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SEC Proposes New Regulation of Fund Valuation

April 24, 2020

Under the proposal issued April 21, the SEC would substantially revise the regulation of fund valuation for the first time in 50 years and rescind much of the current guidance. The proposed rule would clarify the ability of independent directors to assign fair valuation responsibility to an investment adviser, but implementation could pose substantial compliance and operational burdens for fund complexes and their managers – even though the end result may not be that different from current practices.

Key Takeaways:

  • For the first time in nearly 50 years, the SEC would substantially revise the regulation of fund valuation, and would rescind much of the current guidance
  • Proposed Rule 2a-5 under the 1940 Act would implement a framework of risk-based principles, similar to the approach taken by the liquidity rule and proposed derivatives rule
  • There is no indication that existing practices would have to be overhauled and, if adopted as proposed, the procedures that funds adopt could be substantially similar to current practices, but assessing current practices in the context of a new rule could still be burdensome
  • Fund boards would clearly be permitted to assign responsibility to fund advisers but may want to consider whether the proposal imposes too heavy a burden

The US Securities and Exchange Commission (SEC) proposed a new regulatory framework – Rule 2a-5 – on April 21 that would seek to clarify the role of the board of directors of a registered investment company or business development company (“fund”) with respect to fund valuation.[1] Although market practice – and operational necessity – has long been that boards assign day-to-day valuation to a fund’s officers, investment adviser, administrator, and other agents, boards have done so in accordance with a somewhat opaque (and outdated) patchwork quilt of regulatory guidance and SEC staff positions. As the market has become more complex and inputs for valuation have become more voluminous, boards sometimes have struggled to interpret the current regulatory framework as it concerns their responsibility for fund valuation.

It has been nearly 50 years since the SEC last published comprehensive guidance on fund valuation.[2] For years since, the industry has sought more clarity in this area, and for nearly as many years the SEC staff has indicated that additional guidance would be forthcoming. In March 2018 and March 2019, Dalia Blass, director of the SEC’s Division of Investment Management, indicated that the staff was again focusing on valuation guidance.[3] Now, with the SEC’s proposal published, it appears that new guidance finally is on the horizon, which could bring some clarification and modernization to the respective roles and responsibilities of a fund’s board and its investment adviser, but implementation of the rule would also represent a substantial lift for fund compliance and accounting infrastructure.

Background

Section 22 of the Investment Company Act of 1940 (1940 Act), and the rules promulgated thereunder, impose certain requirements in connection with the pricing of a registered fund’s shares. Rule 22c-1 under the 1940 Act requires a fund to sell, redeem, or repurchase its shares “at a price based on the current net asset value” of the shares, but in order for a fund’s per-share price to be determined, the value of the fund’s underlying securities and other assets must first be determined. A fund’s per-share price (frequently referred to as the “net asset value per share”) is equal to the total value of the fund’s underlying securities and other assets, less its liabilities, divided by the number of fund shares outstanding.

“Value” is defined in Section 2(a)(41) of the 1940 Act.[4] Relatedly, “current net asset value” is defined under a framework set forth in Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder. Under the Rule 2a-4 framework, a fund must use one of two valuation processes to obtain a value for each of its underlying securities: current market value or fair value. Which valuation process the fund uses depends on whether a “market quotation” is “readily available” for that particular underlying security.

If a market quotation is readily available for the underlying security, then the underlying security is valued at current market value. In general, market quotations are considered “readily available” for securities that are traded on a national securities exchange. If the security was traded on the day of the fund’s valuation, then the last quoted sale price of the security typically would be used as the value of the security.[5] If the security was not traded on the day of the fund’s valuation, then the fund may value the security somewhere within that day’s bid-ask spread for the security. If a security is traded on more than one national securities exchange, then the fund should look to the exchange on which the security is “principally” traded and use the last quoted sale price or official closing price for the security on that exchange as of the day of the fund’s valuation.

A fund should value securities that are traded directly between parties outside of an exchange in the over-the-counter (OTC) market somewhere within that day’s bid-ask spread in the OTC market. Securities that are infrequently traded may be priced with a matrix pricing system, which values the security according to the prices of securities deemed “comparable” according to a matrix of factors. The SEC has acknowledged that various sources may provide price quotations for unlisted securities, including financial publications and reporting services and individual broker-dealers. The SEC has also acknowledged that a fund will typically have more pricing sources available to it for its OTC underlying securities than its exchange-listed underlying securities.

