Significant regulatory developments coupled with the expansion and complexity of asset portfolios under management have altered how boards, investment advisers, and other market participants address valuation under the federal securities laws. Asset valuation practices have evolved over the years and many funds now engage third-party pricing services to provide asset valuation information, particularly for thinly traded or more complex assets. As a result, the US Securities and Exchange Commission (SEC) proposed a new Rule 2a-5 under the Investment Company Act of 1940 (1940 Act) that would provide boards and investment advisers of registered investment companies with a consistent, modern approach to the determination of fair value. It also sets out requirements for the board should it choose to assign fair value functions to the investment adviser, while still fulfilling its responsibilities through active oversight.
The proposed rule would apply to all registered investment companies and BDCs, regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds, including BDCs), or their investment objectives or strategies (e.g., equity or fixed income, actively managed or tracking an index). In the case of unit investment trusts (UITs), trustees would conduct fair value determinations under the proposed rule since a UIT does not have a board of directors or investment adviser.
In addition to funding board of directors and investment advisors, the rule will likely affect third-party pricing services, trustees, fund valuation committees, and third-party administrators having fiduciary responsibilities. A one-year transition period has been proposed so funds and their advisers can prepare to comply with the proposed rule.
Highlights of the proposed rule
The rule would require the board, management and, in the case of UITs, trustees to assess and manage material risks associated with fair value determinations in good faith. This will require that they:
5 questions you need to answer now
- Routinely assess and manage material risks associated with fair value determinations
- Select, apply and test fair value methodologies
- Oversee and evaluate any pricing services used
- Adopt and implement written policies and procedures addressing fair value determination
- Maintain records evidencing the execution of fair value process
The proposed rule raises key issues and questions that funds need to consider now as they plan their response. These include:
Catalysts behind the new rule
- How will a firm demonstrate compliance with the new rule? Are there necessary processes and reporting mechanisms to show sufficient fair value process, governance and oversight mechanisms over fair value determination?
- Has the firm established a governing body (such as valuation committee) and escalation protocols to provide the board with sufficient resources to enable required valuation process oversight?
- Does the firm have a robust pricing vendor due diligence process, documentation and oversight?
- Has the firm created valuation policies, procedures and documented valuation methodologies for each asset class under management?
- Is there a process that will ensure asset prices are accurate, which may include testing of valuation methodologies, price backtesting, calibration and other similar activities? What is the process for capturing and ongoing review the unobservable valuation inputs?
The SEC last issued valuation guidance in 1970. It cites several regulations and developments since then as an impetus for the proposed rule:
- Major technological changes have altered market and investment practices. Advances in communications technology have greatly enhanced the availability of pricing information and data that influence fair value determinations. Many funds now use third-party pricing services, particularly for thinly traded and complex assets.
- The enactment of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) and the resulting establishment of the Public Company Accounting Oversight Board (PCAOB) added another level of rules and requirements for mutual funds and auditors. In 2003, the SEC adopted compliance rules under the 1940 Act and Investment Advisers Act that require funds and registered investment advisers to adopt and implement written compliance policies and procedures to reasonably prevent violations of the federal securities laws.
- The FASB issued and codified fair value guidance in ASC 820 of generally accepted accounting standards (GAAP), which defined fair value for purposes of the accounting standards for public filers (including mutual funds), and established a framework for recognition, measurement and disclosure of fair value.
- Boards are increasingly anxious over the extent of their involvement in the valuation process and over details stemming from a high-profile SEC enforcement action against fund directors in 2012 for failing to comply with their valuation responsibilities under the 1940 Act — including developing policies, procedures and processes to properly oversee asset valuation.
- SEC’s staff provided valuation guidance for boards in a frequently asked questions release for money-market funds.
As a result, boards have been questioning what level of detail, knowledge and oversight they need to have to fulfill fair value responsibilities, while the universe of investments by fund has grown more complex.
Impact on the fair value process
The proposed rule would permit a fund’s board of directors to assign the fair value determination to an investment adviser, subject to additional conditions and oversight requirements including a written report to the board, at least quarterly, describing the execution of the following key required functions:
- Valuation Risks - A board or adviser would periodically assess material valuation risks and any material conflicts of interest and manage those identified valuation risks. The following key factors should be considered is assessing valuation risk:
- the types of investments held or intended to be held by the fund
- potential market or sector shocks or dislocations
- the extent to which each fair value methodology uses unobservable inputs
- 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)
- reliability of data obtained from pricing services
- the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly considering changes in market liquidity
- reliance on a single source for pricing data
- use of internally developed models to value securities
- extensive use of matrix pricing
- the process surrounding the adviser’s price overrides
- Fair Value Methodologies and Testing – The rule requires selecting and applying in a consistent manner an appropriate methodology for determining the fair value of fund investments. This requirement would include the following considerations:
- determine the key inputs and assumptions specific to each asset class or portfolio holding
- periodic reviews of the selected fair value methodologies for appropriateness and accuracy, and adjustments to the methodologies where necessary
- specify any material changes or deviations of established fair value methodologies
- the methodologies that will apply to new types of investments
- identify fair value methodology testing methods and documentation of testing results
- Pricing Services – The board or investment advisers would be required to establish the oversight and evaluation of pricing services used in the determination of fair value. They would also have to ensure that pricing information received from pricing services is accurate and reliable input in determining fair value in good faith. The board or advisers will have to establish a process for the approval, monitoring, and evaluation of each pricing service provider, while considering the following key factors:
- 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
- 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
- establish criteria for the circumstances under which price challenges typically would be initiated, including objective thresholds
- material changes to the selection and oversight process for pricing services used, including all price overrides
- The adequacy of resources allocated to the fair value process
- Fair Value Policies and Procedures – The proposed rule would require written fair value policies and procedures addressing the determination of the fair value of the fund’s investments to be reasonably designed to achieve compliance with the new rule.
- Recordkeeping - The fund would be required to maintain appropriate documentation to support fair value determinations for at least five years from the time the determination is made. This documentation would include 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.
Boards should critically review the information provided to them by investment advisors and establish robust oversight parameters and processes, which may include the review of the following control activities and reports:
- Summaries of adviser challenges to pricing information provided by third-party vendors and of price overrides, including back-testing results related to the use of price challenges and overrides
- Specific calibration and back-testing data
- Reports regarding portfolio holdings for which there has been no change in price or for which investments have been held at cost for an extended period (stale prices)
- Reports regarding portfolio holdings, the price of which has changed, outside of predetermined ranges over a set period
- Narrative summaries or reports on pricing errors, including the date of any error, the cause, the impact on the fund’s NAV, and any remedial actions taken in response to the error
- Reports on the adviser’s due diligence of pricing services used by the fund
- The results of testing by the fund’s independent auditor provided to the audit committee
- Reports analyzing trends in the number of the fund’s portfolio holdings that received a fair value estimate, as well as the percentage of the fund’s assets that received a fair value estimate
- Reports on the number and materiality of securities whose fair values were determined based on information provided by broker-dealers; the broker-dealers most frequently used for this purpose; and the results of backtesting on the information they provided
Further, the proposed rule would require that the adviser report to the board, within three days and in writing, any matters associated with the adviser’s process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments. This would include any 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.
The proposed rule would also require the funds to reasonably segregate the process of making fair value determinations from the portfolio management of the fund.
Investment funds and BDCs should act now to understand and prepare for this change to the 1940 Act.
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