On April 21, 2020, the US Securities and Exchange Commission ("SEC") proposed new rule 2a-5 under the Investment Company Act of 1940, as amended (the "Investment Company Act"), which is intended to address valuation practices and the role of the board of directors with respect to the fair value of the investments of an investment company or business development company registered under the Investment Company Act (each, a "fund").1 Specifically, proposed rule 2a-5 would establish requirements in connection with the determination of fair value in good faith of fund investments for purposes of Section 2(a)(41) of the Investment Company Act, as well as permit a fund's board of directors to assign this fair value determination to the fund's investment adviser, subject to board oversight and certain other conditions.2 Proposed rule 2a-5 also provides a proposed definition of a "readily available" market quotation for purposes of the Investment Company Act.

The SEC noted in the Proposal Release that there have been significant developments in fund valuation practices since the SEC last comprehensively addressed valuation under the Investment Company Act in a pair of Accounting Series Releases in 1969 and 1970 (ASR 113 and 118) and that proposed rule 2a-5 is meant to establish a "consistent framework for fair value and standard of baseline practices across funds."3 This Legal Update highlights and describes the key requirements under the SEC's proposed fund valuation rule.

A. Determining Fair Value in Good Faith

In order to determine fair value in good faith for purposes of Section 2(a)(41) of the Investment Company Act, proposed rule 2a-5 would require a fund to perform the following specified functions.

  1. Assess and Manage Valuation Risks. Funds would be required to periodically assess material risks associated with the fair value determination of fund investments (collectively, "valuation risks"), including material conflicts of interest, and to manage such identified valuation risks. The SEC noted that its belief that assessing and managing identified valuation risks is an important element for determining fair value in good faith because ineffectively managed valuation risks can make it more likely that a fund board or a fund investment adviser may incorrectly value an investment.4
  2. Establish and Apply Fair Value Methodologies. Under the proposed rule, funds would be required to select and apply in a consistent manner an appropriate methodology or methodologies for determining (which includes calculating) the fair value of fund investments, including specifying (1) the key inputs and assumptions specific to each asset class or portfolio holding and (2) the methodologies that will apply to new types of investments in which the fund intends to invest. The SEC indicated in the Proposal Release that these fair value methodologies must be consistent with ASC Topic 820 and US GAAP in order to be appropriate under proposed rule 2a-5, but noted that "there is no single methodology for determining the fair value of an investment because fair value depends on the facts and circumstance of each investment, including the relevant market and market participants." The proposed rule also would require the selected methodologies to be periodically reviewed for appropriateness and accuracy and to be adjusted if necessary. Under proposed rule 2a-5, funds also would be required to monitor for circumstances that may necessitate the use of fair value and to establish criteria for determining when market quotations are no longer reliable.5
  3. Perform Testing of Fair Value Methodologies. Under proposed rule 2a-5, funds would be required to test the appropriateness and accuracy of the fair value methodologies that have been selected, including identifying the testing methods to be used and the minimum frequency with which such testing methods are used. The SEC stated in the Proposal Release that the manner and frequency of such testing are matters that depend on the circumstances of each fund and thus should be determined by the relevant fund's board or adviser but noted its belief that backtesting could be potentially useful in identifying trends as well as potentially assisting such fund or adviser in identifying issues with methodologies applied by fund service providers, including poor performance or potential conflicts of interest.6
  4. Establishing a Process for Evaluating Pricing Service Providers. Funds would be required under proposed rule 2a-5 to oversee any pricing service providers used in the fund valuation process and would need to establish a process for the approval, monitoring, and evaluation of each pricing service provider as well as the criteria for initiating price challenges (e.g., establishing objective thresholds).7
  5. Fair Value Policies and Procedures. Funds would be required to adopt and implement written fair valuation policies and procedures approved by the fund's board that are reasonably designed to achieve compliance with the above requirements. Should the board assign fair value determinations to the fund's investment adviser (see below), these fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under Rule 38a-1.8
  6. Recordkeeping. In addition to maintaining copies of the above fair value policies and procedures, funds would be required to maintain appropriate documentation to support fair value determinations (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) for at least five years from the time the determination was made.9

Footnotes

1 Good Faith Determinations of Fair Value, Investment Company Act Release No. 33845 (April 21, 2020), available at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf (the "Proposal Release").

2 The Investment Company Act requires funds to value their portfolio investments by using the market value of their portfolio securities when market quotations for those securities are "readily available," and, when a market quotation for a portfolio security is not readily available, by using the fair value of that security, as determined in good faith by the fund's board of directors. See Section 2(a)(41) of the Investment Company Act and rule 2a-4 thereunder.

3 In the Proposal Release, the SEC stated that it last comprehensively addressed valuation under the Investment Company Act in a pair of releases issued in 1969 and 1970, Accounting Series Release 113 ("ASR 113") and Accounting Series Release 118 ("ASR 118") and that fund valuation practices has significantly evolved since then, including (among other things), (i) the enactment of the Sarbanes-Oxley Act of 2002, which led to the adopting of rule 30a-3 under the Investment Company Act (requiring disclosure controls and procedures and internal control over financial reporting); (ii) the compliance program rule (rule 38a-1 under the Investment Company Act), which required funds to adopt and maintain written compliance policies and procedures (including those related to fair valuation); and (iii) the issuance of ASC Topic 820 by the Financial Accounting Standards Board in 2006 and 2009, which defined the term "fair value" for purposes of the accounting standards and established a framework for the recognition, measurement, and disclosure of fair value under US generally-accepted accounting principles ("US GAAP"). Proposal Release at 8-14.

4 Proposal Release at 17-18.

5 Proposal Release at 19-22.

6 Proposal Release at 23-24.

7 Proposal Release at 24-26. In evaluating and overseeing pricing services, the SEC noted that a fund board or adviser generally should take into consideration factors such as (i) the qualifications, experience, and history of the pricing service; (ii) the valuation methods or techniques, inputs, and assumptions used by the pricing service for different classes of holdings and how they are affected as market conditions change; (iii) the pricing service's process for considering price "challenges," including how the pricing service incorporates information received from pricing challenges into its pricing information; (iv) the pricing service's potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and (v) the testing processes used by the pricing service

8 Proposal Release at 26-28.

9 Proposal Release at 28-30.

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Originally published Mayer Brown, May 2020

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