On December 3, 2020, the Securities and Exchange Commission (SEC) adopted new Rule 2a-5 (Rule) under the Investment Company Act of 1940, as amended (1940 Act), addressing valuation practices and the role of the board of directors/trustees with respect to determining the fair value of the investments of a registered investment company or business development company (fund).¹  The SEC also adopted a separate rule, Rule 31a-4, which governs the recordkeeping requirements associated with fair value determinations.

The rules become effective 60 days after publication in the Federal Register, which has not occurred as of the date of this client alert. Compliance with the rules is required 18 months after they become effective.²  Key aspects of the rules that are addressed in the Release are summarized below.

Rule 2a-5

Section 2(a)(41) of the 1940 Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations are “readily available,” and, when a market quotation for a portfolio security is not readily available or if the investment is not a security, by using the investment’s fair value, as determined in good faith by the fund’s board. The Rule: (i) provides requirements for determining fair value in good faith with respect to a fund for purposes of Section 2(a)(41); (ii) permits a fund’s board of directors/trustees (board³) to delegate the fair value determination to a “valuation designee,” subject to board oversight and certain other conditions; and (iii) defines when market quotations are readily available for purposes of the 1940 Act. The Rule also contains other requirements addressing valuation practices.

Determining Fair Value in Good Faith

Under the Rule, determining fair value in good faith for purposes of Section 2(a)(41) of the 1940 Act (“Section 2(a)(41)”) requires a fund to: (i) assess and manage material risks associated with fair value determinations, including material conflicts of interest; (ii) establish and apply fair value methodologies; (iii) test these fair value methodologies; (iv) oversee and evaluate pricing services; and (v) ensure that fair value policies and procedures are in place.

Each of the above required elements is discussed further below.

• Periodically assessing and managing material risks associated with fair value determinations, including material conflicts of interest.In the Release, the SEC stressed that the assessment and management of material valuation risks will help promote an effective overall process for fair valuing fund investments in good faith. The Rule itself does not identify specific valuation risks other than material conflicts of interest⁴that may need to be addressed under the requirement, but the Release provides the following non-exhaustive list of examples of sources or types of valuation risk:
  • the types of investments held or intended to be held by a fund and the characteristics of those investments;
  • potential market or sector shocks or dislocations and the types of disruptions that may affect a valuation designee’s or a third-party’s ability to operate;
  • the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the valuation designee;
  • the proportion of the fund’s investments that are fair valued as determined in good faith, and their contribution to the fund’s return;
  • reliance on service providers that have more limited expertise, the use of methodologies that rely on service provider inputs and service providers’ use of their own service providers; and
  • the risk that methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.

The Rule provides flexibility for boards or their valuation designees to determine which of the identified sources and types of valuation risks are relevant for a fund (as well as additional risks not cited in the Release).

The Rule does not include a required frequency for the periodic re-assessment of valuation risks, and the Release notes that different frequencies for the re-assessment of valuation risks may be appropriate for different funds or risks.

• Establishing and applying fair value methodologies. The Rule provides that fair value as determined in good faith requires a fund’s board or valuation designee, as applicable, to establish and apply fair value methodologies. To satisfy this requirement, a board or valuation designee must select and apply in a consistent manner an appropriate methodology or methodologies for determining the fair value of fund investments. Unlike the Proposing Release, the Rule (i) provides that the selected methodologies for fund investments may be changed if different methodologies are equally or more representative of the fair value of the investment and (ii) does not require the specification of methodologies that will apply to new types of investments in which the fund intends to invest. The Rule also requires that the selected methodologies be periodically reviewed for appropriateness and accuracy and that a board or valuation designee make changes or adjustments to the methodologies when necessary. In addition, the board or valuation designee must also monitor for circumstances that may necessitate the use of fair value.
• Testing fair value methodologies. The Rule requires testing the appropriateness and accuracy of the methodologies used to calculate fair value. This includes the identification of (i) the testing methods to be used, and (ii) the minimum frequency of the testing but does not require particular testing methods or a specific minimum frequency for testing.
• Overseeing and evaluating pricing services used. The Rule requires the board or valuation designee to establish a process for the approval, monitoring and evaluation of each pricing service provider that provides pricing information used by the fund as part of its fair valuation process. The Release states that factors that the board or valuation designee should generally consider before deciding to use a pricing service include the following:
  • 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 by market condition changes;
  • the quality of the pricing information provided by the service and the extent to which the service determines its pricing information as close as possible to the time when the fund calculates its net asset value (NAV);
  • the pricing service’s process for considering price challenges;
  • the pricing service’s actual and potential conflicts of interest and the steps taken to mitigate the conflicts; and
  • the testing processes used by pricing services.

