Shearman And Sterling

Investment Funds, Compass

Jun 17, 2020

SEC Proposes Rule for Funds in Making Good-Faith Fair Value Determinations

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SEC PROPOSES RULE FOR FUNDS IN MAKING GOOD-FAITH FAIR VALUE DETERMINATIONS

On April 21, 2020, the U.S. Securities and Exchange Commission (the “SEC”) proposed a new rule under the Investment Company Act of 1940 (the “1940 Act”) to govern the valuation practices and the role of boards of directors regarding the fair value of the investments of registered investment companies and business development companies. If adopted, Rule 2a-5, (the “Proposed Rule”)[1]  would supersede 50 years’ worth of patchwork regulation and provide funds the first comprehensive regulatory framework in making good-faith fair value determinations when market quotations are not readily available. The Proposed Rule would:

  • Create a framework for determining fair value in good faith for purposes of section 2(a)(41) of the 1940 Act and rule 2a-4 thereunder;
  • Define when market quotations are “readily available”;
  • Permit fund boards to assign fair value determinations to an investment adviser; and
  • Require investment advisers to report to boards of directors (both periodically and promptly) regarding many aspects of the fair value determination process and to facilitate board oversight.

A Framework for the Implementation of Fair Valuation Practices

Valuation Risks

The Proposed Rule provides that determining fair value in good faith requires periodically assessing any material risks associated with the determination of the fair value of the fund’s investments, including material conflicts of interest, and managing those identified valuation risks. Other than material conflicts of interest, the Proposed Rule does not identify any specific valuation risks to be addressed under this requirement. Neither does it specify the frequency with which valuation risks must be assessed. However, the SEC Release does include a non-exhaustive list of the types and sources of valuation risks. The SEC Release provides that periodic reassessment of valuation risk generally should take into account changes in fund investments, significant changes in a fund’s investment strategy or policies, market events, and other relevant factors. The SEC Release notes that specific valuation risks will depend on the facts and circumstances of the particular fund’s investment.

Fair Value Methodologies

The Proposed Rule provides that fair value as determined in good faith requires selecting and applying in a consistent manner an appropriate methodology or methodologies for determining (which includes calculating) the fair value of fund investments. This requirement would include specifying (1) key inputs and assumptions specific to each asset class or portfolio holding, and (2) methodologies that will apply to new types of investments in which the fund intends to invest. The Proposed Rule would require periodic reviews of the selected fair value methodologies for appropriateness and accuracy, and adjustments to the methodologies where necessary. Additionally, it would require the board or adviser to monitor for circumstances that may necessitate the use of fair value as determined in good faith. The Proposed Rule would require the establishment of criteria for determining when market quotations no longer are reliable, and therefore not readily available. The SEC continues to believe that there may be a range of appropriate values for a particular investment that could reasonably be considered to be fair value.

Testing and Fair Value Methodologies

The Proposed Rule would require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value, including the identification of (1) testing methods to be used, and (2) a minimum frequency of the testing.

Pricing Services

The Proposed Rule would provide that determining fair value in good faith requires the oversight and evaluation of pricing services, where used. For funds that use pricing services, the proposed rule would require that the board or adviser establish a process for the approval, monitoring and evaluation of each pricing service provider. The 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. The Proposed Rule would require the establishment of criteria for the circumstances under which price challenges would be initiated, such as establishing objective thresholds.

Fair Value Policies and Procedures

The Proposed Rule would require written policies and procedures addressing the determination of the fair value of the fund’s investments that are reasonably designed to achieve compliance with the rule. Where a board determines the fair value of investments, the board-approved fair value policies and procedures would be adopted and implemented by the fund. Where a board assigns fair value determinations to an adviser, as discussed below, the fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under rule 38a-1.

Recordkeeping

The Proposed Rule would require funds to maintain five years’ worth of documentation to support fair value determinations and all copies of the fund’s or its adviser’s policies and procedures that were in effect during that time.

Definition of “Readily Available” Market Quotations

A board’s role in the valuation of a portfolio holding for purposes of fair value depends on whether or not market quotations are readily available for such a holding. Under section 2(a)(41) of the 1940 Act, if a market quotation is readily available for a portfolio holding, it must be valued at the market value. Conversely, if market quotations are “not readily available,” the holding’s value must be fair value as determined in good faith by the board. Neither the 1940 Act nor the rules thereunder define “readily available.” The Proposed Rule would provide that a market quotation is readily available for purposes of section 2(a)(41) of the 1940 Act with respect to an investment only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. Fair value, as defined in the 1940 Act, therefore must be used in all other circumstances.