If a market quotation is not readily available for the underlying security, then the underlying security is valued at fair value, as determined in good faith by the fund’s board. Market quotations may not be “readily available” during market closures, in thin markets, if the validity of quotations is questionable or for restricted securities.[6] For many fixed income securities, market quotations are not readily available, resulting in such securities having to be fair valued, typically by a pricing service. The SEC has long held the position that fair value is the price that a fund “might reasonably expect to receive upon its current sale.” Fair value is the price that an arm’s-length buyer would currently pay for the particular security, under current market conditions. Fair value cannot be based on an amount that may be obtained for the security at some future time. The SEC has also long recognized that no single process or standard for determining the fair value of a security exists. Instead, a board is required to consider all information that, under the particular facts and circumstances, is available and appropriate for determining the security’s fair value. According to the SEC, among the most important factors in determining fair value is “fundamental analytical information.”[7]

Proposed Rule 2a-5

Proposed Rule 2a-5 under the 1940 Act 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 certain other conditions. The proposed rule would also define when market quotations for an instrument are “readily available” for purposes of the 1940 Act – where, in such circumstances, fair valuation would not be required.

In the Proposing Release and related materials, the SEC acknowledged that the market of investments has grown substantially more complex since the last comprehensive guidance on fund valuation matters was published, including more thinly-traded and complex assets, more asset classes generally, and a substantially higher volume of valuation data, including different types and sources of valuation data, such as third-party pricing services.

The SEC also noted that advances in communication have enhanced the availability of pricing information. The SEC also noted that three substantial regulatory developments since 1970 have fundamentally altered the way that boards, investment advisers, and auditors approach fund valuation: the adoption of the Sarbanes-Oxley Act of 2002 and related rules (which included the establishment of the Public Company Accounting Oversight Board), the adoption in 2003 of the compliance rules under the 1940 Act and the Investment Advisers Act of 1940, and the issuance and codification by the Financial Accounting Standards Board of “fair value” guidance and accounting principles in 2006 and 2009. According to the SEC, all of these factors support modernizing the regulation of fund valuation.

Determining Fair Value in Good Faith

Subject to the board’s ability to assign its responsibilities, as discussed below, Proposed Rule 2a-5 would impose six requirements on a fund’s board with respect to the determination of fair value in good faith for purposes of Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder. Since at least 2014, it has been somewhat unclear as to what extent a board may delegate or assign its valuation function.[8] As a practical matter, it is widely understood in the current market that a board typically adopts a valuation policy and then delegates or assigns day-to-day responsibility to the fund’s adviser, which, in turn, may enlist sub-advisers, the administrator, pricing services and other vendors to assist with the valuation process, with the board retaining ultimate responsibility for that process.

Although the Proposed Rule contemplates the possibility of a board taking a more hands-on approach with respect to fair valuation, nothing in the Proposing Release suggests that the SEC expects boards to abandon their current practices of assignment or delegation and oversight, and we expect most fund complexes to be able to continue to use their current practices, perhaps slightly modified to fit the new rule, if adopted. Each of these requirements, as proposed, are somewhat general in nature in order for a board (or an assigned adviser) to be able to tailor them to the particular facts and circumstances of the applicable funds.

