On April 21, 2020, the Securities and Exchange Commission (SEC) proposed new Rule 2a-5 (Proposed 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 Comments on the proposal are due on or before July 21, 2020.

The Proposed Rule would, among other things, (i) provide requirements for determining fair value in good faith with respect to a fund for purposes of Section 2(a)(41) of the 1940 Act,² (ii) permit a fund’s board of directors/trustees (board) to assign the fair value determination to an investment adviser of the fund, subject to board oversight and certain other conditions; and (iii) define when market quotations are readily available for purposes of the 1940 Act. If the Proposed Rule were adopted, the SEC would rescind certain previously issued guidance on the role of a board in determining fair value and the accounting and auditing of fund investments.

Determining Fair Value in Good Faith

Under the Proposed Rule, determining fair value in good faith for purposes of Section 2(a)(41) of the 1940 Act would require a fund to (1) assess and manage material risks associated with fair value determinations; (2) establish and apply fair value methodologies; (3) test these fair value methodologies; (4) evaluate pricing services; (5) adopt and implement fair value policies and procedures; and (6) maintain records relating to fair value determinations. Each of these required elements is discussed further below.

1. Periodically assessing and managing material risks associated with fair value determinations, including material conflicts of interest. In its release, the SEC stressed that identifying and managing identified valuation risks are important elements for determining fair value in good faith and suggested that the types or sources of valuation risk that should be considered include:

• • the types of investments held or intended to be held by a fund;
  • potential market or sector shocks or dislocations;
  • the extent to which each fair value methodology uses unobservable inputs;
  • the proportion of the fund’s investments that are fair valued and their contribution to the fund’s return;
  • reliance on service providers; and
  • the risk that methods for determining fair value are inappropriate or that such methods are not being applied consistently or correctly.

The Proposing Release gives some specific examples of material conflicts of interest in the context of an adviser or sub-adviser performing fair valuations, such as those resulting from incentives to increase fees, smooth or improve reported returns, or comply with a fund’s investment policies or restrictions.

2. Selecting and applying fair value methodologies. The Proposed Rule would require a fund to specify (i) the key inputs and assumptions specific to each asset class or portfolio holding to be considered in fair valuing an asset or holding, and (ii) the methodologies that will apply to new types of investments in which the fund intends to invest. The Proposed Rule would also require the selected methodologies to be periodically reviewed for appropriateness and accuracy. In addition, the board or adviser would be required to consider the applicability of the selected fair value methodologies to types of investments that a fund does not currently hold but in which it intends to invest in the future, as well as monitor for circumstances that may necessitate the use of fair valuation and establish criteria for when market quotations are no longer reliable.

3. Testing of fair value methodologies. The Proposed Rule would require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value. This would include the identification of (i) the testing methods to be used, and (ii) the minimum frequency of the testing.

4. Overseeing and evaluating pricing services used. The Proposed Rule would require the board or adviser to establish a process for the approval, monitoring and evaluation of each pricing service provider. Factors that the board or adviser should generally consider include:

• • 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 pricing service’s process for considering price challenges;
  • the pricing service’s potential conflicts of interest and the steps taken to mitigate such conflicts; and
  • the testing processes used by pricing services.

5. Adopting and implementing written fair value policies and procedures. The Proposed Rule would require that these written procedures be reasonably designed to achieve compliance with the requirements of the Proposed Rule. In situations where a fund’s board assigns fair value determinations to the adviser, the fair value procedures would be adopted and implemented by the adviser, subject to board oversight.

6. Maintaining certain records. Under the Proposed Rule, a fund would be required to maintain appropriate documentation to support fair value determinations for at least five years from the time each determination was made. A fund would also be required to maintain copies of the policies and procedures required under the Proposed Rule for at least five years.

