On April 21, 2020, the Securities and Exchange Commission ("SEC") proposed new rule 2a-5 ("Proposed Rule") under the Investment Company Act of 1940, as amended ("1940 Act") addressing valuation practices and the board of directors’ role in fair valuing securities of a registered investment company or business development company (each, a "fund").[1] Comments on the Proposed Rule are due by July 21, 2020.

Summary

The Proposed Rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of Section 2(a)(41) of the 1940 Act. Such determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. Under the Proposed Rule, a fund’s board of directors would be allowed to assign fair value determinations to an investment adviser of the fund, who would then be responsible for carrying out these functions, and the assignment would be subject to board oversight and certain reporting, recordkeeping, and other requirements so that the board can effectively oversee the investment adviser’s fair value determinations. The Proposed Rule would also define when market quotations are readily available under Section 2(a)(41) of the 1940 Act. Lastly, the SEC is proposing to rescind previously issued guidance on the board of directors’ role in fair valuation determinations as well as on accounting and auditing of fund investments (Accounting Standards Codification Topic ("ASC") 113 and 118) if the Proposed Rule is adopted. The SEC is proposing a one-year transition period upon adoption of the Proposed Rule. The various aspects of the Proposed Rule are discussed in more detail below.

Section 2(a)(41) of the 1940 Act

Section 2(a)(41) of the 1940 Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations for those securities are "readily available," and, when a market quotation for a specific portfolio security is unreliable or otherwise not readily available, by using the fair value of that security, as determined in good faith by the fund’s board of directors.

Under the Proposed Rule, a market quotation would be readily available only when the quotation is 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. The Proposing Release notes that a quotation would be considered to be unreliable if it would require adjustment under U.S. GAAP or may require consideration or additional inputs in order to determine the value of the security, such as may be needed for a security that principally trades on a closed foreign market when an event occurs prior to the fund calculating its NAV that would likely result in a change in its price. The Proposing Release also notes that as the SEC staff has previously stated, evaluated prices are not, by themselves, readily available market quotations and that broker-dealer "accommodation quotes" would also not be readily available market quotations.

Good Faith Determination of Fair Value under the Proposed Rule

Under the Proposed Rule, the fund’s board of directors may either: (i) determine fair value as set forth in the Proposed Rule or (ii) assign the fair value determinations to the fund’s investment adviser (which may include one or more sub-advisers (each an "adviser")) who would then carry out those functions as required by the Proposed Rule (although delegation to the portfolio manager is not permitted). A multi-manager fund could therefore possibly have multiple advisers assigned the role of determining the fair value of the different investments that those advisers manage, or the primary adviser of such fund could be responsible for all such fair value determinations. If the board determines to assign the fair value determinations to multiple advisers of a fund, the fund’s Rule 38a-1 policies must address how to reconcile differing opinions on the same investment (if applicable) and the establishment of clear reporting structures.

For purposes of this client alert, we have assumed that boards will assign the fair value determinations to the adviser. In the event that a board would decide to determine fair value itself, such board would be responsible for carrying out the functions discussed below.

Valuation Risks

Under the Proposed Rule, there must be periodic assessment of any material risks associated with the determination of an investment’s fair value, including material conflicts of interest, and managing those identified valuation risks. The Proposing Release notes that valuation risk includes the risks associated with the process of determining whether an investment must be fair valued in the first place. The Proposing Release also notes that while there are many potential sources of valuation risk, some types or sources may include:

• the types of investments held or intended to be held by the fund;
• potential market or sector shocks or dislocations (potential indicators of such could include a significant change in short-term volatility or market liquidity, significant changes in trading volume, or a sudden increase in trading suspensions);
• the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the adviser;
• the proportion of the fund’s investments that are fair valued as determined in good faith, and their contribution to the fund’s returns;
• reliance on service providers that have more limited expertise in relevant asset classes; the use of fair value methodologies that rely on inputs from third party service providers; and the extent to which third party service providers rely on their own service providers (also known as "fourth party" risks); and
• the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.