Funds must also establish a process for initiating price challenges as appropriate. The Release indicates that this process generally should outline the circumstances under which a price challenge should be initiated.

5. Provisions for Fair value policies and procedures. As adopted, the Rule does not include a provision contained in the Proposing Release that would have separately required a fund to adopt written policies and procedures reasonably designed to achieve compliance with the Rule. The SEC noted in the Release, however, that policies designed to prevent violations of the Rule are required under Rule 38a-1 of the 1940 Act⁵(Compliance Rule) and are subject to approval by the board. If the adviser is delegated with valuation responsibilities by the board, the adviser is required to adopt procedures to comply with the Rule that must be approved by the board under the Compliance Rule.

Permitted Delegation and Performance of Fair Value Determinations

In the Release, the SEC stated that the Rule is designed to provide boards and valuation designees with a consistent, modern approach to the allocation of fair value functions, while also preserving a crucial role for boards in fulfilling their obligations under Section 2(a)(41). Under the Rule, a board can elect to determine by itself fair value in good faith for any or all fund investments by performing all of the functions required under the Rule. Alternatively, the board can delegate valuation determinations to the fund’s valuation designee – the fund’s investment adviser (but not a sub-adviser) or, if the fund is internally managed, an officer or officers of the fund – subject to certain conditions and oversight requirements discussed below. Under the Rule, a committee composed of independent trustees or directors can fulfill the functions performed by the board, consistent with current practices. Despite many comments from various industry participants, including the Investment Company Institute, investment advisers and legal groups, among others, recommending that the valuation designee include other types of service providers, such as fund administrators and pricing services, the SEC determined to limit valuation designees to fund advisers, underscoring the SEC’s belief that it was critical for the entity actually performing the fair value determinations to owe a fiduciary duty to the fund and be subject to direct board oversight whenever possible.⁶ The Release notes, however, that in fulfilling their duties regarding value determinations, boards and valuation designees may seek assistance from others such as pricing services, fund administrators, sub-advisers, accountants and counsel.

Conditions and Oversight Responsibilities

1. Board oversight of the valuation designee. The Rule permits a board to satisfy its statutory obligations under Section 2(a)(41) with respect to fair value determinations by overseeing the valuation designee responsible for making fair value determinations. In this regard, the SEC stated in the Release that the board must actively be engaged in the oversight process, using appropriate levels of scrutiny, including asking questions and seeking relevant information. A board should also seek to identify potential conflicts of interest of any valuation designee, monitor such conflicts and take reasonable steps to mitigate and manage them. A board should also consider the type, content and frequency of the reports it receives and inquire about material matters that the board becomes aware of from sources other than the valuation designee while taking reasonable steps to be sure that they are addressed.
2. Periodic and prompt reporting to the board.
   • Quarterly Reporting: The Rule requires a valuation designee to provide, at least quarterly to the board, in writing, any reports or materials requested by the board related to the fair value of designated investments or the valuation designee’s process for fair valuing fund investments and a summary or description of material fair value matters that occurred in the prior quarter. This summary and description must include: (i) any material changes in the assessment and management of the valuation designee (and any other service provider involved in the fair valuation process); (ii) any material changes to, or material deviations from, the fair value methodologies; and (iii) any material changes to the valuation designee’s process for selecting and overseeing pricing services, as well as any material events related to the valuation designee’s oversight of pricing services.
   • Annual Reporting: The Rule also requires the valuation designee to provide, at least annually to the board, in writing, an assessment of the adequacy and effectiveness of the valuation designee’s process for determining the fair value of the designated portfolio of investments. The annual report, at a minimum, must include a summary of the results of the testing of fair value methodologies required under the Rule and an assessment of the adequacy of resources allocated to the process for determining the fair value of designated investments.
   • Prompt Reporting: In addition, the Rule requires the valuation designee to provide a written notification of the occurrence of matters that materially affect the fair valuation of the designated portfolio of investments (defined as “material matters”) within a time period determined by the board, but in no event later than five business days after the valuation designee becomes aware of the material matter.⁷

3. Clear specifications of responsibilities and reasonable segregation of duties among the valuation designee’s personnel. The Rule requires a valuation designee to specify the titles and particular functions of the persons responsible for making fair value determinations.⁸Additionally, under the Rule, the valuation designee is required to reasonably segregate the process of making fair value determinations from the portfolio management of the fund.

