On April 21, 2020, the U.S. Securities and Exchange Commission (the “SEC”) voted to propose new Rule 2a-5 (the “Proposed Rule”) under the Investment Company Act of 1940 (the “1940 Act”) that, if adopted, would establish a revised framework governing the role of the board of directors (the “board”)[1] of each registered investment company and business development company (each, a “fund”)[2] with respect to the fair value[3] of the fund’s investments. Under the 1940 Act, where a market quotation for a fund’s portfolio security is not readily available, the fund’s board is statutorily required to determine in good faith the fair value of that security. The Proposed Rule would establish specific requirements for satisfying a fund board’s obligation to determine fair value in good faith for purposes of the 1940 Act.
This Client Alert is organized in the following sections:
- Section I provides background information on the Proposed Rule, including the developments that led the SEC to issue the Proposed Rule.
- Sections II-III describe the key components of the Proposed Rule and discuss considerations regarding how to interpret or apply certain of the Proposed Rule’s requirements, based on examples and other guidance provided by the SEC in the release associated with the Proposed Rule (the “Release”).[4]
- Section IV describes the circumstances under which market quotations for a fund’s portfolio security would not be considered “readily available” for purposes of the 1940 Act under the Proposed Rule and, therefore, would necessitate the use of fair value.
- Section V describes the SEC’s proposed rescission or withdrawal of certain prior SEC releases and SEC staff guidance relating to matters covered by the Proposed Rule in connection with any adoption of the Proposed Rule.
- Section VI sets forth the proposed transition period for funds and investment advisers to prepare to come into compliance with the Proposed Rule, if adopted.
- Section VII summarizes the alternatives considered by the SEC in deciding to issue the Proposed Rule.
I. BACKGROUND
Pursuant to Section 2(a)(41) of the 1940 Act, the term “value” has two prongs: (1) the value of securities for which “market quotations are readily available” is their “market value”; and (2) the value of “other securities and assets” is their “fair value” as determined “in good faith by the board of directors.” As interpreted by the SEC and its staff, the framework combines substantive directives of permissible and impermissible methods for determining “value” with procedural directives regarding the role of the board in determining value, particularly “fair value.”
The SEC last addressed valuation under the 1940 Act in a comprehensive manner roughly 50 years ago, in a pair of SEC releases in 1969 and 1970, Accounting Series Release 113 (“ASR 113”) and Accounting Series Release 118 (“ASR 118”).[5] Since then, market and fund investment practices have evolved significantly. As a result, fair valuation practices have also evolved in connection with funds investing in a greater variety of securities and other instruments, which present different and more significant valuation challenges that require greater resources and in-depth expertise to fair value determinations. There has also been an increase in both the volume and type of data used in fair value determinations and an increased use of third-party pricing services to provide pricing information, particularly for thinly traded or more complex assets.
In addition, the following regulatory developments since ASR 113 and ASR 118, taken together, have fundamentally altered how boards, funds, investment advisers and other fund service providers perform various functions relating to fair value determinations: (i) the enactment of the Sarbanes Oxley Act of 2002 and the adoption of rules mandated by that Act (which established the Public Company Accounting Oversight Board and criteria necessary for the work product of an accounting standard-setting body to be recognized as “generally accepted” for purposes of the federal securities laws); (ii) the SEC’s adoption in 2003 of compliance rules under the 1940 Act (Rule 38a-1) and the Investment Advisers Act of 1940 (Rule 206(4)-7) (which require a fund to adopt compliance policies and procedures with respect to fair value); and (iii) the codification by the Financial Accounting Standards Board of Accounting Standard Codification Topic 820; Fair Value Measurement (“ASC Topic 820”) (which defines the term “fair value”[6] for purposes of the accounting standards and establishes a framework for the recognition, measurement, and disclosure of fair value under U.S. generally accepted accounting principles (“U.S. GAAP”)).
Since ASR 113 and ASR 118, there has also been subsequent guidance issued by the SEC and its staff, at different times and in different forms, on the role of the board regarding fair value under the 1940 Act. This guidance is set forth in, among other documents, a pair of letters from the SEC staff to the Investment Company Institute in 1999 and 2001 (the “ICI Letters”), the SEC’s release adopting Rule 38a-1 in 2003 (the “Rule 38a-1 Adopting Release”), an SEC order finalizing a settlement with former fund directors over claims related to fair value determinations in 2013 (the “Morgan Keegan Case”), and the SEC’s release adopting amendments to the rules governing money market funds in 2014 (the “Money Market Fund Release”). This combination of guidance in various releases, letters, statements and other communications over time has created an inefficient regulatory framework where the board’s role with respect to fair value is not always clear to funds and their boards.
The Proposed Rule would establish a revised framework for the fair value determination process that recognizes and reflects the considerable changes that have taken place since ASR 113 and ASR 118. Additionally, the comprehensiveness of the Proposed Rule would create a more consistent and efficient regulatory framework that is designed to reduce confusion and provide additional clarity on how boards can effectively fulfill their fair valuation determination obligations in light of these changes. Significantly, and in recognition of investment advisers assisting funds with fair value determinations, the Proposed Rule would expressly permit a board to assign fair value determinations to an investment adviser of the fund, subject to certain requirements designed to facilitate the board’s ability effectively to oversee the adviser’s fair value determinations.
