“The devil is in the details”
– quote generally attributed to Ludwig Mies van der Rohe
On April 21, 2020, the Securities and Exchange Commission (SEC) issued a release proposing substantial changes to investment company valuation practices (Proposing Release).1 The SEC would adopt new Rule 2a-5 under the Investment Company Act of 1940 (1940 Act) , which would establish requirements for determining the fair value in good faith of a fund’s investments and would permit boards to assign the determination to the fund’s investment adviser, subject to board oversight and other conditions. The proposed rule would also define “readily available” market quotations for purposes of the 1940 Act. The comment period for the proposed rule ends on July 21, 2020.2
New Rule 2a-5 would replace the current mélange of fifty-plus year-old accounting releases, no-action letters and enforcement actions that currently govern investment company valuation practices. In particular, new Rule 2a-5, if adopted as proposed, would provide some welcome certainty and predictability in an area that has increasingly lacked clear guidelines as investment types and investment markets have evolved. However, as we explain below, we believe that the comment process can help the SEC to clarify ambiguities and anomalies present in the proposed rule that likely were not intended.
TL:DR (Too Long; Didn’t Read)
- Rule 2a-5 would apply to all registered investment companies (RICs)
- Rule 2a-5(b) would permit boards to delegate fair value determinations to a fund’s investment adviser, sub-adviser(s) or combination, or make fair value determinations themselves.
- In all circumstances, Rule 2a-5 would require funds 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.
- In addition, when a fund delegates fair value determinations to an investment adviser or sub-adviser, the rule would require certain reporting, record-keeping, and other requirements intended to facilitate the board’s oversight of the adviser’s fair value determinations.
- Much of the SEC’s current valuation guidance – releases, no-action letters, guidelines – would be rescinded if Rule 2a-5 is adopted.
Current Practices
Despite the fact that the 1940 Act requires fund boards to value in good faith investments for which market quotations are not readily available, the SEC staff has authorized boards to delegate a fair degree of its valuation responsibilities to fund management when there are detailed procedures to guide them. The SEC staff has stated:
We believe that, in general, the degree of involvement required of a board . . . will depend heavily on the comprehensiveness of the pricing procedures adopted for the fund and the degree of discretion vested in fund management. If, for example, a board has approved comprehensive procedures which provide methodologies for how fund management should fair value price portfolio securities . . . a board would need to have comparatively little involvement in the valuation process in order to satisfy its good faith obligation. This necessitates, of course, that the board periodically review the appropriateness of the methods used to fair value price portfolio securities and the quality of the prices obtained through these procedures, and that it make changes when appropriate.
When the board has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague, we believe that the board’s involvement must be greater and more immediate . . . . Depending on the particular circumstances, the board may need to evaluate how particular portfolio securities are being priced, or, when the fund has limited or no fair value pricing procedures, authorize the specific pricing methodology used.3
Questions about precisely how detailed a fund’s fair value procedures are, and consequently, how involved a board must be in fair value determinations, have been the subject of dispute. The SEC settled enforcement proceedings against members of one fund board for delegating fair value determinations to fund management without providing a “meaningful methodology or other specific direction on how to make fair value determinations for specific portfolio assets or classes of assets.”4 The fund’s valuation procedures listed various factors articulated by the SEC in past valuation guidance5 but failed to explain how the listed factors should be applied with respect to various asset classes or valuation issues. The enforcement proceeding was controversial for many reasons, including: (i) the valuation procedures resembled those then employed by many other fund complexes; and (ii) the settlement noted that outside counsel advised the board in connection with the adoption of the procedures and the fund’s auditor advised the board that the procedures were appropriate and reasonable.6
Proposed Rule 2a-5
As noted above, the rule would explicitly authorize a fund board to delegate responsibility for fair value determinations to one or more investment advisers or sub-advisers, as well as allowing a fund board to retain fair value responsibilities for a fund. The trustee of a unit investment trust (UIT) would perform these responsibilities for a UIT.
Fair Value as Determined in Good Faith
Valuation Risks. Proposed Rule 2a-5 would provide that determining fair value in good faith requires periodically assessing any material risks associated with the determination of the fair value of the fund’s investments. The rule would explicitly require assessment of material conflicts of interest but would not explicitly require assessment of other material risks. The rule also does not set forth a mandatory frequency to assess material risks. However, the Proposing Release sets forth a list of types or sources of valuation risks:
- 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.