  1. Valuation Risk. The board would be required to periodically assess and manage any material valuation risks, including material conflicts of interest. In the Proposing Release, the SEC notes many potential sources of valuation risk, including the type of investment, the potential for market or sector shocks or dislocations, the extent to which a fair value methodology uses unobservable inputs, the proportion of a fund’s investments that are fair valued and their contribution to the fund’s performance, reliance on service providers that have more limited experience or that are, in turn, relying on downstream service providers, and the risk that fair value methods are inappropriate or being inconsistently or incorrectly applied. This risk-based approach is similar to what the SEC has adopted for portfolio liquidity and proposed for fund investments in derivatives, signaling a clear pattern in the SEC’s approach to regulating funds, which is conceptually similar to the approach taken by prudential bank regulators in recent years.
  2. Valuation Methodologies. Fair value methodologies would have to be established and applied. This would require the board (or the adviser, if assigned), after taking into account the fund’s valuation risks, to select and consistently apply an appropriate methodology or methodologies for determining and calculating the fair value of fund investments. Such methodology or methodologies would be required to specify key inputs and assumptions specific to applicable asset classes or investments, and must be appropriately applied to new types of fund investments. The appropriateness and accuracy of the selected methodologies would also have to be periodically reviewed and adjusted, as necessary. The board would also have to monitor circumstances that necessitate the use of fair value, and would have to establish criteria for determining when market quotations are no longer reliable. The Proposing Release does not discuss whether the board (or the adviser, if assigned) would have to approve the specific methodology used by a pricing service, which often involve complex, proprietary algorithms. Or if, instead, the methodology established and applied by the board (or the adviser, if assigned) could more generally refer to a pricing service based on certain evaluative criteria. Indeed, the very notion of what is a “methodology” is somewhat vague for purposes of the Proposed Rule, which may be the result of the SEC having to apply a single regulatory framework for a wide range of funds. We expect this likely will be an area of industry comment.
  3. Testing Methodologies. The board (or the adviser, if assigned) would have to test the appropriateness and accuracy of fair value methodologies. Testing methods used, and the frequency of testing, would also have to be established as part of the board’s (or the adviser’s) process. With respect to this requirement, the SEC noted that the results of calibration and back-testing (i.e., comparing determined fair values against observed transactions or other market information) could help to identify trends and could assist in identifying issues with methodologies applied by such service providers, including poor performance.
  4. Pricing Services. Pricing service providers, if used, would have to be overseen, which would include a process for approving, monitoring, and evaluating pricing service providers, and criteria for initiating price challenges. The Proposing Release notes that the board (or adviser, if assigned) should consider the qualifications, experience, and history of the pricing service, the methods, techniques, inputs, and assumptions used by the pricing service for different classes of holdings during different market conditions, the pricing service’s process for considering challenges, potential conflicts of interest, and the testing processes used by the pricing service.
  5. Written Policies and Procedures. The board would also have to adopt and implement written policies and procedures used to determine the fair value of fund investments. Such policies and procedures would have to be designed for the fund to achieve compliance with Proposed Rule 2a-5. The SEC notes in the Proposing Release that Rule 38a-1, the compliance rule for investment companies, would apply to a fund’s compliance obligations with respect to Proposed Rule 2a-5. Accordingly, a fund’s compliance policies and procedures would have to be amended to account for the proposed rule, if adopted.[9]
  6. Recordkeeping. Documentation that supports fair value determinations would have to be maintained, including the specific methodologies applied, the assumptions and inputs considered, and any adjustments to methodologies. And records of the written policies and procedures themselves would have to be maintained.

Performance of Fair Value Determinations

Under the 1940 Act, securities and assets without readily available market quotations are valued at fair value as determined in good faith by a fund’s board of directors. Proposed Rule 2a-5 would confirm that a board can make this determination on its own, but would also permit – consistent with widespread current market practices – a board to assign fair value responsibility for any or all fund investments to one or more investment advisers of the fund. The SEC noted in the Proposing Release that it continues to believe that allocating day-to-day responsibilities to a fund’s investment adviser is appropriate and consistent with the 1940 Act, “subject to robust board oversight.” If a board assigns its responsibilities, it would be required to comply with certain conditions, including:

  • Oversight and Reporting.The board would be required to oversee the adviser and review periodic reports from the adviser. At least quarterly, the adviser would have to provide the board with an assessment of the adequacy and effectiveness of its fair valuation process. The report must include, at a minimum, a summary or description of:
    • assessing and managing material valuation risks, including material conflicts of interest;
    • any material changes to, or material deviations from, the adviser’s established fair value methodologies;
    • results of any testing of fair value methodologies;
    • adequacy of resources allocated to the fair value process, including any material changes to the role or functions of responsible persons;
    • material changes to the adviser’s process for selecting and overseeing pricing services and any material events related to the oversight of pricing services, such as changes in service providers or price overrides; and
    • any other material requested by the board.

    Matters associated with the adviser’s fair value process that materially affect (or could materially affect) the fair value of the fund’s portfolio investments must be promptly reported to the board, and no later than three business days after the adviser has become aware of such matter. This would include significant deficiencies or material weaknesses in the design or implementation of the adviser’s fair value determination process, or material changes in the fund’s valuation risks.

