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

The U.S. Securities and Exchange Commission on April 21, 2020 proposed a long-anticipated framework for fair valuation of fund investments. Proposed Rule 2a-5 under the Investment Company Act of 1940 would establish requirements for good faith determinations of fair value and would address roles and responsibilities for both fund boards and fund advisers relating to fair valuation.

The concept of “fair value” is embedded in the Investment Company Act 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. Recognizing the evolution of markets and fund investment practices since the SEC’s issuance of its most recent comprehensive treatment of fund valuation, as well as three significant regulatory developments since that time, the SEC seeks to modernize and formalize the framework for fair valuation determinations under the Investment Company Act.

Executive Summary

Proposed Rule 2a-5 would create a risk-based fair valuation regime focused on process, testing and oversight. The proposed rule would:

• Set forth detailed requirements for determining fair value in good faith;
  
• Establish the conditions under which a market quotation is readily available for purposes of the Investment Company Act definition of “value”; and
  
• Provide that a fund board may assign its fair value determination responsibilities to a fund adviser subject to a number of conditions.
  
• Under proposed Rule 2a-5, determining fair value in good faith would involve satisfying six requirements:
  
• Periodic assessment of material risks associated with determining fair value of fund investments (valuation risks);
  
• Establishment and application of fair valuation methodologies, consistent with current accounting guidance for fair valuation and taking into account the fund’s valuation risks;
  
• Testing of fair valuation methodologies;
  
• Evaluation of pricing services, if used;
  
• Adoption and implementation of written policies and procedures reasonably designed to achieve compliance with the four preceding requirements; and
  
• Maintenance of specified records.

Proposed Rule 2a-5 would further specify that the establishment and application of fair valuation methodologies (requirement (ii) above) involves:

• Selecting and consistently applying methodologies for determining and calculating fair value, including specifying key inputs and assumptions specific to each asset class or portfolio holding and the methodologies that will apply to new types of fund investments in which a fund intends to invest;
  
• Periodically reviewing the appropriateness and accuracy of selected methodologies and making necessary adjustments;
  
• Monitoring for circumstances requiring fair valuation; and
  
• Establishing criteria for determining when market quotations are no longer reliable.

Proposed Rule 2a-5 also would provide 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. Proposed Rule 2a-5 would specify that a quotation is not readily available if it is not reliable.

Proposed 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 proposed rule would, however, permit the board to assign that responsibility to an investment adviser of the fund (which could include one or more sub-advisers). An investment adviser assigned fair valuation responsibilities would carry out those responsibilities subject to certain additional conditions:

• Periodic reporting and written assessment of the fair valuation process’s adequacy and effectiveness;
  
• Prompt written reporting of matters associated with the fair valuation process that materially affect, or could have materially affected, the fair value of portfolio investments;
  
• Reasonable segregation of the fair valuation determination process from portfolio management; and
  
• Maintenance of certain additional records.

In the Release, the SEC articulated certain high-level expectations regarding board oversight where the board assigns fair valuation responsibilities to an adviser: 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.

While the possibility of a more modern valuation framework and harmonization with accounting standards may be welcome to fund boards and advisers, it is important for industry participants to evaluate the proposal in light of current practices and to provide feedback to the SEC as part of the comment process. As a practical matter, the proposed rule could place prescriptive responsibilities on a fund’s board that are more burdensome than current practices, and also could require the adoption of more detailed valuation policies and procedures and retention of more specific records than is required currently. In addition, the proposed rule’s definition of “readily available market quotations” may reflect a narrower definition than the one used in practice by many funds (particularly with respect to fixed income securities) and have unintended consequences under other provisions of the Investment Company Act and rules thereunder that incorporate this concept.

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