SEC Proposes Modernizing Fund Valuation Practices
On Tuesday, April 21, 2020, the Securities and Exchange Commission (the “SEC” or the “Commission”), voted to propose a new rule to establish a modern framework for fund valuation practices.
Proposed Rule: Key Takeaways
The Proposed Rule is a result of the Commission’s recognition of the evolution of the markets and fund investment practices since valuation practices under the 1940 Act were last addressed comprehensively in 1969 and 1970. In a statement, the SEC’s Chairman Clayton noted that the Proposed Rule would “improve valuation practices, including oversight, thereby protecting investors and improving market efficiency, integrity, and fairness.”
The following are some of the key takeaways from the Proposed Rule:
1. Fair Value as Determined in Good Faith. Fair value as determined in good faith would require (1) assessing and managing material risks associated with fair value determinations, including material conflicts of interest; (2) selecting, applying and testing fair value methodologies; and (3) overseeing and evaluating any pricing services used. The Proposed Rule would also require adopting and implementing written policies and procedures addressing fair value determination, and maintaining certain records.
2. Who Performs Fair Value Determinations. The Proposed Rule would confirm that fair value determinations may be made by a fund’s board of directors and would also permit the fund’s board to assign fair value determinations to a fund’s investment adviser, subject to board oversight. This assignment would include periodic reporting to the board, clear specification of responsibilities and reasonable segregation of duties among the adviser’s personnel, and keeping additional records relevant to the fair value determinations.
3. Readily Available Market Quotation. Under section 2(a)(41) of the 1940 Act, fund investments must be fair valued where market quotations are not “readily available.” The Proposed Rule would clarify that the definition of “readily available” is triggered only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date. Under the Proposed Rule, “valuated prices”, “indications of interest” and “accommodation quotes” would not be “readily available” market quotations.
As an example, the Proposing Release notes that if a fund invests in securities that trade in foreign markets, the board or adviser generally should identify and monitor for the kinds of significant events that, if they occurred after the market closes in the relevant jurisdiction but before the fund prices its shares, would materially affect the value of the security and therefore may suggest that market quotations are not reliable.
Determination of Fair Value
The Proposed Rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of section 2(a)(41) of the 1940 Act and rule 2a-4 thereunder. In order to determine fair value, the Proposed Rule outlines the required functions that must be performed in order to determine in good faith the fair value of a fund’s investments. The required functions are:
1. Valuation Risks – The Proposed Rule would require the periodic assessment of any material risks associated with fair valuing investments, including material conflicts of interest, and managing identified valuation risks;
The Proposing Release notes that there are many potential sources of valuation risk and some of those are:
the types of investments held or intended to be held by a fund;
potential market or sector shocks or dislocations;
the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by an adviser;
the proportion of a fund’s investments that are fair valued as determined in good faith and their contribution to the fund’s returns;
reliance on service providers that have more limited expertise in relevant asset classes; the use of fair value methodologies that rely on inputs from third-party service providers; and the extent to which third-party service providers rely on their own service providers (so-called “fourth-party” risks); and
the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.
2. Fair Value Methodologies – The Proposed Rule would require selecting and applying, in a consistent manner, an appropriate methodology or methodologies for determining fair value of fund investments by specifying:
the key inputs and assumptionsspecific to each asset class or portfolio holding; and
the methodologies that will apply to new types of investments that a fund intends to invest.
The Proposed Rule also would require the selected methodologies to be periodically reviewed for appropriateness and accuracy, and to be adjusted, if necessary.
The Proposing Release further notes that to be appropriate under the Proposed Rule, and in accordance with current accounting standards, a methodology used for purposes of determining fair value must be consistent with ASC Topic 820, and thus derived from one of the approaches outlined in ASC Topic 820.
Testing of Fair Value Methodologies – The Proposed Rule would require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value by identifying:
the testing method for valuation to be used; and
the minimum frequency of that testing.
The Proposing release notes that “calibration”
Pricing Services – The Proposed Rule would require the approval, monitoring, and evaluation of third-party pricing services, when used. The Proposing Release notes that a board or an adviser should take into account the following considerations when approving, monitoring, and evaluating a pricing service provider:
the qualifications, experience, and history of the pricing service;
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;
the pricing service’s process for considering price “challenges,” including how the pricing service incorporates information received from pricing challenges into its pricing information;
the pricing service’s potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts;
the testing processes used by the pricing service.
5. Fair Value Policies and Procedures – The Proposed Rule would require written policies and procedures addressing the determination of the fair value of a fund’s investments. The Proposing Release notes that where the board assigns fair value determinations to a fund’s adviser the fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under rule 38a-1 under the 1940 Act.
6. Recordkeeping – The Proposed Rule would require that a fund maintain:
documentation to support fair value determinations for at least five years, and the first two years in an easily accessible place; and
a copy of policies and procedures that were in effect at any time within the past five years, in an easily accessible place.
