Originally published in: Investment Management Developments - Summer 2001

Co-written by Timothy D Sperry

On April 30, 2001, the staff of the SEC’s Division of Investment Management sent a letter (the "2001 Letter") to the Investment Company Institute (the "ICI") relating to the "fair value pricing" of mutual fund securities. The 2001 Letter clarifies certain guidance previously provided by the staff in a December 8, 1999 letter to the ICI (the "1999 Letter"). It outlines the staff’s positions regarding: (1) the obligations of funds to determine the fair value of portfolio securities when market quotations are not readily available; (2) the ongoing responsibility of funds to assess the appropriateness of their portfolio security valuation methodologies; (3) the "good faith" standard that applies when determining the fair value of portfolio securities; (4) the valuation of foreign securities that are subject to exchange-imposed pricing limits; and (5) the inappropriateness of using fair value pricing when market quotations are readily available. The staff noted that the positions expressed in the 2001 Letter and the 1999 Letter apply to all registered investment companies regardless of their investment objective or strategy.

Background

The rules governing the pricing of mutual fund shares are designed to ensure that the prices at which fund shares are sold and redeemed are fair and do not result in dilution or other unfair results to shareholders. Thus, Rule 22c-1 under the Investment Company Act of 1940 (the "1940 Act") requires mutual funds to sell and to redeem their shares daily at prices based on the current net asset values of their shares next computed after receipt of an order to purchase or redeem shares. In complying with this requirement, mutual funds generally calculate net asset value at or near the close of regular trading on the primary U.S. exchanges and markets (usually 4:00 p.m. EST) using closing prices of portfolio securities as reported by the primary exchanges or markets on which those securities trade. Rule 2a-4 under the 1940 Act requires that funds value their portfolio securities at current market value when market quotations are readily available. When market quotations are not readily available, Rule 2a-4 requires that securities be valued at fair value as determined in good faith by the fund’s board of directors.

Fair Value Pricing

In the 2001 Letter, the staff expressed its concern that practices generally followed by funds in calculating net asset value may result in a fund’s net asset value not accurately reflecting the value of its portfolio securities if an event affecting the value of a security occurs after the closing price of the security is established, but before the time as of which the fund calculates its net asset value. Funds holding securities traded primarily on foreign exchanges or in foreign markets are most susceptible to this risk. For example, markets in the Far East generally operate during the evening and night time in the U.S. and close before the opening of the U.S. markets. Because the closing prices of securities traded primarily in foreign markets can be as much as 12 to 15 hours old by the time U.S. mutual funds typically calculate their net asset values, the closing prices of those securities may not reflect their values at the time of net asset value calculation if a "significant event" occurs after the closing of a foreign market. The staff defined a significant event as one that will affect the value of a portfolio security.

Underlying the staff’s concern is the potential for dilution in the value of shareholders’ interests. Dilution occurs either when a fund’s shares are overvalued, in which case redeeming shareholders are paid too much for their shares, or when a fund’s shares are undervalued, in which case new investors pay too little for their shares. In each case, this operates to the detriment of other shareholders. According to the staff, these situations present an opportunity for short-term investors to exploit the differential between a fund’s share price and the underlying value of its portfolio securities. An example created by the staff and included in the 2001 Letter showed how arbitrage opportunities of this type can negatively impact a fund. The example assumed a $50 million fund that did not use fair value pricing and illustrated how in two days an investor could profit by more than $900,000 on a $10 million investment.

For this reason, the staff believes that funds should fair value price securities for which market quotations are available if there are facts that call into question the validity and reliability of the market quotations. The SEC previously addressed this issue in the context of publicly traded securities for which trading is thin or infrequent. See Accounting Series Rel. No. 118 (December 23, 1970). It stated in this regard that funds should consider whether market quotations for a security are readily available and use fair value pricing if they conclude otherwise.

In the 2001 Letter, the staff took the position with respect to foreign securities that funds are required: (1) to evaluate whether a significant event has occurred during the period between the close of the foreign exchange or market on which a security trades and the time of calculation of a fund’s net asset value; (2) to consider market quotations not to be readily available if a significant event has occurred; and (3) to value the security using a fair value methodology in such cases. The staff noted that the same requirements could also apply to domestic securities if the relevant market or exchange closes early on a given day, if a fund regularly calculates net asset value after the close or if trading in a security is halted during the day and does not resume prior to the close of the exchange or market. In determining the value of a security following the occurrence of a significant event, the staff stated that funds may consider, among other factors, a security’s most recent closing price on its primary exchange or market, and are not precluded from determining that the closing price represents the security’s fair market value.

