinations

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:

  • Provide a skeptical and objective view that accounts for a fund’s particular valuation risks.
  • Identify and monitor potential conflicts of interest and take reasonable steps to mitigate and manage them.
    • The board should serve as a meaningful check on an adviser’s conflicts of interest and those of other service providers involved in determining fair values.
  • Periodically review an adviser’s fair value process, specifically considering the assigned adviser’s financial resources, technology, staff and expertise and the reasonableness of its reliance on other fund service providers as they relate to valuation.
  • Report periodically and promptly regarding many aspects of an adviser’s fair value determination process as a means of facilitating the board’s oversight.

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:

  • Material valuation risks. The assessment and management of material valuation risks including any material conflicts of interest of the investment adviser and any other service provider.
  • Fair value methodologies. Any material changes to, or material deviations from, the fair value methodologies established under the Proposed Rule.
  • Testing results. The results of any testing of fair value methodologies as part of the required fair value policies and procedures.
  • Resources. The adequacy of resources allocated to the process for determining the fair value of the fund’s assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value.
  • Pricing services. Any material changes to an adviser’s process for overseeing pricing services, as well as any material events related to its oversight of such services, such as changes of service providers used or price overrides.
  • Other requested information. Any other materials requested by the board related to an adviser’s process for determining the fair value of fund investments.

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.

Readily Available Market Quotations

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.

Assessing and Managing Material Risks

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

  • The types of investments held by a fund.
  • Potential market or sector shocks.
  • The extent to which each fair value methodology uses unobservable inputs.
  • The portion of a fund’s investments that are fair valued and their contribution to a fund’s return.
  • Reliance on service providers.
  • The risk that methods used for determining fair value are inappropriate or are applied inconsistently or incorrectly.
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:

  • The pricing service’s qualifications, experience and history.
  • Its valuation methods or techniques.
  • Its process for addressing price challenges.
  • The potential for conflicts and how it mitigates them.
  • The testing processes it uses.
Rescission of Prior SEC Releases

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

  • Paul Revere Investors, Inc. (Feb. 21, 1973). Delegation to a board valuation committee.
  • The Putnam Growth Fund and Putnam International Equities Fund, Inc. (Jan. 23, 1981). Fair value of portfolio securities that trade on a closed foreign exchange.
  • Form N-7 for Registration of Unit Investment Trusts under the Securities Act of 1933 and the Investment Company Act (Mar. 17, 1987). Fair value for UITs to be determined by the trustee or its appointed person. 67 of 1940, Investment Company Act Release No. 15612, Appendix B, Guide 2.
  • Investment Company Institute (Dec. 8, 1999). Fair value generally.
  • Investment Company Institute (Apr. 30, 2001). Fair value generally.
  • Valuation Guidance Frequently Asked Questions (FAQ 1 only) (2014). A fund director’s responsibilities when determining whether an evaluated price provided by a pricing service, or some other price, constitutes fair value.
Conclusion

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.

FOR MORE INFORMATION

For more information, please contact:

Andrew J. Davalla
614.469.3353
Andrew.Davalla@ThompsonHine.com

Brian Doyle-Wenger
614.469.3294
Brian.Doyle-Wenger@ThompsonHine.com

Tashia Love
614.469.3284
Latashia.Love@ThompsonHine.com

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