  • Responsibilities and Functions.The adviser must specify the titles and functions of the persons responsible for fair value determinations, which must be reasonably segregated from portfolio management. The SEC noted in the Proposing Release that fund portfolio managers and similar persons may be the most knowledgeable persons regarding a fund’s holdings and, accordingly, may be needed to provide input into the process for determining the fair value of a fund’s holdings. But, because portfolio management personnel are often compensated based – at least in part – on a fund’s performance, their incentives may not be fully aligned with determining fair value and therefore, according to the SEC, they “should not be making the fair value determinations.” The SEC also emphasized the importance of independence of fair valuation from portfolio management, suggesting that independence of reporting chains, oversight arrangements, and monitoring systems and personnel could provide important “checks and balances.” Although portfolio managers would not be subject to a strict firewall, the Proposed Rule effectively would require investment advisers to adopt an appropriate process that is tailored to their particular circumstances, and the fund’s board to oversee that process.
  • Recordkeeping.The fund would have to maintain additional records relevant to the assignment of fair valuation to the adviser, including the reports provided to the board by the adviser and a list of the investments (or investment types) whose fair valuation has been assigned by the adviser.

The Proposing Release also makes it clear that the assignment of fair value responsibility to an adviser would not have to be on an “all or none” basis. Instead, a board could assign fair value responsibility for certain instruments or asset classes to an adviser and retain the remainder itself, or could assign responsibilities among a primary adviser and one or more sub-advisers. Because unit investment trusts do not have boards or investment advisers, the proposed rule would require the trustee of a unit investment trust to determine fair value in good faith.

Readily Available Market Quotations

Under the 1940 Act, fund investments must be fair valued where market quotations are not “readily available.” Paragraph (c) of Proposed Rule 2a-5 would treat 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. The proposed rule would also clarify that a quotation is not readily available if it is not reliable. The Proposing Release also states that indications of interest and accommodation quotes would not be considered “readily available market quotations.” The proposed approach largely is consistent with the current landscape.

Rescission of Prior SEC and Staff Guidance

In view of the Proposed Rule’s modernized approach to fund valuation, the SEC also proposed to rescind two releases, Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118), which were published in October 1969 and December 1970, respectively, and represent the most recent comprehensive guidance provided by the SEC on, among other things, how to determine fair value for restricted securities.

In addition, the Proposing Release stated that certain staff letters and other staff guidance addressing fund valuation matters covered by the proposal would be rescinded or withdrawn in connection with any adoption of the Proposed Rule. Among the six specific items proposed to be rescinded in the Proposing Release are the two letters issued to the Investment Company Institute in 1999 and 2001. This approach of not only modernizing but also streamlining the regulatory space by the removal of outdated or redundant guidance is consistent with the approach taken the by the SEC in other recent rule proposals, such as the proposed amendments to the investment adviser advertising and cash solicitation rules. However, the Proposing Release does not suggest that certain statements made by the SEC in the 2014 money market fund adopting release regarding a board’s inability to delegate its statutory duty would be part of the rescinded guidance.

Transition Period

As proposed, funds would have one year from the date a final rule is adopted to come into compliance with Rule 2a-5. Practically speaking, we would not expect a final rule to be adopted before the fourth quarter of 2020 (unless very few comment letters are received), meaning that funds should have until at least the fourth quarter of 2021 before having to be in compliance with a final rule.

Next Steps

The Proposing Release includes 72 questions – each with subparts – that call for industry input, with comment letters due by July 21. Fund managers, boards of directors and industry groups will want to consider whether the Proposed Rule sufficiently addresses – or at least leaves sufficient room for the adoption of reasonable practices and interpretations –the various issues that funds face with respect to their daily valuation tasks. The current market environment may particularly shed light on more unique and challenging areas of valuation, which may lend a helpfully critical eye for reviewing the Proposed Rule.

Although the Proposed Rule admirably seeks to implement a broad, flexible framework that is somewhat principles-based and not overly detail-driven, if adopted as proposed, implementation of Rule 2a-5 would still represent a substantial compliance and operational burden for fund complexes and their managers, because in most cases all current fair valuation processes would have to be revisited and modernized, even if only partially. For most fund complexes, the end result may not be much different than the procedures and practices currently implemented, but the process of assessing a fund’s current procedures for compliance with a new rule still could be a heavy, resource-consuming lift.

With the Proposed Rule, the SEC seems more to be attempting to modernize and streamline outdated guidance, rather than seeking to require a complete overhaul of market practices. The risk-based principles set forth in the Proposed Rule likely permit most fund complexes to continue business as usual, after undertaking an inventory of the final rule and engaging in an assessment of current practices with their boards. In other words, we don’t expect the market to retreat from current practices if the Proposed Rule is adopted as proposed. Advisers likely will still manage day-to-day fair valuation pursuant to a robust process that includes periodic, minuted meetings and inputs from pricing services, the results of which are then periodically reported up to the board. And boards will still serve in an oversight capacity that may include presentations from key service providers and approval of material changes to the fair value procedures implemented by the investment adviser.