The staff stated that funds, consistent with their obligations under the 1940 Act, should continuously monitor for events that might constitute a significant event and establish criteria for determining when market quotations are not readily available for securities. In the staff’s view, events to monitor for should not be limited only to those that impact the issuers of securities, but should include those that relate to a market or market sector, as well as those not directly related to a particular market (e.g., natural disasters, armed conflicts and significant government actions). Examples of factors to consider in determining the availability of market quotations include a security’s trading volume, the frequency of trades and other data that may call into question the reliability of market quotations.

The staff expressed the view that enhanced plain English disclosure by funds of their fair value pricing policies would benefit both funds and their shareholders. It noted that, from the perspective of shareholders, enhanced disclosure would reduce confusion regarding the ability of funds to value portfolio securities using fair value pricing and the extent to which funds may use this valuation method. Enhanced disclosure would, in the staff’s view, also benefit funds by discouraging investments by certain short-term investors seeking arbitrage opportunities. The staff pointed out that the 1998 amendments to Form N-1A, the registration form for mutual funds, added a requirement that funds contemplating use of fair value pricing explain the method used to value portfolio securities, as well as the circumstances for, and effects of, valuing securities in this manner.

Additional Issues

In the 2001 Letter, the staff also reminded funds of prior SEC guidance that boards must continuously review valuation methodologies. It stated that funds should regularly evaluate whether those methodologies continue to result in values that the funds might expect to receive from a current sale. The staff stated that funds should assess the availability and reliability of market quotations. This might include comparing fair value prices against values available from other sources, including actual trade prices and quotations from pricing services and dealers, and with respect to foreign securities, comparing next day opening prices or actual sales on foreign exchanges or markets.

The staff provided additional guidance with respect to the requirement that fund boards must determine, in "good faith," the fair value of portfolio securities for which market values are not readily available. In the staff’s view, a fund’s board meets this requirement if: (1) the board’s determination results from a "sincere and honest assessment of the amount that the fund might reasonably expect to receive for a security upon its current sale, based upon all of the appropriate factors that are available to the fund"; and (2) the board "continuously reviews the appropriateness of the method used in determining the fair value of the fund’s portfolio securities." A fund’s board of directors may appoint persons to assist it in making fair value determinations, subject to the board’s supervision. On the other hand, a fund’s board generally would not in the staff’s view be acting in good faith if the board "knows or has reason to know that its fair value determination does not reflect the amount that the fund would reasonably expect to receive for the security upon its current sale" or "if it acts with reckless disregard for whether its fair value determination reflects the amount that the fund might reasonably expect to receive for the security upon its current sale."

According to the staff, funds may need to use fair value pricing for portfolio securities for which market values are available, but which are subject to trading limits imposed by the exchanges on which they trade. In this regard, certain foreign securities are subject to mechanisms that prevent their prices from moving outside of pre-determined limits. These limits, known as "collars," may have the effect of preventing a security from trading for days or even weeks. In the event that the price limits of the collar are reached and no trading has taken place at those prices, it is the staff’s view that market quotations for the security are not readily available. If trading has taken place at the collar’s price limit, funds should consider whether market quotations are readily available by considering the frequency of the trades and other factors that may call into the question the validity and reliability of the prices at which the trades occurred.

Finally, with respect to securities for which market quotations are readily available, the staff stated that funds may not ignore those quotations and use fair value pricing. It also stated that, consistent with their obligations under the 1940 Act, funds must exercise reasonable diligence in obtaining market quotations for portfolio securities before concluding that market quotations are not readily available.

Conclusions

Fund advisers and fund boards should review the policies and methodologies being used to value portfolio securities in light of the staff positions articulated in the 2001 Letter. They should assure themselves that appropriate procedures are in place to monitor for the occurrence of significant events that may affect the prices of portfolio securities that are not reflected in the market quotations normally used to value those securities and to identify situations where market quotations are not readily available. In addition, fund advisers and boards should consider whether portfolio valuation procedures are being reviewed on a regular basis with a view toward assuring that those procedures result in values that accurately reflect the prices that would be received from the current sale of portfolio securities. Fund boards should evaluate the need for revising valuation procedures or taking other actions to conform to the staff’s views and should request fund advisers to report on this matter.

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© 2001 Schulte Roth & Zabel LLP