In recent years, the staff of the SEC’s Division of Investment Management had made a number of public statements that it was actively exploring ways in which to recommend updating the SEC’s valuation guidance. As part of these efforts, the SEC staff conducted significant outreach of fund directors and others to review and re-evaluate a board’s responsibilities with respect to valuation. Prior to the Proposed Rule, it was unclear whether valuation guidance would be issued at all and, if issued, whether it would entail formal rulemaking or another “statement” by the SEC or its staff (e.g., written statements, compliance guides, letters, speeches, responses to frequently asked questions, statements included in SEC orders issued as part of enforcement actions).
The use of a proposed rulemaking has several important advantages for boards as compared to different forms of guidance that otherwise could have been issued by the SEC or by its staff. In particular, a rulemaking will take effect only after the SEC publishes a notice of the proposed rulemaking and adopts a final rule which considers public comments on the proposal in accordance with the Administrative Procedure Act (the comment period for the Proposed Rule will remain open until July 21, 2020). In addition, an SEC rule has the force and effect of law, while SEC staff statements and other forms of staff guidance are non-binding and create no enforceable legal rights or obligations of the SEC or other parties. As a result, the Proposed Rule, in whatever form it may be adopted, would provide more certainty that a board is satisfying its fair value obligations under the 1940 Act by fully complying with the requirements of the Proposed Rule. In addition, an investment adviser would have clear authority to conduct fair value determinations upon assignment of such responsibility from the board in accordance with the Proposed Rule. For boards in particular, the Proposed Rule is a welcome development given the past willingness of the SEC to take enforcement actions against individual fund directors in connection with their role with respect to valuation and their involvement in determining in good faith the fair value of securities, most notably in the Morgan Keegan Case.[7] Indeed, valuation-related conduct (or lack of conduct) on the part of fund directors has been the catalyst for many of the publicly available SEC enforcement actions brought against individual fund directors, which have been uncommon, but not unprecedented.
II. REQUIREMENTS FOR DETERMINING FAIR VALUE IN GOOD FAITH
The Proposed Rule would establish a set of required functions (collectively, the “Required Functions”) that must be performed in order to determine in good faith the fair value of the fund’s investments for purposes of the 1940 Act. The Required Functions would apply either (1) to a fund’s board that is determining fair value or (2) if the board chooses to assign any fair valuation determinations to an investment adviser in accordance with the Proposed Rule (as discussed in Section III below), to that adviser. The Required Functions consist of the following and are described in further detail in Sections II.A-F below: (i) assessing and managing material risks associated with fair value determinations; (ii) selecting, applying, and testing fair value methodologies; (iii) overseeing and evaluating any pricing services used; (iv) adopting and implementing policies and procedures addressing fair value determinations; and (v) maintaining certain records relating to fair value determinations. The Required Functions generally reflect the SEC’s understanding of current practices used by funds to fair value their investments and are designed to establish a minimum, consistent framework for fair value and standard baseline practices across funds.
A. ASSESSING AND MANAGING VALUATION RISKS
The Proposed Rule would require the board, or an investment adviser as its assignee, to periodically assess “any material risks associated with the determination of the fair value of the fund’s investments (‘valuation risks’), including material conflicts of interest, and manag[e] those identified valuation risks.” Other than material conflicts of interest, the Proposed Rule does not identify the specific valuation risks to be addressed under this requirement. Instead, the SEC believes that specific valuation risks would depend on the facts and circumstances of a particular fund’s investments.[8] The Proposed Rule also does not include a specific frequency for the required periodic re-assessment of a fund’s valuation risks, as the Release states that different frequencies may be appropriate for different funds or risks. Permissible frequencies for re-assessing valuation risks could include, for example, annually or quarterly. Nor does the Proposed Rule list any specific factors that must be considered in conducting a periodic assessment of the fund’s valuation risks. However, the Release states that the periodic re-assessment 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.
B. FAIR VALUATION METHODOLOGIES
Selecting and Applying Fair Value Methodologies
The Proposed Rule would require the board, or an investment adviser as its assignee, to select and apply “in a consistent manner an appropriate methodology or methodologies for determining (which includes calculating) the fair value of fund investments,” taking into account the fund’s valuation risks. The Release indicates that the SEC believes “there is no single methodology for determining fair value of an investment because fair value depends on the facts and circumstance of each investment, including the relevant market and market participants.” In this regard, the Release provides that the SEC continues to “believe that for any particular investment there may be a range of appropriate values that could reasonably be considered to be fair value,” and that, accordingly, the SEC expects “that the methodologies used may reflect this range of potential fair values and result in unbiased determinations of fair value with the range.”
However, in order to be appropriate under the Proposed Rule, and in accordance with current accounting standards, the methodologies selected and used for purposes of determining fair value must be consistent with ASC Topic 820. Therefore, an appropriate methodology under the Proposed Rule would be one that is derived from any of the valuation approaches, techniques or methods identified in ASC Topic 820 as a way in which to measure fair value, each of which should involve maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.