The Proposing Release notes that the only specific valuation risk that is required to be addressed under the Proposed Rule is material conflicts of interest, as any other specific valuation risks would depend on the facts and circumstances of a particular fund’s investment. Additionally, the Proposed Rule does not specify the frequency for the required assessment of a fund’s valuation risks and the SEC staff in the Proposing Release notes that determining the frequency of such assessment should take into account changes in fund investments, significant changes in a fund’s investment strategy or policies, market events, and other relevant factors.

Fair Value Methodologies

The Proposed Rule would require the selection and application in a consistent manner of an appropriate methodology or methodologies for the determination (including calculation) of the fair value of a fund investment. The requirement would include specifying:

• the key inputs and assumptions specific to each asset class or portfolio holdings, and
• the methodologies that will apply to new types of investments in which the fund intends to invest.

It is noted in the Proposed Release that it would not be sufficient, for example, to simply state that private equity investments are valued using a discounted cash flow model, or that options are valued using a Black-Scholes model, without providing additional detail on the specific qualitative and quantitative factors to be considered, the sources of the methodology’s inputs and assumptions, and a description of how the calculation is to be performed (which may, but doesn’t have to, take the form of a formula).  It is also noted in the Proposing Release that different methodologies may be appropriate for different asset classes, but that any methodology must be applied consistently to the asset class(es) for which they are relevant.

In addition to considering fair value methodologies for current fund investments, the Proposed Rule would require the adviser to consider the applicability of the selected fair value methodologies to types of fund investments that a fund does not currently hold but in which it intends to invest in the future. As an example, the Proposing Release states that an adviser should address, prior to a fund investing in a new type of investment, whether readily available market quotations will be used or if the investment may need to be fair valued on occasion or at all times. The Proposing Release also notes that the adviser should seek to identify sources of price inputs before the fund invests in such asset classes, if possible, in addition to determining an appropriate fair value methodology and should document those decisions.

The Proposed Rule would require the selected methodologies to be periodically reviewed for appropriateness and accuracy, and to be adjusted if necessary. The Proposing Release notes that adjustments to a fund’s fair value methodology could be appropriate as a result of back-testing, calibration, or due to a change in circumstances specific to an investment (such as a change in market conditions or when new information becomes available). The Proposing Release further notes that while a fair value methodology is to be applied consistently for asset classes to which they are relevant, there may be circumstances where it is appropriate to adjust such methodology to get a result that is more representative of fair value.

The Proposed Rule would require the fund’s adviser to monitor for circumstances that may necessitate the use of fair value as determined in good faith and such adviser would be required to establish criteria for determining when market quotations are no longer reliable, and therefore are not readily available. The Proposing Release notes as an example that if a fund has investments that trade in foreign markets, the adviser should identify and monitor for the kinds of significant events that, if they occurred after the market closed in the relevant jurisdiction but before the fund prices its shares, would materially affect the value of the security and therefore may suggest that market quotations are not readily available.

Testing of Fair Value Methodologies

The Proposed Rule would require the testing of the appropriateness and accuracy of the fair value methodologies used by a fund. As with the assessment of a fund’s valuation risks, the Proposing Release notes that the specific tests to be performed and the frequency with which they are performed depend on the facts and circumstances of the fund and should be determined by the adviser. The Proposed Rule would require the identification of the testing methods to be used, and the minimum frequency of the testing. The Proposing Release notes that the SEC staff particularly believes that back-testing and calibration can help identify trends and also can help identify issues with methodologies provided by service providers, including poor performance or potential conflicts of interest. As an example, the Proposing Release notes that if a fair value methodology consistently over-values or under-values one or more fund investments as compared to observed transaction then the adviser would need to investigate reasons for the differences.