Performance of Fair Value Determinations
The Proposed Rule would permit a fund’s board of directors to assign the fair value determination relating to any or all fund investments to a fund’s investment adviser, which would carry out all of the functions required in paragraph (a) of the Proposed Rule, subject to certain requirements, including board oversight.
If a board decides to assign fair value determinations to the fund’s adviser then assignment under the Proposed Rule would be subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board’s ability effectively to oversee the adviser’s fair value determinations. It is worthwhile to note that in her public statement on the Proposed Rule, Commissioner Hester Peirce noted that “a fund board that chooses to assign fair valuation duties to its adviser … would be bound by specific requirements as to how to oversee its adviser…”
If a Board decides to assign fair value determination to the fund’s adviser then the following requirements must be adhered to:
1. Board Oversight – the Proposing Release notes that where a board assigns fair value determinations to a fund’s adviser, the Proposed Rule would require the board to satisfy its statutory obligation with respect to such determinations by overseeing the adviser. The Proposing Release further notes that effective oversight cannot be a passive activity and fund directors should ask questions and seek relevant information. In addition, oversight should be an iterative process and seek to identify potential issues and opportunities to improve the fund’s fair value processes. The Proposing Release does acknowledge that the level of board oversight will vary by fund. For example, a board’s scrutiny would likely be different if a fund invests in publicly traded foreign companies than if the fund invests in private early stage companies. As the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures, the Commission would expect that the board’s level of scrutiny would increase correspondingly.
Boards would also be required to take reasonable steps to manage conflicts of interest associated with adviser’s fair value determinations. The Proposing Release notes that a board 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. Specifically, a fund’s adviser may have an incentive to improperly value fund assets in order to increase fees, improve or smooth reported returns, or comply with the fund’s investment policies and restrictions.
In addition, Boards would also need to consider the type, content, and frequency of the reports they receive from the fund’s adviser. The Proposed Rule would require reporting to the board (both periodically and promptly) regarding many aspects of the adviser’s fair value determination process as a means of facilitating the board’s oversight. While a board would be able to rely on the information provided to it in summaries and other materials provided by the adviser and other service providers in conducting its oversight, the Proposing Release notes that “it is incumbent on the board to request and review such information as may be necessary to be fully informed of the adviser’s process for determining the fair value of fund investments.”
Board Reporting – Boards would be required certain periodic and prompt reporting:
Periodic Reporting: The Proposed Rule 2a-5 would require a fund’s 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 periodic reports would be required to, at a minimum, include a summary or description of the following information:
Material Valuation Risks. The assessment and management of material valuation risks that would be required under the Proposed Rule.
Material Changes to or Material Deviations from Methodologies. Any material changes to, or material deviations from, the fair value methodologies established under the Proposed Rule.
Testing Results. The results of any testing of fair value methodologies as part of the required fair value policies and procedures.
Resources. 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.
Pricing Services. Any material changes to an 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.
Other Requested Information. Any other materials requested by the board related to an adviser’s process for determining the fair value of fund investments.
It is important to note that the foregoing information is not the only information that can be considered by a board and the board could review and consider certain other information as noted in the Proposing Release.
Prompt Board Reporting: The Proposed Rule would require that an adviser promptly report to a board in writing 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.
Specification of Functions – The Proposing Release notes that if a board assigns the fair value determination requirements for one or more fund investments to an adviser, the Proposed Rule would require the adviser to specify the titles of the persons responsible for determining the fair value of the assigned investments, including by specifying the particular functions for which the persons identified are responsible. The Proposing Release also specifically notes that the Proposed Rule would require a fund’s adviser to reasonably segregate the process of making fair value determinations from the portfolio management of the fund because the the Commission views portfolio managers or persons in related functions that have input in the design or modification of fair value methodologies, or in the calculation of specific fair values as a potential source that may lead to conflicts of interest in the fair value determination process.
4. Records of Assignment – Under the Proposed Rule, a fund must also keep records related to the fair value determinations assigned to the adviser. Specifically, the fund would be required to keep:
copies of the reports and other information provided to a board required by the Proposed Rule and
a specified list of the investments or investment types whose fair value determinations have been assigned to an adviser pursuant to the requirements of the Proposed Rule.
Readily Available Market Quotations
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 a fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. Under the Proposed Rule a quote would be considered unreliable in the same circumstances where it would require adjustment under U.S. GAAP or where U.S. GAAP would require consideration of additional inputs in determining the value of the security.
Rescission of Prior Commission Releases
In connection with the Proposed Rule, the Commission also proposed rescinding two previous releases on fund valuation, Accounting, Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118),
Proposed Transition Period
The Commission is proposing a one-year transition period for funds to prepare for compliance with the Proposed Rule. This transition period would begin after publication of the final rule in the Federal Register.
The Commission will accept public comments on the Proposed Rule until July 21, 2020.