The requirement to select and consistently apply appropriate fair value methodologies would include specifying “the key inputs and assumptions specific to each asset class or portfolio holding.” By way of example, in specifying these inputs and assumptions, the Release provides that it would not be sufficient to state that private equity investments are valued using a discounted cash flow model without providing any additional detail on the specific qualitative and quantitative factors to be considered, the sources of the methodology’s inputs and assumptions, and a description of how the calculation is to be performed.
The requirement would also include specifying “which methodologies apply to new types of fund investments in which the fund intends to invest” in the future but does not currently hold. According to the Release, the board or an investment adviser, as applicable, generally should address, prior to the fund’s investing in a new type of investment, whether readily available market quotations will be used or if the investment may need to be fair valued on occasion or at all times. For certain types of investments, it should be clear that the asset will require a fair value at all times; for others, however, market quotations may sometimes be readily available and sometimes not, such that a fair value periodically will need to be determined. The Release also states that the board or an investment adviser, as applicable, generally should seek to identify the sources of price inputs before the fund invests in such asset classes, if possible, and generally should document these decisions.
Periodically Reviewing the Selected Fair Value Methodologies
The Proposed Rule would require the board, or an investment adviser as its assignee, to periodically review “the appropriateness and accuracy of the methodologies selected and mak[e] any necessary adjustments thereto,” taking into account the fund’s valuation risks. Adjustments could be necessitated based on, among other things, the results of back-testing (i.e., comparing the fair value ascribed to the fund’s investment against observed transactions or other market information) or calibration (i.e., the process of monitoring and evaluating whether there are material differences between the actual price the fund paid to acquire portfolio holdings that received a fair value and the prices calculated for those holdings by the fund’s fair value methodology at the time of acquisition) or a change in circumstances specific to an investment.[9] Although the Proposed Rule would require that fair value methodologies be consistently applied to the asset classes for which they are relevant, there can be circumstances where it is appropriate to adjust methodologies if the adjustments would result in a measurement that is equally or more representative of fair value. Thus, the Proposed Rule’s requirement to apply methodologies in a consistent manner would not preclude the board or an investment adviser, as applicable, from changing the methodology for an investment in such circumstances.
Monitoring for Circumstances that Necessitate the Use of Fair Value and Establishing Criteria for Determining When Market Quotations Are No Longer Reliable
The Proposed Rule would require the board, or an investment adviser as its assignee, to monitor “for circumstances that may necessitate the use of fair value” as determined in good faith, taking into account the fund’s valuation risks. Because the use of fair value is required when market quotations are not readily available, the Proposed Rule would also require the board, or an investment adviser as its assignee, to “[establish] criteria for determining when market quotations are no longer reliable,” and therefore are not readily available, taking into account the fund’s valuation risks. For example, if a fund invests in securities that trade in foreign markets, the Release states that the board or an investment adviser, as applicable, 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.
C. TESTING FAIR VALUE METHODOLOGIES
The Proposed Rule would require the board, or an investment adviser as its assignee, to test “the appropriateness and accuracy of the fair value methodologies that have been selected.” Although the Proposed Rule would require the identification of (1) “the testing methods to be used” and (2) the “minimum frequency with which such testing methods are used,” the Release provides that the specific tests to be performed and the minimum frequency of the testing are matters that depend on the circumstances of each fund and thus should be determined by the board or an investment adviser, as applicable. In the Release, the SEC identifies the results of back-testing and calibration as potentially useful in identifying trends and assisting in identifying issues with methodologies applied by fund service providers, including poor performance or potential conflicts of interest. For example, if a specific methodology consistently over- or under-values one or more fund investments as compared to observed transactions, the Release states that the board or an investment adviser, as applicable, should investigate the reasons for this difference.
D. EVALUATION OF PRICING SERVICES
Pricing services are third parties that regularly provide funds with information on evaluated prices, matrix prices, price opinions, or similar pricing estimates or information to assist in determining the fair value of fund investments. Pricing services may be especially useful in obtaining valuation information for thinly traded or more complex assets.
The Proposed Rule would require the board, or an investment adviser as its assignee, to oversee pricing services, if used. Specifically, for funds that use pricing services, the Proposed Rule would require that the board or an investment adviser, as applicable, establish: (1) a “process for the approval, monitoring, and evaluation of each pricing service provider”[10] and (2) the “criteria for initiating price challenges” (e.g., establishing objective thresholds). Price challenges involve, for example, the fund disagreeing with an evaluated price provided by a pricing service and providing additional information to the service suggesting that the provided evaluated price is not correct. The requirement to establish criteria for the circumstances under which price challenges would be initiated is designed to address situations when pricing information from a pricing service differs materially from the board’s or adviser’s view of the fair value of the investment, and the board or an investment adviser, as applicable, may seek to contact the pricing service to question the basis for the pricing information.
E. FAIR VALUE POLICIES AND PROCEDURES
The Proposed Rule would require “adopting and implementing written policies and procedures addressing the determination of the fair value of the fund’s investment” (the “fair value policies and procedures”). The fair value policies and procedures would be required to be “reasonably designed to achieve compliance” with the requirements of the Proposed Rule described above in Sections II.A-D. Under the Proposed Rule, where the board determines the fair value of investments, the fair value policies and procedures would be approved by the board, and adopted and implemented by the fund. Alternatively, where the board assigns fair value determinations to the adviser in accordance with the Proposed Rule (as described in Section III below), 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.