The Proposing Release states that periodic assessments of valuation risk should typically take into account changes in fund investments, significant changes in a fund’s investment strategy or policies and other relevant factors.
Fair Value Methodologies. Proposed Rule 2a-5 would provide that fair value as determined in good faith requires:
- Selecting and applying in a consistent manner an appropriate methodology or methodologies for determining (which includes calculating) the fair value of fund investments, including specifying:
- The key inputs and assumptions specific to each asset class or portfolio holding; and
- The methodologies that will apply to new types of investments in which the fund intends to invest;
- Periodically reviewing the selected methodologies for appropriateness and accuracy, and to adjust a methodology if the adjustments would result in more accurate fair value determinations; and
- Considering the applicability of the selected methodologies to types of fund investments that the fund doesn’t currently hold but in which it intends to invest in the future.
An appropriate methodology is one that is consistent with FASB Accounting Standard Codification Topic 820: Fair Value Measurement (ASC Topic 820). The Proposing Release states that whatever methodology is selected should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
PRACTUS NOTE: The requirement to maximize the use of relevant observable inputs and minimize the use of unobservable inputs is an existing requirement under ASC Topic 820. Furthermore, when a valuation technique utilizes unobservable inputs, ASC Topic 820 requires that the technique “reflect(s) observable market data (for example, the price for a similar asset or liability) at the measurement date.”The Proposing Release states that the SEC believes that for any particular investment, there may be a range of appropriate values that could be considered to be the investment’s fair value.
Testing of Fair Value Methodologies. Proposed Rule 2a-5 would require regular testing of the appropriateness and accuracy of the methodologies used to calculate fair value. The Proposing Release states that the specific tests to be performed, and their frequency, depend on the circumstances of each fund and thus should be determined by the board or the adviser. Funds would be required to identify (1) the testing methods to be used, and (2) the minimum frequency of the testing. The Proposing Release notes that calibration or backtesting could signify updates to a methodology are required.
Pricing Services. Proposed Rule 2a-5 would provide that determining fair value in good faith requires the oversight and evaluation of pricing services, where used. The board or the adviser would have to establish a process for the approval, monitoring, and evaluation of each pricing service provider, and the Proposing Release sets forth a list of factors to consider in connection with this process. We note that, as set forth in the chart below, despite the central importance of valuation to the operation of an investment company, the due diligence that the SEC would require of pricing services is arguably less extensive than the due diligence that the SEC proposes to require with respect to third party proxy advisors:
| Pricing Services | Proxy Advisors |
| Its qualifications, experience, and history | The effectiveness of its process for seeking timely input from issuers and proxy advisor clients with respect to proxy voting policies, methodologies, and peer group constructions |
| Its valuation methods or techniques, inputs, and assumptions used for different classes of holdings, and how they are affected as market conditions change | The adequacy of its disclosure of its methodologies in formulating voting recommendations, such that the investment adviser can understand the factors underlying the proxy advisor’s voting recommendations |
| Its process for considering price “challenges,” including how it incorporates information received from pricing challenges into its pricing information | The nature of any third-party information sources that it uses as a basis for its voting recommendations |
| Its potential conflicts of interest and the steps it takes to mitigate such conflicts | Developing a reasonable understanding of when and how the proxy advisor would expect to engage with issuers and third parties |
| The testing processes it uses | A reasonable review of the proxy advisor’s policies and procedures regarding how it identifies and addresses conflicts of interest |
| Periodic reviews of the proxy advisor and a requirement that the proxy advisor update the investment adviser regarding business changes the investment adviser considers relevant (i.e., with respect to the proxy advisor’s capacity and competency to provide independent proxy voting advice or carry out voting instructions) | |
| Whether the proxy advisor appropriately update its methodologies, guidelines, and voting recommendations on an ongoing basis, including in response to feedback from issuers and their shareholders | |
| Adequacy and quality of the proxy advisor’s staffing, personnel, and/or technology | |
| The extent to which potential factual errors, potential incompleteness, or potential methodological weaknesses in the proxy advisor’s analysis materially affected the proxy advisor’s research or recommendations that the investment adviser utilized |
Rule 2a-5 would require funds to establish criteria for circumstances in which a fund or adviser would initiate a challenge to the price determined by the pricing service.
