While there have been a lot of changes in the investment industry over the past 50 years — in the variety of investment types, pricing providers, pricing models, accounting and auditing requirements, compliance changes and the complexity of investments — it’s been that long since the SEC conducted a major overhaul on fair valuation practices and the role of the board for investment companies.
However, the importance of properly valuing a fund’s investments remains a critical component of the accounting and financial reporting for investment companies. Accordingly, on April 21, 2020, the SEC proposed rule 2a-5a to update the guidelines surrounding fund valuations, namely outlining how 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.
Although many of the proposed requirements have become common practice for boards and advisors over the years, the industry sought clarity. Specifically, 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 Act and rule 2a-4 for a “fund” being defined as a registered investment company or business development company.
It is important to note that the requirements are for securities that do not have readily available market quotations. The proposed rule would value an investment at “market value” when that 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. Fair value, as defined, therefore must be used in all other circumstances.
There are various requirements set forth in proposed rule 2a-5a that must be considered to comply with fair value as defined above. A board will now be able to delegate fair value determinations to an investment advisor or continue to be responsible for their determination. Below are the requirements as covered in the proposed rule.
Determinations should be made as to whether or not a security will need to be fair valued. Risks can be present in a variety of situations, including the type of investment held; changes in liquidity for a particular investment; halted securities; securities that use unobservable inputs, especially if they are provided by the advisor; and securities whose values rely on inputs from a third party service provider.
Fair Value Methodologies, Testing and Pricing Sources
Proposed rule 2a-5 would provide that fair value as determined in good faith requires selecting and applying in a consistent manner an appropriate methodology or methodologies. Consistent with GAAP guidance under ASC Topic 820, the allowable methodologies would include the market approach, income approach, and cost approach along with valuation techniques and methods as ways in which to measure fair value. The board or advisor would have to determine which methodologies they would use based on the type of security, but would allow for changes to those methodologies based on changing circumstances. There is also a proposed requirement to test the effectiveness of the application of the fair value; however, it will be dependent on circumstances of each fund and will be overseen by the board or the advisor.
Common practice within registered investment companies is to oversee the various services they use in pricing their securities and understand the inputs being used. The proposed rule would require the board or advisor to establish a process for the approval, monitoring and evaluation of each pricing service provider. In using pricing services it’s common for an advisor to periodically price challenge or override a price obtained from the service provider for a variety of reasons. The proposed rule would also require that process to be formalized.
Fair Value Policies and Procedures
Which entity approves the fair value policies and procedures will depend on whether the board assigns the fair value determinations to the advisor or if the board determines the fair value of the investments. If the board assigns the fair value fair determinations to the advisor, the advisor would need to adopt those policies and procedures, subject to board oversight under rule 38a-1. However, if the board does not delegate the responsibility, the fund would need to adopt and implement.
Proposed rule 2a-5 would require the supporting documentation used in the fair value determinations along with maintaining the policies and procedures noted above. Once again, this is common practice as the fund’s auditors, CCO or regulatory bodies would need that information with respect to their duties to the fund.
Previously the board was not allowed to delegate the responsibility of fair value to the advisor or sub-advisor(s) and took ultimate responsibility with respect to fair value. Under the proposed rule, the board can delegate the fair value responsibilities with the appropriate level of oversight to fulfill their obligations under the Act. However, if the board so chooses, they can elect to still maintain the previous approach with respect to responsibility over fair value. In most situations the board will delegate these responsibilities.
As most boards will take the approach to delegate the fair value responsibility, the proposed rule lays out the board’s responsibility to oversee that delegation. Generally, the board should continue to take their oversight responsibility with respect to fair value with professional skepticism. They should objectively consider the information they are receiving and consider conflicts of interest, motivations by the advisor or sub-advisor. The board should periodically review the financial resources, technology, staff and expertise of the assigned advisor, and the reasonableness of the advisor’s reliance on other fund service providers related to valuation. The board should also consider the type, content and frequency of the reports they receive.
The proposed rule 2a-5 requires the advisor to report information for the board to evaluate at least on a quarterly basis. Included in the quarterly reporting would be at a minimum:
- Material valuation risks,
- Material changes to or material deviations from methodologies,
- Testing performed,
- Resources used,
- Pricing services used,
- Back-testing results and more.
The final requirement for board reporting would be immediate notification, but no less than three business days if the advisor becomes aware, on matters associated with the advisor’s process that materially affect, or could have a materially affected, the fair value of the assigned portfolio of investments. Examples include a significant deficiency or a material weakness in the design or implementation of the advisor’s fair valuation determination process or material changes in the fund’s valuation risks.
Although the proposed rules won’t materially impact what many of industry participants were already doing, the proposed rules will modernize and clarify the requirements for board and advisors. In addition, it allows boards to officially delegate the responsible for valuation and continue to oversee the fund’s valuation process as a fiduciary. The proposed rule is open for public comment until July 21, 2020.
Contact Brett Eichenberger at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company 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.