With respect to the interplay between Rule 38a-1 under the 1940 Act and the Proposed Rule, Rule 38-1 would apply to a fund’s obligations under the Proposed Rule, and would require a fund’s board to oversee compliance with the Proposed Rule.[11] If the adviser adopts fair value policies and procedures under the Proposed Rule, the fund would still be required to have in place fund valuation policies under Rule 38a-1. The Release clarifies that, in this scenario, to the extent the adviser’s fair value policies and procedures would otherwise be duplicative of the fund valuation policies, the fund could adopt the adviser’s fair value policies and procedures in fulfilling its Rule 38a-1 obligations to avoid any duplication. In addition, the Rule 38a-1 Adopting Release includes a discussion of specific policies and procedures required regarding the pricing of portfolio securities and fund shares.[12] In relevant part, the discussion requires funds to adopt policies and procedures that address fair valuation. The matters required to be covered in such policies and procedures pursuant to Rule 38a-1 overlap to some extent with the requirements of the Proposed Rule described above in Section II.A-D. Accordingly, the Release provides that if the Proposed Rule is adopted, the Proposed Rule’s requirements would supersede the relevant discussion in the Rule 38a-1 Adopting Release.
F. RECORDKEEPING
The Proposed Rule would require that funds maintain certain records, both where the board itself determines the fair value of investments and where it assigns fair value determinations to an adviser in accordance with the Proposed Rule (as described in Section III below). Specifically, the Proposed Rule would require maintenance of: (1) appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations, as well as any necessary or appropriate adjustments in methodologies, for at least five years from the time the determination was made, the first two years in an easily accessible place; and (2) a copy of fair value policies and procedures that would be required under the Proposed Rule that are in effect, or that were in effect at any time within the past five years, in an easily accessible place.
III. PERFORMANCE OF FAIR VALUE DETERMINATIONS
Fund boards have a critical role in connection with determinations of fair value under the 1940 Act. The SEC previously has taken the position that a fund’s board may not delegate the determination of fair value to anyone else. However, the SEC also has recognized that compliance with the 1940 Act does not require the board to perform each of the specified tasks required to calculate fair value itself, which reflects the reality that determinations of fair value often require significant resources and specialized expertise, and that in many cases it may be impracticable for directors themselves to perform every one of the necessary tasks without assistance. For these reasons, and as acknowledged in the Release, “few boards today are directly involved in the performance of the day-to-day valuation tasks required to determine fair value.” Instead, such boards enlist the fund’s investment adviser to perform certain of these functions, subject to the boards’ supervision and oversight. In recognition of the SEC’s continued belief that “allocating day-to-day responsibilities to an investment adviser, subject to robust board oversight, is appropriate and consistent with the requirements of the [1940] Act,” the Proposed Rule is designed to provide a consistent framework for this allocation between boards and advisers, while also preserving a crucial role for boards to fulfil their obligations under the 1940 Act.
Under the Proposed Rule, a fund board may choose to “determine fair value in good faith for any or all fund investments by carrying out all of the [Required Functions],” including, among other things, monitoring for circumstances that necessitate fair value, selecting valuation methodologies, and applying those methodologies.[13] However, a board would not be required to take this approach. Instead, the Proposed Rule would permit a fund’s board to “choose to assign the fair value determination relating to any or all fund investments to an investment adviser of the fund.” When a board assigns the determination of fair value to an adviser, the adviser would be required to carry out all of the Required Funds. In addition, any board assignment under the Proposed Rule would be subject to the following additional requirements designed to facilitate the board’s ability effectively to oversee the adviser’s fair value determinations (each of these additional requirements is described in further detail in Sections III.A-C below): (i) board oversight of the adviser; (ii) periodic and prompt reporting to the board; (iii) clear specification of responsibilities and reasonable segregation of duties among the adviser’s personnel; and (iv) keeping additional records relevant to the assignment to the adviser.[14]
A fund’s board would be permitted to assign fair value determinations to a fund’s primary adviser or one or more sub-advisers. As a result, a multi-manager fund could have multiple advisers assigned the role of determining fair value of the different investments that those advisers manage. This approach may present additional complexities with respect to overseeing multiple assigned advisers, including, for example, challenges regarding how to address reconciling differing opinions on the same investment (if applicable) and establishing clear reporting structures. Accordingly, the Release states that the fund’s policies and procedures adopted under Rule 38a-1 should address such additional complexities in order to be reasonably designed to avoid violating the federal securities laws.
A. BOARD OVERSIGHT
Where the board assigns fair value determinations to an adviser, the Proposed Rule would require the board to satisfy its statutory obligation with respect to such determinations by “oversee[ing] the adviser.” The Release provides that boards should approach this oversight responsibility “with a skeptical and objective view that takes account of the fund’s particular valuation risks, including with respect to conflicts, the appropriateness of the fair value determination process, and the skill and resources devoted to it.” The Release states that, in the SEC’s view, “effective oversight cannot be a passive activity,” that boards should “ask questions and seek relevant information,” and that boards should view oversight as “an iterative process and seek to identify potential issues and opportunities to improve the fund’s value process.” Further, the Proposed Rule would require the fund’s adviser to report to the board with respect to matters related to the adviser’s fair value process, in part to ensure that the board has sufficient information to conduct its oversight (as described in further detail in Section III.B below). The Release states that boards should also “request follow up information when appropriate and take reasonable steps to see that matters identified are addressed.” Notably, neither the Proposed Rule nor the Release would specifically require the board to approve or ratify fair value determinations calculated by the fund’s investment adviser.