Fair Value Policies and Procedures. Rule 2a-5 would require written policies and procedures to address the determination of the fair value of a fund’s investments. Rule 38a-1 under the 1940 Act (Fund Compliance Rule) would encompass a fund’s compliance obligations vis-à-vis Rule 2a-5, and would require a fund’s board to oversee compliance with Rule 2a-5.
Record-keeping. Under Rule 2a-5, funds would maintain:
- Appropriate documentation to support fair value determinations (including documentation sufficient to enable a third party to verify any determination), including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations, as well as any necessary or appropriate adjustments in methodologies; and
- A copy of policies and procedures that would be required under the rule that are in effect, or that were in effect at any time within the past five years.
Performance of Fair Value Determinations
As noted above. Rule 2a-5 would permit fair value determinations to be:
- Made by a fund’s board itself;
- Delegated by the fund’s board to the fund’s investment adviser; or
- Delegated by the fund’s board to any number of the fund’s investment adviser(s) and/or sub-adviser(s)
The Proposing Release notes that if a fund’s fair value determinations are delegated to multiple advisers, the fund’s compliance policies and procedures should address the added complexities of overseeing multiple assigned advisers.
Board Oversight. When a board delegates fair value determinations to an adviser, the board must oversee the adviser to fulfill its statutory obligation vis-à-vis fair value determinations. The Proposing Release states that a board should view oversight as an iterative process and seek to identify potential processes and opportunities to improve funds’ fair value processes. The SEC recognizes that different asset classes demand different levels of scrutiny, with the level of scrutiny increasing as the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures.
- Conflicts of Interest. The Proposing Release calls for boards to attempt to identify, monitor and manage conflicts of interests in the fair valuation process. The SEC has long been concerned about whether advisers overvalue assets to increase asset-based fees collected, improve or smooth returns, or comply with the fund’s investment policies and restrictions. The Proposing Release also identifies conflicts of interest when pricing services or broker-dealers provide price quotes. The Proposing Release recommends that boards understand the role of, and inquire about conflicts of interest regarding, any other service providers used by the adviser as part of the fair valuation input process, and satisfy itself that any conflicts are being appropriately managed.
- Appropriateness of Fair Value Processes. The Proposing Release calls for boards to review periodically the financial resources, technology, staff, and expertise of the adviser assigned to execute fair valuation processes, and the reasonableness of that adviser’s reliance on other fund service providers. The SEC also recommends that boards consider the adviser’s compliance capabilities that support the fund’s fair value processes, and the oversight and financial resources made available to the CCO relating to fair value.
- Board Reports.
- A board must request and review the information necessary to be fully informed of the adviser’s process for determining the fair value of fund investments.
- A board can reasonably rely on the information provided to it in summaries and other materials provided by the adviser and other service providers in conducting its oversight.
- If the board becomes aware of material matters (whether the board identifies the matter itself or the fund’s CCO or adviser or another party identifies the issue), the SEC wants the board to inquire about these matters and take reasonable steps to see that they are addressed.
Board Reporting. Rule 2a-5 would require the adviser’s reports to include the information necessary for the board to evaluate the matters covered in the fair valuation reports. The SEC intends this board reporting requirement to provide sufficient context to facilitate the board’s oversight, by providing the board with enough information to determine whether to ask the adviser additional questions or request additional information, as appropriate.
- Periodic Reporting. Under Rule 2a-5, at least quarterly the adviser would provide the board with a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the assigned portfolio of investments. The quarterly reports would be required, at a minimum, to include a summary of the following information:
- Material Valuation Risks. This would include any material conflicts of interest of the investment adviser and any other service provider.
- Material Changes to or Material Deviations from Methodologies. This permits boards to understand if valuation methodologies should be updated.
- Testing Results. This helps boards determine if updates to policies are necessary, and testing is not limited to calibration (the alignment of a price paid with a fair valued price) or backtesting (the comparison of a price on sale to the price carried on the books).
- Resources. The adequacy of resources allocated to the fair valuation process, including any material changes to the roles or functions of the persons responsible for determining the fair value.
- Pricing Services. Any material changes to the 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. Anything else the board decides to ask for that relates to the adviser’s process for determining the fair value of fund investments, which could include items such as summaries of price challenges; specific testing data or auditor testing data; stale priced securities reports; pricing error reports; reports on pricing errors; reports on the adviser’s due diligence on pricing services; trend analysis on fair valued holdings and the sources of pricing information.
