Half a Century Later, the SEC Modernizes its Fund Valuation Practices Framework

This blog was updated 2/17/21

It has been over 50 years since the Securities and Exchange Commission (SEC) comprehensively addressed valuation rules with respect to the fair value of investments held by registered funds. On Thursday, December 3, 2020, the SEC finalized the new Rule 2a-5 under the Investment Company Act of 1940 to modernize its valuation framework and formalize requirements for complex hard-to-value investments held by registered investment companies — such as closed-end interval and tender offer funds — and business development companies (BDCs). These investments are those that do not have readily available market quotations and require the application of fair value standards and guidance.

Appropriate assessment, review and documentation of the fair value of a fund’s investments continue to be crucial elements of accounting and financial reporting for investment companies. The new rule applies to all registered investment companies and BDCs, regardless of their investment objectives or strategies. The rule’s issuance continues the SEC’s recent modernization efforts and is intended to improve fund valuation best practices, provide enhanced board oversight and benefit everyday investors.

SEC Chairman Jay Clayton describes the new rule: “Main Street investors increasingly access our capital markets through funds and rely on them to value their investments properly. Today’s rule is designed to improve funds’ valuation practices, including by providing for effective board oversight, for the benefit and protection of fund investors.”

Below is a summary of Rule 2a-5 and our take of the rule’s impact on fund boards, management and your everyday investor.

Fund Board Impact, Use of a Valuation Designee and Reporting

The SEC estimates that more than 9,800 funds will be affected by Rule 2a-5, of which approximately  9,300 are not unit investment trusts (UITs). The final rule formalizes the requirements for a fund board to satisfy its obligation in determining fair value in good faith. With respect to UITs, given these trusts do not have boards or investment advisors, the new rule requires the UIT’s trustee or depositor to determine fair value.

Fund boards are now permitted to designate a “valuation designee” to perform fair value determinations. Previously, boards were not allowed to delegate this responsibility and took ultimate responsibility themselves. Valuation designees can be members of the fund’s advisor or an officer of an internally managed fund. The final rule will not allow boards to designate the performance of fair value determinations to fund sub-advisors. However, valuation designees can seek sub-advisor assistance as they deem appropriate. The rule recognizes the crucial role a valuation designee often plays in the day-to-day work of reviewing and establishing fair values. If a valuation designee is used, which is often the case, the board still needs to fulfill its responsibility through:

• Active oversight of the valuation designee, by asking questions and seeking relevant information
• Taking into account the fund’s valuation risks in establishing and applying consistent and appropriate fair value methodologies
  • The final rule will not require the specification of methodologies that will apply to new types of investments in which the fund intends to invest
• Periodic and prompt reporting to the board
  • At least annually, the valuation designee must report in writing its assessment of the adequacy and effectiveness of their process for determining fair value, testing results and adequacy of allocated resources
  • Quarterly, the valuation designee must report in writing to address any issues brought to attention by the board, along with any material changes or events that have occurred during the period
  • Promptly, the valuation designee is required to provide in writing the occurrence of matters that materially affect the fair value of the investments (defined as “material matters”) within a time period determined by the board, but no later than five business days after the valuation designee becomes aware of the material matter
  • The final rule will not require the valuation designee to produce any specific data or data tool, unless requested by the board
• Established clear roles and responsibilities of the valuation designee’s personnel
• Reasonable segregation of duties among the valuation designee’s personnel, e.g., portfolio management from fair value determinations
  • The final rule will not prohibit portfolio managers from participating in the fair value determination process given their unique insights; however, they should be reasonably segregated in the context of fair value determinations (due to competing incentives)

The rule ultimately requires the board or its valuation designee to select, apply, and test fair value methodologies and oversee and evaluate any third-party pricing services, where used. When pricing services are used, the final rule requires that the board or valuation designee establish a process for approval, monitoring and evaluation of each pricing service. Boards should continue to approach their oversight of the valuation designee with a skeptical and objective view, taking into account a fund’s respective valuation risks, the appropriateness of the fair value determination process, and, finally, the skill and resources allocated.

Other Adoptions, Recordkeeping Requirements and Costs to Implement

The final rule adopts the definition of readily available market quotations to be 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.” This definition creates consistency with the definition of a Level 1 input in the fair value hierarchy defined in accounting principles generally accepted in the United States of America (GAAP).

The SEC also adopted new Rule 31a-4 requiring the maintenance and retention of certain fair value documentation by funds and their advisors. This rule also requires recordkeeping related to the designation of the valuation designee.

SEC staff estimates that the one-time incremental costs necessary to comply with these rules range from $100,000 to $600,000 per fund, depending on the current fair value practices of the fund.

Rescission of Prior SEC Accounting Series Releases, Other Guidance

The new SEC rule also rescinds two previous releases, known as Accounting Series Releases (ASR) 113 and 118, which addressed an issue which developed during the 1960s related to the acquisition of restricted securities rather than tradable issues of the same securities. The SEC believes the guidance in the ASRs is superseded and/or now redundant by the adoption of the new rule and by requirements under current accounting and auditing standards. Furthermore, Financial Accounting Standards Board (FASB) ASC Topic 820 provides a principles based framework for valuing all types of investments.

In addition to the rescission of the two ASRs, the SEC is also withdrawing certain SEC guidance, staff letters and other staff guidance that previously addressed a board’s determination of fair value as this guidance will now be moot, inconsistent or superseded. To the extent any other prior SEC staff guidance is inconsistent or conflicts with the new rule, this guidance has now been deemed superseded. A limited list of guidance dating from as early as 1973 is available in the complete rule provided below.

Our Take on the Impact of the New Rules

As markets evolve and fund advisors continue to expand their fund portfolios and enter more complex asset classes to satisfy certain investors with a heightened risk appetite, we welcome the SEC’s new rule to continue to modernize and adapt its 50-year-old valuation guidance with the current times. The final rule provides a consistent framework for fair value and sets standard practice across funds to help ensure fund boards are fulfilling their fiduciary responsibilities. Fund boards will find the added clarity helpful to be able to select valuation designees to aid in their review and determination of fair value in good faith — without significantly changing current market practice over portfolio valuation.

The new rules may also affect overall efficiency and provide some cost savings. With the formal and explicit ability to designate a valuation designee, boards currently determining fair value of investments themselves may now have more time to allocate to oversight and other matters. This would positively impact investors and potentially streamline fund operations. Finally, there may be a resulting lower cost of compliance for funds by relying on the final rules rather than various historical guidance, which can ultimately benefit fund investors through lower fund expenses generated by these resulting cost savings.

The amended rules will be effective March 8, 2021. Registrants will be required to apply the amended rules for their first fiscal year ending on or after September 8, 2021.

Read the final rule: “Final Rule: Good Faith Determinations of Fair Value”

Contact Syed Farooq or a member of your service team to discuss this topic further.

Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.