Securities Regulation Daily SEC modernizes fund valuation framework
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Thursday, December 3, 2020

SEC modernizes fund valuation framework

By John M. Jascob, J.D., LL.M.

In the first comprehensive update in this area in 50 years, the Commission has adopted new rules establishing a fund board’s obligation to determine fair value in good faith under the Investment Company Act.

The SEC has adopted a new rule establishing an updated regulatory framework for fund valuation practices under the Investment Company Act. New Rule 2a-5 is designed to clarify how fund boards of directors can satisfy their obligations to fairly value fund holdings in light of changes in the financial markets since the Commission last comprehensively addressed valuation in 1970. In addition, new Investment Company Act Rule 31a-4 will require funds or their advisers to maintain appropriate documentation to support fair value determinations and documentation related to the designation of the valuation designee. As part of the rulemaking package, the Commission also rescinded previously issued guidance on related issues, including the board’s role in determining fair value and the accounting and auditing of fund investments (Good Faith Determinations of Fair ValueRelease No. IC-34128, December 3, 2020).

"Main Street investors increasingly access our capital markets through funds and rely on them to value their investments properly," said SEC Chairman Jay Clayton in a news release. "Today’s rule is designed to improve funds’ valuation practices, including by providing for effective board oversight, for the benefit and protection of fund investors."

The SEC's adopting release notes that significant developments have occurred in markets and fund investment practices since the Commission last comprehensively addressed valuation 50 years ago, including developments in the accounting and auditing literature, the growing complexity of valuation, and intervening regulatory developments such as the development of ASC Topic 820 (Fair Value Measurement) and the interplay of Investment Company Act Rule 38a-1 (the "Compliance Rule") in facilitating board oversight of funds and the valuation process. The Commission also observed that funds also now invest in a greater variety of securities, some of which did not exist in 1970 and which can present different and significant valuation challenges.

Scope. New Rule 2a-5 applies to all registered investment companies and business development companies (BDCs), regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds) or their investment objectives or strategies. In the case of a unit investment trust (UIT), a UIT’s trustee or the UIT’s depositor must conduct fair value determinations under the rule because a UIT does not have a board of directors or adviser.

Fair value as determined in good faith. Rule 2a-5 requires the performance of certain functions in order to determine in good faith the fair value of a fund’s investments. These functions include periodically assessing and managing material risks associated with fair value determinations, selecting, applying and testing fair value methodologies, and overseeing and evaluating any pricing services used.

Performance of fair value determinations. The new rule confirms that a fund’s board of directors can itself make a good faith determination of the fair value of securities and assets that do not have readily available market quotations. The rule provides that a market quotation is readily available 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.

The rule also permits a board to assign the determination to a "valuation designee," subject to additional conditions and oversight requirements. The valuation designee may be the fund’s investment adviser or, if the fund is internally managed, an officer of the fund. If the board designates the determination of fair value to a valuation designee, certain additional requirements apply, including:

  • board oversight of the valuation designee;
  • periodic and prompt reporting to the board; and
  • clear specification of the titles and functions of the persons responsible for fair value determinations, along with reasonable segregation of duties among the designee’s personnel.

Recordkeeping. The SEC has also adopted new Rule 31a-4 under the Act. This rule will require funds or their advisers to maintain appropriate documentation to support fair value determinations and, where applicable, documentation related to the designation of the valuation designee.

Rescission of prior guidance. In connection with the new fund valuation framework, the SEC will rescind two releases, Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118), which provide guidance on how to determine fair value for restricted securities. The SEC will also withdraw rescind certain additional guidance, staff letters and other staff guidance addressing a board’s determination of fair value and other matters.

Balanced approach. In its adopting release, the SEC stated the importance of establishing a minimum and consistent framework for fair value practices across funds, while also setting forth appropriate oversight measures to help address valuation risks, including those arising from conflicts of interest. While some commenters had asked the Commission to adopt a final rule in the form of a non-exclusive safe harbor, the SEC stated its belief that certain minimum and baseline standards are inherent in any good faith fair value determination. Specifically, the SEC was concerned that a safe harbor might give the misleading impression that an approach to making fair value determinations that did not meet these minimum baseline standards would satisfy the board’s statutory obligations. Accordingly, the final rule establishes a principles-based framework that balances the flexibility of the board to exercise good faith judgment in the valuation process with an appropriate set of baseline standards.

Although supporting the adoption of the final rule, Commissioner Hester Peirce agreed with those who saw value in redrawing the provisions of Rule 2a-5 as a non-exclusive safe harbor. "Many, perhaps even most, fund boards would choose the procedural path that rule 2a-5 has laid out for them and would forgo the option to chart their own course, but boards that think they have a better way to conduct valuation should have the right to try," she stated. "We should be creating opportunities for fund boards to find better ways to do their jobs and serve fund interests, not box them in and limit their ability to adapt and grow."

Effective and compliance dates. The rules will become effective 60 days after publication in the Federal Register. The rules will have a compliance date 18 months following the effective date, however, to allow funds and valuation designees time to come into compliance with the new requirements. A fund may voluntarily comply with the rules after the effective date, and in advance of the compliance date, under certain conditions.

The release is No. IC-34128.

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