Pricing Services

Under the Proposed Rule, if pricing services are used to help determine the fair value of fund investments, then the adviser must have a process for the approval, monitoring and evaluation of each pricing service provider. In carrying out this function, the Proposing Release notes that the adviser should generally take into consideration factors such as:

• the qualifications, experience, and history of the pricing service;
• the valuation methods or techniques, inputs, and assumptions used by the pricing service for different classes of holdings, and how they are affected as market conditions change. In this regard, the fair value policies and procedures should address whether the pricing service is relying on inputs or assumptions provided by the adviser;
• the pricing service’s process for considering price challenges, including how the pricing service incorporates information received from price challenges into its pricing information;
• the pricing service’s potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and
• the testing processes used by the pricing service.

The Proposed Rule also would require the establishment of objective criteria for times when price challenges would typically be initiated.

Fair Value Policies and Procedures

The Proposed Rule would require written policies and procedures addressing the determination of the fair value of the fund’s investments ("fair value policies and procedures"). Such fair value policies and procedures must be reasonably designed to achieve compliance with the requirements of the Proposed Rule. In cases where the board has assigned the fair value determinations to the fund’s adviser, such fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under Rule 38a-1. The Proposing Release notes that if the Proposed Rule is adopted, it would supersede Rule 38a-1’s adopting release’s discussion of specific policies and procedures that are required regarding the pricing of portfolio securities and fund shares.

The fair value policies and procedures would need to specify the titles of the persons responsible for determining the fair value of the assigned investments, including by specifying the particular functions for which the persons identified are responsible. If it is determined to use a valuation committee to assist in fair value determinations, the fair value policies and procedures should describe the composition and role of the committee, or reference any related committee governance documents as appropriate. The fair value policies and procedures should also identify the specific persons with duties associated with price challenges, including those with authority to override a price, and the roles and responsibilities of such persons, and establish a process for the review of price overrides.

The adviser would be required to reasonably segregate the fair value determination process from the portfolio management of the fund. The Proposing Release notes that there may be important perspectives that portfolio management personnel can provide with respect to the value of a fund holding, but that there needs to be a balance with any potential conflicts of interest that a portfolio manager may be subject to in assisting with such determinations.

Recordkeeping

The Proposed Rule would require the maintenance of sufficient documentation supporting fair value determinations such that a third party could verify such determination for at least five years from the time the determination was made, the first two years in an easily accessible place. The Proposed Rule would also require the keeping of fair value policies and procedures that are currently in effect or were in effect during the past five years in an easily accessible place. Both types of records are required to be kept by the fund, even if the board delegated the fair value function to the adviser.  In addition, the fund must keep records related to information provided to the board.

Role of the Board of Directors

The Proposing Release notes that boards should approach their oversight of fair value determinations assigned to an adviser with a "skeptical and objective view that takes account of the fund’s particular valuation risks, including with respect to conflicts, the appropriateness of the fair value determination process, and the skill and resources devoted to it". The Proposing Release also notes that a board’s level of scrutiny should increase as the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures.

With respect to monitoring potential conflicts of interest, the Proposing Release notes that a fund’s adviser may have incentives to improperly value fund assets in order to increase fees, improve or smooth reported returns, to comply with the fund’s investment policies and restrictions. Additionally it is noted that pricing services or broker-dealers providing opinions on prices may have incentives or pressures to provide pricing estimates that are favorable to the adviser. Therefore, boards should ask questions relating to possible conflicts of interest of both the adviser and other service providers and ensure that it is comfortable any such potential conflicts are being appropriate managed.

Under the Proposed Rule, there are two types of required reporting to the board: periodic reporting and prompt reporting. The Proposing Release notes that the content of such required reports may take the form of narrative summaries, graphical representations, statistical analysis, dashboards, or exceptions-based reporting, among other methods.

