Registered Fund Valuation Practices Under Investment Company Act

Published: Mar 5, 2021
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Background

Financial markets and fund investment practices have changed substantially since the SEC last addressed fund valuation comprehensively 50 years ago.

Although market practice and operational issues warranted for a long time that a fund’s board of directors assign day-to-day valuation to a fund’s officers, investment advisor, administrator, and other agents; boards have done so in accordance with a somewhat outdated patchwork of regulatory guidance and SEC staff positions. As the market has become more complex and inputs for valuation have become more voluminous, boards have sometimes struggled to interpret their responsibility for fund valuation under the current regulatory framework.

Introduction to SEC’s New Rule 2a-5 and Rule 31a-4

Rule 2a-5: On December 3, 2020, the 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 clarifies the obligations of fund’s board of directors with respect to the fair valuation of the investments of registered investment companies (including mutual funds, exchange-traded funds (ETFs), registered closed-end funds, unit investment trusts) and business development companies (collectively, funds).

The SEC believes that Rule 2a-5 is necessary due to funds investing a larger amount in a wider variety of securities and other instruments than before, enhanced availability and volume of data used in valuation determinations, and increased use of third-party pricing services. Rule 2a-5 does not establish a single, one-size-fits-all approach but rather establishes a principles-based framework for boards to use in creating their own tailored processes for making fair value determinations. In addition, Rule 2a-5 requires a registered fund’s “valuation designee” to reasonably segregate fair value determinations from the portfolio management of the fund.

Who are the valuation designees? The Final Rule permits a fund’s board to designate a “valuation designee” to perform fair value determinations. The valuation designee is restricted to the investment advisor, or in case of an internally managed fund, to an employee of the fund. Even when using a valuation designee, the board retains the responsibility for the fair value determination. While the advice of sub-advisors and valuation specialists can be sought out, they cannot be a valuation designee of a board under the rule. The Final Rule also recognizes the important role and expertise provided by registered fund advisors in the valuation process.

The Final Rule establishes requirements for satisfying a fund board’s obligation to determine fair value in good faith for purposes of the Act. The rule requires a board or its valuation designee to meet the following requirements:

Periodically assess and manage material valuation risks, including material conflicts of interest;
Select and apply, in a consistent manner, appropriate fair value methodologies, periodically review the appropriateness and accuracy of selected methodologies and monitor for circumstances that necessitate the use of fair value as determined in good faith;
Test the appropriateness and accuracy of the selected fair value methodologies;
Oversee and evaluate any pricing services used, including establishing the process for approving, monitoring, and evaluating each pricing service provider and how price challenges are initiated;
Recordkeeping (see Rule 31a-4 below).

This Final Rule allows portfolio managers, who are the most knowledgeable person regarding the fund investments, to bring in important perspective and insight regarding the value of fund investments while addressing concerns regarding a portfolio manager’s conflict of interest.

Rule 31a-4: The SEC also adopted new rule 31a-4 (“Rule 31a-4”), which provides the recordkeeping requirements associated with fair value determinations.

It will require funds to maintain additional records for at least six years (two years should be easily accessible) relevant to the valuation designee, including the reports provided to the board by the valuation designee, title of persons responsible at the valuation designee and a list of the investments (or investment types) whose fair valuation has been designated. The SEC believes that this documentation should be sufficient for a third party, such as the SEC’s staff, not involved in the fair value determination to verify but not fully recreate the fair value determination, and it expects records to be more extensive when valuation inputs are more subjective.

Investments Covered

The Act requires a fund’s board to determine the fair value of any investments other than securities for which market quotations are “readily available.” The Final Rule states that a market quotation is readily available only when it is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date (i.e., a Level 1 input under U.S. GAAP), provided that a quotation will not be readily available if it is not reliable. The Final Rule notes that Level 2 inputs under the U.S. GAAP hierarchy are not consistent with the concept of readily available market quotations under the Act and as a result, the SEC believes that securities valued with Level 2 inputs are not consistent with the definition of readily available market quotations.

Rescission of Existing Guidance

The SEC rescinded the guidance on the recognition, measurement, disclosure and auditing of investment securities in Accounting Series Release Nos. 113 and 118 (“ASR 113” and “ASR 118”). The SEC believes this guidance is no longer needed, given the new rule and current accounting and auditing standards. With the rescission of ASR 118, auditors have the ability in the conduct of their audit procedures over valuation, under current PCAOB rules, to select a sample of a fund’s investments instead of 100% of the investments, which is currently required under ASR 118. However, the board of directors, if they so desire, can still request the auditors to perform 100% testing. The Final Rule doesn’t impact the statutory requirement in the Act that requires the auditor to test the existence assertion for all securities by verifying securities owned with the custodian or by actual examination.

Effective Date

The rule amendments go into effect on March 8, 2021, with a compliance date set for eighteen months following the effective date of the rules, to allow funds and valuation designees time to come into compliance with the new requirements. A fund may voluntarily comply with the rules after the effective date, and in advance of the compliance date, under certain conditions.