The Release provides that the SEC expects a board engaged in this oversight process to use an appropriate level of scrutiny based on the fund’s valuation risks, including the extent to which the fair value of the fund’s investments depend on subjective inputs. For example, a board’s scrutiny likely would be different if a fund invests in publicly traded foreign companies than if the fund invests in private early stage companies. The Release states that the SEC expects a board’s level of scrutiny to increase commensurate with an increase in the level of subjectivity and the inputs and assumptions that are used to determine fair value and a corresponding decrease in the use of more objective measures.
The Release includes the following additional guidance on how the SEC believes a board should fulfill its oversight duty under the Proposed Rule: (1) boards should seek to identify potential conflicts of interest, monitor such conflicts, and take reasonable steps to manage such conflicts; (2) boards should probe the appropriateness of the adviser’s fair value processes; and (3) boards should consider the type, content and frequency of the reports they receive regarding the aspects of the adviser’s fair value determination process.
B. BOARD REPORTING
If the board assigns fair value determinations to an adviser, the Proposed Rule would require the adviser to provide both periodic and prompt “reports to the fund’s board, in writing, including such information as may be reasonably necessary for the board to evaluate the matters covered in the report[s].” These reporting requirements are intended to help ensure that boards receive the amount and type of information that they need to exercise their statutory and fiduciary duties and to oversee an adviser. As noted in the Release, the reports are intended to supplement, not replace, this oversight. To this end, the Release provides that such reports should “familiarize directors with the salient features of the adviser’s process and provide them with an understanding of how that process addresses the requirements of the [Proposed Rule].” There is flexibility, however, in the form that the content of such reports may take under the Proposed Rule, as the Release confirms that it would permissible to use narrative summaries, graphical representations, statistical analyses, dashboards, or exceptions-based reporting, among other methods.
Periodic Reporting
The Proposed Rule would require the adviser, at least quarterly, to provide the board, in writing, an “assessment of the adequacy and effectiveness of the investment 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 periodic reports must address the “assessment and management of material valuation risks” that would be required under the Proposed Rule. This would include “any material conflicts of interest of the investment adviser (and any other service provider).”
- Materials Changes to or Material Deviations from Methodologies. The periodic reports must describe any “materials changes to, or materials deviations from, the fair value methodologies” that would be established under the Proposed Rule.
- Testing Results. The periodic reports must include “the results of the testing of fair value methodologies” that would be required under the Proposed Rule.
- Resources. The periodic reports must address 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.”[15]
- Pricing Services. The periodic reports must describe “any material changes to the adviser’s process for selecting and overseeing pricing services,[16] as well as material events related to the adviser’s oversight of pricing services (such as changes of service providers used or price overrides).”
- Other Requested Information. The periodic reports must include any “other materials requested by the board related to the adviser’s process for determining the fair value of assigned investments.”
The reporting requirements would not mandate that the adviser’s reports include a list of each individual portfolio holding that received a fair value since the prior board meeting, although some boards, of course, may find this specific information useful and thus request that the adviser provide this level of detailed reporting. Instead, the Release indicates that the use of more targeted forms of reporting designed to identify trends, exceptions would provide a sufficient overview of the current state of the fair value process and may better facilitate the board’s oversight.
Prompt Reporting
If the board assigns fair value determinations to an adviser, the Proposed Rule would also require that the adviser report “promptly” to the board, in writing, “on matters associated with the adviser’s process that materially affect, or could have materially affected[17], 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[18] in the fund’s valuation risks.”
Under the Proposed Rule, the adviser would be required to provide these reports “promptly,” but in no event later than three days after the adviser becomes aware of the matter, rather than waiting until the next periodic report. This requirement is designed to balance the need for the board to be timely informed of material valuation issues, while allowing the adviser to evaluate and respond immediately. In cases where 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, an adviser may need an additional reasonable period time to determine and verify whether an event has or could materially affect the fair value of the portfolio assigned to the adviser. The Release clarifies that the verification period would not be counted as part of the “prompt” trigger period. However, the Release provides that, in general, the SEC believes that the verification and final determination process should be completed within three business days or less, including the day that the adviser becomes aware of the trigger event. Therefore, any prompt reports generally should occur not more than three business days after the adviser becomes aware of the event, but the adviser may, to the extent necessary, take limited additional time (but in no event more than three business days) for the verification and final determination process.
C. SPECIFICATION OF FUNCTIONS
If the board assigns fair value determinations to an adviser, the Proposed Rule would require the adviser to “specif[y] 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.” For example, according to the Release, the fair value policies and procedures generally should describe the composition and role of any committee or similar body established by the adviser to assist in the process of determining fair value (or reference any related charter or similar documents as appropriate) and identify the specific personnel with duties associated with price challenges, including those with the authority to override a price, and the roles and responsibilities of such persons.