Periodic Reporting

The Proposed Rule would require the adviser, at least quarterly, to provide the board a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the fund’s investments. Such reports would be required at a minimum to include a summary or description of the following information:

• Material Valuation Risks: the assessment and management of material valuation risks required under the Proposed Rule, including any material conflicts of interests of the adviser and any other service provider. An example noted in the Proposing Release is the adviser discussing instances where it challenged a price given by a pricing service.
• Material Changes to or Material Deviations from Methodologies: any material changes to, or material deviations from, the fair value methodologies established under the Proposed Rule. An example noted in the Proposing Release is a report discussing when key inputs or assumptions were changed and the reasons for such changes.
• Testing Results: the results of any testing of fair value methodologies as part of the required fair value policies and procedures.
• Resources: the adequacy of resources allocated to the process for determining the fair value of the fund’s assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value. An example noted in the Proposing Release is disclosure to the board when the adviser seeks to hire a new pricing service to cover a new asset type or replacing a person with a valuation background with a person not having that background in a position of authority regarding the adviser’s fair value process.
• Pricing Services: any material changes to the adviser’s process for overseeing pricing services, as well as any material events related to its oversight of such services, such as changes of service providers used or price overrides.
• Other Requested Information: any other materials requested by the board related to the fair value determination process.

In addition to this required information, the Proposing Release notes that a board may want to review and consider, if relevant, additional information it believes is necessary to conduct its oversight responsibilities, such as:

• Summaries of adviser price challenges to pricing information provided by third-party vendors and of price overrides, including back-testing results related to the use of price challenges and overrides;
• Specific calibration and back-testing data, including in the case of back-testing whether fair value prices moved in the same direction (relative to the prior market prices (as the portfolio holdings’ next actual market prices, whether fair value prices were closer to the portfolio holdings’ next actual market prices than the prior market prices (regardless of the direction), and whether the differences between the fair value prices and the subsequent prices was greater than pre-established tolerance levels;
• Reports regarding portfolio holdings for which there has been no change in price or for which investments have been held at cost for an extended period of time ("stale prices");
• Reports regarding portfolio holdings whose price has changed outside of predetermined ranges over a set period of time;
• Narrative summaries or reports on pricing errors, including the date of any error, the cause, the impact on the fund’s NAV, and any remedial actions in response to the error;
• Reports on the adviser’s due diligence of pricing services used by the fund’;
• The results of testing by the fund’s independent auditor provided to the audit committee;
• Reports analyzing trends in the number of the fund’s portfolio holdings that received a fair value, as well as the percent of the fund’s assets that received a fair value; and
• Reports on the number and materiality of securities whose fair values were determined based on information provided by broker-dealers; the broker-dealers most frequently used for this purpose; and the results of back-testing on the information they provided.

The Proposing Release notes that boards could request that this additional information be included as part of the fund’s chief compliance officer’s annual report under Rule 38a-1.

Prompt Reporting

The Proposed Rule would require certain prompt reporting in writing to the fund’s board on matters associated with the adviser’s process that materially affect, or could have materially affected[2], the fair value of the portfolio investments, including a significant deficiency or a material weakness in the design or implementation of the adviser’s fair value determination process or material changes in the fund’s valuation risks. An example noted in the Proposing Release of a material change in a fund’s valuation risks would be a significant increase in price challenges or overrides. Such reports must include such information as may be reasonably necessary for the board to evaluate the matter covered in the report. Such a prompt report must be provided to the board no later than three business days after the adviser becomes aware of the matter. The Proposing Release notes that if an adviser needs additional time to determine and verify whether an event has or could materially affect the fair value of the portfolio, that verification period would not be counted as part of the "prompt" trigger period, but that such additional verification period should not exceed three business days.

[1] Release IC-33845, Good Faith Determinations of Fair Value (April 21, 2020) at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf ("Proposing Release").

[2] The Proposing Release notes that "could have materially affected" is intended to capture circumstances where, for example, a matter was detected which affected one security and which may not be material on its own, but, had the matter not been identified, could have materially affected the larger assigned portfolio or some subset of that portfolio.