SEC Modernizes Framework for Fund Valuation Practices
On December 3, 2020, the U.S. Securities and Exchange Commission (SEC) adopted new Rule 2a-5 under the Investment Company Act of 1940 (1940 Act), which provides an updated regulatory framework for registered fund valuation practices.1 The SEC also adopted new Rule 31a-4 under the 1940 Act, which requires registered funds or their investment advisers to maintain certain documentation relating to their fair valuation determinations and, in some instances, documentation relating to the fund board’s designation of a so-called “valuation designee.” Rule 2a-5, which applies to all registered investment companies including mutual funds, exchange-traded funds (ETFs), registered closed-end funds and unit investment trusts, as well as to business development companies, replaces 50 years of various accounting releases, SEC and staff guidance, no-action letters, and enforcement actions that have governed registered investment company valuation practices.
In response to comments received on the proposed rule,2 final Rule 2a-5 makes certain modifications to the proposed rule, many of which are welcome improvements over the proposal, as described further below. Rule 2a-5 will be effective 60 days after publication in the Federal Register, with a compliance date 18 months after the effective date, which represents an extension of the proposed 12-month compliance date.
Overview of Rule 2a-5
The 1940 Act requires funds to value their portfolio securities using their market value when market quotations are “readily available,” or, when market quotations are not “readily available” (and for all other investments), by using the investments’ fair value, as determined in good faith by the fund’s board. The Adopting Release acknowledges the increasing complexity of valuation given the greater variety of securities and other instruments in which funds invest and the interplay of Rule 38a-1 under the 1940 Act (Compliance Rule) in facilitating board oversight of the valuation process.
Rule 2a-5 establishes minimum and baseline standards for good faith fair value determinations, and generally reflects the SEC’s understanding of current best practices used by funds to fair value their investments. The rule requires assessing and managing material risks associated with fair value determinations; selecting, applying and testing fair valuation methodologies; and overseeing and evaluating any pricing services used. The rule also permits boards, subject to oversight and other conditions, to designate a fund’s adviser, or, if a fund is internally managed, a fund officer (collectively, “valuation designee”) to perform fair value determinations. Finally, the rule defines “readily available” market quotations for purposes of section 2(a)(41) of the 1940 Act. Each of these elements is discussed in greater detail below.
Fair Valuation Process
Rule 2a-5 requires the periodic assessment of material risks associated with the determination of the fair value of investments, including material conflicts of interest, and the management of those identified risks. The rule does not prescribe a frequency for such assessments and includes a non-exhaustive list of examples of sources or types of valuation risk, with several modifications from the proposed list, to reflect additional risks raised in comment letters. The Adopting Release reflects the SEC’s view that a fund’s specific valuation risks depend on the facts and circumstances of its particular investments, and the frequency of risk assessments and the sources and types of valuation risk are matters to be determined by the fund’s board (or its valuation designee, as applicable). The non-exhaustive list of sources or types of valuation risk includes:
- the types of investments held or to be held by the fund and the characteristics of those investments;
- potential market or sector shocks or disruptions that may affect the valuation designee’s or a third-party’s ability to operate;
- the extent to which fair valuation methodologies use unobservable inputs and the conflicts of interest of the provider of those inputs;
- the proportion of the fund’s investments that are fair valued and their contribution to the fund’s performance;
- reliance on third-party service providers and the extent to which those service providers in turn rely upon their own service providers; and
- the risk that fair valuation methods are inappropriate or not applied consistently or correctly.
Rule 2a-5 requires the board (or its valuation designee, as applicable) to select and apply in a consistent manner an appropriate methodology or methodologies for determining the fair value of the fund’s investments. The Adopting Release clarifies that the board or its designee may select different methodologies for different securities within the same asset class, or change the methodology for a particular security, without running afoul of the rule’s “consistent manner” requirement. However, the valuation methodology must be consistent with the fund’s methodology for valuing that security for financial statement purposes. In a change from the proposal, a fund does not need to determine the valuation methodology to be applied to a security that the fund does not currently hold but intends to hold in the future.
The rule requires the board or its designee to periodically review the selected fair valuation methodologies for appropriateness and accuracy, to make changes or adjustments to the methodologies where necessary, and to monitor for circumstances that may necessitate the use of fair valuation. In a change from the proposed rule, the final rule does not include a list of specific criteria for determining when market quotations are not reliable and therefore not readily available.
The final rule also requires the testing of the appropriateness and accuracy of the methodologies used to calculate fair value. The rule does not require particular testing methods or a specific minimum frequency for testing but rather leaves these matters to the board or its designee.
For funds that use pricing services, the final rule requires the oversight and evaluation of those pricing services. The board or its designee will be required to establish a process for approving, monitoring, and evaluating each pricing service provider, and to establish a process for initiating price challenges as appropriate.
Rule 2a-5 does not require a fund to adopt written policies and procedures reasonably designed to achieve compliance with the rule itself. However, the Adopting Release notes that a fund’s policies and procedures adopted under the Compliance Rule requires the adoption of written policies and procedures reasonably designed to prevent violations of the requirements of Rules 2a-5 and 31a-4.
