December 18, 2020

SEC Modernizes Framework for Fund Valuation Practices

On December 3, 2020, the Securities and Exchange Commission (SEC) adopted a new rule 2a-5 (Rule 2a-5 or the Final Rule) under the Investment Company Act of 1940 (the Act). Rule 2a-5 provides an updated regulatory framework for fund valuation practices and establishes requirements for determinations of fair value by registered investment companies and business development companies (collectively, funds). The SEC also adopted new rule 31a-4 (Rule 31a-4), which provides the recordkeeping requirements associated with fair value determinations.

Background

Section 2(a)(41) of the Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations are readily available and to otherwise use the fair value of that security as determined in good faith by the board. The SEC last comprehensively addressed valuation practices in Accounting Series Releases in 1969 and 1970 and related no-action guidance (the ASRs). The ASRs required that boards: (i) choose the methods used to arrive at fair value and continuously review the appropriateness of such methods; (ii) consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available; and (iii) carefully review the fair value findings.

Prior to the proposal of Rule 2a-5 on April 20, 2020 (the Proposing Release), the SEC took the position that a board could not delegate the determination of fair value. The Final Rule recognizes markets and fund investments have evolved in the 50 years since the ASRs went into effect and most fund boards do not play a day-to-day role in pricing fund investments. Thus, the Final Rule aims to “establish a minimum and consistent framework for fair value practices across funds.” Our previous alert on the Proposing Release provides an overview of its requirements, including a fund’s role in assessing and managing material risks associated with fair value determinations; selecting, applying and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining records. The Final Rule was adopted substantially as proposed, but includes modifications designed to provide flexibility in certain areas, which are outlined below.

Overview of the Final Rule

The Final Rule provides requirements for determining fair value of a fund’s investments in good faith for purposes of section 2(a)(41) of the Act. Under the Final Rule, a fund’s board can designate1 a “valuation designee” to perform fair value determinations. A valuation designee can be the fund’s adviser or, if the fund is internally managed, an officer of the fund. This is a change from the Proposing Release, which would only have permitted a fund’s board to assign fair value determinations to the fund’s adviser. The Final Rule rescinds the ASRs in their entirety. Additionally, certain SEC guidance, staff letters and other staff guidance addressing a board’s determination of fair value will be withdrawn or rescinded, and the guidance in the SEC’s 2014 release adopting money market fund reform regarding valuation of thinly traded securities is superseded and restated.

Comments from the industry on the Proposed Rule voiced concern that violations of the rule that did not directly impact the value of a given asset would result in a violation of the Act. In response to these concerns, the Adopting Release notes that although a board’s or valuation designee’s failure to comply with the requirements of the Final Rule will reflect negatively on the effectiveness of the fund’s fair value process and its compliance program, “a violation of the Final Rule does not necessarily mean that the actual values ascribed to particular fund investments were in fact inappropriate or, for example, that the fund has violated rule 22c-1.”

The Final Rule provides the following requirements:

  • Fair Value Determinations. Funds will be required to perform the following functions, either through the board or a valuation designee:
    • Valuation risks — As initially proposed, the Final Rule requires a fund to periodically assess any material risks associated with determining the fair value of the fund’s investments (including material conflicts of interest) and manage the identified risks. The Final Rule does not include specific valuation risks to be addressed or prescribe the frequency of review, but instead notes that these factors would be based on the facts and circumstances of a particular fund’s investments.
    • Fair value methodologies — A fund must select an appropriate methodology and apply it in a consistent manner when determining fair value. The fund’s board or valuation designee must specify the key inputs and assumptions specific to each asset class or portfolio holding. Under the Final Rule, the methodologies selected for fund investments may be changed if different methodologies are equally or more representative of the fair value of the investments. The selected methodologies must be periodically reviewed, and the board or valuation designee must monitor for circumstances under which a fair value determination is needed. This requirement is adopted largely as proposed, but in a change from the Proposing Release, the Final Rule does not require a fund to specify the methodologies that will apply to new types of investments in which the fund intends to invest.
    • Testing of fair value methodologies — As described in the Proposing Release, a fund must test the appropriateness and accuracy of the methodologies used to calculate fair value. The board or the valuation designee must identify the testing methods to be used and the minimum frequency of the testing based on the facts and circumstances of each fund.
    • Pricing services — For funds that use pricing services, the board or valuation designee must establish a process for approving, monitoring and evaluating each pricing service provider. This requirement is adopted as largely as proposed, but under the Final Rule, the board or valuation designee is required to establish a process for initiating price challenges as appropriate, in contrast to the proposed requirement to pre-establish criteria for the circumstances under which price challenges could be initiated.
    • Fair value policies and procedures — In contrast to the Proposing Release, the Final Rule does not separately require a fund to adopt written policies and procedures reasonably designed to achieve compliance with the requirements of Rule 2a-5. Instead, the Final Rule relies on existing rule 38a-1 to require each fund to adopt and implement fair value policies and procedures that are reasonably designed to prevent violations of Rule 2a-5 and Rule 31a-4. These fair value policies and procedures must be approved by the board pursuant to rule 38a-1 and may not be considered material amendments to any existing fair value policies and procedures.
  • Performance of Fair Value Determinations.
    • Board oversight — Board oversight under the Final Rule is adopted largely as proposed and requires a board to satisfy its statutory obligation under section 2(a)(41) of the Act by overseeing the valuation designee if the board has designated a valuation designee. Among others, board oversight includes: (i) identifying potential issues and opportunities to improve the fund’s fair value processes; (ii) asking questions of and requesting follow-up information from the valuation designee when appropriate; (iii) seeking to identify, monitor and manage any conflicts of interest; and (iv) using the appropriate level of scrutiny based on the fund’s valuation risk.
    • Board reporting — Under the Final Rule, where a board has designated a valuation designee, the valuation designee must provide both annual and quarterly written reports to the board.
      • Quarterly reporting: The valuation designee must provide any reports or materials requested by the board related to fair value determinations and a summary or description of material fair value matters that occurred in the prior quarter, including any material changes in the assessment of valuation risks, fair value methodologies and process for selecting and overseeing pricing services. The Final Rule’s reporting requirements are generally more flexible and less prescriptive than those of the Proposing Release.
      • Annual reporting: The valuation designee must provide an annual assessment of the adequacy and effectiveness of its process for determining the fair value of the designated portfolio of investments, including a summary of the results of the testing of fair value methodologies and an assessment of the adequacy of resources allocated to the process of fair value determinations. Under the Proposing Release, a valuation designee would have been required to provide this report quarterly.
      • Prompt board notification and reporting: The valuation designee must provide a written notification of any matters that materially affect the fair value of the designated portfolio of investments within a time period determined by the board, but in no event later than five business days after the valuation designee becomes aware of the material matter. The valuation designee must also provide timely follow-on reports as the board may reasonably determine are appropriate. Under the Proposing Release, the valuation designee would have had three business days to notify the board of any material matters.
    • Specification of functions and segregation from portfolio management — The specification requirement is adopted largely as proposed, with a requirement that the valuation designee specify the individuals responsible for fair value determinations and the functions they cover in the valuation process. The valuation designee must also reasonably segregate the process of making fair value determinations from the portfolio management of the fund.
    • Recordkeeping — The SEC has adopted Rule 31a-4 to cover recordkeeping requirements associated with the Final Rule, rather than including a recordkeeping provision under Rule 2a-5. A fund, or its adviser if the adviser serves as fair value designee, must maintain appropriate documentation to support fair value determinations. Where the board has designated a valuation designee, the reports and other information provided to the board must specify the investments or investment types for which the valuation designee has been designated. The records must be maintained for at least six years under the Final Rule, as opposed to the initially proposed five years.
  • Readily Available Market Quotations. The definition of readily available market quotations is adopted as proposed, and for purposes of section 2(a)(41) of the Act with respect to an investment, it 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.

While Rules 2a-5 and 31a-4 will be effective 60 days after they are published in the Federal Register, funds will have an 18-month transition period beginning from the effective date of the Rules to prepare to come into compliance with Rules 2a-5 and 31a-4.

Practice Points

As stated in the Adopting Release, the Final Rule is an attempt to set a minimum framework for fair valuation that is consistent across funds. In so doing, it encourages funds to put in place a formalized system for designating fair value functions and reporting to the board, which may represent a codification of and minor revisions to existing practice for larger fund groups where the adviser provides significant assistance in the valuation program. For smaller fund groups, the Final Rule will create additional reporting and compliance burdens. The Final Rule adds some limited flexibility to the policies and procedures that a valuation designee, generally the fund’s adviser, will need to adopt. The Final Rule retains the “active oversight” of the valuation designee by the fund’s board, which was a feature of the Proposed Rule, and the reporting requirements will require frequent involvement of boards in the oversight process during times of market turmoil or volatility.

  1. The Final Rule differentiates “designating” a valuation designee as opposed to “assigning” the performance of fair value determinations to the fund’s adviser. The Final Rule adopts the word “designate” as opposed to “assign” in order to better describe the relationship between the board and the valuation designee. The valuation designee performs fair value determinations for the fund on the board’s behalf subject to appropriate oversight by the board.
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