On April 21, 2020, the Securities and Exchange Commission (SEC) issued its long-anticipated rule proposal regarding valuation practice for registered investment companies and business development companies (the Proposal). Section 2(a)(41) of the Investment Company Act of 1940, as amended (the 1940 Act), requires fund boards to utilize fair value “determined in good faith by the board of directors” when valuing portfolio securities without available market quotations. The Proposal, if adopted, would provide requirements for determining fair value in good faith, while acknowledging the larger role played by investment advisers in valuation when compared to 1970 when the issue was last formally addressed by the SEC. To that end, the Proposal would permit a fund board to assign fair value determinations to the fund adviser, subject to conditions, one of which is the continued oversight of the valuation process by the board. The Proposal requires that boards or their advisers do the following when fair valuing securities: (i) assess valuation risks; (ii) select and apply one or more methodologies in fair valuing fund securities; (iii) test the appropriateness and accuracy of those methodologies; (iv) provide oversight and evaluation of pricing services, if used; (v) adopt and implement written fair value policies and procedures; and (vi) maintain certain records regarding the valuation process. Comments on the Proposal are due July 21, 2020.
Fund valuations, including fair value valuations, are critical in calculating a fund’s net asset value (NAV), selling and redeeming fund shares, assessing fund performance, and determining asset-based and performance-based compensation for fund service providers, especially the fund’s adviser, as well as monitoring compliance with investment policies and limitations. The 1940 Act and the rules thereunder impose a variety of responsibilities on fund boards and advisers when valuing fund securities. Despite the importance of fund valuation, the SEC last formally addressed the topic in two releases in 1969 and 1970, respectively. In the intervening decades, the SEC staff issued a variety of informal valuation guidance, while funds invested in an increasingly diverse range of asset classes with various valuation challenges, and the technologies involved in valuation have significantly increased. In addition, since it came out in 2006, FASB Accounting Standard Codification Topic 820: Fair Value Measurement, as amended (ASC Topic 820) has been used by funds and their advisers as a framework for determining fair value of fund holdings.
Assessing Valuation Risks. The Proposal would require funds to periodically assess and manage any material risks when determining fair value, including material conflicts of interests. The Proposal does not specify the frequency of the periodic review. What would constitute a material risk would vary based on the fund and the nature of the investments that need to be fair valued, but the Proposal does mandate that the risk of material conflicts of interests be assessed and managed. The risks identified in the Proposal that funds may want to consider in determining fair value include: (i) the types of investments held by the fund, (ii) potential market or sector shocks, (iii) the use of unobservable inputs, especially those provided by the adviser, (iv) the proportion of fund investments that are fair valued, (v) overreliance on service providers, and (vi) the use of inappropriate methodologies.
Selecting and Applying Fair Value Methodologies. The Proposal also requires that boards or advisers select and apply in a consistent manner an appropriate methodology or methodologies in determining and calculating fair value. This requirement would include specifying the key inputs and assumptions specific to each asset class or holding and the methodologies that would apply to new types of investments in which a fund intends to invest. The Proposal specifies that a selected methodology would have to be consistent with ASC Topic 820. The Proposal also would require periodic reviews of the selected fair value methodologies for appropriateness and accuracy, and adjustments to the methodologies where necessary. However, the Proposal notes that there will be a range of appropriate methodologies across asset classes.
Testing of Fair Value Methodologies. The Proposal would require boards or advisers to test the appropriateness and accuracy of the fair value methodologies. Tests would vary based on the type of methodologies used, but boards or advisers would be required to identify the testing methods used and the minimum frequency of such testing. The Proposal does not specify a minimum frequency of testing.
Third-Party Pricing Services. The Proposal would also require boards or advisers to oversee and evaluate any third-party pricing services utilized in the valuation process. The board or adviser would have to establish a process for approving, monitoring and evaluating each pricing service used. The process would have to take into consideration: (i) the qualifications, experience and history of the pricing service; (ii) the valuation methods, techniques, inputs and assumptions used by the pricing service for different classes of holdings (as well as how such factors are affected by changing market conditions); (iii) the process used by the pricing service for considering price “challenges” (when the fund adviser and pricing service differ on a value for a fund holding); (iv) how the pricing services mitigates potential conflicts of interest; and (v) the testing processes of the pricing service. The Proposal also requires procedures for handling price challenges between the fund adviser and the pricing service.
Fair Value Policies and Procedures. The Proposal would also require written policies and procedures regarding fair value of fund investments reasonably designed to achieve compliance with the requirements of the Proposal. The policies and procedures would be tailored to ensure that a board or adviser, as applicable, determines fair value in compliance with the rule. If a board determines the fair value of a fund’s investments, the policies and procedures would be adopted and implemented by the fund. If the adviser is assigned by the board to determine fair value, the policies and procedures would be adopted and implemented by the adviser, subject to board oversight under Rule 38a-1 of the 1940 Act. Rule 38a-1 of the 1940 Act would also apply to a fund’s obligations under the Proposal.
Recordkeeping. The Proposal would require boards or advisers to maintain certain records regarding the valuation processes, including supporting documentation and policies and procedures. Under the Proposal, the supporting documentation would have to be sufficient for a third party to independently verify the fair value determination.
Board Oversight. As stated above, the Proposal would permit a fund board to assign the fair value determination for any or all of the fund investments to an adviser or to one or more sub-advisers, subject to certain oversight requirements. According to the Proposal, boards should view their oversight of fair value determinations assigned to an adviser “with a skeptical and objective view” based on the fund’s valuation risks and potential conflicts of interest. Further, as the subjective inputs in a fair value determination increase, the board’s scrutiny should also increase. Boards would also be required to review periodically the resources, technology, staff and expertise of an adviser assigned to determine fair value.
Board Reporting. The Proposal also includes requirements to ensure that the board receives timely, relevant and tailored information regarding fair value determinations. The Proposal would require the adviser to provide, at least quarterly, a written assessment of the fair value process designed to identify trends, exceptions, and a sufficient overview of the state of the fair value process. The information provided would include material valuation risks, material changes to or material deviations from methodologies, testing results, resources, pricing services, and any information requested by the board.
In addition to periodic reporting, the Proposal would require advisers assigned to determine fair value to promptly report to the board in writing certain issues regarding fair value that may require the board’s immediate attention. These issues would include those “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.1” These prompt reports would be required no later than three business days after the adviser becomes aware of the matter reported. The three-business-day period would be used, if necessary, for the adviser to verify and determine whether the matter is material enough to warrant prompt reporting to the board.
Specification of Functions. The Proposal would also require an adviser assigned to determine fair value to specify the individuals responsible for particular functions of the fair value processes, including the members of any fair value committee. Additionally, the adviser would have to segregate the fair value process from portfolio management of the fund.
Readily Available Market Quotations. To determine whether a fair value for an investment is necessary, the Proposal 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 (and, thus, a fair value is not required) 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.
Rescission of Prior Commission Releases. Finally, if adopted, the Proposal would rescind a variety of past SEC releases regarding valuation, including ASR 113 and ASR 118, as well as a variety of staff no-action letters and other staff guidance. If adopted, the Proposal would include a one-year transition period.
1See Good Faith Determinations of Fair Value, Rel. No. IC-33845 (April 21, 2020) at II.B.2.