Designation of Valuation Designee
Rule 2a-5 permits a board to designate the performance of fair value determinations relating to any or all fund investments to a valuation designee, subject to the board’s oversight. The SEC declined to expand the types of entities that commenters suggested could be designated (e.g. pricing services, fund administrators, officers of the fund), and, consistent with the proposal, chose to permit only the fund’s investment adviser to be designated, except in the case of internally managed funds, in which case an officer of the fund may be designated. Sub-advisers may assist the valuation designee as appropriate but cannot be designated by the board to perform fair value determinations.
The Adopting Release reiterates the SEC’s guidance on board oversight, noting that oversight cannot be a passive activity, and that boards should approach their oversight with a skeptical and objective view. The SEC notes that boards should take account of the fund’s particular valuation risks, including conflicts of interest, the appropriateness of the fair value determination process and the resources devoted to it. The final rule requires the valuation designee to periodically report to the board with respect to matters related to the fair value process to ensure that the board has sufficient information to conduct its oversight, but the Adopting Release notes that boards should also request follow-up information when appropriate and take reasonable steps to ensure that matters identified are addressed. The final rule also requires the valuation designee to provide the board with written notification of the occurrence of matters that materially affect the fair value of the designated portfolio of investments within a time period specified by the board, but in no event later than five business days (a change from the proposed three business days) after the valuation designee becomes aware of the material matter. The valuation designee must also provide whatever timely follow-on reports as the board reasonably determines appropriate.
A valuation designee is required to specify the titles of persons responsible for determining the fair value of the designated investments, and to specify the duties of each person identified, including those with the authority to override a price. The portfolio manager may participate in the process of fair value determinations but may not determine or effectively determine fair value by exerting substantial influence on determining the fair values of portfolio holdings.
The SEC also adopted new Rule 31a-4 under the 1940 Act, which requires funds or valuation designees, as applicable, to maintain for six years appropriate documentation to support fair value determinations. A separate recordkeeping rule was adopted to address concerns by commenters that incorporating recordkeeping requirements into Rule 2a-5 could call into question the validity of fair value determinations if the recordkeeping provisions were not satisfied.
Definition of Readily Available Market Quotations/Impact on Cross Trading
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 instruments 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 notes that this definition is consistent with the definition of a quotation based upon a level 1 input in the fair value hierarchy outlined in U.S. GAAP. As a result, only securities valued using level 1 inputs will be considered securities for which market quotations are readily available. The SEC states in the Adopting Release that this definition of “readily available market quotations” will apply in all contexts under the 1940 Act.
The SEC’s adoption of this definition may have a profound impact on cross-trading practices in the industry, especially for investment advisers managing fixed income assets. Rule 17a-7 under the 1940 Act, which provides an exemption from Section 17(a) of the 1940 Act for cross trades involving registered funds, limits the universe of securities that may be cross-traded in reliance on the rule to those for which market quotations are readily available. Many fixed income securities that investment advisers seek to cross trade with a registered fund and other clients are priced using third-party pricing services and the prices of such securities typically are not based on level 1 inputs. The valuation of these instruments must therefore be derived based on other inputs, which under the rule results in these instruments being excluded from cross trade eligibility. As a result, this may reduce cross-trading opportunities for many funds. For a more detailed discussion, please see our Practus Legal Insight on this particular issue.4
Rescission of Prior Guidance
The SEC is also rescinding Accounting Series Release (ASR) 113 and ASR 118 in their entireties since the guidance included in these releases is superseded or made redundant by the adoption of Rule 2a-5. In addition, certain SEC guidance, staff letters and other staff guidance addressing a board’s determination of fair value will be withdrawn or rescinded on the compliance date of Rule 2a-5. The Adopting Release lists specific guidance that is being withdrawn or rescinded, but also states that any guidance that is inconsistent with the requirements of Rule 2a-5 is superseded.
The adoption of Rule 2a-5 represents the first comprehensive guidance on fund valuation in 50 years. Although the transition period provided by the SEC is 18 months, fund sponsors should begin reviewing their valuation practices early to ensure ample time to make any modifications needed to comply with the new rule. In addition, funds that engage in cross trades in securities not valued using level 1 inputs should assess the impact that the revised definition of “readily available market quotations” will have on their cross trading activity.
Please contact Steve King or the Practus attorney who usually advises you with any questions you may have or if you would like additional information.
About the Author
- Good Faith Determinations of Fair Value, Investment Company Act Release No. 34128 (Dec. 3, 2020) (“Adopting Release”). The Adopting Release is available athttps://www.sec.gov/rules/final/2020/ic-34128.pdf.
- Good Faith Determinations of Fair Value, Investment Company Act Release No. 33845 (Apr. 21, 2020) [85 FR 28734 (May, 13, 2020)] (“Proposing Release”). The Proposing Release is available at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf.
- In the Matter of ICE Data Pricing & Reference Data, LLC, Advisers Act Rel. No. 5643 (Dec. 9, 2020), available at https://www.sec.gov/litigation/admin/2020/ia-5643.pdf.
Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.