United States: SEC Proposes Modernization Of Investment Adviser Custody Rule

During the course of recent investment adviser inspections conducted by the Securities and Exchange Commission ("SEC"), managers of private investment funds have been queried on methods used to price illiquid positions in a fund's portfolio. Examiners have pointed out that inappropriate pricing of portfolio positions could, when positions are overpriced, unfairly benefit a withdrawing investor and the portfolio manager receiving performance-based compensation to the detriment of investors electing not to withdraw or could, when positions are underpriced, unfairly dilute existing investors when new investors are admitted to the fund. Although issued in the context registered funds, SEC examiners have referred hedge fund managers to two no-action letters that provide some guidance, even in the non-mutual fund environment, for pricing less liquid securities.

In two no-action letters issued to the Investment Company Institute (publicly available December 8, 1999 and April 30, 2001 (the "1999 Letter" and the "2001 Letter," respectively), the SEC staff stated that when market quotations are not readily available for a security, mutual funds must in good faith price the security based on its fair value. As a general principle, the fair value of a portfolio security is the price that a fund might reasonably expect to receive, upon its current sale to an arm's length buyer, under the then-existing circumstances. The staff further stated that the fair value of a portfolio security may not be based on what a buyer might pay in some future date (e.g. when the market ultimately recognizes the security's true value as perceived by the fund manager or, with respect to fixed-income securities, valuing bonds at par based on the expectation of holding such bonds until maturity, if a fund could not receive par value upon the current sale of such bonds).

The staff indicated in the 1999 Letter that the SEC had recognized that no single standard exists for determining fair value in good faith, but rather has adopted a more flexible standard which requires that all appropriate factors relevant to the value of securities for which market quotations are not readily available to be considered. The staff stated that while valuing a security using fundamental analytical information is of primary importance, use of external sources may be necessary in determining fair value. Some of these external sources include: the value of other financial instruments, including derivative securities, traded on other markets or among dealers; trading volumes on markets, exchanges or among dealers; values of baskets of securities traded on other markets, exchanges or among dealers; changes in interest rates; observations from financial institutions; government actions or pronouncements; and other news events. With respect to securities traded on foreign markets, other factors that also might be included are: the value of foreign securities traded on other foreign markets, ADR trading, closed-end fund trading, foreign currency exchange activity and the trading prices of financial products that are tied to baskets of foreign securities (e.g. WEBS).

In the 2001 Letter, the staff recommended that fair pricing policies cover situations in which pricing may be effected because of significant events occurring after the market close on which a fund's securities are traded. For example, when there is a lag between the closing of a particular market and the calculation of a fund's net asset value ("NAV") (e.g., for foreign securities), fair pricing policies should discuss the valuation of such portfolio positions when a significant event occurs after such exchange or market close. In addition, fair pricing policies should cover valuation issues arising when a market closes early on a given day or when trading is suspended. Examples of significant events that may effect valuation include: events relating to a single issuer or market sector, natural disasters, armed conflicts or significant governmental actions.

Finally, the 2001 Letter indicated that the SEC stated that funds must evaluate the validity and reliability of the market quotations under other circumstances, including if there is a thin market or low trading volume for a security, if sales have been infrequent or if other data exists that would call into question the reliability of a market quotation.