Readily Available Market Quotations

A board’s role in the valuation of a portfolio holding for purposes of fair value depends on whether market quotations are “readily available” for the holding, but neither the 1940 Act nor the rules thereunder currently define the term. Under the Rule, a market quotation is readily available for purposes of Section 2(a)(41) with respect to a portfolio security 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.”⁹ The SEC emphasized in the Release that Section 2(a)(41) requires the use of market values only for securities for which market quotations are readily available and that non-security holdings must always be fair valued regardless of whether readily available market quotations exist for the holdings. The definition under the Rule is consistent with the definition of a level 1 input in the fair value hierarchy outlined in U.S. GAAP.¹⁰ The SEC stated in the Release that it does not believe that level 2 inputs are consistent with the concept of readily available market quotations, as securities valued using level 2 inputs include securities that are not traded on an active market, and/or are valued using inputs other than quoted prices for the specific security.

The SEC noted in the Release that a quote would be considered unreliable under the Rule if the quote would require adjustment under U.S. GAAP or if U.S. GAAP would require consideration of additional inputs in determining the value of the quoted security (e.g., a significant event with respect to an issuer occurring subsequent to a foreign market closing that affects the closing market price of its securities). The SEC also reiterated that “evaluated prices” are not, by themselves, readily available market quotations and noted that “indications of interest” and “accommodation quotes” would not be readily available market quotations for purposes of the Rule.

The SEC explained that the definition of readily available market quotations applies in all contexts under the 1940 Act, including Rule 17a-7. Rule 17a-7 permits cross trades between affiliated mutual funds subject to certain conditions, including that the cross-traded security have a “readily available market quotation.” The Release noted that a number of commenters raised concerns that the proposed definition of readily available market quotations may affect current practices on cross trades under Rule 17a-7, specifically with respect to certain fixed-income securities. The Release acknowledged that certain securities that had been previously viewed as having readily available market quotations and being available to cross trade under rule 17a-7 may not meet the new definition and thus would not be available for such trades. The Release indicated that the SEC staff was reviewing for possible modification or withdrawal previous no-action guidance under Rule 17a-7 addressing the application of the term readily available market quotations in the context of certain transactions under Rule 17a-7. The Release noted separately that consideration of potential revisions to Rule 17a-7 was on the SEC’s rulemaking agenda.

Recordkeeping

The SEC adopted new Rule 31a-4, which contains the recordkeeping requirements associated with the Rule. Rule 31a-4 requires, substantially as originally provided in the Proposing Release, that funds or their advisers to maintain appropriate documentation to support fair value determinations. When a fund has designated a valuation designee, the reports provided to the board must include a specific list of the investments or investment types for which the valuation designee has been designated. Records will generally be required to be maintained for six years, the first two in an easily accessible place.

S&K Observations and Insights

The Rule provides a baseline for fund valuation practices and permits the board of a fund to delegate the valuation responsibilities to fund advisers, recognizing the industry practices that have been utilized for many years without the benefit of a formal regulatory sanction. While this likely means business as usual for many larger fund complexes, the SEC limited the parties to which a board can delegate this responsibility, such as fund administrators, and the Rule will require certain types of funds (such as many umbrella trusts, and in some cases, series trusts) to modify their practices. This may impact the arrangements between those trust sponsors and the investment advisers managing funds of the trust, as the advisers will likely be asked to take on these valuation responsibilities without a commensurate increase in their advisory compensation (absent shareholder approval of an increase in their advisory fees). The SEC’s continued use of the Compliance Rule as a means to expand and push out regulatory obligations to investment advisers of funds is potentially challenging for some in an industry confronting increasing fee pressures and increasing costs of complying with the trifecta requirements of the liquidity risk management program rule, derivatives rule and now a fair value rule.

Recent SEC Administrative Proceeding Involving a Pricing Service Provider. A recent SEC administrative proceeding highlights the importance of the valuation procedures of pricing service providers, which typically play a critical role in fair value determinations for funds. The SEC recently settled charges against a global securities pricing service and registered investment adviser (Pricing Service), for compliance deficiencies relating to its delivery to clients of prices for certain categories of fixed-income securities based on quotes it received from a single market participant (single broker quotes).¹¹  According to the SEC order (Order), the Pricing Service failed to adopt and implement policies and procedures reasonably designed to address the risk that the prices based on single broker quotes would not reasonably reflect the value of the securities. The Order indicates that these failures (which occurred from at least 2015 through September 2020 and affected the prices for more than 40,000 fixed-income securities) impaired the firm’s ability to assess the reliability of quotes it received from market participants and determine whether a market participant was an accurate source of information. The Order illustrates the type of valuation oversight issues a board or valuation designee may need to consider when approving, monitoring and evaluating a pricing service, specifically the methodologies of the pricing service.  The Order indicates that the valuation methodologies of a pricing vendor may pose a material valuation risk for a fund and may require rigorous review and oversight.

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Seward & Kissel LLP will continue to provide insight on any related developments. If you have any questions regarding the matters covered in this memo, please contact any member of our Registered Funds Group.