The Securities and Exchange Commission (SEC) recently voted to propose a new rule under the Investment Company Act of 1940 (‘40 Act) to establish an updated framework for fund valuation practices with a focus on fair value. With pandemic-fuelled market volatility on the rise again, and public comments due back by July 21, fund boards must be confident that they can determine fair value in good faith for portfolio valuations they oversee.
Why is the SEC issuing this guidance?
We’ve previously noted that one of the SEC’s missions is the modernization of certain rules in need of renovation, and valuation is just another step on the path to achieving this goal. The SEC last addressed ‘40 Act valuation practices in a pair of comprehensive releases dated 1969 and 1970. Much has changed since then, not least the variety and complexity of available assets which ‘40 Act funds may invest in. While the timing may appear to be related to the recent market volatility, the proposal is in fact the result of years of research and feedback, with the SEC making updating valuation guidance a top priority in recent years.
Since Jay Clayton was appointed as SEC Chairman in 2017, and said in his first speech that he would focus on retail investors, there has been a pronounced uptick in focus on the “Main Street” investor and associated protection and transparency. As to how this focus relates to the fair valuation proposal, fund valuations–including fair value valuations — are critical in calculating a fund’s net asset value (NAV), selling and redeeming fund shares, assessing fund performance, and determining asset-based and performance-based compensation for fund service providers, especially the fund’s investment manager. Fund valuations are also critical in monitoring compliance with investment policies and limitations. The proposal of this new rule has shown the SEC wants to clarify how fund boards can satisfy their valuation obligations; obligations which have several critical knock-on impacts to investors. Chairman Clayton put it succinctly:
“The way a fund values its investments is critical to our Main Street investors. 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.”
But what is changing?
The SEC has long recognized that many boards are not directly involved in the day-to-day valuation of investments. Perhaps the most impactful measure of the proposal is that it allows for delegation to the investment manager subject to demonstration of specific oversight requirements:
- Board oversight of the investment manager
- Periodic and prompt reporting to the board
- Clear specification of responsibilities and reasonable segregation of duties among the investment manager’s personnel
- Keeping additional records relevant to the assignment to the investment manager
The ability of Fund Boards to delegate will likely be well received by the industry. But the proposal also contains very detailed guidance as to the fair value process. The proposal requires that fund boards or the appointed investment manager (with continued oversight by the board) do the following when fair valuing securities:
- Assess valuation risks
- Select and apply one or more methodologies in fair valuing fund securities
- Test the appropriateness and accuracy of those methodologies
- Provide oversight and evaluation of pricing services
- Adopt and implement written fair value policies and procedures
- Maintain certain records regarding the valuation process
Where the ‘40 Act currently notes, “as determined in good faith,” the proposed new rule establishes a much more detailed regime for determining fair market value. It brings a degree of prescription to such determinations, making fair valuation more transparent for boards, investments managers, and ultimately investors, but also less flexible to meet the disparate circumstances under which a fair value determination is required. If there will be industry push-back to the proposal, it is likely to focus on this aspect of the proposed rule.
For those fund boards and/or investment managers who to date, have not created such reports, they will need to receive new and possibly customized reporting to ensure they can conduct their oversight duties. Standard reports may include daily fair valuation reports, weekly stale/static reports, monthly management reports, and quarterly board reports with dedicated pricing/valuation sections. Custom reporting may also be developed depending on investment strategy and portfolio complexity. Examples include reporting details of liquid and illiquid assets, percentage exposure to overall fund size, and holdings priced (with board or investment manager instruction and back-up) outside of the standard pricing process, where the standard price source is not “readily available.”
The proposed rule also includes a definition of the term “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. In practice, if a price is available, but cannot be independently verified to a second pricing provider, it may not be considered reliable or readily available. For instance, for equity holdings, a second independent source should always be available. For fixed income, a second source within a predefined tolerance is standard.
Some boards and investment managers may already have established these practices across their global fund ranges due to regulations in other domiciles. Take UCITS as an example — reports on fund valuation generally, and fair valuation specifically are already commonplace for both monthly reports to investment managers and management companies/AIFM and quarterly board reporting. With the proposal of this rule, however, it would mean that, upon implementation, all ‘40 Act funds would need to establish and demonstrate adherence to this new rule. The largest impact may be seen by the investment managers related to the reporting they will be obliged to provide to back up all fair value determinations made and be able to stand over such decisions both quantitively and qualitatively if challenged by its board or indeed the SEC inspectors.
As the SEC look to refresh and upcycle some old-fashioned policies like this Rule 2a-5, many US asset managers may look at their fair valuation process and ask themselves if it needs to be renovated.
This article was written by Caitriona Flynn, Vice President, Global Fund Accounting and Fund Administration.