In addition, the Proposed Rule would require the adviser to “reasonably segregate the process of making fair value determinations from the portfolio management of the fund.” The level and kinds of input that fund portfolio managers (or persons in related functions) have in the design or modification of fair value methodologies, or in the calculation of specific fair values, presents a significant source of potential adviser conflicts of interest in the fair value determination process. That is, because portfolio management personnel are often compensated in part based on the returns of the fund, a portfolio manager’s incentives may not be fully aligned with the fund with respect to the determination of fair value. For this reason, the Release asserts that a portfolio manager should not be making fair value determinations. However, it may be appropriate for portfolio managers to provide input into the process for determining fair value, given that, in many cases, a fund’s portfolio manager may be among the most knowledgeable person at an investment adviser (especially at a smaller advisory firm) regarding a fund’s portfolio holdings.
To balance these considerations, the Proposed Rule would permit fund portfolio managers to provide inputs that are used in the fair value determination process, provided that there is a reasonable segregation of functions. This requirement is designed to provide independent voices and administration of the process as a check on any potential conflicts of interest to the extent appropriate. The Release states that funds could institute this requirement through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. The Proposed Rule would allow funds to structure their fair value determination process and portfolio management functions in ways that are tailored to each fund’s facts and circumstances (e.g., the size and resources of the fund’s adviser), and would not mandate any prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific personnel. In this regard, the Release clarifies that the reasonable segregation requirement is not meant to indicate that portfolio management must necessarily be subject to a communications “firewall.”
D. RECORDS OF ASSIGNMENT
In addition to the records that would need to be kept as part of a good faith determination of fair value generally (as described in Section II.F above), the Proposed Rule would also require funds to keep records related to the fair value determinations assigned to the adviser. Specifically, the fund would be required to keep (1) copies of the reports and other information provided to the board required by the rule and (2) a specified list of the investments or investment types whose fair value determinations have been assigned to the adviser pursuant to the requirements of the Proposed Rule. In each case, these records would be required to be kept for at least five years after the end of the fiscal year in which the documents were provided to the board or the investments or investment types were assigned to the adviser, the first two years in an easily accessible place.
IV. DEFINITION OF “READILY AVAILABLE”
Under 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. Therefore, the board’s role in the valuation of a portfolio holding for purposes of fair value depends on whether market quotations are “readily available” for such a holding. The term “readily available” is not currently defined in the 1940 Act or the rules thereunder, although industry practice has developed to incorporate many of the concepts of ASC Topic 820 when evaluating whether market quotations are readily available.
The Proposed Rule would provide that a market quotation is “readily available” for purposes 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.” In all other circumstances, fair value would have to be used. Accordingly, the Proposed Rule would define “fair value” to mean “the value of a portfolio investment for which market quotations are not readily available” under the Proposed Rule. The Release notes that evaluated prices are not, by themselves, readily available market quotations, and “indications of interest” and “accommodation quotes” would also not be readily available market quotations for purposes of the Proposed Rule.
Under the Proposed Rule, a quotation would not be readily available if it is not reliable. The Release states that a quote would be considered unreliable (and therefore would not be readily available) under the Proposed Rule 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. For instance, the Release states that, under current U.S. GAAP, funds looking to the Proposed Rule would use previous closing prices for securities that principally trade on a closed foreign market to calculate the value of that security, except when an event has occurred since the time the value was established that is likely to have resulted in a change in such value. In such circumstances, the fund would need to fair value the security.
V. RESCISSION OR WITHDRAWAL OF PRIOR SEC RELEASES AND EXISTING SEC STAFF GUIDANCE
In connection with any adoption of the Proposed Rule, the SEC is proposing to rescind ASR 113 and ASR 118 in their entirety. The Release states that the SEC believes that, since ASR 113 and ASR 118 were issued, developments in accounting standards have modernized the approach to accounting topics addressed in ASR 113 and ASR 118, and that guidance provided in these releases may no longer be necessary due to the considerable evolution of market and fund investment practices since the releases were issued. Further, the Release states that the SEC also believes that many of the matters addressed in ASR 113 and ASR 118 would be superseded by the Proposed Rule, or also have been superseded by subsequent requirements under U.S. GAAP.
In addition, certain SEC staff letters and other staff guidance addressing a board’s determination of fair value and other matters covered by the Proposed Rule would be withdrawn or rescinded in connection with any adoption of the Proposed Rule on the basis that such letters and other guidance, or portions thereof, would be moot, superseded, or otherwise inconsistent with the final rule. Among the SEC staff guidance that would be withdrawn are the ICI Letters from 1999 and 2001, which together provide guidance on fair value generally, and the FAQ #1 of the Valuation Guidance Frequently Asked Questions published by the SEC staff in 2014, which provides guidance on fund directors’ responsibilities when determining whether an evaluated price provided by a pricing service, or some other price, constitutes fair value.[19] However, the SEC’s prior guidance regarding the use of the amortized cost method in the Money Market Fund Release would not be modified or rescinded, as the Release notes that the SEC recently considered this topic in 2014 and believes that further guidance in this area is not required at this time.
The Release indicates that if commenters believe that additional letters or other guidance, or portions thereof, should be withdrawn or rescinded, they should identify the letter or guidance, state why it is relevant to the Proposed Rule, how it or any specific portion thereof should be treated, and the reason why it should be treated as such.
