Section 2(a)(41)(B) of the Investment Company Act of 1940 (1940 Act) requires that portfolio securities without readily available market quotations be valued at "fair value as determined in good faith by the board of directors." On April 20, the Securities and Exchange Commission (SEC) voted to propose Rule 2a-5, establishing a new framework for funds' fair value determinations.
Section 2(a)(41) is a definitional provision, not a substantive one, but the SEC has long taken the position that directors have a "duty" to "determine" fair value. The most substantive formal guidance comes from accounting releases approximately 50 years ago. The Proposed Rule would expressly permit boards to assign the making of fair value determinations to the fund's investment adviser, subject to normal board oversight and certain special conditions to be established by the rule. The proposals would apply to open- and closed-end funds and business development companies . Shops that also run private funds will have to decide whether they are capable of running two different valuation regimes; otherwise, the new rule may determine how portfolio securities are valued across the board.
Specifically, the Proposed Rule would permit a board to assign valuation functions to the fund's investment adviser (as is common practice now, but with implied board responsibility for the valuations), subject to additional oversight requirements: assessing and managing material risks associated with fair value determinations; selecting, applying and testing fair value methodologies; overseeing and evaluating pricing services used, if any; adopting and implementing valuation policies and procedures; and maintaining certain records.
With the delegation to the adviser, the following key guardrails would be required:
- Board oversight of the adviser — with identification of
some specific responsibilities, not just what may be required by
- The Proposed Rule would require the adviser to report to the board with respect to "matters related to the adviser's fair value process." The breadth of the term "matters" is left open. Specifically, boards would be expected to probe the appropriateness of the adviser's fair value determination processes; periodically review the financial resources, technology, staff and expertise of the assigned adviser; and assess the reasonableness of the adviser's reliance on other fund service providers with respect to valuation.
- Boards would be expected to seek to identify, monitor and take reasonable steps to manage potential conflicts of interest of the adviser. They would also be expected to monitor conflicts of interest regarding any other service providers used by the adviser as part of the valuation process and seek to ensure that they are being managed.
- Periodic and prompt reporting to the board.
- Periodic reporting. The Proposed Rule would require the adviser, at least quarterly, to provide the board with a written assessment of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments. Such report would, at a minimum, include a summary of material valuation risks, material changes to or material deviations from methodologies, testing results, pricing vendor services, and any other materials requested by the board.
- Prompt reporting. The Proposed Rule would require that the adviser promptly report to the board in writing (but in no event later than three business days after the adviser becomes aware of the matter) on matters associated with the adviser's process that "materially affect, or could have materially affected, the fair value of the assigned portfolio of investments," including a significant deficiency or a material weakness in the design or implementation of the adviser's fair value determination process or material changes in the fund's valuation risks. Commenters have already questioned whether it could be possible in three days to assess whether a "matter" (whatever that might be) "could have" affected valuations. For example, if the adviser becomes aware that a new pricing service has come into the market that utilizes a novel methodology, does that constitute a "matter associated with the adviser's process"?
- Clear specification of responsibilities and reasonable segregation of duties among the adviser's personnel.
- Keeping additional records relevant to the assignment to the adviser.
In addition, the proposals would also define "readily available market quotations" in order to align the concept with accounting guidance on fair value for generally accepted accounting principles (GAAP), particularly ASC Topic 820's categorization of positions as falling into Level I, II or III accounting buckets. The proposing release identifies Level II and III assets as requiring fair value determination and describes circumstances in which Level I assets' market quotations are "unreliable" and therefore would also require fair value adjustment. We note that GAAP guidance on "fair value," which generally relates to financial statement reporting, not daily pricing, was only clarified about ten years ago and is subject to changes that may not be focused on the use of the fair value concept under the 1940 Act. The proposal leaves open whether its conflation of "readily available" and GAAP "fair value" establishes that the actual fair values or just the timing of valuations correspond to GAAP.
As can be seen from the above, although boards would be free from responsibility for making actual pricing determinations, they would not be relieved of reviewing significant documentation and overseeing the entire valuation process. In particular, boards will have to review evidence that the adviser satisfies the conditions under which delegation to the adviser is permissible, including that conflicts are handled, risks are evaluated and methodologies resulting in the values determined are sufficiently detailed.
The public comment period on the proposals will remain open until July 21.
The complete SEC release, including the full text of the Proposed Rule, is available on the SEC's website at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf.
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