Assigning Fair Value Determinations to Investment Advisers

The SEC has previously taken the position that fund boards may not delegate the determination of fair value to anyone else. However, the SEC Release accompanying acknowledges that determinations of fair value often require significant resources and specialized expertise, and that it may be impracticable for directors themselves to perform every one of the necessary tasks without assistance. Under the Proposed Rule, boards may assign fair value determinations to an investment adviser. In doing so, boards must assess and manage material risks associated with fair value determinations; select, apply, and test fair value methodologies; oversee and evaluate any pricing services used; adopt and implement policies and procedures; and maintain certain records. The SEC Release makes clear that rule 38a-1 under the 1940 Act will continue to apply.

Overseeing Advisers and Adviser Reporting

Where a board assigns fair value determinations to an adviser, the Proposed Rule would require the board to oversee the adviser. The SEC outlined in the SEC Release that it would “expect that boards engaged in [assignment of fair value determinations] would use the appropriate level of scrutiny based on the fund’s valuation risk, including the extent to which the fair value of the fund’s investments depend on subjective inputs.” The SEC Release states that boards should serve as a meaningful check on the conflicts of interest of the adviser and other service providers involved in the determination of fair values. Boards should understand the role of, and inquire about conflicts of interest regarding, any other service providers used by the adviser as part of the process, and satisfy itself that any conflicts are being appropriately managed. They should probe the appropriateness of the adviser’s fair value processes. In addition, boards should consider the adviser’s compliance capabilities that support the fund’s fair value processes, and the oversight and financial resources made available to the Chief Compliance Officer relating to fair value.

The Proposed Rule would require the adviser, at least quarterly, to provide the board a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the assigned portfolio of investments. The assessment would include, at a minimum, a summary or description of:

  • The assessment and management of material valuation risks, including any material conflicts of interest of the investment adviser and any other service provider;
  • Any material changes to, or material deviations from, the fair value methodologies;
  • The results of any testing of fair value methodologies;
  • The adequacy of resources allocated to the process for determining the fair value of the fund’s assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value;
  • Any material changes to the adviser’s process for overseeing pricing services, as well as any material events related to its oversight of such services, such as changes of service providers used or price overrides; and
  • Any other materials requested by the board related to the adviser’s process for determining the fair value of fund investments.

Prompt Reporting

The Proposed Rule would also require that the adviser “promptly” report to the board “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 material weakness in the design or implementation of the adviser’s fair value determination process or material changes in the fund’s valuation risks.” The Proposed Rule would require these “prompt” reports in no event later than three business days after the adviser becomes aware of the matter, rather than waiting until the next periodic report. The SEC Release acknowledges that “there may be some circumstances when an adviser becomes aware of an issue that may affect fair value of the portfolio but that the materiality of a given event may be in question.” In such circumstances, that verification period would not be counted as part of the “prompt” trigger period.

Rescission of Previously Issued Guidance and Transition Period

The Proposed Rule would rescind ASR 113 and 118, which provide guidance on, among other things, the role of the fund board in fair value determinations as well as guidance on certain accounting and auditing matters. In addition to the rescission of ASR 113 and ASR 118, the Proposed Rule would withdraw or rescind certain staff letters and other staff guidance addressing a board’s determination of fair value and other matters covered by the Proposed Rule. The SEC Release contemplates a one-year transition period to provide time for funds and their advisers to come into compliance with the Proposed Rule. Thus, the effect date of the Proposed Rule would be one year following the publication of the final rule in the Federal Register.

Our Take

The Proposal Rule would clarify and expand existing valuation guidance without significantly changing current market practice regarding portfolio valuation. While we believe that boards and advisers will find the Proposed Rule an improvement over existing guidance, the Release proposes several questions for consideration by industry participants to determine whether the Proposed Rule addresses the various valuation issues faced by boards and advisers. The deadline for submitting comments on the Proposed Rule is July 21, 2020.

Footnotes

[1]  See Good Faith Determinations of Fair Value, SEC Release No. IC-33845 (Apr. 21, 2020) (the “SEC Release”).

Authors and Contributors

Paul Schreiber

Of Counsel

Investment Funds

+1 212 848 8920

+1 212 848 8920

New York

Thomas Majewski

Counsel

Investment Funds

+1 212 848 7182

+1 212 848 7182

New York

Regional Experience