VI. PROPOSED TRANSITION PERIOD
The SEC proposed a one-year transition period to provide time for funds and their advisers to prepare to come into compliance with the Proposed Rule. The effective date of any adoption of the Proposed Rule, therefore, would be one year following the publication of the final rule in the Federal Register. At that time, the SEC would rescind ASR 113 and ASR 118, and the identified SEC staff letters and other guidance would be rescinded or withdrawn.
VII. ALTERNATIVES
In the Release, the SEC describes the following three alternatives that it considered in connection with deciding to issue the Proposed Rule:
- More Principles-Based Approach. The SEC considered a more principles-based approach that would not specify the types of fair value functions that must be performed, but instead would only state that funds should have in place policies and procedures, reporting, and recordkeeping that would allow fair values to be determined in good faith by the board or the investment adviser. Although the benefits of such an approach would be that funds would have more flexibility to tailor their policies and procedures, reporting, and recordkeeping to their valuation needs, the SEC believes that under such an approach funds could be less certain on how to comply with the Proposed Rule, which could increase compliance costs and may not adequately ensure that boards provide sufficient oversight over the investment adviser’s fair value determinations. Further, unlike the consistent framework for funds to apply under the Proposed Rule, the SEC believes that a more principles-based approach would not mandate a minimum prescribed set of fair value policies and procedures, reporting, and recordkeeping. Consequently, the SEC believes that not all funds necessarily would put in place adequate policies and procedures, reporting, and recordkeeping to achieve accurate and unbiased fair value determinations. For these reasons, the SEC did not opt to incorporate a more principles-based approach in the Proposed Rule.
- Assignment of Responsibilities to Service Providers Other Than Investment Advisers. The SEC considered allowing the board to assign the fair value determinations to service providers other than the investment adviser, such as a pricing service provider. Such an approach would provide additional flexibility to boards and could free up board resources tied to fair value determinations and redirect them to oversight in situations where the investment adviser was unable or unwilling to accept the responsibility to determine the fair value of fund investments. However, the SEC believes that such an approach potentially could limit a board’s ability to effectively oversee the service provider that performs the fair value determinations because the board does not have the same level of visibility, access to information, and control over the actions of service providers other than the investment adviser. In addition, the SEC believes that this approach potentially could compromise the integrity of fair values because, unlike an investment adviser to a fund, other service providers may not owe a fiduciary duty to the fund and thus their obligation to serve the fund’s and its shareholders’ best interests may be limited. As a result, the SEC decided not to permit boards to assign fair value determinations to service providers other than investment adviser.
- Not Permit Boards to Assign Fair Value Determinations to an Investment Adviser. The SEC considered not permitting fund boards to assign the fair value determinations to an investment adviser to the fund but instead only requiring funds to adopt the policies and procedures, reporting, and recordkeeping as described in the Proposed Rule. The SEC also considered requiring boards periodically to ratify the fair value determinations calculated by the fund’s adviser using the methodology determined by the board. The SEC believes that such an approach would not give funds the flexibility to leverage the fair value expertise of the investment adviser and assign a role to the fund’s board that is more in line with the board’s experience and expertise. Relatedly, the SEC believes that such an approach would not result in more efficient use of boards’ time and more efficient fund operations, and would not result in improvements in fund governance, which would ultimately benefit fund investors. Consequently, the SEC decided to permit boards to assign fair value determinations to an investment adviser, subject to the requirements set forth in the Proposed Rule.
[1] All references herein to the “board” as used in the context of the Proposed Rule mean the fund’s entire board of directors or a designated committee of such board composed of a majority of directors who are not “interested persons” of the fund (i.e., independent directors), as that term is defined in the 1940 Act. The Proposed Rule defines the term “board” to include a designated committee of the board composed of a majority of the fund’s independent directors (for example, an audit committee). Therefore, the responsibilities of the board under the Proposed Rule could be performed either by the fund’s entire board or by any such designated committee.
[2] The Proposed Rule would apply to all registered funds, regardless of their classification or sub-classification (e.g., open-end funds (including money market funds and exchange-traded funds)) and closed-end funds (including business development companies, interval funds and tender offer funds), or their investment objectives or strategies (e.g., equity or fixed income; actively managed or passively tracking an index). In the case of a unit investment trust (“UIT”), because a UIT does not have a board or investment adviser, a UIT’s trustee would conduct fair value determinations under the Proposed Rule.
[3] This Client Alert generally uses the term “fair value” herein as that term is defined in the definition of “value” in the 1940 Act, which is the value of securities for which no readily available market quotations exist.
[4] Good Faith Determinations of Fair Value, Investment Company Act Release No. 33845 (April 21, 2020)
[5] In general, ASR 113 addressed a number of federal securities law and accounting topics related to the purchase of restricted securities by funds, including how to determine fair value for such securities. A year later, ASR 118 expressed the SEC’s views on certain valuation matters, including accounting and auditing, as well as the role of the board in the determination of fair value. The SEC acknowledged in ASR 113 and ASR 118 that the board need not itself perform each of the specific tasks required to calculate fair value in order to satisfy its obligations under the 1940 Act. However, under ASR 113 and ASR 118, the board chooses the methods used to arrive at fair value, and continuously reviews the appropriateness of such methods. In addition, the SEC stated that boards should consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available. The SEC also stated that whenever technical assistance is requested from individuals who are not directors, the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the result valuations are fair.
