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Vedder Thinking | Articles SEC Proposes New Fair Valuation Framework for Registered Funds

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Under the Investment Company Act of 1940, securities held by a fund for which market quotations are readily available are to be priced at current market value, and securities for which market quotations are not readily available are to be priced at fair value as determined in good faith by the fund’s board. On April 21, 2020, the SEC proposed new Rule 2a-5 under the 1940 Act, which is intended to provide a framework for fund valuation and to provide clarity on how fund boards can satisfy their statutory obligations in the valuation process. Key elements of the proposal are as follows:

  • Assignment of the fair value determination. Under Rule 2a-5, a fund’s board would be permitted to assign the responsibility to make fair value determinations for some or all fund investments to the fund’s investment adviser or to one or more sub-advisers. Assignment to the investment adviser or to a sub-adviser would trigger certain requirements, including the following:

    - the fund’s board would be required to oversee the investment adviser’s performance of the fair value function, and the adviser would be required to make periodic reports (at least quarterly) on fair valuation to facilitate the board’s oversight;

    - the investment adviser would be required to make prompt (generally within three business days) written reports to the board on matters associated with the fair value process that materially affect, or could have materially affected, fair value determinations;

    - the investment adviser would be required to clearly specify responsibilities and duties among advisory personnel involved in the fair value process, including reasonably segregating (but not necessarily eliminating) portfolio managers from the process; and

    - the fund would become subject to certain additional recordkeeping requirements.

  • Determining fair value in good faith. Rule 2a-5 would provide that determining fair value in good faith requires the performance by a fund’s board or investment adviser of certain functions, including:

    - a periodic assessment of any material risks associated with fair value determinations, including material conflicts of interest, and the management of those risks;

    - the selection and consistent application of appropriate fair value methodologies and the periodic assessment of those methodologies;

    - periodic testing of the appropriateness and accuracy of fair value methodologies, and adjustments to methodologies where necessary;

    - oversight of any pricing services, including establishing both a process for approving, monitoring and evaluating pricing services and criteria for initiating price challenges;

    - adopting and implementing written policies and procedures to address fair value determinations that are reasonably designed to achieve compliance with Rule 2a-5’s requirements; and

    - adequately documenting and retaining certain records relating to fair value determinations.

  • “Readily available” market quotations. Under the 1940 Act, a fair value determination must be made when a market quotation for an investment is not readily available. Under Rule 2a-5, a market quotation would be “readily available” only when the quotation is a quoted price (unadjusted) in active markets for identical investments that a fund can access at the measurement date. However, a quotation would not be considered readily available if it is unreliable, which would be the case if U.S. GAAP would require an adjustment to the quotation or the consideration of additional inputs to determine the value of the investment.

  • Board guidance. In addition, the proposing release for Rule 2a-5 included guidance to fund board members regarding the SEC’s expectations for board oversight of the valuation process. Under the guidance, a fund’s board should play an active role in fair valuation oversight and take a skeptical and objective view of the fair valuation function that takes into account fund-specific valuation risks. The board should be mindful of subjective inputs used to fair value investments and should seek to identify and monitor, and take reasonable steps to manage, conflicts of interest. Finally, the guidance suggests that boards probe the appropriateness of the investment adviser’s fair value process, periodically reviewing the adviser’s financial resources, technology, staff and expertise, as well as the compliance capabilities that support the fair value process.

    The public comment period on Rule 2a-5 will remain open until July 21, 2020. If Rule 2a-5 is adopted, the SEC would rescind previously issued guidance on the role of the board in determining fair values and certain accounting-related guidance.

    The proposing release is available here.

    The authors of this executive summary have prepared a comprehensive summary of the Proposed Rule available here.

    If you have any questions regarding the topics discussed in this article, please contact John S. Marten at +1 (312) 609 7753, Jacob C. Tiedt at +1 (312) 609 7697, Nathaniel Segal at +1 (312) 609 7747, or any Vedder Price attorney with whom you have worked.



Professionals



John S. Marten

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Jacob C. Tiedt

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Nathaniel Segal

Counsel