Fund boards may also want to consider whether the role contemplated in the Proposed Rule and the Proposing Release permits them sufficient flexibility to assign and oversee, without having to be overly involved – in other words, whether the proposed framework permits them to be overseers of fund governance, and not day-to-day managers. Given the complexity and scale of the modern fund marketplace, which was noted by the SEC as support for the Proposed Rule, it will be critical for investment advisers to be able to perform their assigned responsibilities without being tasked with having to get buy-in and approval from the board as they carry out regular day-to-day functions.

CONTACTS

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Barry N. Hurwitz
Roger P. Joseph
Marion Giliberti Barish
Jeremy B. Kantrowitz
Lea Anne Copenhefer
Paul B. Raymond
Toby R. Serkin
Mari Wilson

New York
Elizabeth Belanger

Philadelphia
Timothy W. Levin
John J. O’Brien
Sean Graber

Orange County
Laurie A. Dee

Washington, DC
Laura E. Flores
Thomas S. Harman
Christopher D. Menconi
W. John McGuire
Mana Behbin
Kathleen M. Macpeak
Monica L. Parry


[1]Good Faith Determinations of Fair Value, Investment Company Act Rel. No. 33845 (Apr. 21, 2020) (Proposing Release).

[2]See Statement Regarding “Restricted Securities,” Accounting Series Release No. 113 (Oct. 21, 1969); Accounting for Investment Securities by Registered Investment Companies, Accounting Series Release No. 118 (Dec. 23, 1970).

[3]See Dalia Blass, Dir., Div. of Inv. Mgmt., Keynote Address at the 2018 ICI Mutual Funds and Investment Management Conference (Mar. 19, 2018); Dalia Blass, Dir., Div. of Inv. Mgmt., Keynote Address at the ICI Mutual Funds and Investment Management Conference (Mar. 18, 2019).

[4]The definition of “value” set forth in Section 2(a)(41) also permits a fund’s board to determine, in good faith, the value of a fund’s securities issued by a controlled company, even if a market quotation is readily available for such securities, so long as the value provided by the board is not greater than the market value of the securities.

[5]If the last sale occurred intraday, however, the last quoted sale price of the security may no longer represent market value and the mean between bid ask at closing may be more appropriate, under the circumstances.

[6]See December 1999 Letter to the Investment Company Institute Regarding Valuation, Douglas Scheidt, Associate Director and Chief Counsel, SEC Division of Investment Management (Dec. 8, 1999) (noting that market quotations are not readily available “when the exchanges or markets on which those securities trade do not open for trading for the entire day” and no other market prices are available); See Investment Company Act Release No. 5847, Accounting Series Release No. 113 (Oct. 21, 1969) (market quotations are not readily available with respect to securities that are not registered with the SEC under the Securities Exchange Act of 1933); April 2001 Letter to the Investment Company Institute Regarding Valuation, Douglas Scheidt, Associate Director and Chief Counsel, SEC Division of Investment Management (Apr. 30, 2001) (noting that if number of quotations available indicates that market for particular security is thin, then board should give further consideration as to whether market quotations are “readily available.”).

[7]See December 1999 Letter, supra note 6. External information from financial markets and about financial products also may assist the board in determining a fair value for either the particular underlying security at issue or a comparable security.

[8]See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) at n.890 (“[A]lthough a fund’s directors cannot delegate their statutory duty to determine the fair value of fund portfolio securities, the board may appoint others, such as the fund’s investment adviser or a valuation committee, to assist them in determining fair value.”); see also, id. at n.898 and accompanying text (“Although a fund’s directors cannot delegate their statutory duty to determine the fair value of fund portfolio securities for which market quotations are not readily available, the board may appoint others, such as the fund’s investment adviser or a valuation committee, to assist them in determining fair value, and to make the actual calculations pursuant to the fair valuation methodologies previously approved by the directors.”).

[9]We note that, increasingly, Rule 38a-1 has become a conduit through which the SEC can question board processes, making the SEC’s reference to Rule 38a-1 in the discussion of the Proposed Rule’s written policies and procedures particularly relevant. Further, it is not without precedent that the SEC has used Rule 38a-1 as a means of attacking independent directors with respect to issues of fund valuation. See In the Matter of J. Kenneth Alderman, et al., Investment Company Act Rel. No. 30,557 (June 13, 2013) (alleging that directors’ conduct caused funds to violate Rule 38a-1).