The SEC adopted a new rule under the Investment Company Act codifying fair valuation requirements for registered investment companies. The last time the SEC comprehensively addressed valuation was more than 50 years ago. Rule 2a-5 establishes requirements for making good faith determinations of fair value in accordance with Section 2(a)(41) of the Investment Company Act and clarifies a board's role relating to such determinations. The adopting release makes clear that the rule does not shift the statutory fair valuation responsibilities away from directors, but rather establishes the requirements the board must meet to fulfill its continuing statutory obligations. The new rule will allow boards to delegate fair valuation to the fund's investment adviser, but will require revisions to valuation procedures, the adoption of testing methods and new reporting requirements prior to the compliance date in September 2022.
The rule provides that fair valuation is required where market quotations for a security are not "readily available," which was not previously defined. The new rule provides that a market quotation is "readily available" only when it is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the valuation date, provided that the quotation is reliable. This definition is intentionally similar to the definition of Level 1 inputs used in ASC Topic 820.
The Role of the Board and Valuation Designees. Rule 2a-5 allows a fund board (or a designated committee composed of a majority of independent directors) to designate a "valuation designee" to perform fair value determinations on its behalf by carrying out the fair value functions described below. Alternatively, boards may perform such fair value functions themselves.
"Valuation designee" is defined to include the adviser of a fund (but not the fund's sub-adviser), or an officer of an internally managed fund. Although subadvisers cannot be valuation designees, the adopting release clarifies that the board or valuation designee is permitted to seek a sub-adviser's assistance in making fair value determinations. In addition, fund boards or valuation designees may seek assistance from other service providers, such as fund administrators or pricing services, to perform back-testing or other functions under Rule 2a-5. The SEC noted that it is critical for the entity actually performing the fair value determinations to owe a fiduciary duty to the fund and be subject to direct board oversight.
A valuation designee is subject to the board's oversight, as the board remains responsible for the fair value determinations required under Section 2(a)(41), and is required to provide the following reports to the board:
- Quarterly reports on material changes or other developments affecting fair valuation and any additional information requested by a board on fair valuation;
- An annual report providing an overall assessment of the adequacy and effectiveness of the fair valuation process; and
- Prompt reports (within five business days) of matters that materially impact the value of a fund's holdings, such as a significant deficiency or material weakness in the design or effectiveness of the valuation designee's fair value determination process, or material errors in the calculation of NAV. The SEC declined to establish a standard for what constitutes a material NAV error, but noted that the industry standard of $0.01 a share or 0.5% of the NAV would not be unreasonable.
The adopting release emphasizes the fact that boards should approach their oversight of the valuation designee's fair value determinations with a "skeptical and objective view that takes account of the fund's particular valuation risks, including with respect to conflicts, the appropriateness of the fair value determination process, and the skill and resources devoted to it." The release states that board oversight cannot be a passive activity, and a board should ask questions and seek appropriate information, including information regarding potential conflicts of interest of the valuation designee and other service providers assisting with the determination of fair values.
Rule 2a-5 requires that valuation designees specify the titles of persons responsible for determining fair value, including a description of their responsibilities. The valuation designee is required to reasonably segregate fair value determinations from fund portfolio managers such that they are not allowed to determine, or effectively determine by exerting substantial influence on, fair values attributed to investments. The adopting release notes that portfolio managers may be important sources of information regarding a security's value and may provide inputs into the fair value determination process, but the segregation requirements will help mitigate their potential conflicts of interest.
Fair Value Functions and Related Procedures. The final rule requires the performance of the following functions by the board or its valuation designee to determine "fair value in good faith:"
- a periodic assessment of material valuation risks (taking into account changes to investments, investment strategies or policies or market events) and conflicts of interest associated with fair value determinations and the management of such risks and conflicts;
- the establishment and periodic review of fair value methodologies and monitoring for circumstances that may necessitate the use of fair value;
- testing of fair valuation methodologies for appropriateness and accuracy such as disposition analysis, which compares a fair value with the price obtained for the security upon its disposition by the fund; and
- evaluating and overseeing any pricing services used and establishing a process for initiating price challenges.
Fair Value Policies and Procedures. The final rule release provides that Rule 38a-1 (the compliance rule) requires a fund's board to approve policies and procedures reasonably designed to prevent violations of Rule 2a-5's requirements. As such, Rule 2a-5 does not include a separate policies and procedures requirement, but, as noted above, provides for board reporting requirements in addition to the chief compliance officer's annual Rule 38a-1 report.
From a practical standpoint, funds will continue to have valuation policies and procedures in place that were adopted prior to Rule 2a-5's compliance date; however, in order to comply with Rule 38a-1 following such date, either the fund (on behalf of the board) or the adviser (as the board's valuation designee) is required to adopt new fair value policies and procedures.
Level 2 Securities. The adopting release states that the definition of "readily available" market quotations is consistent with the definition of a Level 1 input in the fair value hierarchy outlined in GAAP. Thus, Level 2 securities must be fair valued including the securities held by many bond funds. As a practical matter, this means that fixed income securities may continue to be priced using inputs provided by pricing services, subject to the pricing service oversight and other requirements of the new rule. This guidance also means that Level 2 securities may not be eligible for cross-trades under Rule 17a-7 of the Investment Company Act, which requires that a security must have a "readily available" market quotation. The adopting release clarifies that the definition of a "readily available" market quotation applies across the Investment Company Act and the rules thereunder, including Rule 17a-7. The SEC notes, however, consideration of potential revisions to Rule 17a-7 is on the rulemaking agenda.
Recordkeeping. The SEC also adopted Rule 31a-4, a companion recordkeeping rule to Rule 2a-5, that requires funds or advisers (if designated as the valuation designee) to keep appropriate documentation to support fair value determinations for six years.
Rescinded SEC Guidance. In connection with the adoption of Rules 2a-5 and 31a-4, the SEC staff rescinded Accounting Series Releases 113 and 118, which provide guidance on a fund board's role in fair value determinations and certain accounting and audit matters. The adopting release also provides that certain SEC staff no-action and interpretative letters regarding a board's role in the fair value process and other matters covered by the final rules are being withdrawn. Finally, guidance on oversight of pricing services and valuation of thinly traded securities contained in the SEC's Money Market Funds Adopting Release, which was published in 2014, is also superseded. The relevant SEC guidance will be withdrawn effective as of the compliance date noted below.
Effective and Compliance Dates. The new rules will become effective on March 8, 2021, and funds will have until September 8, 2022 to come into compliance.
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