[6] In contrast to the 1940 Act, ASC Topic 820 uses the term “fair value” to refer generally to the value of an asset or liability, regardless of whether the value is based on readily available market quotations or on other inputs.
[7] See In the Matter of J. Kenneth Alderman, et al., Investment Company Act Release No. 30557 (June 13, 2013). In the Morgan Keegan Case, eight former directors of registered funds settled claims by the SEC that they failed to fulfill their responsibility to properly oversee the fair valuation process for the during the period from January 2007 to August 2007. In relevant part, the SEC found that the directors had failed to “specify a fair valuation methodology pursuant to which the securities were to be fair valued” and, in this regard, that the directors “approved policies generally describing the factors to be considered but failed to determine what was actually being done to implement those policies.” The SEC concluded that, as a result, the directors failed to exercise their responsibilities with regard to the adoption and implementation by the funds of procedures reasonably designed to prevent violations of the federal securities laws. Although no monetary sanctions were assessed on any individual fund director, the SEC’s order found that the directors caused the funds to violate Rule 38a-1 under the 1940 Act and were ordered to cease and desist from causing any future violations of Rule 38a-1. See also In the Matter of Heartland Advisors, Inc., William J. Nasgovitz, et al., Investment Company Act Release No. 28136 (Jan. 25, 2008); Parnassus Invs., Exchange Act Release No. 40534, 68 SEC Docket 586 (Oct. 8, 1998).
[8] The Release includes a non-exhaustive list of the types or sources of valuation risk, which includes: (i) the types of investments held or intended to be held by the fund; (ii) potential market or sector shocks or dislocations; (iii) the extent to which each fair value methodology uses observable inputs, particularly if such inputs are provided by the adviser; (iv) the proportion of the fund’s investments that are fair valued as determined in good faith, and their contribution to the fund’s returns; (v) 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; and (vi) the risk that methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.
[9] ASC Topic 820 provides a non-exhaustive list of events that may warrant a change or an adjustment to a valuation technique, including where (1) new markets develop, (2) new information becomes available, (3) information previously used is no longer available, (4) the valuation technique improves, and (5) market conditions change. According to the Release, boards or advisers, as applicable, generally should seek to account for such occurrences and consider specifying alternative sources.
[10] The Release provides that, in conducting such evaluation, the board or an investment adviser, as applicable, 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.
[11] Rule 38a-1 requires a fund’s board, including a majority of its independent directors, to approve the fund’s policies and procedures, including those on fair value, and those of each investment adviser and other specified service providers, based upon a finding by the board that the policies and procedures are reasonably designed to prevent violation of the federal securities laws. Rule 38a-1 also requires that the fund’s chief compliance officer provide and annual report to the fund board that must address any material changes to compliance policies and procedures.
[12] Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299, at nn.39–47 and accompanying text (Dec. 17, 2003).
[13] As noted above, because a UIT does not have a board of directors or an investment, a UIT’s trustee would conduct fair value determinations under the Proposed Rue.
[14] The assignment of fair value determinations to investment advisers pursuant to the Proposed Rule raises a question of whether advisers would seek additional compensation for their responsibilities under the Proposed Rule. In the Release, the SEC specifically requested comments on, among other things, whether any such assignment would change the services provided by advisers with respect to valuation and, if so, whether such a change would have any implications for the board’s consideration of the advisory contract under Section 15(c) of the 1940 Act (e.g., changes in compensation).
[15] For example, the Release states that an adviser should disclose to the board when the adviser seeks to hire a new pricing service to cover a new asset type or when replacing a person with a background in valuation with a person without that background in a position of authority regarding the adviser’s fair value process.
[16] The Release notes that board generally would be aware of an adviser initially appointing, and the establishment of the process for overseeing, a pricing service as part of its oversight and approval of the adviser’s policies and procedures under Rule 38a-1. Accordingly, the Release provides that the SEC is not specifically proposing to require that information be included in these periodic reports.
[17] As explained in the Release, “could have materially” is intended to capture certain circumstances where, for example, “a matter was detected which affected one security and which may not be material on its own, but, had the matter not been identified, could have materially affected the larger assigned portfolio of investments or some subset of that portfolio.” This concept, however, is not intended to mandate reporting in circumstances “where, at the time the matter was detected, it did not seem that the matter would materially affect the fair value of the assigned portfolio but the matter later ended up having such an effect.”
[18] For example, the Release states that a significant increase in price challenges or overrides likely would reflect a material change to the fund’s valuation risks that should be promptly reported to the board.
[19] The additional staff letters and guidance that would be withdrawn or rescinded would include, but would not necessarily be limited to, the following letters and other guidance: Paul Revere Investors, Inc. (Feb. 21, 1973) (delegation to a board valuation committee); The Putnam Growth Fund and Putnam International Equities Fund, Inc. (Jan. 23, 1981) (fair value of portfolio securities which trade on a closed foreign exchange); and Form N-7 for Registration of Unit Investment Trusts under the Securities Act of 1933 and the Investment Company Act of 1940, Investment Company Release No. 15612, Appendix B, Guide 2 (Mar. 17, 1987) (fair value for UITs to be determined by the trustee or its appointed person).