- Prompt Board Reporting. The rule would require that the adviser promptly provide a written report 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, 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. According to the SEC, “could have materially affected” is intended to capture circumstances in which a matter occurred, that affected one security, which in that instance was not material, but if the matter had not been identified, it could have materially affected the fair value of the assigned portfolio of investments.
- Rule 2a-5 would require reports on these matters to be provided not later than three business days after the adviser becomes aware of the matter. The Proposing Release states that some situations may warrant an immediate report, while in other cases it may be appropriate for the adviser to take some additional time to evaluate how to address the matter before engaging with the board. The Proposing Release also notes that in some instances, an adviser may need time to verify and determine the materiality of a matter. In those instances, an adviser can take up to three business days to do so, before the time frame to report to the board begins to elapse.
- Specification of Functions. If the board delegates the fair value determination requirements to an adviser, Rule 2a-5 would require the adviser to specify the titles of the persons responsible for determining the fair value of the investment assigned to that adviser, including by specifying the particular functions for which the persons identified are responsible. The rule would also require the adviser to reasonably segregate the process of making fair value determinations from the portfolio management of the fund. This segregation requirement would not prevent portfolio managers from providing inputs that are used in the fair value determination process, but is intended to reduce and manage potential conflicts of interest.
PRACTUS NOTE: The Proposing Release states that funds could reasonably segregate functions through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel.We note that “reasonable segregation” closely mirrors the “reasonable segregation” requirements of the proposed fund derivatives rule, where a fund’s portfolio manager cannot also serve as its sole derivatives risk manager, and is aligned with the approach taken in the Liquidity Risk Management Rule, which prevents portfolio management personnel from serving as the sole program administrator but permits consultation with portfolio managers in administering a fund’s liquidity risk management program.- Records of Assignment. A fund would be required to: (1) keep copies of the reports and other information provided to the board required by the rule and (2) 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 rule. In each case, these records would be required to be kept for at least five years after the end of the fiscal year in which the documents were provided to the board or the investments or investment types were assigned to the adviser, the first two years in an easily accessible place.
PRACTUS NOTE: The Proposing Release states that the 1940 Act requires a portfolio holding to be valued at its market value if a market quotation is available for that portfolio holding.We note that the statutory language of the 1940 Act applies only to portfolio securities.We believe that if the SEC wants to extend this interpretation to other types of portfolio instruments, such as futures or forwards, it should explicitly interpret the 1940 Act in this manner.
PRACTUS NOTE: The requirement that quotations be unadjusted could lead to interpretive issues.While it appears that the SEC intended “adjustments” to refer to adjustments made by an issuer, quotations such as the Nasdaq Official Closing Price are often adjusted to exclude transactions that do not take place on Nasdaq.
Miscellaneous Issues
Conclusion
Proposed Rule 2a-5 would be a welcome improvement in guidance over the current collection of 50-year old releases, no-action letters and enforcement actions. It would increase certainty and predictability in valuation, and align fund valuations with GAAP accounting practices more directly. Moreover, it would provide boards and advisers with clearer guidance regarding their valuation, reporting, record-keeping and oversight obligations. However, there are aspects of the rule-making that could benefit from the notice and comment process, particularly with respect to variable insurance separate accounts registered as UITs. Practus attorneys look forward to collaborating with clients to comment on this important SEC proposal.
1 Good Faith Determinations of Fair Value, Investment Company Act Rel. No. 33845 (Apr. 21, 2020), 85 Fed. Reg. 28734 (May 13, 2020).
2 The SEC has recently noted that it has “historically considered comments submitted after a comment period closes but before adoption of a final rule or order, consistent with the Commission’s Informal and Other Procedures (17 C.F.R. 202.6).” SEC Coronavirus (COVID-19) Response: Effect on Comment Periods for Certain Pending Actions (https://www.sec.gov/sec-coronavirus-covid-19-response) (visited Apr. 22, 2020).
3 Investment Company Institute, SEC No-action Letter (pub. avail. Dec. 8, 1999).
4 J. Kenneth Alderman et al., Investment Company Act Release No. 30557 (June 13, 2013) (“Alderman”).
5Accounting Series Release No. 118 (Dec. 23, 1970) (“ASR 118”).
6 Alderman, supra note 4.
