SEC Rulemaking: Good Faith Determinations of Fair Value Under the Investment Company Act

The U.S. Securities and Exchange Commission on December 3, 2020 adopted a long-anticipated rule for the fair valuation of fund investments.¹ Rule 2a-5 under the Investment Company Act of 1940 (final rule or rule): defines “readily available market quotations” as used throughout the Investment Company Act; establishes requirements for determining fair value in good faith; addresses both the board’s and the “valuation designee’s” role and responsibilities relating to fair valuation; and more closely ties together the applicable legal and accounting guidance on valuation.

The concept of “fair value” is embedded in the Investment Company Act’s definition of the “value” of a fund’s assets: the value of securities for which market quotations are not readily available is defined as fair value as determined in good faith by the fund’s board of directors.² Recognizing the evolution of markets and fund investment practices since the SEC’s issuance of its most recent comprehensive treatment of fund valuation,³  as well as three significant regulatory developments since that time,⁴  the SEC sought in the final rule to modernize and formalize the framework for fair value determinations under the Investment Company Act. The more formal framework and governance structure under the rule contains notable similarities with other recent SEC rulemakings relating to liquidity, funds of funds and derivatives.

Executive Summary

Rule 2a-5 creates a fair value regime focused on process, testing and oversight. The final rule:

• Defines “readily available market quotations” for purposes of the Investment Company Act definition of “value,” which establishes the scope of Rule 2a-5’s requirements;
  
  
• Sets forth detailed requirements for determining fair value in good faith; and
  
  
• Provides that a fund board may designate a valuation designee to perform fair value determinations, subject to a number of conditions.

Rule 2a-5 provides that, for purposes of Section 2(a)(41) of the Investment Company Act, a market quotation is “readily available” only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date. This definition will more closely align Investment Company Act valuation principles with U.S. generally accepted accounting principles (GAAP). Rule 2a-5 specifies that a quotation is not readily available if it is not reliable. The SEC stated that the “definition of readily available market quotations” under Rule 2a-5 “will apply in all contexts under the Investment Company Act and the rules thereunder, including [R]ule 17a-7,” which may have far-reaching ramifications.

Under Rule 2a-5, determining fair value in good faith involves satisfying four requirements:

• Periodically assessing material risks associated with determining fair value of fund investments (valuation risks), including material conflicts of interest, and managing identified valuation risks;
  
  
• Establishing and applying fair value methodologies, taking into account the fund’s valuation risks;
   
• Testing the appropriateness and accuracy of fair value methodologies selected, including identifying testing methods and minimum frequency for their use; and
  
  
• Overseeing pricing services, if used.

Rule 2a-5 states that a fund’s board must determine fair value in good faith by carrying out the required functions noted above. The rule, however, permits the board to designate the fund’s “valuation designee,” which the board would continue to oversee, to perform fair value determinations relating to any or all fund investments. “Valuation designee” is defined as the fund’s investment adviser (excluding sub-advisers) or, for internally managed funds, a fund officer or officers. A valuation designee would carry out those responsibilities subject to certain additional conditions:

• Quarterly reporting containing a summary or description of material fair value matters during the prior quarter, as well as other materials requested by the board related to the fair value of designated investments or the valuation designee’s process;
  
  
• Annual reporting that includes a written assessment of the adequacy and effectiveness of the valuation designee’s process for determining the fair value of portfolio investments;
   
• Prompt written reporting of matters associated with the fair value process that materially affect the fair value of portfolio investments; and
  
  
• Reasonable segregation of the fair value determination process from portfolio management. 

The Release indicates that the rule “establishes a principles-based framework for boards to use in creating their own specific process for making fair value determinations, including through designating and appropriately overseeing a valuation designee to perform certain valuation tasks.”⁵

In the Release, the SEC articulated certain high-level expectations regarding board oversight where the board designates a valuation designee to perform fair value determinations: boards should be objective and approach this oversight with a skeptical view; effective oversight is not passive but rather involves continuous engagement; and boards should consider this oversight to be an iterative process of identifying issues and opportunities for improvement.

The SEC also adopted a new recordkeeping rule – Rule 31a-4 – that requires certain records relating to fair value determinations to be maintained and preserved. These recordkeeping requirements relate to documentation to support fair value determinations and, when the board designates a valuation designee, certain board reports and lists of investments or investment types designated to the valuation designee.

The final rule reflects some modifications in response to industry comments, particularly as related to the content of valuation policies and procedures and to board reporting. However, the SEC declined to reframe Rule 2a-5 as a safe harbor, as many commenters had recommended. In addition, the rule’s definition of “readily available market quotations” reflects a narrower definition than the one used in practice by many funds (particularly with respect to fixed income securities, where the use of “evaluated prices” based, to varying degrees, on market activity, is the norm for daily valuations). As such, the implementation of the rule could have significant consequences under other provisions of the Investment Company Act and rules thereunder that incorporate this concept, notably Rule 17a-7.

The requirements of proposed Rule 2a-5, together with certain related considerations, are discussed in more detail below.

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