Performance of Fair Value Determinations

In its release, the SEC stated that the Proposed Rule is designed to provide boards and advisers 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 Proposed Rule, a board can elect to determine by itself fair value in good faith for any or all fund investments provided that it satisfies the various conditions set forth in the Proposed Rule. Alternatively, the board can assign valuation determinations to the fund’s adviser, subject to certain conditions and oversight requirements, including:

• Board oversight of the adviser (and sub-advisers). The Proposed Rule would permit a board to satisfy its statutory obligations under Section 2(a)(41) with respect to fair value determinations by overseeing the adviser (and sub-advisers) responsible for making fair value determinations (Responsible Adviser). In this regard, 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 Responsible Adviser, 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 they receive and inquire about material matters that the board becomes aware of from sources other than the adviser while taking reasonable steps to be sure that they are addressed.
• Periodic and prompt reporting to the board. The Proposed Rule would require a Responsible Adviser, at least quarterly, to provide the board with a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the assigned portfolio of investments. These periodic reports would be required to, at a minimum, include a summary or description of the following information: (i) material valuation risks; (ii) material changes to or material deviations from methodologies; (iii) testing results; (iv) adequacy of resources; (v) pricing services; and (vi) any other information requested by the board related to the adviser’s process for determining fair value. In addition, the Proposed Rule would require a Responsible Adviser to promptly report to the board in writing on matters associated with the adviser’s process that materially affect, or could have materially affected, the fair value of any security in the assigned portfolio of investments.
• Clear specifications of responsibilities and reasonable segregation of duties among the adviser’s personnel. The Proposed Rule would require a Responsible Adviser to specify the titles and particular functions of the persons responsible for determining the fair value of the assigned investments. Additionally, the Responsible Adviser would be required to reasonably segregate the process of making fair value determinations from the portfolio management of the fund.
• Keeping additional records. In addition to the recordkeeping requirements discussed above, a fund would also be required to keep records related to the fair value determinations assigned to a Responsible Adviser, including (i) keeping copies of the reports and other information provided to the board required by the Proposed Rule; and (ii) a specified list of the investments or investment types whose fair value determinations have been assigned to the adviser. In each case, these records would be required to be maintained for at least five years after the end of the fiscal year in which the documents were provided to the board or investments were assigned to the adviser for valuation purposes.

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 such term. Under the Proposed Rule, a market quotation is readily available for purposes of Section 2(a)(41) 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.”³

In its release, the SEC noted that a quote would be considered unreliable 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 a 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 Proposed Rule.

Rescission of Prior Commission Releases

Since the SEC issued ASR 113 and ASR 118 in 1969 and 1970, respectively, developments in accounting standards have modernized the approach to accounting topics addressed in those releases, and market and fund investment practices have evolved considerably. Because the SEC believes that many of the statements in ASR 113 and ASR 118 would be superseded by the Proposed Rule, or have already been superseded, the SEC proposes to rescind ASR 113 and ASR 118 in their entirety if the Proposed Rule is adopted. Certain related staff letters and staff guidance would also be withdrawn or rescinded in connection with the adoption of the Proposed Rule.

S&K Observations and Insights

It certainly is welcome news to have the SEC finally take action on the valuation front and endeavor to settle a number of longstanding issues. This is a significant step forward. In moving forward with the Proposed Rule, the SEC has acknowledged the current state of the fund industry in addressing portfolio security valuations by permitting funds to delegate fair value determinations to their advisers. We would observe that the permitted sharing of valuation responsibilities between boards and advisers contemplated by the Proposed Rule is currently followed, to one degree or another, by many fund complexes. Accordingly, if the proposal proceeds as drafted, it would not appear to result in a major change of approach for these complexes. For other funds, if adopted as proposed, the Proposed Rule would likely require these funds to modify their current valuation policies and procedures to address aspects of each of the following: (i) the periodic review of selected methodologies, (ii) the selection and ongoing review of pricing services, and (iii) the adviser delegation and oversight functions. The Proposed Rule would also likely require advisers to modify their valuation procedures to address aspects of the requirements, including the “prompt” reporting to the board and personnel designation aspects of such delegation.

As noted above, the comment period for the Proposed Rule ends in July 2020. Particularly given the number of questions posed by the SEC to the industry, it is likely to draw a significant number of responses. Stay tuned and we will keep you apprised on developments.

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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.

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¹ Good Faith Determinations of Fair Value, SEC Rel. No. IC-33845 (April 21, 2020) (the “Proposing Release”), available at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf. The SEC proposed that the effective date of any adoption of the proposal would be one year following the publication of the final rule in the Federal Register.

² Section 2(a)(41) of the 1940 Act defines “value” with respect to funds. The SEC has stated that fair value is the amount that an owner of a portfolio holding might reasonably expect to receive upon its current sale.

³ Proposing Release at 57-58 and 140.