SEC Proposes to Modernize Framework for Fund Valuation Practices

The Securities and Exchange Commission today announced that it has voted to propose a new rule that would establish a framework for fund valuation practices.  The rule is designed to clarify how fund boards can satisfy their valuation obligations in light of market developments, including an increase in the variety of asset classes held by funds and an increase in both the volume and type of data used in valuation determinations.

The Commission last addressed valuation practices under the Investment Company Act in a comprehensive manner in a pair of releases issued in 1969 and 1970. Since then, markets and fund investment practices have evolved considerably. Many funds now engage third-party pricing services to provide pricing information, particularly for thinly traded or more complex assets. In addition, significant regulatory developments have altered how boards, investment advisers, independent auditors, and other market participants address valuation under the federal securities laws. The proposal recognizes and reflects these changes, including the important role that funds’ investment advisers may play and the expertise they may provide.

“The way a fund values its investments is critical to our Main Street investors,” said SEC Chairman Jay Clayton. “It affects the fees they pay, the returns they receive, and the value of the fund shares they hold.  Today’s proposal would improve valuation practices, including oversight, thereby protecting investors and improving market efficiency, integrity and fairness.”

The proposed rule would establish requirements for satisfying a fund board’s obligation to determine fair value in good faith for purposes of the Investment Company Act of 1940. The rule would require a board to assess and manage material risks associated with fair value determinations; select, apply and test fair value methodologies; oversee and evaluate any pricing services used; adopt and implement policies and procedures; and maintain certain records.

Recognizing that most fund boards do not play a day-to-day role in the pricing of fund investments, the proposed rule would permit a fund’s board to assign the determination of fair value to the fund’s investment adviser, subject to additional conditions and oversight requirements.  These detailed conditions include specific reporting by the adviser both periodically and promptly; clear specification of responsibilities and reasonable segregation of duties among the adviser’s personnel; and additional recordkeeping. The proposal makes clear that a board’s effective oversight of this process must be active.

The proposal will be published on the Commission’s website and in the Federal Register. The comment period for the proposal will be open until July 21, 2020.

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FACT SHEET

Good Faith Determinations of Fair Value under the Investment Company Act of 1940

Highlights

The Commission voted to propose a new rule establishing a framework for funds’ fair value determinations. Proposed new rule 2a-5 under the Investment Company Act of 1940 (the “Act”) would establish requirements for determining the fair value in good faith of a fund’s investments and would permit boards to assign the determination to the fund’s investment adviser, subject to board oversight and certain other conditions.  The rule would also define “readily available” market quotations for purposes of the Act.

Determining Fair Value in Good Faith

Proposed rule 2a-5 would require the performance of certain functions in order to determine fair value in good faith. These functions include, for example:

• Periodically assessing and managing material risks associated with fair value determinations, including material conflicts of interest;
• Selecting, applying and testing fair value methodologies; and
• Overseeing and evaluating any pricing services used.  

The proposed rule would also require the adoption and implementation of written policies and procedures addressing fair value determination and the maintenance of certain records.

Who Performs Fair Value Determinations

Under the Act, securities and assets without readily available market quotations are valued at fair value as determined in good faith by a fund’s board of directors.  The proposed rule would confirm that a board can make this determination itself.  The proposed rule would also permit a board to assign the determination to the fund’s investment adviser, subject to additional conditions and oversight requirements.  The adviser would be required to carry out the fair value determination functions described above, and additional requirements would apply, including:

• Board oversight of the adviser;
• Periodic and prompt reporting to the board;
• Clear specification of responsibilities and reasonable segregation of duties among the adviser’s personnel; and
• Keeping additional records relevant to the assignment to the adviser.

Because unit investment trusts do not have boards or investment advisers, the proposed rule would require the trustee to determine fair value in good faith.

Readily Available Market Quotations

Under the Act, fund investments must be fair valued where market quotations are not “readily available.”  The proposal would treat a market quotation as “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. The proposal would also provide that a quotation is not readily available if it is not reliable.

Rescission of Prior Commission Releases and Review of Relevant Staff Guidance

In view of the proposal’s modernized approach to fund valuation, the Commission proposed to rescind two releases, Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118), which provide Commission guidance on, among other things, how to determine fair value for restricted securities.

In addition, the proposal stated that certain staff letters and other staff guidance addressing fund valuation matters covered by the proposal would be rescinded or withdrawn in connection with any adoption of the rule.

What’s Next?

The proposal will be published on the Commission’s website and in the Federal Register. The public comment period will remain open until July 21, 2020.